Financial Markets Operations Management (29 page)

Clearing is a set of post-trade activities and is the process of transmitting, reconciling and, in some cases, confirming payment orders or security transfer instructions prior to settlement, possibly including the netting of instructions and the establishment of final positions for settlement.

As soon as the trade is captured from the Front Office systems, it goes through the following stages:

• Trade validation and enrichment – this takes the basic trade details and adds extra information such as the settlement date, cash amounts, accrued interest, fees and commissions, etc.;
  
• Trade confirmation – exchanging confirmations between market participants or affirming trade details with customers/clients;
  
• Transmitting delivery/receipt instructions to a clearing system;
  
• Responding to unmatched reports from the clearing systems;
  
• Forecasting cash requirements and securities availability.
  

On the satisfactory completion of the clearing process, the transactions can go forward to settlement. This is the topic of the next chapter.

In the previous chapter we followed a typical transaction from the Front Office through to clearing. In this chapter we will cover the final phase in the transaction lifecycle, in which the liabilities of both the buyer and the seller are completed. We refer to this as
settlement
.

The term “settlement” can be defined as:

This
¹
definition is valid for securities and other cash market financial instruments, but what about derivatives? “Open” derivatives contracts can be open for months, if not years, and the concept of settlement is only truly valid when derivatives contracts are exercised, i.e. in instances where the underlying asset is delivered or received. You will recall from the previous chapter that open derivatives contracts are either margined (for open exchange-traded and cleared OTC derivatives transactions) or collateralised (for non-cleared OTC derivatives).

In this chapter you will learn about the following topics:

• The different types of settlement;
  
• The concept of delivery versus payment and the three BIS DVP models;
  
• The locations in which settlement takes place;
  
• The reasons why transactions fail to settle;
  
• The ways in which settlement fails are managed.
  

In the BIS/CPSS definition of settlement above, you will have noticed the term “DVP”. We will discuss this in Section 8.3.

Whilst it would appear from the definition that the seller delivers securities direct to the buyer (and the buyer pays the seller), in reality most settlements take place by a process known as
book-entry transfer
; in other words, electronic transfers rather than physical transfers.

In the days when securities were certificated (i.e. held in physical form) investors would typically arrange for their banks to hold their share and bond certificates in the banks' own vaults. In order to settle their sales, the investors would instruct their banks to withdraw the appropriate certificates from the vaults. Having done this, the banks would arrange for the buyers' brokers to collect the certificates, together with any transfer documentation, and in exchange hand a cheque or bank draft to the bank by way of payment.

This activity required a small army of bank and broker messengers who would spend their day delivering payments in exchange for securities and delivering securities in exchange for payment. We could describe this as an extreme example of a decentralised settlement system (see
Figure 8.1
). Today, not only is the clearing process centralised but also the settlement process. This makes settlement much more efficient and cost-effective and enables the settlement cycle to be shortened from trade date plus many days to trade date plus three days or less.

One further consequence is that we do not see many messengers.

Today, in the 21st century, securities are delivered electronically by book-entry transfer. Delivery can be made either on a transaction-by-transaction basis or on a collective basis. The former is known as
gross settlement
and the latter as
net settlement
.

The common theme in all four scenarios is the separation of the securities transfer and the corresponding payment of cash. In order to overcome the separation, it is good market practice to ensure that delivery and payment occur at the same time and in the same place. Furthermore, if the seller does not have availability for delivery and/or the buyer does not have sufficient cash, then the transaction will not settle.

From the seller's point of view, we refer to this connection of securities and cash as
delivery versus payment
or DVP. Conversely, from the buyer's point of view, we have
receipt versus payment
or RVP. Irrespective of whether we are discussing a sale or a purchase, we tend to use the term DVP in both instances.