Clearing, Settlement and Custody

Introduction

The financial markets are constantly undergoing change.

This change has and continues to happen across both the front office side, trading, investment, sales and brokerage as well as the operational areas of post trade, asset servicing, fund administration, custody and of course clearing and settlement.

Historically major change occurred with for example the dematerialization of securities, the switch from paper/physical securities to electronic book-entry securities and the move from settling trades over a period to rolling settlement.

The growth of financial derivatives was another significant development and the introduction of both CLS Bank in the FX settlement flow as well as Target 2 Securities (T2S) in the settlement of Euro denominated securities has changed the landscape considerably for operations teams.

On a general note considerable change occurred as manual processes became replaced by automated processes.

Change in the current environment revolves around the development of distributed ledger technology (DLT), sometimes called blockchain, part of the Fintech impact.

The expectation of these changes has been mainly related to efficiencies, including costs, and capacity as global continue growth.

DLT however has potentially more wide reaching impact creating not just change but perhaps the death of some institutions and key processes that have served the industry for many, many years.

This is not a new phenomenon, the demise of open-outcry trading of many financial instruments to be replaced by electronic markets removed much of the confirmation work that teams needed to do as the electronic market meant the trade details between the two parties was automatically matched.

Market infrastructure has evolved with more products, even over-the-counter (OTC) bilaterally negotiated ones, now centrally cleared rather than settling directly between the parties to the trade.

Of course, internally there is still the need to verify the trade was correct and so for example client clearing, reconciling the trade in the market matched the client trade details, still exists.

Perhaps one of the biggest drivers for change has been the growth of the global markets encompassing both mature and emerging markets with many new products and variants on existing products.

To this we can add the emergence of cryptocurrencies such as Bitcoin which are challenging traditional structure of central bank managed currencies that has been the way for centuries.

However, it the changing approach to regulation and risk that has been the biggest change with which firms have been challenged.

Demands on management, people skills and technology has been massive, time consuming and in many cases expensive and given it relates to regulation and risk there is no option to ignore the requirements.

With transparency being a major part of the regulatory structure, reporting of all transactions including those as a result of securities lending, has placed an onerous challenge for the firm's systems.

No one escapes as the changes impact all the major players, banks, brokers investment funds, investors etc. including in some cases corporate businesses as well.

The comment on centrally cleared OTC trades above is an example. For example, under EU regulation, the regulator requires it for all products that can be cleared such as swaps and options.

Managing risk has also been a major driver and so the impact of margining and collateral management has been immense and again wide reaching.

Change is a challenge and of course operations managers and teams should, and usually do, embrace the challenge.

The importance of the operations teams, middle and back office has grown in the last 10 years driven to some degree by the aftermath of the global market crash which of course also prompted the regulatory changes and increased emphasis on managing risk.

The new phase of DLT/blockchain developments in the market infrastructure will present another perhaps greater level of change and thus challenge for probably all players in the markets and yet ----.

The following article in the UK Guardian newspaper suggests that expectation is not universally accepted.

Predictions that bitcoin and other cryptocurrencies will fail typically elicit a broader defense of the underlying blockchain technology. Yes, the argument goes, more than half of initial coin offerings to date have already failed, and most of the 1500-plus cryptocurrencies also will fail, but blockchain will nonetheless revolutionize finance and human interactions generally.

In reality, blockchain is one of the most overhyped technologies ever. For starters, blockchains are less efficient than existing databases. When someone says they are running something on a blockchain, what they usually mean is that they are running one instance of a software ap.

https://www.theguardian.com/business/2018/mar/05/bitcoin-is-based-on-the-blockchain-pipe-dreamplication that is replicated across many other devices.

Meanwhile the Australian Stock Exchange, ASX has initiated a major project to replace its securities settlement system CHESS with a DLT based solution.

ASX has been working since January 2016 with its technology partner Digital Asset to examine and test the ability of a distributed ledger technology (DLT) based system to underpin the replacement of CHESS. This process led to the decision in December 2017 to proceed with a DLT-based solution.

As well as providing a solid foundation for the provision of clearing, settlement and other post-trade services, it has become clear that DLT's highly secure environment, where permissioned users have real-time access to the data to which they are entitled, will enable ASX's customers or third-parties engaged by them to build new services across the market to generate significant value for customers.

