Current Legal Issues Affecting Central Banks, Volume IV.

26C. Securities Clearance and Settlement

Robert Effros
Published Date:
April 1997
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The Importance of Securities Clearance and Settlement

Two stories illustrate why securities clearance and settlement should be of interest to central banks, as well as to securities regulators. They demonstrate that problems in these areas, if not promptly and satisfactorily resolved, may cause problems for a country’s whole financial system.

Hong Kong

The first story is set in Hong Kong in October 1987. The Hong Kong stock market, like many others around the world, was booming. Trading was active not only in equities but also in a relatively new instrument, futures on the Hang Seng index. Many local individual investors were betting that the market would continue to rise and were thus long in futures. Foreign institutional investors were generally short in futures, hedging their stock portfolios. Trading in these futures contracts was so active that, in terms of the number of contracts traded, volume in Hong Kong was second only to volume in Chicago.

On Monday, October 19, the Hang Seng Index declined by 11 percent. Later that day, the Dow Jones industrial average fell by an amazing 22 percent. When this news reached Hong Kong, early in the morning of Tuesday, October 20, the Hong Kong Stock Exchange decided to close for the remainder of the week. One reason that the stock exchange cited for closing was the large backlog of unsettled share trades. (Settlement at that time was done trade by trade, between brokers, by delivery of a share certificate against a check. Delays and backlogs were common.) Many believed, however, that the real reason that the stock exchange closed was to attempt to save the local Chinese investors from financial ruin in the futures exchange.

Many of these Chinese investors, who were long in futures, did not pay the margin calls that they received on October 19–20. In turn, many of the futures brokerage firms, small firms without much capital, did not pay the margin that they owed to the futures clearinghouse. Thus, the clearinghouse could not pay what it owed to brokers, who were generally short in the futures market. The guarantee corporation set up to guarantee futures contracts had less than $3 million in capital. This corporation could not call upon the healthy firms for additional capital, just as they, apparently, could not call directly upon the guarantee.

On the morning of October 21, the Government, exchanges, major banks, and brokers met to discuss the problem. Some suggested that the problem could be solved by “closing out” all the outstanding futures contracts at the last price on October 19. Others pointed out that this action would force the foreign institutions to close out by sale their positions in the stock market, which would lead to a collapse in the stock market and probably to serious adverse effects for Hong Kong’s currency and economy.

After several days of discussion, a “rescue package” was agreed to late on Sunday, October 25. The package included a $250 million loan to the guarantee corporation: half of it from the Hong Kong Government’s exchange fund and half of it from major banks and brokers. Although this was called a loan, to be repaid out of transaction fees and collections from defaulting brokers, it was not at all clear on October 25 that it would be repaid.

It was also not clear whether $250 million would be sufficient to satisfy the guarantee corporation’s obligations and to allow the futures market to continue. Indeed the next day, October 26, the Hong Kong stock market declined by 33 percent, making it necessary to arrange another $250 million standby facility for the guarantee corporation. It was only on October 27 that the market “found its feet” and recovered by 7 percent. It was many months, however, before there was any significant volume of trading in the futures contract.1

New York

The second story is set in New York in February 1990. On February 13, 1990, the Drexel Burnham Lambert Group (Drexel) announced that it would file a bankruptcy petition. The announcement emphasized, however, that the bankruptcy petition would not cover Drexel’s broker-dealer or government securities subsidiaries. Later in the day, the Securities and Exchange Commission (SEC) announced that, according to Drexel’s books, the broker-dealer subsidiary still had a positive net worth and was still in compliance with the SEC’s net capital rule. The Federal Reserve Bank of New York announced simultaneously that Drexel’s government securities subsidiary remained a primary dealer in good standing in the government securities market.

At this point, the SEC, the Federal Reserve, and Drexel all wanted to see an orderly liquidation of Drexel’s securities portfolio and an orderly transfer of its customer accounts to other firms. This process, however, was hindered by problems in the clearance and settlement system.

Drexel had pledged much of its securities portfolio to its lender banks; accordingly, it needed to obtain releases of this collateral from its banks to deliver securities in settlement. Drexel’s banks, however, were unwilling to release the collateral. Indeed, in part because of legal uncertainty about the effect of a pledge on Drexel’s books, many of Drexel’s banks insisted that Drexel start to record pledges on the books of The Depository Trust Company. This demand made it essentially impossible for Drexel to settle its securities trades, many of which were liquidating trades, in the normal way.

