User:WikiDorset/Securities trade settlement

Stock trade settlement (United States) is the process of changing ownership of an equity security from the seller to the buyer. This article addresses the process in the US, as well as American industry jargon, and outlines settlement flows through the US clearing organization, National Securities Clearing Corporation, and the central securities depository, Depository Trust Company, both owned by DTCC. The settlement process in other countries is largely similar, though with different institutions and jargon.

Order Execution
To understand the rational for these processes, one first has to understand how equity trades are executed. Suppose an institutional investor orders a broker-dealer buy 100,000 shares of a security. The broker-dealer sends its order electronically (keeping the identity of the client anonymous) to the stock exchanges (if a member), or to another broker-dealer if not a member of a stock-exchange, to execute ("fill") it. The order is then chopped into smaller orders by a computer algorithm and sent electronically to all broker-dealers displaying quotations at the order price. Quotations are for 100 shares, unless a larger quantity is displayed. Orders and quotations at the same price are matched instantaneously, and the algorithm continues send to slices of the total order, up to the limit price, until completely filled. In theory the fill could consist of 1,000 trades (100 shares X 1,000 trades = 100,000) with dozens or hundreds of other broker-dealers, though this would be an extreme occurrence. The point is that one client order can require hundreds of individual broker-to-broker fills.

Clearing versus settlement
"Clearing" refers to the processes of settling trades between and among broker-dealers. All the operational risks involved in settlement, such as the costs of failed trades, remain among the broker-dealers which are dealing with one another. Such trades are netted, as described below, rather than settled individually.

"Settlement" involves a third party, such as a custodian bank, acting as agent for the investor. The broker-dealer and custodian bank settle trades for their common client, but the custodian bank acts in an agency capacity only. The custodian bank will not take any principal risk on behalf of its client. For example, should the broker-dealer attempt to deliver a security for which the custodian bank has not received settlement instructions from the investment manager, the custodian denies ("DK" or "don't know") settlement. It only acts on instructions from its clients, and only completes the transaction when the client's account has enough cash (buy) or securities (sell).

Netting versus trade-for-trade
Trades between broker-dealers are settled on a netted basis. Once trade data have been compared (see below), and any breaks resolved, the data is submitted to NSCC's Continuous Net Settlement system. At midnight the business day after the trades were done (T+1), all trades are given a new counterparty: NSCC. At that instant, NSCC takes on the settlement risk of each participant. To illustrate, assume that broker A has 1,000 buys trades in security ABC, and 800 sells. The buys total 65,000 shares, worth $15,000,000, and the sells 52,000 worth $11,960,000. Once NSCC becomes the counterparty, broker has a net long position of 13,000 (more bought than sold), and a net SHORT cash position of $3,040,000. CNS processes all this information for all broker participants during the night, and publishes net long/short securities positions and a single long or short cash position in the morning. All brokers run similar calculations for their positions and compare them with NSCC's numbers before the start of trading the following morning. By this process, the millions of individual stock and cash movements that would be required in a series of individual trade settlements are reduced to a single credit or debit in each broker's security account, and a single credit or debit in their cash account.

CNS is a central counterparty clearing system (CCP), though in existence long before that term was coined.

Trades involving a custodian bank, acting as agent for the institutional investor, are settled on an individual basis. The details of the trade must be matched using instructions from the delivering and receiving parties. Custodian banks will not deliver securities should the client not have them available on settlement date. On the other hand, institutional clients are likely to have short term borrowing arrangements with their custodian banks to pay for securities received. The custodian has a lien on the securities received, thereby minimizing credit risk.

Comparison versus confirmation
The US securities market has a long tradition of focusing on exception processing. Confirming each broker-to-broker trade would be a very expensive to process, and long to complete. Rather, each trade is submitted to DTCC by the participating brokers with the trade's information: security (CUSIP), quantity, prices, buy/sell, time of execution, contra broker. Through a process known as "comparison", the details of each trade are matched. Should a mismatch occur, it is known as a "break", which both the buyer and seller investigate and resolve. The comparison process limits the amount of data brokers submit, provides each submitting broker with details of matches and breaks, and allows the brokers to focus on what's wrong, rather than confirming to each other what's correct.

