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User:Alexkachanov/Finance/Depositories and Clearing Corporations

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Depositories

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A depository can be compared to a bank for shares. Just as a bank holds cash in your account and provides all services related to transactions of cash, a depository holds securities in electronic form and provides all services related to transactions of equity shares, debt instruments, or other securities.

A depository plays an important role in settling transactions. To increase their reach, just like banks, depositories have accredited agencies that represent them. In many countries, members of the clearing corporation themselves become agencies of the depository and provide brokering as well as depository services to their customers. In other countries, the agency is called a depository participant. Apart from brokers, banks and financial institutions also become depository participants. The Depository Trust Corporation (DTC) is the largest depository in the world.

An investor requiring depository services has to approach the member or the depository participant to open an account. The investor has to fill out an account opening form and fulfill some documentation requirements. Once the documentation is complete, the agency interacts with the depository and opens the account. The investor is given an account number, which he has to provide for reference for all future transactions. Shares are then kept in electronic form in this account just like money is kept in the form of electronic credits in any bank account.

The type of accounts depositories have vary from country to country. Two types of accounts are found in most depositories:

  • A beneficiary account is an account held by an investor. As the name suggests, this type of investor enjoys all the benefits that accrue to him as a virtue of being a shareholder. These benefits include price appreciation and benefits arising from corporate actions such as dividends, bonuses, rights issues, and so on, declared on the stocks held in the beneficiary account.
  • A clearing member account is held by a clearing member and used for facilitating settlements. This account works as a conduit, and shares flow from investors into this account and from this account to clearing corporations for pay-in, and vice versa for pay-out.

Worldwide depositories operate on a variety of architectures. Some hold the details of an investor’s accounts, including details of the shares held. Others maintain details at the agency level and require that agencies maintain the details of investors and investor accounts. Some depositories use a hybrid model, meaning they hold details about the holdings of an investor and also make it mandatory for agencies to hold the same information. Though this setup means redundancy in data, at times it may be a good approach if the connectivity between the depository and the agency is not reliable or the depository is untested and is working in a relatively new environment.

The kind of transactions that depositories support varies from country to country and from market to market. Some common types of transactions in every market are as follows:

  • Off-market transfer: As the name suggests, these are transfers that are not backed by any market transactions on the exchange. These are transfers from one beneficiary account to another. A friend giving shares to another friend or a husband moving shares from his account to his wife’s account is an example of off-market transfers where no market buying/selling is involved. This type of transfer usually takes place in large corporate deals such as acquisitions and stake sales where shares are transferred from one corporate entity to another.
  • Market transfers: These are transfers that result from the purchase/sale of transactions in the market (read: exchange). An investor doing a sale transaction, for example, will have to go to the depository agency and give an instruction to debit his account and credit the account of the broker through which the transaction was conducted. Similarly, if he has done a buy transaction and the broker has received securities in his account on behalf of the investor, the broker will have to give a debit instruction to debit his account and credit the account of the investor.
  • Interdepository transfers: This is the transfer of securities from one account in one depository to another account maintained in another depository. Depositories normally maintain connectivity with each other for these kinds of transactions, and such transactions take place as a batch process at one time or at multiple times during the day.
  • Pledge: An investor holding securities can pledge his securities in favor of someone to raise money or for any other reason. The securities that have been pledged cannot be transferred. When the term of the pledge expires or when both parties agree, the pledge can be closed, and the securities are again moved to the free balance. Once securities move to the free balance, they can be transferred freely.

Most of these instructions are tagged with an execution date. When the investor/broker gives a debit or credit instruction, they also specify when the transfer has to take place. The depository conducts the transfers on that particular date. All transactions within the depository can be executed instantaneously. All transfers that happen are irrevocable in nature, which means that once the transfer is complete, it cannot be transferred back without the consent and signature of the recipient.

Note that a risk is associated with a debit instruction from any investor’s account. Hence, it is mandatory that investors include their signatures and expressly give all debit instructions. Credit instruction has no such risk. The investors are required to give a standing instruction once, and then all credits will flow automatically into their account. This method reduces the number of instructions flowing to the depository and provides convenience to investors. An analogy of this is a bank where you need to write a check to get your account debited, but for any credits coming in, you don’t give any instructions. The credit just flows in. Institutions, however, don’t use this facility much. They also keep a check on what securities are flowing into their accounts. Hence, they expressly give instructions for crediting their accounts.

Most brokers make investors sign a power of attorney. They use this power of attorney to generate debit instructions automatically on behalf of the investors for sale transactions they do on behalf of the investors. This saves an investor’s time and effort, considering the strict timelines imposed for meeting T+2 settlements.

Depositories perform millions of such transfers daily. Apart from the transfers, depositories also safely keep shares. Instead of keeping their shares with themselves, investors hold them in a depository and don’t risk losing them. Depositories also keep track of corporate actions and facilitate in providing benefits of these corporate actions to investors. For all these services, depositories levy a small fee. The agencies of depositories with which the investors interact increase these charges to levy their own charges.

