Clearing and Settlement through Central Counterparty: A Paradigm Shift (2003)

1. Introduction:
Clearing and Settlement processes form the backbone of any financial system. The reason of existence of any financial system is to facilitate flow of resources from the ones who have in surplus to the others who need it. Hence, passing the obligations and ownership has to figure prominently as they are the ways and means of achieving the flow. The importance of a settlement system also lies in the fact that failure of one obligation leads to a domino effect and crashes the whole financial system. The clearing and settlement system is an infrastructure comprising institutions, instruments, rules, regulations, procedures, standards and technology, apart from the crucial support elements. The efficiency of this system determines the efficiency of use of transaction money in the economy and also the management of risks associated with transactions. An efficient clearing and settlement system reduces the costs of securities and funds transactions by reducing risks, thereby making the financial markets efficient. On the other hand, a weak system will drag on the stability and development capacity of the economy, causing inefficient use of financial resources, actual losses for participants, uneven risk-sharing among players and lack of confidence in the financial system of the economy. In the recent years, the trading and settlement volumes have soared as security markets have become an increasingly important for intermediating flow of funds between borrowers and lenders. With the rise in cross-border finances and flow of funds due to integration of global markets, a strong and resilient clearing and settlement system has become critical for success of any financial system.

Let’s analyze the clearing and settlement processes from the point of origin of settlement needs to the paradigm shift brought about by technological advancements. A trade of the securities is the epicenter for clearing and settlement needs. Understanding the trade cycle will make for a start of comprehensive analysis of clearing and settlement.

2. Trade Cycle:
Investment decision: The investment decision is the root of all transactions. It largely depends on the savings and the modes of investment available. The most important parameter for making an investment is the risk perception of the investor. The returns from the investment must be in commensuration with the risks associated with it. Not only does risk appear in making a trade off with expected returns but it does figure prominently in calculations of utility, since utility function is dependent on risk tolerance.

Order Indication: Once an investment decision is made, it manifests itself in the form of order indication. Orders are of various kinds. In the Over The Counter (OTC) markets, one can directly place the order for specific instruments. In the Exchange traded instruments, orders are generally indicated to Brokers who place the orders in the Order Book.

Order Management: Order management has to do with the choice of investment and kind of order. It starts with the placement of orders in the books and ends with execution of trades or deals. Management of orders is dependent on the quantum of instruments required, price range of instruments and the validity of order in terms of time span. Orders are managed differently when concepts of Preferred Markets are applied, wherein the participants have the choice of determining exposure limits for each of the counterparties in the market based on their risk perception.

Trade Execution: Order management leads to execution of deals or trades. The trades are specified in terms of counterparties, quantity of instruments, deal price, gross and net considerations, deal time, settlement date, yield, seller side and buyer side broker identities, and other details regarding transactions.

Trade Allocation: The execution of trades needs information to be passed on to the concerned parties who hold funds and securities for the trading members. They get the details about the impending liabilities in form of securities or funds payable to their respective counterparties.

Trade Confirmation: The trading members confirm the details of the trades allocated to them and the bankers, depositories and custodians verify the availability of funds and securities and thus, confirm the trades.

Clearing and Settlement: Clearing means fixing of liabilities in terms of funds and securities to each member on a pre-determined basis, agreed upon by all participants in the trade. Settlement means the transfer of ownership of securities and funds in accordance with the liabilities established after the clearing process. However, these processes are not always smooth and involve management of shortages of securities and funds in a manner that can shield the financial system from the ill-effects of shortages.

Reconciliation: After the trades are settled with final transfer of ownership of securities and funds, the accounts are reconciled for payment of transaction charges, penal charges if any, interest charges and commitment charges for Lines of Credits and Securities Lines of Credit. This process also includes replenishments and release of securities and funds shorted and withheld in the process of settlement.