Separately, the broker-dealer informs its client that the order had been filled, at an average price of all the trades done with the selling brokers. Under SEC Rule 10-b-10, the broker-dealer confirms to its customer the execution of the order, the execution price, the market(s) on which it was executed, along with fees and broker commissions, plus other required disclosures. Clients are expected to report back to their executing brokers the correctness of each confirmation. This is known as "affirmation". Over 90% of institutional trade confirmations are affirmed daily. Of course, if the institutional investor disagrees with any aspect of the confirmation, there is no affirmation. Rather the two sides resolve the issue and a corrected confirmation is issued by the broker.

DVP/RVP versus free delivery settlement instructions
Delivery versus payment (DVP) is the simultaneous exchange of assets against payment. It protects both parties to the transaction from settlement risk, where for example a seller delivers securities but never receives payment. When used at a securities depository, one party initiates a DVP instruction, while the other party initiates a receive versus payment (RVP) instruction. The depository's settlement system matches the two, and finding no differences, completes the transaction. At some depositories, such as DTC, the matching system allows for small money differences, in which case the seller's numbers are used to complete the transaction. The reason for tolerance rules is that the costs of investigating small money differences by both parties, sustaining financing costs should settlement be delayed one or more days for the investigation, and completing the transaction outweigh the automatic adjustment.

A free delivery is an instruction to move cash or securities from one account or party to another, without a corresponding receipt of securities or cash. Firms moving cash or securities from one custodian or prime broker to another would typically send to the receiving agent a free receipt instruction. In case the cash or securities are not delivered, the receiving party would then be able to notify the initiator of a problem.

Fungibility
Fungibility is the property whereby a security can be substituted for another. For example, US dollar bills all have serial numbers printed on them, but they are freely substituted, one for another, within each value. Bearer bonds are similarly fungible. Were you to deposit one with a friend or financial institution, you would not expect to get the same piece of paper, with the same serial number, back when you retrieved it. As long as the note received is for the same security (issuer, coupon, maturity data and so on), you are getting back what you deposited.

By definition all uncertificated (dematerialized) securities are fungible, since there is no serial number to distinguish one from another. Similarly, immobilized securities are fungible. Only fungible securities can be processed in the settlement methods described above. Should a DTCC participant present a non-fungible (certificated) security for settlement, the depository first sends it to the appropriate transfer agent, for two reasons: 1) ensure that the certificate is valid (has not been stolen or counterfeited), and 2) to convert it into book-entry form.

Finality
Imagine that person A and person B have somehow agreed to exchange bearer bonds for cash. A has a number of bonds which in aggregate are valued at one million dollars. B agrees to pay that amount, and the two meet to exchange assets. A gives B a bag of cash, and B gives A a folder of bonds. Is the trade settled?

The answer is no. Both A and B need to do further verification to make sure that they received what they expected. A needs to count the cash, and to take it to a financial institution, such as a bank, that has the resources to inspect each bill to make sure none are counterfeit. Similarly, B needs to send the bonds to the issuer's transfer agent to verify that none are stolen or counterfeit.

Settlement can only be immediate and final when done at a central bank, in the case of the US, at the Federal Reserve. There both dematerialized securities and cash can be moved from the buyer's account to the seller's and vice versa without the possibility of later reversal. The same is not the case at a depository such as DTCC, which is not a bank. DTCC settles its cash positions at a major US bank, which in turn settles at the Federal Reserve. The risk against which all depositories must protect is that a member firm defaults during the settlement day.

In times of severe market stress, such as the liquidation of Drexel Burnham or the bankruptcy of Lehman Brothers, a central securities depository must have the rules to apportion losses among members and a guarantee fund to meet its financial obligations. The unwinding of settlements done earlier in the day because of the default of a member would be calamitous. Since securities markets are global, the failure of a depository such as DTCC to close its accounts on schedule, when the New York evening is already early morning in Tokyo, could be disastrous. Traders in Asia would not be confident of their positions in the US, which in turn could snowball into a global crisis as the European markets begin their day. Central security depositories have risk management protocols, guaranty funds and loss apportioning rules whereby the elimination of a member firm because of a bankruptcy during the settlement day would ensure that settlement is completed at day's end.