Trading debt securities in capital markets involves several steps before the electronic transfer of ownership from one owner to another is complete. For ownership to pass from seller to buyer, a process of “clearing” and “settlement” must take place. The terms “clearing” and “settlement” are often used interchangeably. However, they represent separate processes.
Steps Involved in Clearing and Settlement
Once the parties have executed a corporate action, the clearing and settlement processes begin. It involves several sequential actions.
- Confirmation: There is a confirmation of a sale of securities of a determined amount at a given price between the buyer and the seller.
- Clearing: The buyer and the seller receive documentation to establish their obligations. The netting process takes place before settlement begins.
- Rules: The settlement process involves the delivery of securities from the seller to the buyer and the delivery of funds from the buyer to the seller. Although clearing and settlement can take place on the same day, the delay may be longer depending on the complexity of the transaction.
- Payment: Payment is made through the Fedwire system of the Federal Reserve. The system assigns a reference number to confirm receipt of funds.
- Delivery: DTC’s Electronic Account Enrollment System issues and credits the appropriate account.
Depository Trust Company (DTC)
the Depository trust company, or DTC, is one of the largest securities depositories in the world. DTC facilitates the clearing and settlement of securities transactions. To do this, it maintains a “book-entry” system. It is an electronic method of maintaining records, as opposed to issuing physical security certificates.
Companies eligible for the DTC have access to Fast Automated Securities Transfer (FAST) Processing. This service allows companies, security holders, brokers and other parties to electronically transfer securities between DTC participants in an expedited manner.
DTC also acts as a custodian and holds physical security certificates on behalf of brokers, traders and banks. DTC appoints Cede & Company as the depository agent for DTC. Debt securities are represented by the issuance of global notes, generally registered in the name of Cede & Company’s agent for DTC.
DTC is a subsidiary of The Depository Trust & Clearing Corporation (DTCC), a securities holding company. Not all securities are eligible for settlement via DTC. To be a DTC Participant, a company, broker, bank or other entity must have an account with DTC.
Euroclear and Clearstream
In Europe, the two largest clearing systems are Euroclear and Clearstream. Similar to DTC in the United States, Euroclear and Clearstream provide settlement services for securities. Both services operate electronic book-entry transfer systems. This eliminates the need for physical certificates.
A series of steps facilitate cross-market transactions between DTC and Euroclear or Clearstream participants. The settlement process generally takes longer for cross-market trades.
Debt Clearing and Settlement Trading Mechanisms
There are two methods of transferring securities between brokers/dealers and DTC—the Deposit/Withdraw to Custodian (DWAC) process and the Direct Registry System (DRS). Both use the FAST system. The electronic format of securities transfers offers investors efficiency and savings.
Both systems allow securities to be held “on the books” by a transfer agent. A transfer agent is usually a trust company or bank that records transactions and maintains investors’ financial records. In other words, they act as an intermediary between the company registrar and the investors.
Deposit/Withdraw With Custodian (DWAC) offers investors efficiency and cost savings. As an electronic stock transfer system, the DWAC process minimizes delays. The fact that the DWAC process does not involve the transfer of physical certificates speeds up the settlement process.
The Direct Registry System (DRS) also allows investors to hold their securities in book-entry form with a transfer agent. This enables the transparent clearing and settlement of shares in electronic form. The main distinguishing factor is that DWAC filings require a Medallion Guaranteed Stock Power while DRS filings are paperless. A Medallion Guaranteed Stock Power is a special certification stamp on a stock certificate that confirms its authenticity. This locket signature guarantee may be waived under certain circumstances.
In order for a company to have its securities settled through DTC, it must have a representations letter on file. A letter of representations is a standardized agreement that outlines the terms under which DTC will act as depository for the company.