3. Means of Clearing and Settlement:
There are many approaches to clearing and settlement depending upon the number of parties involved in the process. Bilateral clearing and settlement occurs when the two counterparties to the trade decide about their liabilities and settle them according to their own conveniences. Bilateral clearing and settlement occurs in most Over The Counter (OTC) products. Inter-bank foreign exchange trades are an example of bilateral clearing and settlement. Multilateral clearing and settlement is affected in most exchange traded products. This is, however, carried through a central counterparty that acts as the clearing house. The existence of a central counterparty, for all practical purposes, guarantees the settlement and thus, limits the settlement risks.

4. Significance of Central Counterparty in Clearing and Settlement:
Central Counterparty or the clearing house concept has gained ground over the years because of the stability they provide to the clearing and settlement process. These are specialized financial institutions that facilitate trading in cash securities and derivatives by simplifying the clearing and settlement process, to an extent of guaranteeing payments and transfer of ownerships. The central counterparty breaks each trade obligation and replaces them with two obligations each; for every buyer it becomes a seller and for every seller it becomes the buyer. This legal process is known as Novation, and is the backbone of the clearing process. Since central counterparty places itself in the shoes of every counterparty, the trades are settled through the central counter party’s accounts. This enhances confidence of the market participants by reducing settlement risk. For each party, the central counterparty reduces the exposures to many counterparty risks with a single one, and with a well established risk management mechanism, central counterparty risk is almost negligible. For the central counterparty too, a cumulative counterparty risk is lower analogous to the insurance companies. Higher the number of market participants choosing to settle their obligations through the central counterparty, the closer moves the risk for the central counterparty to the systematic risk. This underlines the significance of the central counterparty as it does reduce the cost of funds by reducing risk, and cost of transactions by simplifying clearing and settlement.

5. Mechanism of Clearing and Settlement through Central Counterparty:
The processes involved in clearing and settlement are receiving of trades and checking them against exposure limits set for the trading parties. The trades that qualify for settlement are novated. After Novation, the securities and funds obligations are computed based on agreed basis. With the determination of obligation the clearing process ends. The custodians of the securities and bankers for the trading members are informed and instructed to make transfers of funds and securities in and out of the clearing house’s account, with inflows given precedence over outflows to mitigate risk of default. If there are defaults in securities or funds, the clearing house has mechanisms in place to manage them. The objective of the shortage management is to contain the ill effects of shortage to a bare minimum. The mechanisms are fine tuned to protect the clearing house too from the losses. The post shortage management processes involve penalizing the defaulters and making recoveries. With the transfer of ownership of securities and funds, the settlement process comes to its logical end.

6. Elements of Clearing and Settlement through clearing house:
The elements that are involved in clearing and settlement are described as follow:

Membership: The market participants are inducted in the clearing house for fees including membership fee, transaction fee and other charges. Membership also involves mandate to the clearing house for use of the participation funds placed with it. Legal documents are prepared and the custodians and the bankers of participating members are given standing orders to abide by the instructions issued by the clearing house.
Contribution to the participation fund: The collaterals placed with the clearing house are used to assess the exposure limits of the members. This fund is also used to manage any shortages created by defaulting members and for loss allocation. The collaterals are collected from the members in the form of specified securities and cash. The interest bearing instruments placed as collaterals enhance the value of collateral when interests are paid on them. In some systems, the cash contributions are considered for initial margins while, in others, the initial margins are collected as and when required.
Trade notification: The trades of the members are notified to the clearing house for clearing and settlement. Trades can be notified as separate deals by the buyer as well as the seller, and will be accepted for clearing if the specifications match. The other means is to get the information regarding the trades from a trading platform directly. Trading platform can be an exchange or a trading facility provided by a third party, such as NDS sponsored by RBI in India.
Trade validation: Trades accepted by the clearing house must fall within the exposure limits set by the trading members. The validation on this account is done upon the notification of trades and the trades that exceed the limits may not be settled by the clearing house.
Novation: After the trades are validated, they are novated by placing the clearing house as the central counterparty.
Clearing: This process involves computation of securities and funds obligations for each trading member. The principles of clearing vary from gross settlement of securities and funds to net settlement. These are dependent on a number of parameters including liquidity, risk perception and operational convenience.
Settlement: Settlement begins with the end of clearing and involves instructing the bankers and the custodians of the trading members for transfer of ownership of securities and funds. The clearing house is informed if there are shortages in securities and funds. The shortage management depends upon the principle used for clearing. If all the obligations are netted, the shortage management becomes difficult as the trades that resulted in shortage creation can not be identified precisely. This can result in multilateral shortage allocation and loss allocation. In case of gross settlement, however, the trades can be identified and withdrawn affecting only a single counterparty. The severity of this impact is high and can result in a chain of defaults.
Risk Management: The process of risk management forms the most important aspect of central counterparty concept. The central counterparty assumes individual counterparty risks and transforms into a systematic risk, thereby, reducing the impact. The ways of managing risks are: collecting collaterals, collecting initial margins, variation margins and volatility margins. The valuation of collaterals deposited for the purpose of setting exposure limits is done with due consideration to fluctuations in prices of securities deposited. Risk management also includes establishment of methods to allocate eventual losses.

