What it means
When two parties agree a trade, several steps follow before it is complete. The trade must be confirmed, the amounts of securities and cash owed must be calculated, and then the securities and cash must be exchanged.
This is called clearing and settlement, and DTCC's job is to carry it out safely and efficiently. DTCC operates through a group of subsidiaries with different roles.
The Depository Trust Company holds securities and moves them between accounts, the National Securities Clearing Corporation clears and settles trades in stocks, bonds and funds, and the Fixed Income Clearing Corporation does similar work for government and mortgage-backed securities. Each is regulated, and together they cover a large share of the US market.
A central feature is netting. Instead of settling every trade one by one, DTCC adds up each participant's purchases and sales in the same security and settles only the net difference.
Netting greatly reduces the number of securities and the amount of money that have to be moved, which lowers cost and risk. DTCC also acts as a central counterparty for many trades.
That means it steps between the buyer and the seller, becoming the buyer to every seller and the seller to every buyer, and so protects each side from the risk that the other will fail to deliver. To cover this risk, participants put up collateral in a clearing fund, which is a pool of money and assets that can be used if a member defaults.
For businesses and investors, DTCC matters because it reduces settlement risk, the danger that one side of a trade is completed and the other is not. It is owned by its users, including banks and brokers, and operates largely as a utility.
Its role also means that disruptions or changes in settlement rules, such as shortening the time between trade and settlement, can affect funding needs and operations across the industry.
In practice
Real-world examples.
Example
A broker-dealer buys and sells thousands of different shares for clients during one day. At the end of the day, DTCC calculates a single net position per security for the broker. The broker funds only these net amounts on the settlement date.
Example
A small investment firm uses a custodian bank to settle its trades in US bonds. The custodian is a participant in the DTCC system, so the firm never deals with DTCC directly. The firm checks that the custodian has strong controls and clear fees.
Example
A regulator reviews how a market disruption affected trading. It examines the risk controls at the clearing houses, including the collateral each member must post. The review concludes that the system worked, although some members needed to post extra funds.
Formula
Calculation
Reduction from netting = (Gross obligations - Net obligation) / Gross obligations
Worked example: in one day a broker buys $50,000,000 of a security from various counterparties and sells $48,000,000 of the same security.
Step 1: Gross obligations = $50,000,000 + $48,000,000 = $98,000,000
Step 2: Net obligation = $50,000,000 - $48,000,000 = $2,000,000
Step 3: Reduction = ($98,000,000 - $2,000,000) / $98,000,000 = $96,000,000 / $98,000,000 = 98.0% (rounded)
Instead of settling $98,000,000 of trades one by one, the broker only needs to settle a net $2,000,000, which reduces the money and securities that must be moved by about 98%.Case study
Seen in the real world.
Atlas Clearing Partners is an illustrative, fictional broker-dealer that handles 20,000 trades a day, with total buys and sells of $2,000,000,000. Settling each trade separately would require large flows of cash and securities.
Through the central clearing system, its obligations in each security were netted. The firm's net settlement amount for the day was $150,000,000, or 7.5% of the gross figure, and it needed liquidity for that amount only.
When regulators discussed shortening the settlement cycle, the treasury team modelled the effect on funding and staff schedules. The illustrative lesson is that central clearing greatly reduces risk and cost, but participants must still plan for the liquidity and operations that settlement requires.
Watch out
Common mistakes.
- Thinking DTCC is a government agency, when it is a user-owned company regulated by authorities.
- Confusing clearing with settlement, when clearing calculates obligations and settlement is the final exchange of cash and securities.
- Assuming individual investors deal with DTCC directly, when they use brokers that are participants.
Questions
People also ask.
What is the difference between DTC and DTCC?
DTCC is the parent group, and DTC is one of its subsidiaries that holds securities and handles book-entry transfers.
What does a central counterparty do?
It stands between the buyer and the seller of a trade so that each side faces the clearing house and not the other party, which reduces default risk.
Why is netting useful?
It combines many trades into one net amount per security, which reduces the volume of cash and securities that must be moved and lowers settlement risk and cost.
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