Financial Settlement
Definition
Settlement is the "final step in the transfer of ownership, involving the physical exchange of securities or payment". After settlement, the obligations of all the parties have been discharged and the transaction is considered complete.
Example:
- You enter a farmer's market and approach a farmer selling apples
- You speak to the farmer and agree to purchase 10 apples for $10
- the trade has been entered
- You hand the farmer $10 and he hands you 10 apples
- the trade has been settled.
Before a trade has been settled, the deal is still pending. If the buyer becomes insolvent or the seller's inventory is destroyed, the deal is at risk.
After settlement, the property rights have transfer to the buyer permanently.
This risk (called counter-party risk) is eliminated.
History
Physical Settlement
Prior to modern financial systems, settlement involved physical pieces of paper (representing ownership) and in-person exchanges for money. While complicated and prone to disruption/errors/fraud, our ancestors built the modern world with physical settlement systems.
From the early days of the savannah up until the 1960s, finance settled physically.
The Paper Crunch
Certificates, transfer forms and other documents swirled in an endless tornado; the entire world's wealth wrapped up in an impossibly massive amount of paper.
And then, the Paper Crunch.
In 1965, ~5MM stocks were being traded daily on the NYSE, creating an overwhelming paperwork burden.
3 years later, NYSE volumes reached 15MM per day.
Certificates were left out for weeks. Stocks were sent to wrong addresses. Overtime was mandatory. Turnover reached 60%.
Wall Street's first response was to borrow from the Europeans, following in the footsteps of the Austrians.
The idea: centralization. Hold all paper stock certificates in one location, manage & exchange assets centrally.
Centralization
In 1968, the NYSE created the Central Certificate Service (CCS). The CCS transferred securities electronically and kept track of the shares held by NYSE members.
Depository Trust & Clearing Corporation
The CCS would transform a few times before becoming the Depository Trust & Clearing Corporation (DTCC). The DTCC has many subsidiaries and operates in more capacities than could possible be described, but it has two main purposes:
- Maintain ownership records of the US financial system
- Facilitate settlement for all trades within the financial system
The Depository Trust Company (DTC - a DTCC subsidiary) is responsible for ownership records. Acting as the central securities depository for the US, the ownership of (nearly) all financial assets are determined by the journal entries at the DTC.
The National Securities Clearing Corporation (NSCC) and the Fixed Income Clearing Corporation (FICC) are responsible for a trade from the time after the deal is made until it is settled.
Both the NSCC and the FICC are DTCC subsidiaries.
Think of the market as a space for potential deals. When a deal is made, a trade is sent to the NSCC or FICC who are responsible for the execution. Finally, the change of ownership is recored within the DTC.
All 3 of these entities are owned by the DTCC.
While the DTCC is a uniquely American creation, it has clearly shown the value of centralized clearing. In 2011, DTCC settled the vast majority of securities transactions in the United States and close to $1.7 quadrillion in value worldwide.
Quadrillion.
Modern Considerations
Centralization provides so many benefits:
- universal agreement
- efficient clearing/settlement
- pooled liquidity
- specialization
- reduced administration and coordination requirements
All of these deliver improved performance and reduced costs the DTCC's customers.
The DTCC is a monument to centralization, a testament to the power of concentration. It provides countless benefits, all for the small price of giving up control.
You just gotta trust the guy in charge. Today and tomorrow. In celebration and in conflict.
Do you?
Resources
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