The industry benefits of the DLT-based solution include: reduced risk, cost and complexity through improved record keeping; reduced need for reconciliation between multiple databases; more timely transactions and better quality source of truth data. Digital Asset's smart contract modelling language (DAML), combined with the DLT-based solution will over time, drive industry innovation and enable customers to develop an exciting new generation of products and services based around multi-party automated and simplified workflows.

file:///C:/Users/dalay/Documents/DLR/response-to-chess-replacement-consultation-feedback.pdf

Bring it on!

Chapter 1

The structure of clearing and settlement

Abstract

This chapter introduces the concepts of clearing and settlement. It discusses the process in respect of payments and securities identifying the key systems. The chapter also looks at the evolution of clearing and settlement and the key recommendations that have shaped the processes use today.

The role of the clearing house and an overview of the major providers of central clearing are explored including DTCC, Euroclear and Euroclear Great Britain and Ireland (CREST), Clearstream, LCH Clearnet, TARGET2.

We look at the flow for a transaction through to settlement seeing how each player is involved.

Keywords

Clearing; Settlement; Clearing house; Securities depositories; Payments; Central clearing; G30

Contents

What is clearing and settlement?

The clearing house

Changes in clearing

Development of the clearing structures

In 2006 the G30 published its final monitoring report for global clearing and settlementa executive summary

Interoperability

Mitigating risk

Improving governance

Conclusion

Objectives of clearing houses

What is clearing and settlement?

An interesting question and one that, on the face of it, could be answered by a simple definition and yet in the financial markets it is often a very little understood but vital process.

For every transaction that takes place in the markets there is a process that concludes the transaction, the finality of settlement. In general terms that will mean some kind of exchange taking place between the two parties to the trade. The exchange may be cash for a security or the netted outcome of more than one transaction, for instance the end result of a purchase and sale or a series of purchases and sales.

Clearing is a term that is easily associated with banking so that we have the clearing banks. In this instance the item being cleared is money and, historically, cheques. When a cheque is drawn it has a value that is only realized when the receiving bank has presented it to the drawing bank and received the value, hence the term value date. As most people know, the time to obtain the value may be three or even more days from the paying into the account of the cheque. Today the somewhat antiquated process of cheques being cleared has been largely replaced by automated processes or electronic banking. The payment systems that allow electronic transfer of money are usually owned and operated by the Central Bank of the country of the currency. Example of payment systems are Fed Wire and CHIPS in the USA, BACS and CHAPS in the UK and TARGET2 for the Euro. There are also other ways of making a payment for example via SWIFT, Paypal or Western Union or in the UK the Faster Payment System (FPS) however with the exception of SWIFT these are generally small or low-value payments.

In the financial markets there is not only cash but also near cash or money market instruments like treasury bills. A transaction in these bills is settled in the UK through the CREST system at Euroclear. Euroclear UK and Ireland (Euroclear) provides via CREST the UK securities settlement service for both money market instruments and also UK and international securities and bonds. This includes equities, bonds, unit trusts and shares in open-ended investment companies (OEICs).

In the USA treasury instruments are cleared via the Government Securities Clearing Corporation (GSCC), securities via the National Securities Clearing Corporation (NSCC) and in Europe via TARGET2Securities (T2S) for euro denominated securities.

So we know that money is cleared and settled in banking and so are securities including treasury instruments, equities, debt as well as commodities and derivatives; although the processes may be very different.

We looked at clearing and settlement in the overview so we can look again at what the two terms mean.

The process of clearing can be defined as:

The preparation through matching, recording and processing instructions of a transaction for settlement.

Settlement can be defined as:

The exchange of cash or assets in return for other assets or cash and transference of the ownership of those assets and cash.

In each market around the world transactions in financial market instruments follow the same basic principle of clearing and settlement. The process of clearing and settlement is often linked with another process, the holding of the records of securities, in electronic form or sometimes in physical form. When this occurs we find a key player in the central securities depositories or CSDs for short. CSDs hold securities centrally on behalf of their members to speed the process of clearing and settlement. This is particularly relevant where physical securities still exist as the selling party does not have to send the securities to the buying party who may be resident overseas. The risk in moving physical securities is the possibility of the loss of the securities. As noted, this is extremely important in the case of for example bearer securities where there is no evidence of ownership recorded. However the markets are always changing and in response to worries about money laundering, bearer instruments in many countries can no longer be issued.

