July Central Counterparty for Equities Settlement Netting. Service Outline

Transcription

1 July 2001 Central Counterparty for Equities Settlement Netting Service Outline

2 Important note Recipients should not construe the contents of this document as investment, tax or legal advice and each recipient is urged to consult with his own professional advisers as to these matters. This document does not constitute an offer to sell or a solicitation of an offer to buy an investment and does not carry any legal rights. This document sets out the current position regarding the provision of settlement netting services within the central counterparty services for SETS, which is, as is in the nature of development projects, subject to change. If you have any general queries relating to this document, or if you require further copies, please contact: CRESTCo Limited Tel: [email protected] London Stock Exchange plc Tel: [email protected] The London Clearing House Limited Tel: [email protected] Further copies of this document can also be downloaded from the websites at or or This document has been produced by CRESTCo Limited, London Stock Exchange and The London Clearing House Limited to assist users of their systems. While it has been prepared on the basis of the best information available, the authors accept no liability for decisions taken, or systems work carried out by any party, based on this document. This document does not form part of the contractual documentation between any of its authors and their customers. June 2001 CRESTCo Limited, registered in England and Wales No , London Stock Exchange plc, registered in England and Wales No and The London Clearing House Limited, registered in England and Wales No The CREST logo is a trademark of CRESTCo Limited. SETS, SEAQ and the London Stock Exchange crest and logo are trademarks of London Stock Exchange plc. The London Clearing House logo is a trademark of The London Clearing House Limited.

3 Contents 1 Introduction 5 2 Context Market Conditions Drivers for settlement netting Other markets 7 3 Service overview What is settlement netting? Scope Optionality Contractual basis of netting 9 4 Implementation Approach Timescales Impact on participants 12 5 Optionality Selecting the options Enriched transaction Treating gross transactions as automatically matched Netting Treating net transactions as automatically matched Changing the options 17 6 The netting process The netting algorithm Timing of netting 20 7 Legal and regulatory considerations Type of netting Contractual framework Use of settlement agents Agency netting Protecting clients safekeeping assets Netting across trading participants Books and records Default 27 8 Settlement Splits Settlement Settlement management 29 9 Corporate events Benefits Corporate actions 31 1

4 10 Risk management Reporting to members Standing data Transaction data and reconciliation Stamp duty and regulatory reporting Stamp duty and SDRT Regulatory reporting 35 2

5 Guide to readership The guide to readership is intended to help readers find the most relevant sections of the document for them. Section Scope Readership Overview 1: Introduction Description of this document 2: Context 3: Service overview 4: Implementation Detailed description 5: Optionality 6: Trading and settlement 7: Legal and regulatory considerations 8: The netting process 9: Handling late settlements 10: Corporate events 11: Risk management 12: Reporting to members 13: Stamp duty and regulatory reporting The reasons why participants want settlement netting Overview of the complete service How the service will be delivered Description of the choices available in the service Impact of netting on trading and settlement Description of the legal approach to netting and the impact of this on how firms structure their approach to settlement Details of the netting algorithm Description of the methods used to handle late settlements Description of the changes to corporate action processing Description of the impact of netting on risk management Description of the new information available to CREST participants Description of the proposed changes to stamp duty and regulatory reporting All readers All users of the service and other CREST participants, including front, middle and back offices, technical teams and compliance officers 3

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7 1 Introduction The London Stock Exchange ( the Exchange ), London Clearing House ( LCH ) and CRESTCo jointly introduced a central counterparty service for electronically executed trades on SETS and SEAQ Crosses on 26 February The objectives of this first phase of the service were to introduce LCH as the central counterparty, with the associated clearing member relationships, while keeping the trading and settlement process as unchanged as possible. The first phase delivered full counterparty anonymity and improved counterparty risk protection to the market. Settlement remained on a gross basis, although it was generally recognised by many market participants that the service should be enhanced to deliver settlement netting, because significant cost savings would result, at least to some participants. Settlement netting was not included as part of the first phase because it has a significant impact on trade processing, and it was felt introducing netting at the same time would demand too great a degree of change for the market to cope with easily in one step. Because of this, both CRESTCo and LCH commenced consultations with their members in late LCH established the EquityClear Advisory Group in late 2000 in order to focus on its members needs, while the CRESTCo consultation was addressed to all interested parties. The results of CRESTCo s consultation have now been published (see the CREST newsletter for April 2001) and the three organisations have now commenced a new programme with the intention of delivering a settlement netting service in early This Service Outline provides the first document describing how the initial implementation of settlement netting will work and which trades it will apply to. Further documents will develop the detail of the service. It is also recognised that the scope of settlement netting is likely to expand over time and that some areas of expansion will require enhancements to the service as described in this document. These expansions will be the subject of further documents. This document describes: the market context for the introduction of settlement netting an overview of the netting service specific detail on those areas where settlement netting will change today s approach to trading, clearing and settlement an outline of the implementation approach. Further documents will be published by CRESTCo, LCH and the Exchange detailing systems developments, rule changes, operational and implementation issues before the service goes live. It should be noted that some details within this document must, where necessary, be approved and ratified by the relevant CRESTCo, LCH and Exchange governance bodies. Alterations to detail are therefore possible. Any significant changes will be notified to recipients in later versions of this Service Outline or other documents, as appropriate. 5

8 The parameters and timings stated in this document are for illustrative purposes only. Actual values will be confirmed before implementation. In this document, the term Exchange refers to the London Stock Exchange, except where explicitly noted. The term member refers to membership of CREST, the Exchange or LCH, depending on the context. The term participant refers to a participant in the services offered by CRESTCo, the Exchange or LCH depending on the context, although settlement participant always refers to the CREST system. 6

