Moving Money - Securities Settlement

In this, the last instalment in this series we take a look at the complex process behind the buying and selling of securities. I must confess this is the area I understand least well so please use this as a starting point for your own research. Nevertheless, I hope it establishes a few concepts that are helpful for you.

Bob, in the US, has invested in UK equities and now wishes to sell them. Alice in the UK wants to buy the same security. Alice transfers funds from her main bank to her trading account at her UK custodian bank ⓪. Bob instructs his broker to sell his shares and Alice instructs her broker to buy the same stock. Using a matching application the brokers agree a quantity and a price, either as an OTC (Over-The-Counter) deal directly between them or via the London Stock Exchange for a listed company.

The brokers instruct their clients' custodian banks ①,④ to authorize the trade, whilst the deal instructions are separately passed to the securities depository (CREST for UK equities) for settlement. Bob's US global custodian instructs their UK custodian to proceed ② who in turn instructs CREST ③. In parallel Alice's UK custodian does the same, also transferring the necessary funds into their settlement account with CREST. The stage is now set for the swap.

As with foreign exchange payments (described in part 3) we need to avoid the risk that one side of the transaction proceeds but the other fails. Instead of simultaneously coordinating two payments (called PvP or Payment-versus-Payment) like CLS Bank does, here we have DvP (Delivery versus Payment). In one transaction CREST makes a book transfer of the funds from Alice's custodian's settlement account to the UK custodian's settlement account whilst also redesignating ownership of the securities from Bob's custodian to Alice's custodian in its ledger ⑥. During the transfer the securities don't move - they are said to be 'immobilized' in the depository.

The transferred funds may then be sent from the UK custodian's CREST settlement account to Bob's US Custodian Bank ⑦, then on to Bob's broker's Bank ⑧ and finally transferred to Bob's bank ⑨. CREST is a member of the UK CHAPS gross settlement system so it can conduct the initial high-value transaction with finality.

For exchange-traded securities there is potentially another step in the process. Instead of the deal instruction going directly to the depository it passes to a clearing house (for UK equities this is the London Clearing House or LCH). The clearing house novates the trade, stepping into the middle and splitting the trade into two parts, becoming the buyer to Bob and the seller to Alice. It may also net transactions in the same security between counterparties, potentially resulting in a net trade for a smaller amount and with a different counterparty than Alice's and Bob's brokers originally agreed. These novated (and potentially netted) trades then pass to the depository for execution. Should any of these linked trades fail the clearing house steps in to complete the transaction for the impacted party and undertakes to resolve the default.

One thing I confess I don't fully understand is how the novated trades are executed as DvP transactions when the clearinghouse sits on the selling side of the trade. As it doesn't start the day owning any securities it isn't clear to me how these transactions proceed. Perhaps the securities purchase transactions complete first and then the sale transactions follow, with the security held in the name of the clearing house at the depository in between. If any of my readers know please comment on this article - thank you!

This completes our brief look into how money 'moves' through the financial system. Of course there are many other means to transfer value (or debt), including money service businesses, digital payment providers, cryptocurrencies and Hawala networks. If you have a topic you think I should explore please let me know. I hope you found this series helpful. I'd love to hear your feedback.