The future of clearing and settlement

Whenever the ownership of a security is transferred from one individual or institution to another, whether it be the sale of new shares via an initial public offering (IPO) or existing shares sold on an exchange, there are three key processes that each transaction must go through:

• Execution
• Clearing
• Settlement

Of the three processes, execution is easily the simplest of them all. Execution refers to a filled order, which happens when seller of a security finds a buyer willing to purchase it at a certain price, with the two parties entering into a legally binding transaction. Once the initial execution occurs the order will then go through clearing and finally to settlement. Put simply, settlement is where the actual exchange of money and securities between two parties in a trade is finalised, with trades usually settled within three days.

Clearing is arguably the most complex of the three processes, with it dealing with the transference or money and securities. For investors and companies looking to execute a trade, there are two different types of clearing options available: bilateral and central clearing.

Bilateral clearing is commonly used in over-the-counter (OTC) or off-exchange trading. In bilateral clearing, a contract is agreed directly by two parties without the oversight of an exchange or any other intermediary. Instead, these contracts are traded via what is commonly referred to as a dealer network, not a centralised exchange, such as the London Stock Exchange, but rather through direct negotiations often facilitated by broker-dealers like Fidelity Investments. One of the major advantages of OTC and bilateral clearing is that it offers individual investors or companies increased flexibility compared with standardised exchange-traded contracts, allowing parties to agree on an unusual contract size or other special requirement, with the contract’s price not necessarily made public.

But despite the many advantages of OTC and bilateral clearing, without a third party in the form of a clearing house or exchange being present, there is an increased default risk associated with OCT contracts for both parties. Furthermore, the lack of transparency in the OTC market means that regulators are often left in the dark about the risk profile of contracts which can contribute to increased systemic risk.

Functions of a clearing house

The safer alternative to OTC and bilateral clearing is central clearing, which uses intermediaries, usually in the form of a clearing house or exchange, to clear trades. Stock exchanges, such as Nasdaq or London Stock Exchange (LSE) have their own clearing operations, which ensure that investors have enough capital in their respective accounts, whether that be in the form of their own cash or broker-provided margin, to finance positions they are taking in the market at any given time, with this oversight function helping to reduce counterparty risk.

The clearing units of these exchange operators not only reduce the risk of defaulting on a trade, but they also help facilitate a smoother transference of funds from one investor to another. Ultimately, when a trader wishes to exit his/her position in a given market they want to rest in the knowledge that their money will be delivered to them in as fast and as timely a fashion as possible. A key requirement to make sure that that happens is ensuring the buyer has enough funds to clear the trade. Put simply, the clearing house makes sure that both parties have all their ducks in a row so that trading can happen as smoothly as possible so that the trade is settled ASAP. To do this, clearing houses like LCH take both positions on each side of a trade, effectively becoming the counterparty to the both the buyer and the seller and, therefore, acting as a guarantor for the trade in the event of one of the two defaulting on the agreement. The clearing house will charge a fee for offering this service from traders to cover any potential losses that it may incur as the result of either a buyer or seller defaulting so that it can ensure that trade is settled at the current market price, helping to preserve overall market stability.

Clearing houses also provide several other important functions that improve the overall clearing and settlement process. One is hiding buyers and sellers’ identities from one another, helping investors keep a degree of privacy about what actions they are taking in the market and the positions they hold and have exited from. Clearing houses also help to reduce the overall number of transactions being settled at any given time across various markets, which helps to reduce systemic pressure and allows financial markets to run more smoothly by limiting the value of obligations being settled – allowing capital to move more efficiently.

How blockchain will revolutionise clearing and settlement

As easily the most technical process within the trade cycle, clearing does not easily lend itself to technological innovations. But despite the challenges, clearing houses and exchanges have spent millions in overhauling antiquated legacy systems to improve overall functionality. Most recently, in January this year, the Options Clearing Corporation (OCC) announced that it will replace its legacy clearing system with Cinnober’s TRADExpress RealTime Clearing platform.

The upgrade will see the OCC’s clearing system provide users with better data submission and reporting functionality, as well as other benefits such as improved control mechanisms, futures processing and product support.

“Following a lengthy and rigorous analysis, we decided to pair our internal work with the adoption of the TRADExpress RealTime Clearing solution,” Chief Operating Officer at the OCC John Davidson said in a statement.

“The new systems will deliver many advantages to our participating exchanges and clearing firms in a modern and flexible technology architecture, including enhanced functionality to procure and submit data to and from the system for external and internal users, enhanced ad-hoc reporting capabilities, enhanced control mechanisms, expanded new product support capabilities, improved futures processing, and greater flexibility in processing clearing member trade agreements.”

The adoption and implementation of new clearing systems is great news for a sector that has been relatively slow to adopt new technologies, but there is still plenty of room for further innovation around clearing and settlement, particularly with regards to blockchain, with many in financial services industry believing that it represents a new frontier in the trade life cycle.

“Reporting is at the forefront of the RegTech revolution,” CEO of NEX Regulatory Reporting Collin Coleman said in company report on innovation in the trade life cycle. “We are witnessing a multiplication of reporting regimes seeking to satisfy public authorities’ needs for transparency. But we are also seeing true innovation, driving efficiencies in reporting by leveraging the cloud and in the future DLT and AI technology. In combination, the reporting ecosystem is going to look very different to what we know today.”

Clearing houses and exchanges, for some time now, have even been looking at whether a form of distributed ledger technology (DLT) could be used to form a new basis for clearing and settlement. As far back November 2015, the London Stock Exchange, CME Group and clearing houses LCH and Euroclear partnered with French lender Société Générale and the Swiss bank UBS to try and see if blockchain technology can revolutionise the way that securities are recorded, cleared and settled.

Around about the same time, the European Central Bank (ECB) and the Bank of Japan (BoJ) began their own investigation into DLT and whether a blockchain could replace real-time gross settlement (RTGS) systems that the two use for clearing and settlement. The result was a 23-page report that was published in the latter half of 2017 which concluded that despite their being ‘encouraging evidence’ that some form of DLT could be used at some point in the future, ‘given the relative immaturity of the technology, DLT is not a solution for large-scale applications’ like those used by the ECB and BoJ for clearing and settlement processes.

However, the long-awaited implementation of DLT-powered clearing and settlement is finally on its way, with the Australian Stock Exchange (ASX) announcing plans to roll out its blockchain platform for clearing transactions… even if it won’t be up and running until at least the end of 2020.

Traditional market infrastructures like ASX are rather late to the DLT party, largely due to innovation at these companies being incumbered by large legacy systems, a high degree of regulatory oversight and clients that want access to the better clearing and settlement functionality but not at the expense increased market risk.

“We are often told by many, including other market infrastructures, ‘you’re so brave that you’re going first, you’re using DLT’ – we actually genuinely consider it brave to embark upon a large transformation program and not adopt this technology,” ASX executive general manager of Equity Post-Trade Services Cliff Richards told onlookers at the Sibos conference in Sydney last year.

“We do not consider ourselves brave; we think perhaps the ones that don’t make this step are the brave ones. Time will tell,” he added.