9 2 Context 2.1 Market Conditions The primary trading service for the Exchange is SETS. Launched in October 1997, SETS is an electronic order book that facilitates central price formation and trade execution for securities comprising the FTSE 100 index and other liquid securities. SETS regularly executes more than 50,000 trades per day. In addition, the percentage of transactions executed in order book securities on SETS has steadily risen since its inception to 58 per cent. The impact of the increase in trade volumes (and value) on SETS is an ever-increasing number of settlements: in the current gross settlement world there is at least one settlement for each trade Drivers for settlement netting This increasing volume of settlements creates strain in market participants back offices, potentially impeding their ability to cope with more trading, and leading to an increase in their back office costs. This leads to the main drivers for settlement netting: Reducing back office costs and operational risk by reducing the number of settlements and associated CREST inputs. Reducing future investment by capping the number of settlements. The market consultations earlier in 2001 confirmed these drivers and stated that they were most important for SETS trades. 2.3 Other markets Other major markets either already use settlement netting or are moving towards it. The US markets have had settlement netting since the mid-1970s. Netting in the US covers all market-side trades and regularly achieves netting efficiencies (ie a reduction in the number of settlements required) of around 97%. It also caps the total number of settlements per participant per day. The Euronext markets also use settlement netting. 1 For example because of client-side settlements in addition to the market-side settlement. 7

10 3 Service overview This chapter gives an overview of the settlement netting service while later chapters provide more detail on areas specifically impacted by netting. However, this document does not describe the entire service at a detailed level this will be covered in subsequent publications, especially the CREST White Book on settlement netting, due to be published in July Areas of trading, clearing and settlement not described in this document should generally be assumed to remain unchanged by the introduction of settlement netting. 3.1 What is settlement netting? The objective is to allow participants to have just one net settlement per security per day with LCH, irrespective of the number of trades they had dealt on SETS. Participants will sometimes have more than one net settlement per security per day. This depends on various factors, including whether they trade as both agent and principal, how they choose to use the optional parts of the service, and as a result of some types of corporate event. The reasons are set out in more detail later in this document, particularly chapter 5. For example, if a firm had executed two trades on SETS in the same security on the same day, with one being a purchase of 100 shares at 4 each and the other being a sale of 50 shares at 3 each, then today each of these transactions would have to be settled separately. If the firm was using settlement netting (and providing certain other conditions were met), then it could do just one settlement a net purchase of 50 shares for a net consideration of 250 that would meet all of its market-side settlement obligations. The type of settlement netting being applied is multi-lateral netting with LCH as the central counterparty. In this service therefore, the settlement of one (net) transaction may settle several underlying (gross) transactions. The settlement netting algorithm is explained in more detail in section Scope In the longer term, it is clearly in the market s interest for as many trades as possible to be included in the settlement netting service. However, in line with preferences expressed by participants during the market consultations, the service will initially only deliver netting for automated trades on SETS or SEAQ Crosses, but is expected to be expanded later 2. The netting service only applies to market-side settlements with LCH and not, for example, to client-side settlements. Any participant involved in settlement of SETS trades will be able to take part in the service, but the netting functionality will be optional, for reasons explained in the next section. 2 In the rest of this document, the term SETS is generally used to cover automated executions on both SETS and in SEAQ Crosses for simplicity. There is no difference to the nature of the netting service between executions on SETS and SEAQ Crosses. 8

11 It is possible that some securities will have to be excluded from the netting service, at least at first. A possible example of this is Irish securities, because of the way that Irish Stamp Duty works (see section ). 3.3 Optionality A key feature of the netting service is that participation will be optional. The optionality is designed to ensure that participants opting in to the service receive the expected benefits, whilst those opting out do not suffer any disruption to existing processes; in particular, it allows for one side of a market trade (eg the seller) to use net settlement with LCH, while the other side (eg the buyer) settles gross the two sides do not need to know what each other are doing because LCH stands between them. Making netting optional also avoids the need to have a big bang implementation with all the difficulties this causes. Netting will be particularly advantageous for high-volume participants, particularly proprietary traders. However, there is a cost involved in changing from gross to net settlement. There are likely to be some SETS users whose SETS trading volume is too small to justify moving to settlement netting at first. This picture could of course change if SETS volumes continue to grow or if settlement netting was extended beyond SETS trades. In fact, there are three different optional components of the service designed to provide complete flexibility for participants; one of these options may be attractive to participants that do not want to net their settlements. Service optionality is explained in more detail in section Contractual basis of netting Type of netting The netting service is designed so that the underlying gross contractual obligations relating to delivery and payment still remain, with settlement of the net transaction performing those obligations. In practice, the continuing existence of the underlying gross obligations should have no material impact except in the event of a default when processing will still be based on the (gross) contractual obligations, although principal positions are still subject to close-out netting in a default (see section 7.8) Agency and principal netting Netting can only take place between sufficiently similar contracts (eg same settlement participants etc) as defined in section 6.1. In order to avoid problems in default management, agency and principal business can only be netted as follows: principal business can only be netted with other principal business agency business can only be netted with other agency business. It is not possible to net between these categories. For the avoidance of doubt, it should be noted that, for the purpose of this document, the definition of principal business includes client business transacted by broker-dealers as a riskless principal, where the broker-dealer contracts with their 9

12 client as legal counterparty, but executes the client order immediately on SETS and takes no market price risk. Firms that propose to net agency business will have to consider whether their settlement arrangements continue to achieve sufficient effective protection amongst their clients to meet their regulatory requirements. For example, if market-side settlements are netted, it will no longer be possible to freeze individual clients market-side settlements in order to achieve effective protection Who decides to take part in netting? It is the principals to the contracts involved in the net settlement that need to give effective consent to the performance of their contracts by way of settlement netting. General Clearing Members may have to accommodate situations where some of their Non- Clearing Members opt in to components of the netting service while others do not. 10

