Clearing and settlement for financial markets: clearing houses. Financial markets mobilize savings, allocate investment, and provide derivative instruments that (when properly used) reduce enterprise risk from fluctuating interest rates, foreign exchange rates, and raw material or commodity prices. Financial market transactions include interbank overnight borrowings, bank large value certificates of deposit, government debt securities, enterprise equity and (short and long-term) debt securities, as well as a whole host of futures, options, and other derivative instruments related to money market securities, foreign exchange, and commodities. All transactions in financial markets have to be cleared and settled, just like transactions that occur among enterprises or between enterprises and consumers.

Financial market transactions are typically large value transactions and there are two primary ways they are cleared and settled. The most common method is to set up a clearing house that only clears a particular type of financial instrument, such as only government securities (for a government debt market) or only enterprise equity securities (for a stock market). Once the direct and indirect parties to a financial market transaction have been notified by the clearing house what the net positions are that they owe after each day's trading, the payment and settlement of these transactions is then handled through the banking system and the central bank, essentially following the payment cycle outlined for non-cash payments in Figure 2. The second method for handling financial market transactions involves a specialized depository which immobilizes the security being traded and, as discussed below, integrates the clearing house function with the payment transaction (called delivery against payment).

Financial market clearing houses centralize purchase and sale information, perform multilateral netting of contracts to buy and sell, and notify market participants of the net positions they owe one another. If participants are trading for their own account, they then notify their respective banking institutions to make payments - typically using electronic wire transfers - to participants' banks to complete the transaction, with physical or book-entry delivery of the securities occurring with a lag that differs among markets. Settlement of these interbank payments is either immediate (on a RTGS network) or end-of-day (on a net settlement network). Additional payments and delivery are required if participants are acting as an agent in the transaction for enterprises, banks, or other types of financial institutions (who may be the ultimate purchaser of the security). The payment cycle for financial market transactions follows that shown in Figure 2. As shown in the figure, payments are initiated by purchasers of financial instruments through an entry bank, which then may go to a settlement bank, to a processing center (e.g., wire transfer network), to the receiving bank (typically also the exit bank), and finally to the payment receiver (which can be the clearing house acting as an agent for the seller of the financial instrument). Settlement is through the central bank.

While settlement of financial market transactions is timely, clearing may not be. The efficiency of the clearing process is a function of the number of participants, the trading volume, and the extent that the trading information is computerized. Only recently in the U.S. has the time lag for many stock market transactions and their final settlement moved from 5 to 3 days. This time lag generates risk.

If the participant selling a security fails prior to settlement, two types of risk may occur. First, payment may have been made before the securities were delivered to the purchaser, in which case the purchaser is now a creditor of the failed participant. Alternatively, if no payment or delivery of securities has occurred, then the purchaser faces the (likely smaller) risk that the price of the security may have risen and the purchaser will now have to pay more for the security than before. These risks are reduced by (a) reducing the time lag between when a financial transaction occurs and when the transaction is settled and (b) instituting loss-sharing agreements among participants in the clearing house (thereby internalizing the risk and providing an incentive to carefully screen and control the risky behavior of clearing house members). A major problem with the clearing house approach has been that some participants are members of many different specialized clearing houses, reflecting their trading in different financial instruments, so that a failure of one participant in one clearing house may affect the solvency of participants in clearing houses where the failed participant was not even a member (creating systemic risk). Greater consolidation and coordination among clearing houses can reduce this problem but a more effective solution--at least for certain types of financial market instruments--is the establishment of a depository.

Payment cycle for immobilized or book-entry securities in depositories. Financial transactions involve promises to pay (debt securities, futures, options) or ownership rights (equity securities). In those cases where the promise to pay or ownership rights are highly valued by the market, because of the creditworthiness of the institution making the promise or the solvency of the institution being owned, it is possible to immobilize the security being traded in book-entry form within a centralized depository and use it to collateralize the underlying transaction. If the purchaser (new owner) of the security fails to pay for the security, the security (collateral) can be returned to the original seller (who is unpaid) or it can be liquidated in the market with the funds then transferred to the seller. This arrangement substantially reduces the risk of loss from the failure of a financial market participant and thereby also reduces the possibility that the failure of a participant in one market will cause problems for participants in other markets in a systemic manner.

Depositories also further reduce risk by adopting rules and operating procedures that permit delivery against payment, which is when ownership of the underlying security is not transferred until, and simultaneously with, the actual receipt of the payment (over a RTGS wire transfer network). This eliminates the time gap between when a transaction occurs and when payment and settlement takes place. In effect, delivery against payment goes one step further than a (credit transfer) GIRO payment since the transaction does not even occur until the security being purchased is in fact paid for in final funds.

Figure 3 illustrates the payment cycle for financial transactions within depositories. In the U.S., depositories currently handle U.S. government debt securities, mortgage-backed securities, and enterprise commercial paper, bonds, and equities (but not futures, options, or foreign exchange transactions). In depositories without delivery against payment, there is an initiating financial transaction between the purchaser and seller of the security. The depository, acting as a clearing house, clears the trade and notifies the purchaser who then initiates the payment (through its bank or through the depository if it acts as a bank) over a RTGS wire transfer network. The wire transfer network settles each transaction separately as it occurs through the central bank and distributes the payment to the security seller's bank or to the depository (for the seller's account). The actual transfer of ownership of the securities need not be simultaneous with the receipt of the payment. Only in depositories with delivery against payment will the ownership to the securities occur simultaneously with the receipt of payment, thereby eliminating almost all of the payment risk in the financial market transaction.