Any transfer of financial instruments, such as stocks, in the primary or secondary markets involves 3 processes:
- execution
- clearing
- settlement
Execution is the transaction whereby the seller agrees to sell and the buyer agrees to buy a security in a legally enforceable transaction. All processes leading to settlement is called clearing, such as recording the transaction. Settlement is the actual exchange of money, or some other value, for the securities.
Clearing is the process of updating the accounts of the trading parties and arranging for the transfer of money and securities. There are 2 types of clearing: bilateral clearing and central clearing. In bilateral clearing, the parties to the transaction undergo the steps legally necessary to settle the transaction. Central clearing uses a third-party — usually a clearinghouse — to clear trades. Clearinghouses are used by the members who own a stake in the clearinghouse. Members are often broker-dealers. Only members may directly use the services of the clearinghouse; retail customers and other brokerages gain access by having accounts with member firms. The member firms have financial responsibility to the clearinghouse for the transactions cleared. It is the responsibility of the member firms to ensure that the securities are available for transfer and that sufficient margin is posted or payments are made by the customers of the firms; otherwise, the member firms must cover any shortfalls. If a member firm becomes financially insolvent, only then will the clearinghouse make up for any shortcomings in the transaction.
For transferable securities, the clearinghouse aggregates the trades from each of its members and nets out the transactions for the trading day. At the end of the trading day, only net payments and securities are exchanged between the members of the clearinghouse. For options and futures and other types of cleared derivatives, the clearinghouse acts as a counterparty to both the buyer and the seller, so that transactions can be guaranteed, thereby virtually eliminating counterparty risk. Additionally, the clearinghouse records all transactions by its members, providing useful statistics, as well as allowing regulatory oversight of the transactions.
Settlement is the actual exchange of money and securities between the parties of a trade on the settlement date after agreeing earlier on the trade. Most settlement of securities trading nowadays is done electronically. Stock trades are settled in 2 business days (T+2), while government bonds and options are settled the next business day (T+1). The T+3 settlement time prevalent before 2018 was shortened by the SEC in 2017 to T+2 (Source: SEC.gov | SEC Adopts T+2 Settlement Cycle for Securities Transactions). Forex transactions involving currencies from North American countries have a T+1 settlement date, while trades involving currencies outside of North America have a T+2 settlement date. In futures, settlement refers to the mark-to-market of accounts using the final closing price for the day. A futures settlement may result in a margin call if funds are insufficient to cover the new closing price.
Modern day settlement and clearing evolved to solve the mushrooming paper crisis created by recording the many more security trades of stock and bond certificates being traded in the 1960's and 1970's, while payments were still made with paper checks. Brokers and dealers either had to use messengers or the mail to send certificates and checks to settle the trades, which posed a huge risk and incurred high transaction costs. At this time, the exchanges closed on Wednesday and took 5 business days to settle trades so that the paperwork could get done.
The 1st solution to this problem was to hold the certificates at a central depository — sometimes called certificate immobilization — and record change of ownership with a book-entry accounting system that was eventually done electronically. The New York Stock Exchange was the 1st to use this method through its Central Certificate Service, which eventually become the Depository Trust Company, then became a subsidiary of the Depository Trust and Clearing Corporation (DTCC). In Europe, Euroclear and Clearstream are the major central depositories. The process of eliminating paper certificates entirely is sometimes called dematerialization.
A further improvement was multilateral netting, which further reduced the number of transactions. Brokers have accounts at central depositories, such as the DTCC, which acts as a counterparty to every trade. So instead of sending payments and securities for each transaction, trades and payments were simply aggregated over the course of the day for each member broker, then were settled at the end of the day by transferring the net difference in securities and funds from 1 account at the depository to another.
For example, if a broker bought 100 shares of Microsoft for a customer and sold 50 shares of Microsoft for another customer, then the broker's net position is the accumulation of 50 shares of Microsoft, which would be recorded at the end of the market day. If the broker paid $25 per share to buy the 100 shares of Microsoft stock and sold the 50 shares for the same price on the same day, then the net difference plus transaction costs is debited from the broker's account at the end of the market day, and credited to the account of the central depository. Likewise, only 50 shares of Microsoft would be transferred to the broker's account, since this is the net difference of buying 100 shares and selling 50 shares.
Because it takes time to settle a trade and to protect the financial integrity of the clearinghouses, clearinghouses require collateral from member firms. Member firms must post collateral depending on
- the number of trades they are executing
- the volatility and risk of the securities being traded
- the imbalance between buying and selling, and
- the firm’s financial condition
Because trading volume and risk changes every day, firms must adjust their collateral at the clearinghouse daily. Clearinghouses even provide tools to their member firms so that they can anticipate the daily changes of collateral requirements. But, sometimes, a trading frenzy of volatile securities can quickly drive up collateral requirements. For instance, in early 2021 Robinhood Securities, which uses the DTCC as its clearing firm, was required to post more than 10 times their normal collateral because their customers were trading GameStop and other meme stocks in a frenzy, quickly driving up stock prices well beyond their value as measured by traditional means. The DTCC feared that Robinhood’s customers would not be able to meet their margin requirements, which may have made it difficult for Robinhood to meet its own margin requirements with the DTCC. Robinhood responded by temporarily curtailing the trading of volatile securities, especially GameStop, to limit their risk and to lower the amount of additional collateral they had to post with the DTCC. Even so, Robinhood was forced to obtain additional funding from its investors to cover the greatly increased collateral requirements.
Brokers must post collateral with the clearinghouses because there is financial risk between the time the securities are purchased to when they are settled. With so many financial transactions nowadays being electronic, many people have wondered why the settlement time must be so long. Why not settle the trade as part of the trade? Australia has tried to cut down the settlement time from days to minutes on the Australian Stock Exchange since 2016, but as of March 2021, it is still reportedly 2 years behind schedule. Some companies are also trying to use the blockchain to settle trades more quickly, but none are in widespread use as of 2021. A major reason for the delay is that many banks, brokerages, hedge funds, and other financial institutions would have to update their systems to handle instant settlement.
Nowadays, governments around the world are promoting, or even requiring, central clearing, so that they can assess the systemic risk being imposed upon economies by their financial institutions, especially in the trading of derivatives, as was witnessed in the recent Great Recession of 2007 - 2009, when governments had to bail out many financial institutions because of a possible domino effect of major institutional failures. Central clearing is the best means of maintaining records so that financial risks to the economy can be better monitored.
- Paxos Trust Company, a blockchain startup serving financial institutions, is settling stock trades within hours rather than the days the DTCC usually requires. The DTCC can only settle trades by the end of the day if they are logged by 11:00 AM. The Paxos system uses the Ethereum blockchain to connect investors directly with each other instead of using an intermediary like the DTCC. Risks are reduced by requiring margin from the traders. Settlement risk is reduced by using swaps to exchange tokenized versions of money and shares. (Note that tokenization still requires an intermediary, since there must be some way to ensure that the tokens have a legally verified value, that the tokens actually represent a beneficial interest in the underlying asset. Paxos, for instance, is a trust company and a custodian of its tokenized assets, regulated by the New York State Department of Financial Services. However, transactions can proceed without an intermediary if the system is constructed properly.) Paxos plans to file a full clearing-agency registration with the SEC by early June 2021. (4/6/21: Stock Trades Settled in Hours, Not Days, as Blockchain Model Grows)