13 4 Implementation 4.1 Approach The implementation of settlement netting will be managed as a collaborative project between CRESTCo, LCH and the Exchange, as was the case for the introduction of the initial central counterparty service. Elements of the service are being developed by each of the Exchange, LCH and CRESTCo. Each organisation also has some system and rule-book development of its own to do. Once these are complete, there will be a period of integration testing between the three organisations, followed by testing with market participants. As with the initial implementation of the central counterparty, the LCH regulations will be adapted to cover changes to the relationship between LCH and its clearing members, while the Exchange rules cover other areas such as the relationship (particularly on default) between General and Non-Clearing Members. Because the service is optional, the implementation approach for participants will be different from the first phase of the central counterparty for equities. Before any participant can go live with settlement netting, they will have to go through a period of testing. The testing services required for this will be made available, probably every two months, depending on demand. Documentation will be produced, as appropriate, throughout this period. This will include: a detailed description of the CREST changes required to implement settlement netting 3 rule changes testing specifications updates to existing documents and guidance notes as necessary. Customers will also be supported by business and technical seminars and by the client support teams in each organisation. 4.2 Timescales The indicative timescales for optional settlement netting are shown in the chart below. Actual dates will be confirmed later. The target live date for the settlement netting service is Q but this will not be confirmed until a more detailed assessment of the size of the development is completed by CREST. Testing facilities will be made available to market participants, both before and after the live date, allowing flexibility when planning development schedules and project timetables. Progress updates will be published to the market by various means, including the CREST monthly newsletters. 3 CREST will publish details of the enhancements to CREST as a White Book due in July 2001 and an updated Data Exchange Manual due in September

14 Q Q Q Q Q Service Outline More detailed documentation and seminars Development Draft rule changes published Rule changes published Participant testing First participant live 4.3 Impact on participants One of the objectives of settlement netting is to have as little functional or system impact as possible on trading and settlement participants that do not choose to opt in to the service 4. However, participants that opt in to the service will clearly have to change their systems, and there will be some impacts on other parts of the industry as well. All participants will have to take note of changes to various rules and regulations to underpin the effectiveness of settlement netting. An overview of the impacts is outlined below Trading participants There is no direct impact of settlement netting on trading activities, although the anticipated reduction in the marginal cost of trading is expected to lead to greater trading volumes, particularly from proprietary trading organisations Members of LCH There is no direct impact on clearing and there will be no change to the margin model or the collection of margin, however the parameters relating to assumed settlement will be reviewed in the light of settlement performance. However, GCMs that wish to track the settlement of individual (NCM) trades will need to establish how they will handle this when the resulting settlement obligations are netted together CREST settlement participants The biggest operational impact is on CREST settlement participants, if they opt in to the service. The impact is in several areas, all described in more detail later in this document. Because some elements of the service are optional, the impact will vary between firms. The areas impacted are: 4 There may be new data items and status values relating to netting on CREST transaction records, although CREST will also support the previous version of the messages for a limited period of time in order to provide backwards compatibility. 12

15 Specification of the desired options, including the CREST member account to be used if relevant options are chosen Settling a net amount instead of the gross transactions together with any associated reconciliation requirements (this component is optional) Consequential changes to the handling of optional stock events Removal of the requirement to match settlements with LCH in CREST (this component is optional) Removal of the requirement for Exchange members to input market-side transaction reports, but some possible increase in the requirement for client-side transaction reports, see section CREST settlement banks There is no functional impact on settlement banks, but the use of netting will change settlement flows to some extent, and this may change the liquidity and credit demands of equity settlement Registrars Where net settlement is used, registrars will receive information about the settlement of the net transaction via the Register Update Request (RUR) and will not receive information about the underlying trades due to statutory restrictions on providing confidential customer information. Anonymous details of gross trades will continue to be available on the Exchange s market data feed. 13

16 5 Optionality There are three separate optional areas of the settlement netting service and settlement participants can choose which of these they want to make use of in any combination. They are: Whether the participant wishes to make use of settlement netting for the relevant business. Whether the settlement participant wishes to match the gross transactions (as today) or to have them automatically matched (irrespective of whether settling net). If opted in to netting, whether the settlement participant wishes to match the net transactions, or to have them automatically matched and thereby undertake the minimum possible CREST input. The relationships between these three options are shown in the flowchart below. The flowchart is explained in more detail in the following sections. Enriched transaction no Treat gross transactions as matched? yes Settlement participant must match transaction Transaction treated as matched yes Net this transaction? no Add transaction to net no Settlement participant must match net settlement Treat net transactions as matched? yes Transactions ready for settlement 14

17 5.1 Selecting the options It should be noted that each of these options apply to all relevant business ie a participant cannot select on a trade-by-trade basis which of these options are used. Although settlement participants will select the options they will need to secure any necessary permissions from clearing members and other affected participants. It is possible that not all of a settlement participant s business will be netted together. The settlement participant can select different options for different trading participants (ie different BIC codes this may be particularly relevant to settlement agents acting on behalf of several trading firms) and trading capacities. For example, a participant could choose to net their principal business, but not their agency business. Legal and regulatory constraints on the choice of options are discussed in chapter 7. As noted above, each individual option can be selected separately, although obviously selecting the ability to treat netted transactions as automatically matched is meaningless if netting has not been selected in the first place. Thus there are six overall choices in practice: Treat gross as matched? Net the gross transactions? Treat net as matched? 1 No No No 2 No Yes No 3 No Yes Yes 4 Yes No No 5 Yes Yes No 6 Yes Yes Yes Choice 1 corresponds to today s position, and will be the choice of participants that do not want to take part in settlement netting. Participants that do not express any decisions will be deemed to have chosen choice 1. Choice 4 allows a participant to reduce their CREST input without actually taking part in settlement netting itself and allows for straight through processing (STP) of gross trades. Choice 6 provides the greatest STP and settlement efficiency both for market participants and for LCH. Over time, it is anticipated that the industry will move towards choice 6. However, there is no current intention to mandate use of any of the options. It is recognised that matching rates for SETS business currently are very high and that some firms will want to continue to use matching as a control mechanism and to allocate their own references to transactions in CREST. 15