7. Means of loss allocation:
Let’s first take a look at the measures by which the central counterparty manages its own risks in the face of losses occurring due to defaults on the part of its members:

Margin cover of the defaulting member on account of the trades undertaken is blocked and adjusted towards the losses.
Any default/participation/guarantee fund contribution made by the defaulting member to take the membership of the clearing house is withheld.
Assets of the defaulting member at the disposal of other clearing houses that are linked or connected are blocked. This measure is effective when a member does not have sufficient collateral at the clearing house where the member defaults but has some assets at the disposal of other clearing houses.
Other members’ default/participation/guarantee fund contribution made and clearing house’s assessment rights so as to mutualize risk. This is a measure to distribute risks so as to minimize intensity of risk for any individual member or the central counterparty.
Insurance cover forms the third party risk coverage method. Insurance can be invoked in case of a default of pre-specified character for which an insurance company agrees to pay.
Reserves of clearing house accumulated over the years for covering risks or other purposes.
Capital of clearing house to write off losses as a measure of the last resort.

Keeping a close watch on the trading patterns of the participating members, and a control over their exposures through increasing margin requirements can be handy in alleviating high risks for the central counterparty. Another way of exercising control over the member exposures is to compute exposure limits after every successive trade vis-à-vis valuation of the collaterals deposited by the member, and rejecting trades that exceed such limit by a specified tolerance.

Before making the analysis of various methodologies of clearing and settlement, let’s take a look at the types of risks involved in these processes for the counterparties involved in trading.


8. Risks in Settlement:
There are three fundamental risks involved in the clearing and settlement process:

Replacement Cost Risk: This is the risk that in case of default of a counterparty, one has to buy the securities from the market at prevailing market prices.
Principal Risk: Risk that the seller will deliver the securities without getting payment or that the buyer will pay without the securities being delivered. This can lead to severe systemic problems and its ultimate failure.
Liquidity Risk: Risk that the seller upon the default by the buyer may not convert the security assets into cash to settle his obligations. This can create severe solvency problems.

The prime concern for the central counterparty is principal risk. However, replacement cost risks and liquidity risks should also be considered and there should be mechanisms established for mitigating them.

Now the ground is prepared to have a look at the approaches to clearing and settlement processes in view of the management of risks in settlement.

9. Paradigms of Clearing Process:
The clearing process has Deliver Versus Payment (DVP) concept and Real-Time-Gross-Settlement (RTGS) system concept. By virtue of advances made in electronic funds transfer technology, the RTGS systems have become a reality and are going live in many financial markets. A look at both the concepts is worthwhile. The DVP systems are as follow:

DVP – I: System that settles both securities and funds transactions on a trade-by-trade (gross) basis, with final (unconditional) transfer of securities from the seller to the buyer (delivery) occurring at the same time as final transfer of funds from the buyer to the seller (payment).