A similar problem occurred with Drexe Ps portfolio of mortgage-backed securities. In 1990, trades in certain types of mortgage-backed securities settled only once a month, through delivery of a certificate in return for a wire transfer later in the day. However, on February 14, 1990—the day after Drexel filed for bankruptcy—$3.3 billion worth of trades between Drexel and other government securities dealers did not settle. In part, this was because few firms had provided Drexel with the standard two-day notice as to what securities they would deliver to Drexel on February 14. Also, firms were unwilling to follow the standard practice of delivering a negotiable certificate to Drexel in return for a wire transfer later in the day.

These problems created serious risks that Drexe Ps financial difficulties would cause financial difficulties for other securities firms. They also raised the prospect of “financial gridlock,” with no bank or securities firm willing to extend customary credit to any other firm, for fear that it, like Drexel, was about to file for bankruptcy.

Fortunately, Drexel, the banks, the brokers, the SEC, and the Federal Reserve were able to work out the problems. The problem of the pledged securities was solved by an agreement among Drexel and its banks on February 19, 1990. This agreement allowed for settlement of approximately $260 million in liquidation transactions, segregation of $40 million in customers securities that were fully paid for, and reduction of the outstanding loans to the banks through the proceeds of these transactions. The problem of the mortgage-backed securities was solved when Goldman Sachs purchased Drexel’s entire mortgage-backed securities portfolio. Goldman Sachs then settled the failed settlements and liquidated the portfolio.2

Reducing the Risks Involved in Securities Clearance and Settlement

These stories illustrate that the legal and practical aspects of securities clearance and settlement are important. What, however, can be done to reduce the risks involved in the securities clearance and settlement system? In particular, what can be done to reduce the risk that problems in the securities clearance and settlement system will cause problems for a country’s whole financial system?

Unfortunately, there is no simple answer or set of answers. Perhaps the closest thing to an agreed agenda is the March 1989 report of the Group of Thirty, with its nine recommendations for strengthening securities clearance and settlement systems.3 Each of these recommendations, however, raises its own issues, many of which are specific to the practices or laws of a particular country. Rather than attempt a catalog of issues, one can focus on three issues that seem both significant and universal: shortening the settlement cycle, demobilizing or dematerializing securities, and creating or improving netting transactions.

Shortening the Settlement Period

One way to reduce the risk in the clearance and settlement system is to shorten the settlement period (the period between trade date and settlement date). A shorter settlement cycle reduces the number of trades that, at any one time, are still outstanding and unsettled; it also tends to reduce the disparity between the trade price and the price on the settlement date, which, in turn, reduces market risk. The National Securities Clearing Corporation, the major clearinghouse for equity securities in the United States, estimated in 1992 that moving from the then current five-day settlement cycle to a three-day settlement cycle would reduce the National Securities Clearing Corporation’s market risk by almost $200 million in the event of a failure of a major securities firm during a market crisis.4

A shorter settlement cycle, however, has costs. In the United States, some securities firms fear that a shorter cycle would make it impossible for customers to buy securities in the way that many normally do: by placing their order by telephone, receiving a confirmation by mail, and then sending a check by mail. Meanwhile, some securities customers are concerned that a shorter settlement cycle would make it impossible for them to hold securities in the way that they normally do, in physical certificates at their banks. Others point out, however, that there are ways around these problems. Customers could deposit funds with brokers before placing buy orders or return the certificates to the broker before placing sell orders.

The SEC resolved this issue through a compromise: it arranged for a long transition to a shorter settlement cycle. The SEC rule establishes three business days as the standard settlement cycle for equity securities transactions in the United States.5 The rule, however, did not take effect until June 1995.6 The SEC explained that the long transition period would allow for both the development of new systems and, perhaps more important, for the education of participants and customers about the rule and systems.7

Demobilizing or Dematerializing Securities

A second way to strengthen the settlement system is to “demobilize” or dematerialize securities. The demobilization of securities is somewhat different from the demobilization of an army. In the case of an army, demobilization takes people who are organized in military units and sends them to their separate homes. In the case of securities, demobilization takes securities certificates that are spread around the country and brings them into one home, a central securities depository. It is sometimes described, perhaps more aptly, as “immobilization.”