18 5.2 Enriched transaction An enriched transaction (as shown on the flowchart above) is one that has been fed from SETS into CREST and has been enriched with standard information required for settlement as part of the automated processing of these transactions. There will be two transactions resulting from each execution on SETS, one with LCH buying and one with LCH selling. This process is unchanged from the initial implementation of the central counterparty. In particular, the following information will have been derived from the trade: Intended settlement date Settlement participant Clearing member. It is important to note that this basic enrichment does not include the CREST Member Account that the participant wants to use to settle the transaction or any extra information required in today s transaction reporting or stamp duty regimes. All of this information is added to the transaction when the participant matches it. 5.3 Treating gross transactions as automatically matched One option for settlement participants is to treat gross transactions as if they were matched. This reduces the participant s CREST inputs and hence their network usage. It only applies to the market side of SETS trades, not to other business settled by the participant. The way that this option works is that in effect the SETS trade generates the CREST inputs for both LCH and the settlement participant and matches them. In order to make use of this option, the participant must specify the Member Account (and nationality for transactions in relevant securities) to be applied to the resulting transactions. CREST will hold this in standing data and then add it automatically to the relevant transactions. For participants that do not take part in settlement netting, the gross settlement transaction will proceed directly to a status of being ready for settlement without further participant input. Clearly, participants will not gain the full benefit of not having to match transactions for settlement unless the other reasons for CREST input and matching are also removed: transaction reporting and specifying the accounting treatment for stamp duty. The way in which this is achieved and the consequential impact on participants are described in chapter Netting Participants can opt into settlement netting for their SETS trades. Where netting is in use, the original (gross) transactions are not settleable items. Details of the netting process and the time at which it occurs are described in chapter 6. 16

19 5.5 Treating net transactions as automatically matched Participants that have opted into netting can also choose whether they want explicitly to match the resulting net settlement or to have it treated as automatically matched. If the participant chooses to match the net settlements, then the net settlement transaction will not settle unless the participant has matched it. There are no transaction reporting or stamp duty issues with net transactions apart from one issue with Irish stamp duty, described in section Changing the options Participants will be able to change their selections. Changes will normally only be permitted to take effect overnight (unless a participant s options have been incorrectly set up, in which case an intra-day change may be permitted). A notice period may be required for planned changes. Changes to selections are not retrospective but apply only from the time at which they are effective. This is interpreted in the following ways. Changing the option to treat gross transactions as automatically matched takes effect from the moment the change is made. Transactions that were entered into CREST before the change of this option do not have their status changed. Changing the option to have gross transactions netted takes effect from the moment the change is made. If the change is made intra-day, then some of the day s transactions will be netted and some will not. Changing the option to treat net transactions as automatically matched takes effect from the point at which the net settlement transactions are deemed to be generated (see section 6.2), thus it cannot change the status of net settlements that already exist when the option is changed. 17

20 6 The netting process 6.1 The netting algorithm What can be netted together? This service only provides netting for settlements where LCH is one of the settlement participants. The detailed parameters for netting are described in the following section and some contractual issues in chapter Netting parameters in detail The netting algorithm will combine gross transactions together if the two participants have both opted into netting (LCH, as one of the two participants, can be assumed to have opted in) and if the security concerned is eligible for netting. A net transaction will be created combining gross transactions where the following characteristics are the same: Clearing member LCH Account (ie House or Client ) Settlement participant CREST member account Dealing capacity (ie Agent or Principal ) Security (ISIN code) Country of register, where applicable, ie for securities which have more than one register but the same ISIN code 5 Currency Trade date Intended settlement date (for SETS business, this is always implied by the trade date and security type) Benefit status (ie Cum or Ex, for SETS business, this is always implied by the trade date). Note that this approach allows for netting of transactions dealt under different BIC codes on SETS. However, it is not always possible to do so. This is described further in section Note that this situation does not arise on SETS at the time of writing this document as SETS only trades one of the relevant versions of the security for securities with more than one version. 18

21 6.1.3 How is the net calculated? The quantity of stock and consideration are the two items that are netted. These are both the simple sums of the underlying transactions, taking purchases and sales into account appropriately. For example, if a participant had the following trades that were capable of being netted together: Type Quantity Price Consideration Purchase Purchase Sale (170) 2.30 ( 391) The net position would be Purchase Note that the price of the net position is no longer meaningful, although an effective price can still be calculated in this case by dividing the net consideration by the net quantity. However, the nature of this netting algorithm is that there are a number of possible outcomes. Essentially, the different outcomes result from different combinations of trades of varying sizes and prices. Scenarios 1 and 2 are the mostly likely outcomes, but the others could occur with particular trading patterns or price changes during the day. The complete list of the possible net outcomes is as follows. Stock movement Cash movement 1 Normal purchase Receive Deliver 2 Normal sale Deliver Receive 3 Delivery with payment Deliver Deliver 4 Receive with payment Receive Receive 5 Deliver stock with no cash Deliver 0 6 Receive stock with no cash Receive 0 7 Deliver cash but no stock 0 Deliver 8 Receive cash but no stock 0 Receive 9 No stock or cash movement

22 It should be noted that net settlement transactions will be generated for all of these outcomes, including case 9, which will settle on its due date 6. This is to aid reconciliation. An example of how case 4 could arise is shown below, using an adapted version of the previous netting example, in which the price of the stock has risen significantly between the purchases and the sale. Type Quantity Price Consideration Purchase Purchase Sale (170) 3.00 ( 510) The net position would be Purchase 10 ( 68) In this example, the participant would be receiving both stock and money Impact of contras If a SETS trade is contra d on the day of trade for a participant that has opted into settlement netting, then both the original trade and the contra will be fed into the net position, where they will cancel each other out. If these are the only trades, then they will form a net trade with zero movement of stock and cash as in 9 above. Contras done after trade date will continue to be handled according to the current process ie agreed contras are settled bilaterally between the trading participants without the involvement of LCH. This type of contra is not included in the netting process. 6.2 Timing of netting CREST diary event The net settlement transactions will be generated at a new CREST diary event which will be timed for early evening, after the last SETS trade or contra, but before the end of CREST input for the day. This is so that a participant that wishes to take part in netting, but elects to match both the gross and net transactions, has time to do so on the day of trade. The net settlement transactions will not be visible in CREST before this diary event Nets not re-opened Once the net settlement transaction has been created, it will not be changed by having new transactions added to it, or existing transactions removed from it 7. 6 CREST will not create null net transactions if there are no relevant gross transactions, so this is the only example in which a null net transaction can be created. 20

