Clearing, Custody, and Settlement
• 10 min
• 10 min
Congratulations, you’ve picked a great week to join us for this adventure!
We recently covered topics relating to trading so it only makes sense to talk about what happens after a trade is completed, also known as clearing, settlement, and custody. Note that there are hundreds of (very long!) books written about this process so we’ll try to keep this very high-level since you probably have plans tonight!
The ultimate goal of clearing and settlement is for a buyer in a trade to receive the securities and for the seller to receive the money.
The process of comparing trades (reconciliation), and confirming the details of a transaction in a security between two parties is known as clearing. There are several players involved in this process: the buyer and seller of the securities (counterparties), their brokers (broker-dealers), their clearing firms, and the exchange where the trade took place.
Clearing firms receive “end of day” (EOD) reports from broker-dealers (aka correspondents) and exchanges detailing all of the completed trades. “Post-trade” processing systems compare the broker-dealer’s and exchange’s reports against one another to ensure proper matching of trades. Once everything checks out, the clearing firm sends a report to the central clearing house and we move on to settlement.
Before we move any further, we need to clarify a few things:
- Broker-dealers don’t actually hold their client’s securities or cash - they are simply intermediaries.
- Securities CAN be held by a clearing firm, but in the U.S. equity markets, they are held by the Depository Trust Company (DTC), which acts as a central clearing house for all clearing firms.
- Cash is held by...you guessed it, a bank.
Settlement is the process of taking instructions from different clearing firms, comparing the information to make sure it matches, and then actually changing the ownership of securities in the DTC electronic ledger (called electronic book entry). You may have heard that trade settlement in the U.S. equity markets takes 3 days (known as T+3 settlement), and now you know why it takes so long!
In addition to updating the electronic records of who owns the securities, DTC is responsible for sending settlement instructions to different banks that hold cash on behalf of clearing firms. Settlement instructions simply tell one bank to move money to another to pay for the securities that have changed ownership as a result of a trade. This is done via a Fedwire.
Once the securities have “settled” and the money has been moved, the process is over, and we have achieved custody finality, meaning the buyer in the trade has custody of the securities, and the seller has custody of the cash.
Adding Blockchain Securities to the Mix
Contrary to what you may be thinking, the “BS” in the Weekly BS stands for blockchain securities. Therefore we need to explain a few essential things about how clearing, settlement, and custody is different with blockchain securities.
Remember T+3 settlement? Well using a blockchain (a general ledger, smart contracts and a digital wallet system) dramatically reduces the time for settlement, allowing for same-day settlement.
Same-day settlement means that banks don’t hold your money for three days, but rather that settlement is reached on the day the trade is executed. Additionally, many of the processes related to clearing and settlement can either be fully automated or simplified. This is important because most trading fees (commission fees, broker fees, clearing fees, DTC/NSCC fee, etc.) are a result of the process being complex, manual, and time-consuming. On a blockchain, the only fee that needs to be paid is the reward to the validator or miner for updating the ledger - that’s called Gas, and that’s what we’ll cover next week.