Once securities are in a depository, they can be transferred or pledged by entries on the books of the depository. This simplifies true delivery against payment, in which electronic payment and delivery occur simultaneously. Demobilization also reduces the risks involved in the physical transfer of securities certificates. If thousands of securities certificates are delivered or mailed every day, some of them will be lost or stolen. However, demobilization also creates some new issues. For example, it is often necessary to amend the relevant commercial code to address the transfer or pledge of securities that are on deposit and thus cannot be delivered in the traditional sense. In the United States, revisions to the Uniform Commercial Code have been drafted in order to accommodate the transferring or pledging of dematerialized securities.8

“Dematerialization” is not confined to science fiction; in the securities markets, it is the process of moving from paper securities certificates to electronic records of securities ownership. Dematerialization allows securities to be transferred by electronic entries on the books of the issuer or its agent. In the United States, for example, most U.S. treasury securities are issued only in “book-entry” form; there is no certificate, only a record of ownership on the books of the Federal Reserve Bank of New York. Mutual fund shares are also issued only in book-entry form; investors receive statements only, and not certificates.

Although many individual investors in the United States own one or more of these “uncertificated” securities, some individual investors still want the ability to obtain physical certificates for their common stock. In moving to a three-day settlement cycle, the SEC has reassured investors that three-day settlement will not make it impossible for them to obtain share certificates. One of the great strengths of the U.S. equity market is the active participation of individuals—over 50 million at last count. The SEC wants to encourage individual participation in the market, but it also wants to create a settlement system that is safe for all participants.

Netting Systems

A third way to strengthen the clearance and settlement system is to create or improve netting systems. The simplest form of netting is bilateral. Rather than settle each securities trade separately, two firms net all their trades in each security, so that one of them delivers to the other only the net position in the security. The firms also net their obligations to deliver funds, so that rather than exchanging large sums, one firm delivers a comparatively small net sum.

Bilateral netting among firms reduces the number of securities and funds transfers, but it still requires daily transfers among all the active firms. Many securities markets now use continuous net settlement, through a central clearinghouse, to reduce the number and increase the security of transfers. In a continuous net settlement system, each firm’s obligation to each other firm becomes, at some defined point, an obligation to the clearinghouse. The clearinghouse continuously nets all these obligations; each day, it transfers to, or receives from, each firm a net amount of each security. The clearinghouse also transfers to, or receives from, each firm the net amount of cash due daily or more frequently.

Continuous net settlement solves many problems but raises others. For example, transforming obligations among firms to obligations between firms and a clearinghouse eliminates the need for firms to assess the credit of each of their counterparties. However, it makes it imperative, as the Hong Kong experience demonstrates, that the clearinghouse itself have unquestionable credit. It also becomes imperative that the clearinghouse have adequate information about the creditworthiness of its member firms. The proliferation of products, markets, and clearinghouses may make this difficult. The National Securities Clearing Corporation, for example, may have complete information about a member firm’s positions in U.S. equity securities but little or no information about its positions in overseas equities or over-the-counter (OTC) derivatives.

Derivatives show why the task of strengthening the clearance and settlement system never ends. Although the instruments themselves are often quite complex, the settlement system for OTC derivative transactions is quite primitive. Transactions settle firm by firm, often transaction by transaction, through fund and in some cases securities transfers. This means, as many have pointed out, that participants may use OTC derivatives to reduce market risks, such as the risk of a shift in two interest rates; however, this benefit often comes at the cost of increased credit risk, namely, the risk that the counterparty will fail between the initiation and the end of the interest rate swap agreement. Clearly, as the OTC market continues to grow, participants and regulators need to focus on improving the clearance and settlement system for this market. Two areas to consider are the standardization of agreements and the creation of netting arrangements.


The securities clearance and settlement system is important to both securities regulators and central bankers. The issues involved in improving the clearance and settlement system are not only practical but also legal. Lawyers are important in this process because good lawyers raise the unpleasant hypothetical questions that must be raised and answered to improve the clearance and settlement system. The issues involved also have a political dimension: the costs of improving the securities clearance and settlement system are often immediate and concentrated, while the benefits of such improvements may seem distant and diffuse. Securities regulators and central banks must be involved in these political issues. Without disregarding the costs involved in improving the clearance and settlement system and without overstating the risks, regulators and bankers must work together to improve the clearance and settlement system and to educate the public and interested parties about it.