Having shares in a dematerialized form is a prerequisite for T+1 and T+2 settlements. This eliminates the risk of bad deliveries to a large extent and provides a lot of operational convenience. It was not unusual during the physical certificate days to see truckloads of certificates being brought to a clearing corporation for the delivery of large orders. Imagine the effort it took for the clearinghouse to count, sort, and redistribute those shares to the buyers. In all, it used to take a lot of time and effort. In the depository system, the ownership and transfer of securities takes place by means of electronic book entries. At the outset, this system rids the capital market of the dangers related to handling paper. This system provides a lot of other benefits too:

  • Elimination of risks associated with physical certificates: Dealing in physical securities has the associated security risks of theft of stocks, mutilation of certificates, loss of certificates during movements through and from the registrars (thus exposing the investor to the cost of obtaining duplicate certificates and advertisements), and so on. This risk does not arise in the depository environment.
  • Some governments exempt stamp-duty requirements for transferring any kind of securities in the depository. This waiver extends to equity shares, debt instruments, and units of mutual funds.
  • Immediate transfer and registration of securities: In the depository environment, once the securities are credited to the investor’s account on pay-out, the investor becomes the legal owner of the securities. The investor has no further need to send the security to the company for registration. Having purchased securities in the physical environment, the investor has to send it to the company’s registrar so that the change of ownership can be registered. This process is cumbersome and takes a lot of time.
  • Faster settlement cycle: Markets could offer T+3, T+2, and so on—down from T+5—because dematerialized mode enables faster turnover of stock and more liquidity with the investor.

Having discussed various important entities, we will now provide a brief overview of how a typical trade life cycle moves from the order initiation phase to the final settlement phase.

Clearing Corporations

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брокер-дилер может работать с клиринговой фирмой, а может быть self-clearing firm.

A stock exchange is an interesting market. Traders enter into hundreds of thousands of transactions with other traders without settling them immediately. They simply trust that other traders/members will honor their purchases and sale commitments. In reality, with such a complex web of transactions, any default could start a chain of defaults and could prove catastrophic. Therefore, a clearing corporation settles all trades executed in a stock exchange. In this section, we will first cover the importance of the role played by clearing corporations, and then we will cover how a clearing corporation functions.

Even with differences in opinion about the value of a security, trades will happen only when the parties involved in the trade are comfortable with each other, especially on the front of financial soundness. When members transact with each other, they need to believe their trade commitments will be honored. Large institutions would otherwise shy away from trading with smaller traders if they perceive the risk that small traders will not honor their commitments. Advanced exchanges have thousands of members. Even assuming 1,000 members, there could be 999,000 potential trading relationships. It is not possible for each member to verify the financial stability of the others before they enter into a trade, especially on an ongoing basis. The costs associated with this verification would be immense, and this would make markets very illiquid. In a market that does not foster confidence, few will come forward to trade.

Clearing corporations take on the onus of doing credit checks on each member. They lay down capital adequacy guidelines and make the members adhere to them. They provide exposure limits on the amount of collateral collected from members. This collateral is in the form of cash, fixed deposits, and bank guarantees. In addition to this collateral, clearing corporations ask for day-to-day margins, which are commensurate to the positions that members take on a daily basis. The position limits of members are monitored closely. Margin calls are made to members who the clearing corporation thinks can endanger the financial integrity of the overall market. In the event of a member breaching his limits, the clearing corporation immediately recommends disconnecting the trading facility for that particular member until the member brings additional collateral.

Most clearing corporations identify only members. They don’t identify a member’s customers and don’t maintain personal- and trading-related data for a member’s customers. However, in reality it is a member’s customers who place the majority of orders on any exchange. Just as the clearing corporation takes responsibility of verifying the credit worthiness of its members, it leaves the verification of credit worthiness of end customers to its members. Members by and large use the same concept of asking for margins and collateral from their customers to cover their risks, and they in turn validate a customer’s exposure vis-à-vis collateral and margins submitted.

Running credit checks only does not suffice, though. What if a member or customer defaults after all the precautions have been taken? A member might not put in fresh trades, but adverse price changes could result in severe losses and could make him a defaulter. In addition to having stringent credit checks, clearing corporations also guarantee transaction settlement through the concept of novation, discussed in detail in Chapter 2.

The level of guarantee that clearing corporations provide goes a long way in providing peace of mind to institutions and large investors, so much so that now most trading is anonymous. This means that while trading on a screen-based system, traders don’t even know who they are trading with. With novation, they know that legally, their counterparty is the clearing corporation itself, and in case the counterparty defaults, the clearing corporation will make their losses good.

Every exchange usually hooks up with one or more clearing corporations to settle its trades. The clearing corporation normally levies a small fee and builds a corpus of funds over a period of time to provide this kind of guarantee. This fund is normally called a trade guarantee fund. Some even buy insurance policies to cover this kind of default risk.

Every member of the exchange either has a clearing agreement with one of the members of a clearing corporation or directly holds membership in the clearing corporation. Members of a clearing corporation settle either their own trades or the trades of other trading members. One trading member who is a member of a clearing corporation may sometimes choose to route trades through other clearing members because they have reached their clearing limits.

For trades executed on the NYSE, the National Securities Clearing Corporation (NSCC) acts as the clearing corporation and guarantees and settles transactions between market professionals and ensures sellers are paid and buyers receive their securities in a manner that reduces risk, cost, and post-trade uncertainties.

Since losses arising from becoming a central counterparty could be huge, clearinghouses pay a lot of attention to the credit quality of members. They also pay a lot of attention to the settlement risks faced by the clearing corporation from time to time. Risk is also controlled by the imposition of margins from members in correlation to the position they hold in the market at any given point of time.

We will now discuss how settlement takes place in brief and cover it in detail in subsequent sections. At the end of every trading period (also known as the settlement period), the clearing corporation arrives at figures relating to every member’s obligation toward the clearing corporation and the clearing corporation’s obligation toward the members. The members deliver securities and cash to discharge their obligations at the time of pay-in and receive money from the clearing corporation at the time of pay-out. Cash is interchanged through the banking channel, and securities are moved through demat accounts. This entire process is called settlement.

In terms of technology and capacity, clearing corporations must be able to handle average volumes but also peak volumes, such as the market could have witnessed after the September 11 disaster. Any shortfall in handling capacity could potentially doom the entire financial market, which in turn would become a catalyst to its demise.

Список

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  • Japan Securities Clearing Corporation
  • JASDEC - Japan Securities Depository Center - www.jasdec.com/en/
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