We should also note at this point that CSDs and International Central Securities Depositories (ICSDs) like Euroclear, Clearstream and DTCC only operate in instruments they have approved as eligible. We cannot forget that a wide range of instruments cannot be processed via a CSD or for that matter a CCP, for example private equity, which are shares in small unlisted or privately owned companies.

The clearing house

It is important to note that the clearing process is carried out by a designated function, and the organization that performs this function is often called a clearing house. The clearing house operates either completely independently from or to a significant degree as part of the exchanges or market it serves. The responsibility for managing and overseeing the trading process is therefore quite separate from the process of controlling the transactions through to settlement. The clearing house does not make the rules and regulations pertaining to carrying out transactions, but it does establish the rules, in conjunction with the regulator and the exchange, by which its members will clear and settle the business they do.

Fig. 1.1 shows the process associated with an equity transaction on the NYSE whilst Fig. 1.2 shows the process for a trade on NYSE Euronext in Paris.

Fig. 1.1 The process associated with an equity transaction on the NYSE. (From The DSC Portfolio Ltd.)

Fig. 1.2 The process for a trade on NYSE Euronext in Paris. (From The DSC Portfolio Ltd.)

We can see where some of the participant organizations that we have mentioned are located in the trade and post-trade clearing and settlement process, including the CSD and payment systems.

The relationship between the clearing house and its members is that the clearing house settles trades on a net basis between itself and its members. Netting means that bought and sold trades are offset and the cash position across trades is also netted. The opposite to netting is gross settlement, which is where every trade will settle separately. Fig. 1.3 below illustrates this and as we can see not only is netting applied, but also settlement takes place on a delivery versus payment (DVP) process, which again helps to reduce the risk of failed settlement on one side or leg of the trade.

Fig. 1.3 The flow for an OTC transaction. (From The DSC Portfolio Ltd.)

Changes in clearing

We noted in the overview that today, as with so much of the financial markets, change is taking place in the way in which activity on markets is cleared and settled.

Let us recap on this and explore further.

The central clearing counterparty (CCP), essentially a process of not just facilitating settlement but guaranteeing it, is becoming common in securities markets and thus the clearing and settlement of securities is moving towards the same process as that used for derivatives.

In the UK, the London Clearing House (LCH), a major clearer of derivatives for many years, joined with CREST to provide a central clearing process for equities called EquityClear.

In Figs. 1.1–1.3 above we saw the possible relationships between the trading, clearing and settlement and the relationship with the CCP. Note that there need not necessarily be a one-to-one relationship between the trading member as legal entity and either the clearing member or the settlement entity.

We look at the CCP again in more detail later in the book but it is important to remember that the changes in clearing and settlement are impacting on operations teams and, of course, the procedures and controls they use. There are many benefits, as we have already determined of the CCP structure, but there is also a need to ensure that firms and clients are aware of what the changes mean to long-established procedures, particularly in areas like some OTC derivatives where the concept and introduction of central clearing is more recent.

We also need to focus on the fact that clearing and settlement processes in different markets are covered by local conventions and in turn these differ sometimes considerably from jurisdiction to jurisdiction and also from one product to another.

Development of the clearing structures

The introduction of many initiatives over the years has led to a more streamlined process and yet one that is by no means uniform across countries. These initiatives include those set out by the Group of 30, an industry body made regarding issues surrounding the settlement of securities in the late 1980s. The International Securities Services Association (ISSA) later took on board the recommendations that they made, updated them and monitored markets to ascertain the extent of their implementation. Today we see many of the recommendations as standard practice in most, but not all, markets. Times have changed, and ISSA issued more recommendations in 2000 that sought to build on those of G30 and improve the whole settlement environment from the angles of both efficiency and risk. It is worth looking at the G30 and ISSA 2000 recommendations and the key points follow:

Insight

Group Of 30 Recommendations

1.All comparisons of trades between direct market participants (i.e. brokers, broker dealers and other exchange members) should be accomplished by T + 0. Matched trade details should be linked to the settlement system.

2.Indirect market participants (such as institutional investors, and other indirect trading counterparties) should achieve positive affirmation of trade details on T + 1.