23 For a participant that opts to match the gross transactions, this can mean that more than one net settlement transaction is created with the same basic netting attributes ie the parameters of two net transactions (as described in section 6.1.1) could be the same. This situation would arise when the participant matched some gross transactions before the CREST netting diary event and some afterwards. The transactions matched afterwards would be carried forward to the next day s netting calculation. On that next day, the carried forward transactions can be netted with each other, but not with new transactions dealt on that next day, because the trade dates (and hence the intended settlement dates) would be different Single transactions A net settlement will be created if there is only one gross transaction, ie the net and gross transactions are effectively the same. This is for reconciliation purposes so that participants can see that netting has taken place and can match the net, if that is their requirement. 7 It should be noted that the following events some corporate events, see chapter 9, splits, see section 8.3.3, or default, see section 7.8 could modify a net settlement in the same way as they do today, but this does not change the underlying set of transactions that were used to construct the net settlement. 21

24 7 Legal and regulatory considerations This chapter provides an overview of the legal and regulatory considerations for settlement netting. It does not attempt to be a definitive or complete description of the legal structure or the rules, regulations or contractual issues that will arise. The complete description with regard to the Exchange, CRESTCo and LCH will be supplied by the changes to the various rules. Where legal changes require consultation, it is intended that the proposed changes will be published for consultation in Q Participants are advised to contact their regulators to confirm any conduct of business or prudential supervision implications. 7.1 Type of netting The legal approach to netting will be administrative netting (which is sometimes referred to as settlement netting ). In this approach, the underlying contractual obligations remain in existence, however settlement of the net transaction is agreed between the contracting parties as providing performance of the underlying obligations. The implications of this are described in more detail in the rest of this chapter. 7.2 Contractual framework Settlement netting in this service is only supplied for transactions resulting from SETS trades where LCH is one of the settlement participants, ie for the market-side settlements. There are two different models of settlement that are used and different issues arise in the two of them. 1. Settlement between LCH and a Clearing Member. 2. Direct settlement between LCH and a Non-Clearing Member. These are described further below. In either case, participants could be making use of settlement agents. In the interests of simplicity, this situation is ignored in the description below, except where it is significant. LCH and its clearing members will continue to be acting as principals to all the relevant contracts Settlement with a clearing member Here the settlement chain replicates the contractual chain as shown in the diagram below. The diagram shows the most complex case, where the clearing member is a GCM and there is a client of an NCM involved in the trade. The contracts on the diagram (and on the diagrams in sections and 7.4 are the contracts for purchase or sale of securities that result from a trade on SETS. There are other contracts between the participants relating to the supply of the central counterparty service, but these are not shown on the diagrams. 22

25 LCH GCM NCM Client Contract Settlement The service provides (optional) netting of the settlement between LCH and the clearing member. The settlements between the clearing member and further participants in the contractual chain are not created by this service but must be entered by the participants Direct settlement with a non-clearing member Here the settlement chain bypasses part of the contractual chain, ie where the clearing member only provides risk management services and does not wish to provide settlement services as well. This is shown in the diagram below. The diagram shows the more complex case, where the clearing member is a GCM and there is a client of an NCM involved in the trade, in this example as principal counterparty to the NCM. LCH GCM NCM Client Contract Settlement Where there is direct settlement between LCH and the participant beyond the clearing member in the contractual chain (eg the NCM in the diagram above), then in legal terms: (1) the NCM is settling its own contract(s) with the GCM; and (2)the NCM is also acting as a settlement agent for the clearing member (GCM) and settling the GCM s contracts with LCH. This is nothing to do with whether the NCM is acting in an agent or principal capacity when trading, although in this case the contractual structure shown in the diagram is one where the NCM is acting as what is known as a riskless principal. For a description of the analogous situation where the NCM is acting as an agent, see section

26 The service will provide (optional) netting of the settlement between LCH and its settlement counterparty, ie the NCM in the example. 7.3 Use of settlement agents A trading participant can make use of a CREST participant as a settlement agent. It should be noted that where an Exchange member firm enters orders into SETS under its own BIC code but uses a Model B settlement agent, it is the settlement agent that is actually the NCM and is the contracting counterparty to the GCM, not the Exchange member firm. In other words, for the purpose of the diagram in section 7.2.2, the NCM (as the Model B settlement agent) is actually doing its own settlement and not making use of a separate settlement agent. This situation will not change as a result of the introduction of settlement netting, but there will be some related impacts that affect the ability of settlement agents to have one net settlement with LCH on behalf of multiple clients, see section Agency netting Within the clearing structure, only NCMs can act as agents in effecting trades, and this does not change as a result of settlement netting. GCMs always act as the principal counterparty to LCH and, if an NCM is trading as agent, the GCM is also acting as the principal counterparty to the underlying clients of the NCM. Agency trades can be netted with each other, although not with principal trades of that NCM. However, in order to achieve the netting of agency trades, the consent of the underlying clients is required. This is because the net settlement fulfils the GCM s obligations to the NCM s clients, as the contracting principals in respect of the underlying gross transactions. The legal background to this is described in more detail in the CREST Green Book on Settlement Netting dated January The mechanism for achieving client consent is still being reviewed. As described in section 7.2, the service does not net the settlement between an agent NCM and its client. The client s contractual counterparty is actually the GCM (the NCM acted as an agent in creating this contract on behalf of its client). If settlement occurs directly from LCH to the NCM (as described in section 7.2.2) and this settlement is netted, the net settlement is performing the GCM s part of the client-gcm contract, as well as the LCH-GCM contract. It is up to the NCM to allocate any stock or money due to each of its clients, whether delivered by LCH in the net settlement or by other clients. If the NCM defaults between settlement with LCH and with its clients, then the clients have claims against the liquidator of the NCM, not against the GCM (provided the client has given effective consent to the performance of the client-gcm contract by way of settlement netting in this way). This approach is similar to the current situation without settlement netting, where the client consents to the use of his assets for the account of another client of the NCM. The contractual and settlement structure where LCH settles directly with an NCM is shown in the diagram below where the contract lines are between the principals to each contract. 24

