Unit 2 - 7. Clearing and Settlement

Question 1

Introduction to Settlement Systems

Unit 2 - 7. Clearing and Settlement

Answer 1

Settlement occurs after a deal has been executed.

Change in legal ownership is immediate, but the transfer of securities from the seller and the payment from the buyer takes some time.

Stages

1. Pre-settlement and clearing = as soon as trade is executed, checks on both buyer and seller (trade confirmation, check both parties trade details are the same)
2. Settlement = process through which ownership is transferred in exchange for cash
3. Post-settlement = management of failed transactions and accounting for trades

Trade matching
1. Trading counterparties compare trade details (trades via electronic order book are auto-matched)

2. Custodians acting on behalf of buyer/seller will compare settlement instructions

Clearing (clearance) is the process through which the obligations held by the buyer/seller to a trade are defined and legally formalised.

Points of Difference between markets/instruments

• Timing of Settlement ( T (trade date) + number of business days)
• Structure of the settlement system

Question 2

Settlement Methods

Unit 2 - 7. Clearing and Settlement

Answer 2

DvP = delivery vs payment, both parties face risks other party will cheat them.

BIS (Bank for International Settlements)

Model 1 = systems that settle transfer instructions for both securities and funds on a trade-by-trade (gross) basis, with final (unconditional) transfer of securities from the seller to the buyer (delivery) occurring at the same time as final transfer of funds from the buyer to the seller (payment)

Model 2 = systems that settle securities transfer instructions on a gross basis, with final transfer of securities from the seller to the buyer (delivery) occurring throughout the processing cycle, but settle funds transfer instructions on a neet basis, with final transfer of funds from the buyer to the seller (payment) occurring at the end of the processing cycle

Model 3 = systems that settle transfer instructions for both securities and funds on a net basis, with final transfers of both securities and funds occurring at the end of the processing cycle

Question 3

Custody

Unit 2 - 7. Clearing and Settlement

Answer 3

A custodian is a reputable (usually large) third party firm or company that holds securities or other assets that belong to an investment institution for safekeeping and/or security.

Types of custodian

• local
• global (who can employ sub-custodian)
• regional (apac region wide example)

Question 4

Registered Title

Unit 2 - 7. Clearing and Settlement

Answer 4

Settlement must involve communicating the change in ownership to the company registrar. The company registrar is responsible for updating the register of members/addresses and giving the new owner registered title.

Most shares are in registered form. Registered title, therefore, means ownership that is backed by registration, where as bearer form means in possession of the physical share certificates without any underlying register entry.

Shareholders sometimes want to avoid the admin connected with registered title, so appoint someone to act as a nominee. The nominee takes the registered title to the shares and all the responsibilities that go with it, but the nominee’s client retains beneficial ownership.

Question 5

Designated and Pooled Nominees

Unit 2 - 7. Clearing and Settlement

Answer 5

Nominee shareholder = nominee shareholders hold the shares in trust for the beneficial owners, and it is the nominee shareholders that are identified on the register of shareholders.

Nominee company types
- Pooled (omnibus) = whereby individual clients are grouped together within a single nominee registration

• Designated (numbered accounts)= where the nominee name includes unique identifiers for each individual client
• Sole = where a single nominee name is used for a specific client

A corporate nominee = when the issuing company itself provides a facility for its smaller shareholders to hold their shares within a single corporate nominee.

Question 6

Cum and Ex Dividend

Unit 2 - 7. Clearing and Settlement

Answer 6

Cum-dividend = with the next dividend
Share becomes ex-dividend (without dividend) prior to the dividend being paid.

Dividend events:

1. dividend declared
2. record or books closed date (date a copy of the shareholders register is taken)
3. ex-dividend date (business day before the record date)
4. dividend paid
5. ex-dividend period

Question 7

Continuous Linked Settlement (CLS)

Unit 2 - 7. Clearing and Settlement

Answer 7

CLS is a process by which most of the world’s largest banks manage FX settlement among themselves (and customers/third parties). The process is managed by CLS Group Holdings.

CLS settles transactions on a payment versus payment basis (PvP). The two parties to an FX transaction will buy/sell the respective currencies exchanged and the payments made will simultaneously.

Settlement risk = Herstatt risk (from german bank which failed with loads of counterparty loss)

CLS was a result, robust reliable system across countries and time zones.

Question 8

Distributed Ledger Technology

Unit 2 - 7. Clearing and Settlement

Answer 8

DLT = centralised ledger of transactions with a decentralised network of computers all holding copies of exactly the same ledger. Computers are often referred to as ‘nodes’ and any changes to the ledger must be done by consensus using a consensus algorithm.

Blockchain is an example of DLT (bitcoin)

Question 9

Stock Borrowing and Lending

Unit 2 - 7. Clearing and Settlement

Answer 9

Stock lending is the temporary transfer of securities, by a lender to a borrower, with agreement by the borrower to return equivalent securities to the lender at a pre-agreed time.

• securities driven = borrowing firms seek specific securities
• cash driven = the lender is able to increase the returns on an underlying portfolio, by receiving a fee for making its investments available to the borrower.

short selling requires the sellers first pre-borrow shares in those issues.

Risks of stock lending
- some believe securities lending can aid market manipulation through short-selling.

Stock borrowing and lending intermediaries (SBLI)

• custodian banks (act as SBLI to earn extra revenue from existing infrastructure)
• administration
• legalities (legal and clearly regulated in most of the world)

Note: when a security is loaned, the title of the security transfers to the borrower.

GMSLa = Global Master Securities Lending Agreement, the market standard for securities lending.