3.Each country should have in place an effective and fully developed central securities depository, organized and managed to encourage the broadest possible direct and indirect industry participation. The range of depository eligible instruments should be as wide as possible. Immobilization or dematerialization of financial instruments should be achieved to the utmost extent possible.

4.Each market is encouraged to reduce settlement risk by introducing either Real Time Gross Settlement or a trade netting system that fully meets the Lamfalussy Recommendations.

5.Delivery versus payment (DVP) should be employed as the method for settling all securities transactions. DVP is defined as simultaneous, irrevocable and immediately available exchange of securities and cash on a continuous basis throughout the day.

6.Payments associated with the settlement of securities transactions and the servicing of securities portfolios should be made consistent across all instruments and markets by adopting the same day funds convention.

7.A rolling settlement system should be adopted by all markets. Final settlement for all trades should occur no later than T + 3.

8.Securities lending and borrowing should be encouraged as a method of expediting the settlement of securities transaction. Existing regulatory and taxation barriers that inhibit the practice of lending securities should be removed.

9.Each country should adopt the standard for securities messages developed by the International Organization of Standardization (ISO Standard 7775). In particular, countries should adopt the ISIN numbering system for securities issues as defined in the ISO Standard 6166.

It is readily apparent from these recommendations that certain issues pertaining to clearing and settlement did, and in some cases still do, have a significant impact on the efficiency of the process and, therefore, the efficiency of the market as a whole.

In 2006 the G30 published its final monitoring report for global clearing and settlementa executive summary

This report presents the assessment by the Group of Thirty (G30) Global Monitoring Committee (GMC) of developments in the clearing and settlement arena since the publication of the G30 report, Global Clearing and Settlement: A Plan of Action, in January 2003. It identifies places where progress is being made as well as areas where little or no progress is apparent. A great deal has already been achieved, but many recommendations require further work. The Global Monitoring Committee notes that the clearing and settlement objectives and goals set out only 3 years ago remain achievable and, in many cases, are already being progressively implemented. The Committee underscores that the improved infrastructure that would result from full implementation of the G30 recommendations would help enhance confidence in the markets themselves and ensure that the vision of a safer, more efficient global clearing and settlement system can be brought to fruition.

Insight

The key points of the ISSA 2000 recommendations

1.Securities systems have a primary responsibility to their users and other stakeholders. They must provide effective low-cost processing. Services should be priced equitably.

2.Securities systems must allow the option of network access on an interactive basis. They should cope with peak capacity without any services degradation, and have sufficient standby capabilities to recover operations in a reasonably short period within each processing day.

3.The industry worldwide must satisfy the need for efficient, fast settlement by full adherence to the International Securities Numbering process (ISO 6166) and uniform usage of ISO 15022 standards for all securities messages. The industry should seek to introduce a global client and counterparty identification methodology (BIC—ISO 9362) to further facilitate straight-through processing. Applications and programs should be structured in such a way as to facilitate open interaction between all parties.

4.Each market must have clear rules ensuring investor protection by safeguarding participants from the financial risks of failed settlement and that listed companies are required to follow sound policies on corporate governance, transfer of economic benefits and shareholder rights.

5.The major risks in securities systems should be mitigated by five key measures, namely:

•the implementation of real delivery versus payment

•the adoption of a trade date plus one settlement cycle in a form that does not increase operational risk

•the minimization of funding and liquidity constraints by enabling stock lending and borrowing, broad-based cross-collateralization, the use of repos and netting as appropriate

•the enforcement of scripless settlement

•the establishment of mandatory trade matching and settlement performance measures.

6.Convergence of securities systems, both within countries and across borders, should be encouraged where this eliminates operational risk, reduces cost and enhances market efficiency.

7.Investor compliance with the laws and regulations in the home countries of their investments should be part of their regulators' due diligence process. Investors, in turn, should be treated equitably in the home country of their investments especially in respect to their rights to shareholder benefits and concessionary arrangements under double-tax agreements.

8.Local laws and regulations should ensure that there is segregation of client assets from the principal assets of their custodian; and no possible claim on client assets in the event of custodian bankruptcy or a similar occurrence. Regulators and markets, to further improve investor protection, should work:

•to ensure clarity on the applicable law on cross-border transactions

•to seek international agreement on a legally enforceable definition of finality in a securities transaction

•to ensure that local law fully protects the rights of beneficial owners

•to strengthen securities laws to secure both the rights of the pledgee and the protection accorded to client assets held in securities systems.