This comment addresses (i) the project in the United States for the reform of private law concerning the transfer of interests in investment property, such as securities, and (ii) how reform and harmonization of this area of the law might be addressed on the international level.

U.S. Rules for Transferring Security Interests in Investment Securities

The sponsors of the Uniform Commercial Code (UCC) promulgated a revised version of UCC Article 8 (Revised Article 8) in 1994, accompanied by related revisions of Article 9.1 Revised Article 8 and the related Article 9 revisions, dealing with security interests in investment securities, came before the membership of the American Law Institute at its annual meeting in May 1994; the revisions also came before the membership of the National Conference of Commissioners on Uniform State Laws in August 1994.2

For several reasons, the drafting committee faced an enormous challenge in undertaking this private law reform project. Revised Article 8 codifies the private law for a type of property that the current law addresses only obliquely—claims to securities controlled by an intermediary, such as a broker or bank. The principal goal of revised Article 8 is thus to provide a new legal framework for the indirect holding system that has developed in this country.

In the United States today, most publicly traded shares on the exchanges and the over-the-counter market are held in a nominee name used by The Depository Trust Company. This company acts as a depository, holding physical securities for the benefit of some 600 participating broker-dealers and banks. The use of this common depository eliminates the need for physical deliveries between these parties incident to their trading activities. Entries are made on the depository’s books for net changes in the positions of each participant at the end of each day by the National Securities Clearing Corporation. The broker-dealers and banks that participate in this system provide, in turn, analogous clearance and settlement functions to their own customers. This system is called the indirect holding system because the corporate issuer’s records do not show the identity of the beneficial owners of the securities. Instead, a sub-stantial part of the outstanding securities of a given issue are recorded by the issuer as belonging to a depository, the records of the depository show the identity of the banks and brokers, and the records of these securities intermediaries show the identity of their customers. The advantages of the system include the elimination of the need for physical deliveries of securities and, as a consequence of the netting of transactions between participants, a significant reduction in the number of entries that would have to be made on the depository’s books if each transaction between the participants had to be recorded separately.

The newly revised law deals with these complex, arcane, and constantly changing financial market systems and practices and financial assets. Moreover, these new rules, intended for enactment by the various states, are written in the presence of comprehensive federal regulatory schemes for securities intermediaries. Revised Article 8 will achieve its purposes only if it is clear and accessible both to business lawyers generally and to the experts on financial markets.

International Harmonization of Rules for Transferring Security Interests in Investment Securities

It may be suggested that rules of this sort might be appropriate for other countries that wish to improve the efficiency of their financial markets. Two general observations can be made about the prospects for the international harmonization of rules relating to investment securities. The first concerns the “who,” and the second relates to the “how” and “what” of this harmonization. First, taking into account the highly specialized practices and ever-changing landscape of the financial markets, the more traditional sponsors of projects for harmonizing private international law—the United Nations Commission on International Trade Law, the International Institute for the Unification of Private Law, and the Hague Conference—are not likely candidates for sponsoring harmonization in the area of securities transfers. It was difficult enough to locate and involve the necessary expertise to pursue the Article 8 revisions in the United States. Organizations with no past involvement in the area of financial markets would probably not be up to the task.

If international harmonization of rules relating to investment securities and other investment property is to occur, the governmental regulators of the banks and securities firms in the financial markets around the world are more appropriate sponsors for the project. If a useful product were to emerge, moreover, the regulators would be well situated to encourage adoption of that product (be it a regulation, model law, or even an international convention). In this regard, the process that led to the adoption of more uniform capital adequacy rules for banking institutions may serve as a model.

Second, as for the structure of the international harmonization of investment property rules, what product might emerge from a regulatorsponsored program of harmonization? An international convention may not be feasible or wise. It would take too long, the issues are too arcane, and absolute uniformity among states is not necessary in any event. Model laws or regulations seem more appropriate, and they would be important only in the handful of states where major financial markets are located.

As to the substance of model laws or rules, it might be appropriate to limit the scope to transactions and relationships at the “wholesale” level, that is, as among the financial intermediaries, such as banks and securities firms that deal with each other in many markets and across many borders. For example, it may not be as important to harmonize the law concerning the rights of an investor as against its bank or broker. Perhaps the more important (and realistic) approach would be to develop rules that would apply only to the relationships among the intermediaries and to their rights as against clearinghouses and depositories.

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