It can eliminate principal risk by ensuring that securities are transferred from the seller to the buyer if and only if funds are transferred from the buyer to the seller. However, completion of such transfers may require participants to maintain substantial money balances, so as to adjust obligations through the processing cycle. If sufficiently high balances are not maintained, failure rates will rise and will lead to high replacement risks and liquidity risks. To eliminate this, the systems have the provision of extending credits to participants to maintain high money balances. Extension of this intra-day or over-night credit has inherent credit risk, which at times is as intense as the principal risk that is sought to be eliminated by providing credit. Hence, credit collateralization becomes inevitable.

DVP – II: Systems that settle securities obligations on a gross basis with the final (unconditional) transfer of securities occurring throughout the processing cycle, but settle funds obligations on net basis with final funds transfer occurring at the end of processing cycle.

Final securities transfers precede final funds transfers in this scheme of operations and have the potential to expose the sellers of securities to substantial principal risk. Systems operating on DVP-II have to provide strong assurance to the sellers of securities that they will receive payments for the securities delivered. In most cases, this involves creation of an assured payment system in which the seller delivers securities in exchange for an irrevocable commitment by buyers’ banks to make payment to sellers’ banks at the end of the processing cycle. To protect itself, the guarantor in this system, typically seeks a lien on securities held by the buyer. However, the guarantor may be exposed to credit risk of the same magnitude as the principal risk due to the nature of lien created or securities pledged as the values of these securities are likely to fall.

DVP – III: Systems that settle both securities and funds obligations on net basis, with final and unconditional transfer of securities and funds occurring at the end of the processing cycle.

In this case large exposures are avoided since obligations are netted. Principal risks are also eliminated by ensuring that final transfer of securities on a net basis is made if and only if final transfer of funds on a net basis is made. However, failure of a participant to cover a net debit position exposes the system operator or its participants to replacement cost risks and liquidity risks.

Some DVP-III systems do not guarantee settlement and they respond to a failed payment by a participant by unwinding or deleting some or all of the transfers involving that participant and recalculating the settlement obligations for of all other participants. The key issue here is whether the participants can be expected to cope up with the potential liquidity pressures that may arise from such unwinding. The magnitude of the pressure will depend upon the size of net positions of the defaulting participant and how widely the underlying transfer activities are divided among other participants. Liquidity risk magnitude depends on money market and security lending markets.

Another important issue is the vulnerability of the system to insolvency or liquidity problems on the part of settlement bank, the entity that holds funds accounts used for the payments in settlement system. The safest solution is to use central bank accounts for funds transfers.

In the context of Indian market, RBI acts as custodian as well as banker for settlement of government securities. The clearing and settlement processes are handled by the central counterparty, namely, the Clearing Corporation of India Limited (CCIL). RBI has mandated a shift to DVP-III regime that will usher a new era in Indian financial market. CCIL acts as a guarantor for all trades reported to it for settlement. Hence, RBI, in a significant move, has permitted selling of securities where a buy trade has been guaranteed by CCIL even though the party does not have the possession of those securities. This assumes significance due to the fact that a party can enter into a buy contract to be settled at CCIL and take an opposite position elsewhere leveraging its outstanding buying position at CCIL. Hence, the shortage management process at CCIL assumes a higher significance since an unwinding occurring at CCIL will in all probability cause the counterparty to default at its selling obligation. This can lead to disastrous results. Hence, a prudent approach to securities shortage management is a must before jumping into DVP-III bandwagon.

Real Time Gross Settlement (RTGS) Systems: RTGS system provides flexibility in the time of settlement. In this type of a system, the processing and final settlement of securities and funds transfer instructions can take place continuously. As it is a gross settlement system, transfers are settled individually without netting debits against credits. As it is a real time settlement system, the system affects final settlement continuously rather than at pre-specified time intervals, provided the custodians and the banks have sufficient balances and credit available for the members involved in trades. The constraint for the system participants is, therefore, of keeping high balances at their accounts.