Interoperability

Progress is being made in achieving the interoperability agenda, which seeks to facilitate clearing and settlement across different national and international systems. This is most evident in Europe, but advances are under way between the USA and Canada. In other regions, the G30’s recommendations are being acted upon, but mainly at the level of domestic markets. The longer-run aim remains the achievement of interoperability on a global basis.

Concerning specific recommendations of the original G30 report:

•Coordinated timing between systems is well advanced in domestic markets and in certain regions. The USA and Canada are largely synchronized. In Europe, the introduction of the TARGET2 integrated infrastructure will allow better coordination of securities settlement and payments systems. In the Asia-Pacific markets, some barriers remain and further synchronization is needed. By far the most significant long-term challenge will be synchronizing payment and securities settlement systems on a global scale. Progress to date on that front has been limited.

•The goal to have central counterparties in place and functioning in all major securities markets is almost fully implemented.

•The availability of securities lending is implemented at a basic level in all major markets. However, the supportive framework of law and regulation necessary to make the process an attractive economic proposition is not uniformly available in all markets. This is an area requiring further improvement.

•Significant progress on immobilization and the elimination of paper from clearing and settlement has been made, but paper and manual processes are still being used in some areas. Fully achieving this goal requires changes in law, business processes, and culture. Dematerialization remains the ultimate goal.

•The adoption of uniform messaging standards and communication protocols is under way, but not on a wide enough basis. While all large financial intermediaries have moved to adopt common international standards, most infrastructure providers still operate proprietary standards.

•Automated institutional trade matching schemes exist in all major European markets, the USA and Canada, but not yet in Asia-Pacific markets, with the exception of Japan.

•Efforts to automate and standardize asset servicing processes, including corporate actions, tax relief arrangements, and restrictions on foreign ownership, are long-term goals that have yet to be achieved.

Mitigating risk

The G30’s risk management agenda and recommendations center on financial, operational, and legal risks. Overall, there has been considerable progress in implementing the G30’s recommendations in many areas, but in some cases the record is more mixed:

•On business continuity and disaster recovery planning, the news is positive. The implications of a large-scale market disruption have been carefully considered and improvements have been made in all major markets. The September 11, 2001 terrorist attacks, more recent acts of terrorism, epidemics of disease, and natural catastrophes have highlighted the stark consequences of inadequate and insufficiently tested disaster response plans. Business and government actors have undertaken planning exercises aimed at preparing for such circumstances.

•Risk management awareness among clearing and settlement services has clearly increased, but monitoring the extent of implementation among users of these services is beyond the scope of the G30 monitoring exercise. At present, the business models of individual service providers are not open enough. The G30 called for each provider to publish an outline of the risk framework, including underlying risk management processes and standards. In many markets this is a vital step where further action is required.

•Scenarios for dealing with a key market player that is disabled have yet to be addressed in most markets. An appropriate response to such a scenario remains to be formulated. Greater international cooperation will be needed to coordinate the response to failure of international intermediaries.

•Limited progress has been made in some markets on ensuring the final simultaneous transfer and availability of assets. Although all major markets generally offer some variant of delivery versus payment (DvP), in many markets users are still exposed to ambiguity.

•All of the target 15 securities markets looked at by the GMC have generally adequate conditions of legal enforceability with respect to contracts.

•The G30’s call to advance legal certainty over rights to securities, cash, or collateral raised complex legal issues regarding conflict of law and substantive law matters. Both of these are being addressed by work on The 2002 Hague Securities Convention and the future UNIDROIT Convention on Intermediated Securities.

•On the issue of better valuation and support for closeout netting arrangements, there have been a number of significant improvements. These include more flexible close-out netting methodologies and the passage of EU statutes that provide momentum for convergence of close-out netting laws in the European Union. On a global scale, the ISDA Model Netting Act provides a good template against which to measure national legislative fixes.

Improving governance

On governance, the GMC reports progress in a number of areas and notes that boards and senior management are increasingly recognizing the critical importance of governance. Nonetheless, challenges remain; continued focus and effort are required on governance