Clearing and Central Counterparties

Learning Objective

4.1.14 Understand the role of the central counterparty in clearing and settlement

Clearing is the process through which the obligations held by buyer and seller to a trade are defined and legally formalised. In simple terms, this procedure establishes what each of the counterparties expects to receive when the trade is settled. It also defines the obligations each must fulfil, in terms of delivering securities or funds, for the trade to settle successfully.

Specifically, the clearing process includes:

• Recording key trade information so that counter parties can agree on the trade’s terms.

• Formalising the legal obligation between counterparties.

• Matching and confirming trade details.

• Agreeing procedures for settling the trans action.

• Calculating settlement obligations and sending out settlement instructions to the brokers, custodians and central securities depository (CSD).

• Managing margin and making margin calls. (Margin relates to collateral paid to the clearing agent by counterparties to guarantee their positions against default up to settlement.)

Trades may be cleared and settled directly between the trading counterparties – known as bilateral

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each counterparty that it trades with. Hence, it will typically bear direct liability for any losses incurred through counterparty default.

The alternative is to clear trades using a central counterparty (CCP). A CCP interposes itself between the counterparties to a trade, becoming the buyer to every seller and the seller to every buyer. As a result, buyer and seller interact with the CCP and remain anonymous to one another. This process is known as novation.

Regulators are increasingly keen to promote the use of CCPs across a wide range of financial products.

While this does not eliminate the risk of institutions going into default, it does spread this risk across all participants, and is making these risks progressively easier to monitor and regulate. The risk controls extended by a CCP effectively provide an early warning system to financial regulators of impending risks, and are an important tool in efforts to contain these risks within manageable limits.

Central counterparty (CCP) services have been introduced in a range of markets in order to mitigate this risk. For example, LCH.Clearnet provides CCP services in the UK and Euronext European markets for trading in equity, derivatives and energy products.

13. Settlement

Learning Objective

4.1.15 Understand the role played by Euroclear UK & Ireland in the clearing and settlement of equity trades: uncertificated transfers; participants (members, payment banks, registrars)

Settlement is the process through which legal title (ie, ownership) of a security is transferred from seller to buyer in exchange for the equivalent value in cash. Ideally, these two transfers should occur simultaneously, known as delivery versus payment (DvP).

CREST is the computer-based system operated by Euroclear UK & Ireland, the central securities depository for UK and Irish equities. Some of its key features are:

• Holdings are uncertificated; that is, share certificates are not required to evidence transfer of ownership.

• There is real-time matching of trades.

• Settlement of transactions takes place in multiple currencies.

• Electronic transfer of title (see below) takes place on settlement.

• Settlement generates guaranteed obligations to pay cash outside CREST.

• Coverage includes shares, corporate and government bonds and other securities held in registered form.

• A range of corporate actions is processed, including dividend distributions and rights issues.

• It also provides a mechanism to facilitate the settlement of trades when the investor holds paper share certificates.

13.1 Electronic Transfer of Title (ETT)

The Companies Act confers powers on the Treasury to make regulations to enable title to securities to be evidenced and transferred without the need for a written instrument.

The legal framework for the CREST settlement system was implemented by the Uncertificated Securities Regulations 1995. In 2001, further regulations eliminated the interval between settlement in CREST and transfer of legal title by entry on the share register, by introducing transfer of legal title at the point of electronic settlement, known as Electronic Transfer of Title (ETT).

13.2 CREST Structure

Each CREST member has a participant ID and at least one member account ID but further accounts will also be used so that the investments of different clients can be segregated. The shares of different companies are held within the member account and allocated to separate securities accounts.

The securities accounts distinguish amounts that are available to settle outstanding transactions and amounts that are in deposit, which are used to facilitate transfers of certificated shares.

CREST users input their instructions and receive information via one of the two electronic networks operated by BT SettleNET and SWIFT. Users are able to communicate with CREST only through the network and do not communicate directly with one another.

13.3 Holding Securities in CREST

Shares in CREST are held in an uncertificated form in one of the following three ways:

• Direct member – involves the member’s name appearing on the issuing company’s register. Each member has a stock account containing records of its securities and each appoints a CREST payment bank to pay out and receive monies in respect of CREST transactions. Direct members are permitted to hold more than one account, to facilitate designation of accounts (for example, for different underlying clients).

• Personal members – these are generally private investors and their name will appear on the issuing company’s register. A direct member will act as their sponsor to provide the link to CREST and is typically a broker, fund manager or custodian who charges a fee for the service. A sponsored member is also required to appoint a CREST payment bank.

• Custodian – when the beneficial shareholder appoints a nominee who is a direct member of CREST.

The nominee holds the securities on behalf of the shareholder, through a specially designated stock account. The nominee company’s name appears on the issuing company’s share register, as opposed to the shareholder’s name. The nominee company is typically operated by a broker, fund manager or custodian.

13.4 Payment Banks and Cash Memorandum Accounts

As mentioned above, CREST members are required to appoint a CREST payment bank to receive and pay out monies in respect of settlements in CREST.

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electronic transaction ledger which shows the net balance of payments made and received at any time during the course of the settlement day.

Settlement is instantaneous and sterling payments are made between settlement banks on the central accounts at the Bank of England as they occur.

13.5 Transfers and Registers of Title

Under the CREST system, the ‘register’ of securities comprises two parts.

• CREST maintains the uncertificated part of the register – the operator register of securities.

• The relevant issuer maintains the certificated part of the register – the issuer register of securities.

When any transfer of title occurs in CREST, the CREST system will generate a register update request (RUR) requiring the issuer to amend the relevant record of uncertificated shares.

The issuer’s register of uncertificated securities is simply a duplicate of the CREST register but the combination of this and the issuer’s register of certificated securities means that the issuer is aware of, and can communicate with, all the holders of its securities.

13.6 Settlement in CREST

The diagram below illustrates how a sterling sale of UK-registered shares between two counterparties on a recognised exchange is input, matched and settled in CREST.

Issuer register