27 LCH GCM NCM Client Contract Settlement 7.5 Protecting clients safekeeping assets As set out above, participants acting as agents may be required to ensure effective protection of their clients safekeeping assets under SFA or IMRO, or, after N2, FSA rules 8. These rules prevent firms using the safekeeping assets for one client account for another client account except where the appropriate consents described in the rule have been obtained. There are three core settlement structures that agents typically use in CREST, although it should be noted that some agents combine components of these structures when setting up their settlement model. These raise different issues for ensuring the protection of clients safekeeping assets if net settlement is adopted. 1. Wash-through settlement account. In this case, the agent always settles its market-side settlements into one settlement account and the agent s own accounting records will identify the account of which client particular stock or cash are held for and should be allocated. This is typically supported by separate allocating settlements within CREST to its clients (eg by own account transfers - OATs) or outside CREST (eg stock withdrawals - STWs). With gross settlement, effective protection of client safekeeping assets can be achieved by managing the priorities of the market-side gross settlements and the client-side settlements. If the market-side settlement is netted, then effective protection of client assets may have to be achieved by managing the client-side settlements only. 2. Direct settlement to a pool nominee. In this case, the market-side settlements are directly into a pool nominee containing client stock. Netting of the market-side settlements could be regarded as effectively using one client's stock for another client's settlement. 3. Direct settlement to a designated nominee. In this case, the market-side settlements are directly into accounts in the nominee designated by customer. Settlement netting can be used in this case without mixing different clients stock or other assets, but is unlikely to be beneficial as netting between clients will not occur, thereby reducing the resultant netting efficiency. In this case, the participant would not be able to opt into automatic matching of gross transactions either, because the participant would have to specify the CREST member account on each transaction (see section 5.3). 8 See proposed Rule in the FSA Conduct of Business Sourcebook (policy statement issued in February 2001) and SFA Rule 4-102(2). 25

28 7.5.1 Partial settlement Where net settlements are split (see section 8.1) it will be important to understand how underlying clients transactions are allocated to each split. This is essentially so that the agent knows how much of each client s transactions have settled. 7.6 Netting across trading participants It is possible in some circumstances to net across business that was dealt under different BIC codes. This is likely to benefit three types of participant: 1. Those that use multiple BIC codes within an organisation (often for historic reasons), but where all the BICs represent a single legal entity. In this instance it will be possible to net all this business into a single settlement provided the participant wishes to settle the net transactions through a single CREST participant and member account. 2. Model B settlement agents that wish to net all the SETS business that they are transacting, irrespective of the underlying Exchange member firm. It should be noted that the settlement participant can control which transactions are netted together in this sort of situation by using their CREST member accounts appropriately settlement can only be across BIC codes if the resulting transactions are settling (on the market side) via the same member account. Similar client protection issues may arise here to those described in section GCMs that wish to settle back-to-back with LCH and their NCMs so that the settlement chain replicates the contractual chain (see section 7.2.1). Netting across BIC codes is not possible in other situations, such as use of a Model A settlement agent for multiple NCMs via a pooled settlement account and where settlement is direct to LCH (as described in section 7.2.2). This is because of the risk of not being able to insulate one Exchange member from the default of another. In this case the pooled settlement account cannot be used. 7.7 Books and records A key benefit of settlement netting for many market participants is the ability to close down trades in their front office systems and reduce the scale of their downstream processing. This requires passing only the net transactions to their accounting systems supporting their balance sheet. Although equity contracts are on balance sheet items, advice received so far indicates that, assuming the conditions of FRS 5 Reporting the Substance of Transactions are met, it should be possible to apply the net transactions only to balance sheets, although this will depend on the opinions of firms own individual advisers. Similar treatment should also be available under GAAP. Participants should take their own advice in this area as there may be particular circumstances that mean that this advice is not correct in some cases. However, the following paragraphs provide some general background information. FRS5 includes the requirement that debit and credit balances should be aggregated into a single net item, only where conditions are met which ensure that the records represent the close-out position of the entity, in the event of the default of its counterparty. In fact the default rules of both LCH and the Exchange support the close-out netting of principal contracts, although some of the 26

29 technicalities of the close-out differ eg the price at which contracts are valued. In the LCH default rules, regulation 39A defines the rights of clearing members to net their open contracts with LCH, if LCH were to default. The Exchange default rules define similar rights in relation to principal contracts between GCMs and NCMs. When calculating regulatory capital, for credit risk relating to delivery against payment cash equity transactions, there is no impact on Counterparty Risk Requirement (CRR) until five days after intended settlement date 9. (Position Risk requirement PRR does apply from trade date but is independent of the nature of settlement.) FSA rules allow offset in the calculation of CRR on failed trades with the same counterparty as long as certain requirements are met in the event of default of that counterparty, including the contractual rights to close-out net 10. Consequently the introduction of settlement netting is not anticipated to change the basis of calculating CRR, since the default rules of LCH and the Exchange in relation to principal contracts already support these rights of offset. FSA also have a series of rules relating to the keeping of financial and accounting records 11. These require regulated market participants to have an audit trail that allows any balance potentially to be dis-aggregated into each of the individual underlying transactions. In other words market participants will have to keep records of the individual trades, although this need not be a balance sheet accounting record, but could be for example a back office or front office record. Put another way, if participants do not wish to process every trade through their downstream systems, then, subject to the advice of their own advisers, it would appear that the existing accounting and regulatory standards would support this approach. 7.8 Default More details on default handling will be published as part of the Exchange draft rule and regulation changes in Q and LCH rule and regulation changes in Q Default of a clearing member There is no proposed change to the handling of the default of a clearing member as the result of introducing settlement netting. This is covered by LCH s default rules in relation to the contracts between the clearing member and LCH; and is covered by the Exchange s rules in relation to the contracts between the clearing members and the NCM (or its clients) Default of a Non-Clearing Member If a Non-Clearing Member (NCM) that was taking part in settlement netting defaulted, then unsettled net agency settlements would not be settled net. Instead, the default process would work from the underlying gross transactions. In other ways, there is no proposed change to the Exchange s handling of default of an NCM and if the NCM is acting as principal the Exchange s close-out default rules apply. 9 SFA Rule (1) 10 SFA Rules (10) and (4) 11 SFA Rules 3-10 to

