Clearance and settlement in U.S. securities markets.

CLEARANCE AND SETTLEMENT IN U.S. SECURITIES MARKETS

Patrick Parkinson and Jeff Stehm-Staff, Board of Governors Adam Gilbert, Emily Gollob, Lauren Hargraves, Richard Mead, and Mary Ann Taylor-Staff, Federal Reserve Bank of New York Prepared as a staff study in fall 1991 Interest in clearance and settlement arrangements in securities markets by the Federal Reserve and other central banks reflects an increasing awareness that disturbances in settlement processes in those markets can adversely affect the stability of payment systems and the integrity of the financial system generally. Such interest had been growing throughout the 1980s and was heightened by the worldwide collapse of equity prices in October 1987. In the United States, for example, many observers, including senior officials of the Federal Reserve, concluded that the potential for a default by a major participant in the settlement systems for equities and equity derivatives had posed the greatest threat to the financial system during that turbulent period. Concerns intensified in early 1990, when orderly liquidation of units of the Drexel Bumham Lambert Group was threatened by difficulties in settling transactions in certain mortgage-backed securities and in foreign exchange that arose when participants lost confidence that the units would fulfill their settlement obligations.

The paper presents an analytical framework for evaluating credit and liquidity risks in securities clearance and settlement arrangements and describes arrangements in place in the United States. (In this context, securities refers to a wide range of financial instruments, including securities, securities options, money market instruments, futures, and futures options.) The paper was first prepared for a December 1990 meeting of the Committee on Payment and Settlement Systems of the Central Banks of the Group of Ten Countries, and the framework it presents builds on an analysis of netting and settlement systems by the Committee on Interbank Netting Schemes of that group.

A common analytical framework is applicable to a wide range of markets and instruments for two reasons. First, credit risks in clearance and settlement stem from common factors: (1) changes in asset prices between the time a trade is initiated and the time it is settled and (2) gaps between the timing of final transfers of securities (deliveries) and final transfers of money (payments) on the settlement date. Second, similar arrangements have been designed to reduce credit risks and liquidity risks: multilateral netting systems and delivery-against-payment systems.

These arrangements involve two types of specialized financial intermediaries, collectively termed clearing organizations: (1) clearinghouses, which perform multilateral netting of purchase and sales contracts and in many cases provide trade comparison services, and (2) depositories, which immobilize or dematerialize securities and in many cases integrate a book-entry securities transfer system with a money transfer system. By integrating securities and money transfer systems, a depository can provide strong assurances to participants that final securities transfers (deliveries) will occur if, and only if, final money transfers (payments) occur, that is, it can achieve delivery against payment.

In general, the Committee on Interbank Netting Schemes' central conclusions about the effects of cross-border and multicurrency netting arrangements also apply to securities clearing organizations (and to futures clearing organizations as well). A clearing organization has the potential to substantially reduce counterparty credit and liquidity risks to its participants. However, actual risk reduction depends critically on the clearing organization's financial and operational integrity. Should participant defaults impair-or merely create doubts about-the organization's financial condition, the consequences for the organization's participants, the participants' customers and banks, and the financial and payment system could be severe.

To preserve their financial integrity and to minimize the likelihood of systemic consequences, clearing organizations have instituted risk-management systems. The systems are designed so as to (1) limit losses and liquidity pressures resulting from participant defaults, (2) ensure that settlement will be completed on schedule and any losses can be recovered from the surviving participants, and (3) provide reliable and secure operating systems to support the organization's critical functions.

Securities clearance and settlement arrangements in the United States are noteworthy for the large and growing number of separate clearing organizations serving different market segments. Across product groups, separate clearinghouses and depositories have been created for corporate and municipal securities, U.S. government securities, and mortgage-backed securities. Within product groups, cash, futures, and options transactions typically are cleared by separate clearinghouses.

The specific credit, liquidity, and operational safeguards employed by clearing organizations in the United States vary considerably. The 1987 stock market crash revealed potential problems and areas needing improvement in arrangements for clearance and settlement of equities, futures, and options. Since that time, clearing organizations for equities and equity derivatives have significantly strengthened their risk-management systems. Also since 1987, depositories designed to limit settlement risks have begun to immobilize certain mortgage-backed securities and commercial paper, and a clearinghouse has begun multilateral netting of transactions in U.S. government securities. In addition, market participants have been working on recommendations by the Group of Thirty to shorten the interval between trade and settlement of corporate securities (equities and bonds) from five to three business days and to use same-day rather than next-day funds for settlement payments.

With these improvements in place, further efforts to strengthen U.S. clearance and settlement arrangements have been directed primarily at improving coordination among clearing organizations, especially those that clear inter-related products (notably equities and equity derivatives) for common participants. Lack of coordination among clearing organizations can heighten credit and liquidity risks in at least three ways. First, lack of information about their participants' positions with other clearing organizations may hinder efforts by clearing organizations and other creditors to assess risks accurately. Second, lack of a mechanism for netting obligations across markets may expose individual clearing organizations to substantial risks from positions that would present relatively little risk if all the positions were held with a single clearing organization; clearing organizations attempting to protect themselves may require participants to post more collateral or cash than would otherwise be necessary. Third, liquidity pressures on participants in many cases are exacerbated by differences in settlement cycles or in the timing of daily settlements.

Participants tend to rely extensively on bank credit to fund their settlement obligations to the various clearing organizations, especially when markets are turbulent. Consequently, monitoring and control of credit risks by commercial banks may, to some degree, be a reasonable substitute for greater consolidation of or coordination among U.S. clearing organizations. However, the heightened demand for bank credit resulting from the fragmented clearing system increases the need to address two issues that to date have received scant attention: (1) the adequacy of available credit to support participants' settlement obligations and (2) the adequacy of banks' measures to monitor and control the credit and liquidity risks, especially intraday risks, created by the need to extend such credit.

The perception that fragmentation of the U.S. clearing system has exacerbated credit and liquidity risks led the Congress to pass legislation calling for establishment of "linked or coordinated facilities" for settling securities and derivative products. Currently there appear to be significant obstacles to consolidation of existing U.S. clearing organizations. Instead, clearing organizations, with the support and encouragement of regulators, have focused on incremental actions to improve coordination and create linkages that may achieve many of the potential benefits of consolidation. Clearing organizations have concluded several agreements to share information about common participants and have made some progress on synchronizing daily settlements. Clearinghouses in the futures and options markets have developed so-called "crossmargining" agreements intended to reduce credit and liquidity risks on intermarket positions, in one case through obligation netting and in other cases through shared control of positions and collateral. In the securities markets, each clearinghouse for corporate and municipal securities has established a payment netting scheme with its associated depository, and several organizations are discussing ways to share (and thereby reduce the need for) collateral.

In light of the growing recognition that disturbances in securities settlement systems can destabilize payment systems and financial markets, the Federal Reserve has in recent years taken a more active role in both the oversight of settlement arrangements and the provision of payment services to clearing organizations. For example, in June 1989 the Federal Reserve issued a policy statement on private delivery-against-payment systems that applies to all large-scale private book-entry systems that settle directly or indirectly over Fedwire. The policy addresses the credit, liquidity, and operational safeguards such systems must implement to ensure that settlement is timely and that participants do not face excessive intraday risks. All the clearing organizations that have been formed in recent years settle over Fedwire, either directly, or indirectly through the accounts of their settlement banks.