The design of RTGS systems differ primarily in their approach to managing payments when the custodian or the bank does not have sufficient credits. One way of managing such a situation is to reject the corresponding instructions, and if possible, resend them when the member accounts have sufficient credits. Alternatively, the instructions can be held as pending till an offsetting instruction or credit is pooled in the member account. Yet another way is to provide intraday credits to the members for honoring the instructions relating to their accounts. All these alternatives are not necessarily mutually exclusive and a combination of them can be used to manage shortage incidents.

The single most important advantage of RTGS system is reduction in settlement risks. The provision of final transfers occurring in real time can help the participants go ahead with the settlement of other obligations, which they would have been able to settle at the end of trade processing cycle in case of a DVP system. This opens up a scope of better treasury management. By reducing the lag between the actual trading and settlement processes, RTGS reduces the default risk considerably. For all these benefits, RTGS can help contain systemic risk, which has been the motive of all central banks across the globe. And that explains the paradigm shift towards RTGS systems.

10. The Indian Perspective:
The clearing house for the government securities in India is the Clearing Corporation of India Limited (CCIL).

The trades being cleared and settled through CCIL definitely are approximately 90% of the total market volumes. The trend proves the utility of central counterparty in the clearing and settlement process. The trades are being settled in Delivery Versus Payment – II (DVP-II) basis. The trades are received from RBI’s Negotiated Dealing System (NDS). Upon business validations, these trades are novated and funds obligations are netted while securities obligations are settled on gross basis. The risk of security shortage is met by creating pool of collateral, which is a membership criterion as well. CCIL maintains a balance of securities in its own account that can be utilized in times of need. Funds shortages are met by Lines of Credit extended by various banks and by CCIL’s own kitty. In extreme cases the trades leading to acute security shortage are withdrawn. However, CCIL with inspiration from RBI will move to DVP-III regime in a short while. With this change, the shortage management will require robustness and resilience. Some of the banks and financial institutions have vowed to provide Securities Lines of Credit analogous to funds lines of credit. Trade withdrawals will not be adhered to in normal circumstances. But in some cases when the securities shortage can not be handled, shortage allocation will be done. However, CCIL has committed to compensate for the transaction and replacement costs to non-defaulting participants. The recovery process will henceforth be triggered to cushion CCIL from the ill-effects of default. This leap forward is definitely a revolutionary step in the Indian scenario and the effectiveness with which it goes on to smoothen the functioning of government securities market is yet to be seen.

The trades in equity markets are also cleared and settled through central counterparties. The National Stock Exchange (NSE) has the services of the National Stock Clearing Corporation Limited (NSCCL) that acts as the central counterparty, whereas the Bombay Stock Exchange (BSE) has in-house clearing and settlement. And as in case of CCIL, the clearing houses of NSE and BSE have the major volume of trades occurring at these exchanges being cleared and settled through them. However, these exchanges have rolling settlement concepts and the clearing and settlement is done on gross basis.

11. Conclusions:
The significance of central counterparty can not be undermined taking a look at their efficiency in management of risk and their contribution towards stabilizing the financial markets. The bases of clearing and settlement have moved from DVP-I to DVP-III and the technological advances made in the direction of on-line real-time transactions have made it possible to migrate to RTGS system, though in India, it is yet to open up in big way. The systems have their respective challenges and opportunities, and a prudent risk management can make them successful in a given situation. However, the costs and benefits must be assessed thoroughly before making headway. The future trends, as of now, indicate a move towards RTGS systems. The success of this system however, depends a lot on the modes of network security infrastructures through which the transactions will be carried out. With advancements taking place in leaps and bounds, the systems seems to be in the reckoning. The timing of RTGS systems making a full impact in the Indian market can, however, only be speculated. Let’s keep the fingers crossed.

(This is one of my old research works, hence, data and conclusions may be dated.)