30 7.8.3 Default of a client There is no proposed change to the handling of the default of a client as the result of introducing settlement netting Impact of splits of net settlements If a net settlement has been split and one split has settled while another has not, new Exchange allocation rules will determine the proportions of underlying transactions that have settled. These will apply where the net settlement includes trades dealt under different BIC codes see section 7.6) and where agency trades have been netted together for settlement (see section 7.4). The allowable approaches to netting across BIC codes described in section 7.6 are intended to minimise the possibility that the default of one participant will affect other participants. 28

31 8 Settlement Settlement is not materially changed except as specifically noted in this chapter. 8.1 Splits Participants will be able to split net settlements in the same way as gross settlements. There are two obvious reasons why a participant might want to do this, although the use of splits is not restricted to these two reasons. 1. To enable partial settlement if there has been a fail, see section To allow more than one option when electing in a corporate event, see chapter 9. Whichever reason applies, one issue for participants is the allocation of underlying gross trades to the resulting shapes, although this may only be an issue in practice for agency trades 12. It is not necessary (and indeed there are no facilities) for participants to inform CREST of this allocation, which only becomes important if the participant defaults in a situation where some, but not all, of the shapes have settled; see section Settlement The basic process of settlement remains unchanged for settlement netting. It should be noted that net settlements are still stock and cash movements consistent with final and irrevocable delivery vs payment in CREST, eliminating settlement risk. See section for examples of how the net settlement is calculated and the resulting stock and cash movements. 8.3 Settlement management Settlements efficiency is very important in a net settlement environment. The intended approach to managing late settlements will be to use a combination of the following methods. CREST settlement discipline regime Buying-in Splitting net settlements if only a partial delivery is possible Stock borrowing Interest claims. These are described in more detail below. 12 The Exchange intends to provide an allocation algorithm in its rules to define which underlying transactions are included in which split in situations, such as participant default, where this becomes important. 29

32 8.3.1 CREST settlement discipline regime This will operate in the same way for all participants, whether they take part in netting or not. However, the impact of settlement netting means that participants that opt in to one or more parts of the service could find that this changes the impact of the regime on their business. If a participant opts not to have to match transactions (either at gross or net level), then these pre-matched instructions will be ignored for the purpose of calculating the participant s matching performance ie only those transactions that are (or should be) explicitly matched count towards the participant s performance. A participant that opts into netting will settle fewer transactions than otherwise. The settlement performance measure for such a participant will thus be weighted more towards non-sets business. It is possible that changes to this regime will be introduced for central counterparty settlements. Any such changes will require approval by the CREST Settlement Discipline Committee. Market participants will be notified of any changes Buying-in Exchange member firms will continue to be able to request buying-in irrespective of whether they take part in netting or not. Because, under netting, there is no longer a direct link between bought and sold settlements across LCH, the Exchange will generally buy in against the oldest unsettled sale to LCH in order to meet the buying-in request. If the buying-in request proceeds through to an actual buy-in, then LCH will ensure onward delivery on the intended settlement date of the buy-in to the purchaser Splitting Market participants with outstanding net sales holding only some of the stock should split the net settlement to allow as much to settle as possible. This will use the standard CREST splitting functionality. LCH will also make use of splits if they hold some stock but not enough to be able to deliver an outstanding settlement in full. It is intended that LCH would only use this facility at defined points in the settlement day. However, LCH may split large positions at any time if, in their judgement, this would improve their or the market s settlement efficiency Stock borrowing Market participants are encouraged to borrow stock to meet outstanding settlements just as they do today Interest claims LCH will continue to make use of the CREST interest claim facility to recover the cost of funding stock positions that are not delivered on as a result of the buyer being in technical default (ie not having sufficient cash to take delivery). 30

33 9 Corporate events Most corporate event processing remains unchanged by the introduction of settlement netting. This chapter describes some specific changes that are required and describes the impact of netting. The basic principle is that the introduction of netting should not change the entitlement of the owners of stock to benefits nor their ability to elect in optional events. 9.1 Benefits There is no change to the basic process of distributing benefits, however there will be some changes to claims handling. Claims will be raised as soon as possible so that LCH can manage the resulting risk properly. Claims will be raised on gross settlement transactions unless these transactions have already been netted, in which case the claim will be raised on the net transaction. Claims will also be raised on unmatched transactions where LCH is one of the participants. Netting only occurs on gross settlement transactions that are matched. If a participant has elected to match the gross settlement transactions explicitly, then it is possible that matching will only be achieved after the daily netting event but before the end of CREST input for the day (as described in section 6.2.1). In this case, the net transactions would not yet have been created when the claim generation process is run overnight. The consequence of this is that the resulting claims will be generated at the gross level instead of the net level. This is one reason why it is advantageous for participants to opt to treat their gross transactions as automatically matched (as described in sections 5.3 and 5.5) because this means that their claims will always be raised at a net level. Neither stock nor cash claims will be netted with each other or with other transaction types. However, for participants using settlement netting, the number of claims will be lower because claims will normally be generated from their net settlements. CREST is also intending to introduce new processing for handling the optionality in some scrip dividend distributions at the same time as the introduction of the settlement netting service. More details on this area will be made available by CREST in a forthcoming consultation. 9.2 Corporate actions There is no change to the basic processing of corporate actions, however some of the actions will be performed at the net level. It should be noted that the central systems will not explode out the net transactions back to the gross level if a corporate event arises. The impact of netting on transformations and elections is described below Transformations In general, transformations will be generated as described below. 31

