What it means
When you buy shares, the trade is only the start of the process. The buyer must pay, the seller must deliver the shares, and someone has to make sure both happen even if one side runs into trouble.
The NSCC acts as a central counterparty, meaning that once a trade is accepted it becomes the buyer to every seller and the seller to every buyer. A major part of what the NSCC does is netting.
Rather than settling every individual trade, it adds up each member firm's purchases and sales in each security and produces one net obligation to deliver or receive. This approach, called continuous net settlement, greatly reduces the number of transfers and the amount of money that must move.
To protect against a member failing, the NSCC requires its members to contribute to a clearing fund, which is a pool of money and securities held as margin against possible losses. If a member defaults, the fund and other resources are used to complete the trades.
This is a key reason why the failure of a single broker does not normally cause a chain reaction across the market. For ordinary businesses, the NSCC works in the background, but its effects reach every investor.
Faster, safer settlement reduces counterparty risk (the risk that the other party fails to pay or deliver) and lowers costs for brokers, which helps keep trading fees down. When settlement cycles shorten, as they have over the years, it is the NSCC and its partners who update the systems.
The NSCC is regulated by the Securities and Exchange Commission as a clearing agency. Its rules are published and its risk controls are reviewed, since a problem at a central clearing body would affect the whole market.
Shortening the settlement cycle has been a theme in recent years. A shorter cycle means less time between trade and settlement, which lowers the exposure that builds up while trades wait to settle and reduces the margin that members must hold.
In practice
Real-world examples.
Example
A retail investor buys 200 shares through an online broker. Behind the scenes, the broker's trade is matched, sent to the NSCC and netted with the broker's other trades before settlement.
Example
A brokerage firm sees its daily trading double during a volatile week. The NSCC raises the firm's clearing fund requirement, so the firm has to post more collateral to cover the higher risk.
Example
A fund manager sells $25,000,000 of an exchange-traded fund. The NSCC guarantees settlement, so the manager does not need to worry about whether the individual buyer is able to pay.
Formula
Calculation
Net obligation = Total purchases - Total sales
Suppose a broker buys $9,000,000 of shares and sells $6,000,000 of shares in one day across many trades. Gross settlement would be $9,000,000 + $6,000,000 = $15,000,000 of movements. Net obligation = $9,000,000 - $6,000,000 = $3,000,000 to be paid. The netting reduces settlement flows by ($15,000,000 - $3,000,000) / $15,000,000 = 80%.Case study
Seen in the real world.
Ironbridge Securities is a fictional brokerage that handles about 40,000 trades a day. Before using central clearing, its back office had to match and settle each trade with the other firm, and a failed trade could leave it exposed for days. The chief operating officer wanted to cut both costs and risk.
By joining the NSCC, the firm sent its trades to a central system that netted them each day. Settlement instructions fell from tens of thousands to a few hundred, the firm needed fewer staff to chase failed trades, and it knew that the NSCC stood behind each trade once accepted.
In this illustrative story, the firm did have to post a clearing fund deposit of $3,500,000, which tied up cash. The chief financial officer judged that the lower operational cost and risk justified it, but treated the deposit as part of the true cost of doing business. She also asked the treasury team to forecast the deposit each quarter, because the requirement can rise when trading volumes or market volatility increase.
Watch out
Common mistakes.
- Confusing clearing with settlement. Clearing is confirming and netting the trades, while settlement is the actual transfer of cash and securities.
- Assuming the NSCC deals directly with retail investors. It serves member firms such as brokers and banks, and individuals reach it through them.
- Thinking the guarantee removes all risk. It reduces counterparty risk, but market risk and operational risk remain.
Questions
People also ask.
What does NSCC stand for?
It stands for the National Securities Clearing Corporation.
How is it related to the DTCC?
The NSCC is a subsidiary of the Depository Trust and Clearing Corporation, which also owns the depository that holds most securities.
Why do members pay into a clearing fund?
The fund protects the system, so that if one member fails, others are not left covering the loss.
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