Clearing arrangements!!

Today I like to say few things about clearing. Clearing is an area which I started to work recently and when I started to work I had few basic doubts about various account in clearing like position account, house account, margin account and clearing arrangement between various trading brokers (fully disclosed and omnibus). Accounts are basic one which is very useful for beginners and clearing arrangement which will be very useful for everyone to understand the role of trading broker and clearing broker. Let us see in detail later.

In the earlier post I mentioned about clearing membership and it is very risky one in today finance industry. Clearing members have lot of policies and regulatory measures and because of that reason you can see many trading brokers but only few clearing brokers. I thought of understanding their roles and responsibilities so that we can understand the difficulty in playing such roles.

Few of the clearing broker’s responsibilities are

  1. extending credit in margin accounts
  2. providing written confirmations of executed orders to customers
  3. receiving or delivering funds or securities from or to customers
  4. maintaining books and records that reflect transactions, including rendering monthly or periodic statements of account to customers
  5. clearing and settling transactions effected in customer accounts
  6. opening, approving, and monitoring customer accounts

Before moving deeper, let’ just see how clearing are handled before IT system automation so that we can understand clwaerly. My usual practice is to understand the manual work style so that as an IT person I can give solution to automate. Risk comes from not knowing what you’re doing.

In olden days, if two clearing brokers have to clear trade means manually reconcile the trades between two parties and issue the confirmation then settle the trade by sharing certificates (shares) and cash. For example, if buyer broker X bought ABC Company common stock for a customer by purchasing from broker-dealer Y, X would settle the transaction directly with Y. A confirmation note would be generated by each broker for confirming the trade and then brokers will confirm their customers. After that broker X will send one person to Y location for giving cash and take stock delivery back, so that broker X can give the certificate back to the customer. Then slowly clearing world has thought of netting process because brokers have multiple trades for the same security for different customers that they moved into approach of net basis once a day i.e.) X would aggregate all transactions with Y as a counterparty, determine the total net amount bought and sold in a security, and the net amount to be received or paid for all securities.

For example, if X’s customers bought 500 shares, and sold 300 shares, of XYZ Company with Y as the counterparty broker, Y would be obligated to deliver 200 net shares to X. Likewise, the total amount to be received or paid from all transactions with a specific counter broker-dealer during the day would be netted once in a day.

Earlier I told about clearing membership is quite risky and costly as well for individuals. Every exchange has having their own capital requirements to qualify for clearing member because it involves huge transaction of money and also clearing member has to adhere to technology standards along with resource pool. The table below shows the requirement for becoming clearing member in NSE (National stock exchange of India). Because of these infrastructure and capital requirements, the number of clearing members or participants is limited.

Deposit & Networth Requirements(Individual / Partnership Firms)

DEPOSIT STRUCTURE ( in lakhs)
Segment Type of Membership Cash-NSEIL Non-Cash NSEIL Cash NSCCL Non-Cash NSCCL Total Net Worth
Capital Market TM & SCM 26.5 6 17.5 50 75
Wholesale Debt Market TM & SCM 50  50 200

* TM = Trading Membership.
* TM & SCM = Trading and Self Clearing Membership.

Fees and Charges :

  • Application Processing Fees : 10,000/- + Applicable Service Tax.
  • Admission Fees : 5,00,000/- + Applicable Service Tax
  • Annual subscription charges (Captial Market Segment):For Corporates – 1,00,000 P.A.+ Applicable Service TaxFor Individuals/Partnership Firms – 50,000 P.A.+ Applicable Service Tax

By looking at the above cost you can easily guess how difficult to become clearing member with the capital required and also IT infrastructure cost. Then question comes in mind how I can clear my trades if I am not matching the clearing member criteria because I am a wealthy individual and became direct trading member with exchange (not through broker). Either you have to become self-clearing member by above standards (which I won’t because huge money and infrastructure) or clearing arrangements.

Clearing arrangements:

There are essentially two types of clearing arrangements, namely

  1. fully disclosed
  2. omnibus

In fully disclosed clearing agreement, the trading broker discloses the identity of each of its customers to its clearing broker. The clearing broker then establishes on its books and records an account in the name of each introduced customer and “carries” that account with its own net capital.  Moreover, the clearing broker prepares trade confirmations and monthly statements for each introduced customer.

In omnibus clearing agreement, the trading broker neither discloses the identity of its customers to the clearing broker, nor its customers are informed of the existence of the omnibus clearing arrangement. An omnibus introducing firm usually maintains one “omnibus” account with its clearing broker. The omnibus introducing firm maintains its own records of its customers’ trades, provides its own trade confirmations and monthly statements to its customers and performs all “customer-side” settlement functions.

There are many accounts in clearing and I am just listing few for reference

House Account

  1. An investment account a brokerage firm uses for its own investments, rather than those on behalf of a client.
  2. An investment account in a brokerage that is large or otherwise important enough to be managed from the brokerage’s main office, often with a major executive as the broker.

 

Omnibus Account

  1. An account carried by a member firm for a non-member correspondent firm.
  2. In futures and options, an account that one broker holds with another in which all of the first broker’s sub-accounts are combined under one heading and traded in that broker’s name.

Clearing functions:

Give up:

An action where executing broker will place the trade on behalf of some other broker.

For example:  Broker X gets a buy order from a client but is too busy to place the trade, so he asks Broker Y to place the order for him/her. Broker Y then buys the stock from Broker Z on behalf of Broker X’s client. However the floor Broker Y places the trade, he must “give up” the transaction and record it as if Broker X placed the trade since the client belongs to him/her.  Thus, the transaction is recorded as if X & Z made the trade, even though Floor Broker Y executed the trade

Take up:

Take up is the action where other side of the clearing broker will do on give up. Basically if someone did give up then other side will do take up.

Exercise:

An option holder want to exercise means then he/she will inform the broker, then they will raise request to clearing house for exercising the option.

Margin:

Throughout the trading day our clearing houses monitor the positions and market exposure of each clearing member to ensure that there are enough funds on deposit to cover their risk. This is done through real-time profit and loss calculations using up-to-date pricing and position monitoring. Margin requirement varies from exchange to exchange and even within exchange it depends on asset classification.

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