34 Gross settlements not due for netting will be transformed as normal. Net settlements will be transformed like other settlements, but see note below on rounding issues. Transforming a net settlement does not make it eligible for further netting. There will be some timing issues where participants have not opted for automatic matching; these will be described in detail in the CREST white book. Transformations sometimes involve rounding and fractions, eg three outcome shares for every two underlying. Therefore where a transformation is carried out on a net transaction, the result could be different from if the transformation had been carried out on the underlying gross transactions. This could cause issues for participants where they have related gross settlements with clients which have also been transformed 13. This arises because even where participants have flat settlement positions, due to the shapes of different open settlements, out-turn settlements after transformation and rounding may not themselves result in a flat settlement position. This issue will be dealt with under LCH and Exchange rules which will ensure that LCH does not acquire principal positions as a result of transformations Optional events Buyer instructions in optional corporate events can be made on net settlements, just like other settlements. If the corporate event has options, then there will be instances where a participant wishes to elect in different ways on different parts of the net settlement because of instructions from underlying clients or proprietary trading decisions. In this case, it is proposed that the participant splits the net settlement into appropriate shapes to allow this. However, if the net settlement has both purchases and sales within it, it can be less straightforward to generate suitable shapes. Participants will have to ensure that client sales are also delivered to it in such a way as to ensure that purchasers (including LCH) will be satisfied. More detail on this area will be published along with the draft rule changes in Q Similar issues will result from some claims as well. 32

35 10 Risk management There will be no change to the calculation of margin as a result of the introduction of settlement netting. This is because LCH already margins based on the net positions of its members, relying on its ability to perform close-out netting in the event of their default. It makes no difference to LCH in this calculation whether the participant is actually settling net or not. LCH will keep the margin parameters under review, in particular the assumption that transactions settle early on their due date. If the settlement performance of net transactions is materially worse than that for gross transactions, then the margin parameters might have to be changed to cover the resulting increase in risk. There will be no change to either the change to the process of making margin calls or the methods by which LCH members provide collateral as cover. 33

36 11 Reporting to members Exchange and LCH reporting to participants relating to SETS trades and the use of the central counterparty is not changing as a result of settlement netting. The only changes are to CREST information. The CREST changes will be described in more detail in the CREST White Book on Settlement Netting. This chapter provides an overview Standing data CREST will hold additional standing data to show which participants are taking up which options, as described in chapter 5. This data will be visible to participants to enable them to check their options Transaction data and reconciliation The result of the optionality described in chapter 5 is that, for participants that make use of any of the optional components of the service, the lifecycle of their transactions changes to a greater or lesser extent. The CREST White Book will explain the actual status values etc that will be applied in each case. CREST provides the following reconciliation facilities, which can be used in combination. These facilities will be available to both settlement and clearing participants. The ability for the participant to calculate the net settlement themselves and reconcile with the CREST calculation using the Net Transaction Id and the underlying Trade Codes (UTIs) from SETS on the gross transactions. Links from the underlying gross transaction to the resulting net transaction: in particular, the gross transaction will have the transaction id of the net transaction added to it. This will be visible on enquiries from CREST. If a net transaction is split, then the standard CREST functionality will retain an audit trail from the resulting transactions to the one that was split. 34

37 12 Stamp duty and regulatory reporting This chapter outlines the impact of settlement netting on stamp duty and transaction reporting. More detail will be published in the CREST White Book on settlement netting Stamp duty and SDRT UK stamp duty and SDRT Stamp Duty Reserve Tax ( SDRT ) is calculated based on matched transactions in CREST. With the introduction of the settlement netting service, this will be assessed on the gross transactions. SDRT will be applied to the gross transactions irrespective of whether they are automatically matched or not. Intermediary reliefs will continue to be applied as now and CREST will populate SDRT fields on the gross transactions using the trade information received from SETS. The fields will be completed according to existing market practice and the gross transactions will then be assessed for SDRT by the Stamp Processing Unit. CREST will send transaction reports to the Inland Revenue for every transaction assessed by the Stamp Processing Unit irrespective of whether it was automatically matched or not. For participants that opt for automatic matching of gross transactions, this will remove the ability to specify reliefs or exemptions on a transaction-by-transaction basis, eg for charities. These reliefs will have to be applied for separately. CREST will publish more details about this in due course. The calculation and collection of stamp duty will not change as it is only SDRT that is impacted by settlement netting Ireland stamp duty Discussions are being held with the Irish Revenue Commissioners regarding how Irish stamp duty might operate in a netted environment. The relevant legislation was not written with a net settlement environment in mind. It is possible that Irish securities would have to be initially excluded from settlement netting. More detail on this will be published when it is available. The same issues about transaction-by-transaction reliefs and exemptions also apply to Irish stamp duty as for SDRT Regulatory reporting Both the Exchange and FSA collect data known as transaction reports and this is usually done (for SETS trades) as part of participants inputs into CREST. A participant that opted not to match the gross transactions would no longer have the ability to provide this data by this means. However, the existence of the link from SETS to CREST put in place as part of the initial central counterparty project allows for a re-examination of the means and necessity of certain elements of transaction reporting. The conclusions of this are as follows. 35

38 Exchange member firms will no longer have to enter market-side transaction reports to the Exchange or FSA for trades fed directly from SETS to CREST. CREST will have sufficient information to supply the Exchange and FSA without further participant input. However, participants can still choose to enter transaction report information on their market-side inputs if they choose to match the gross transactions in CREST. Where participants would have used the market-side transaction report to supply a client reference (ie where they had one and only one client), but are treating the market-side transaction as automatically matched, then the client reference should be supplied on a client-side transaction report. Participants will be unable to input additional information to automatically matched trades and the Exchange is still considering how participants should link their client-side reports to these. Where there is more than one client, there is already a requirement to provide client-side transaction reports with the client references on them this requirement will not change. It should also be noted that there is no requirement to transaction report net settlements, although they are still classified as on-exchange business. Further guidance will be published by the Exchange during Q