The Clearing Process — from trade to obligation

Where this chapter sits

Chapter 5 carries 15% of the paper, and it pairs with Chapter 6 (Settlement Process), also 15%. Between them they are nearly a third of the marks. The distinction to hold from the start is simple:

Clearing is the process of determination of obligations, after which the obligations are discharged by settlement.

The exam: 120 minutes, 100 marks, 50% to pass, 25% negative marking. This chapter is full of clock times — 4:15 pm, 7:30 am, 9:00 am, 1:30 pm, 3:30 pm. They are close together by design. Learn them or leave those questions blank.

The settlement cycle today

SEBI vide circular dated September 07, 2021 provided guidelines for "Introduction of T+1 rolling settlement on an optional basis for cash market segment. Further, all Exchanges, clearing corporations and depositories introduced T+1 rolling settlement in a phased manner and all trades in the equities market are now settled in T+1 Settlement. Hence the pay-in and pay-out of securities and funds for equities also take place on T+1 day.

The T+1 clearing timeline

The clearing corporation

When a trade occurs on the Stock Exchange it is a legal contract between the buyer and seller. If there is a default by either the buyer or the seller the counter party to the trade will have to bear the loss.

The clearing corporation removes that risk. It acts as a legal counterparty to all trades through the process called novation. Thus Clearing Corporation becomes the buyer to every seller and seller to every buyer. If there is a default in this scenario, Clearing Corporation being counter party, is responsible for ensuring the settlement, thus managing risk and guaranteeing settlement to both the parties.

The formal definition, from the SECC Regulations, 2018: "novation" means the act of a clearing corporation interposing itself between both parties of every trade, being the legal counterparty to both.

Why it matters in a netted market: in a multi-lateral netting scenario, when a default occurs, it is difficult to unwind the trade to find the original counter party who will have to bear the loss. The process of "novation" addresses this risk.

And the guarantee is not free-standing — it is funded: to provide such a guarantee, robust risk management practices are put in place including an efficient margining system so that in the event of default, the Clearing Corporation has sufficient funds from the defaulter to cover the loss.

The eight roles

• Central Counterparty (CCP) — becomes the buyer to every seller and the seller to every buyer after a trade is executed.
• Settlement Guarantee — the primary function is to guarantee the final settlement of trades, ensuring that a trade will be completed as agreed, even if one of the original parties defaults.
• Risk Management — a comprehensive risk management system to mitigate counterparty and systemic risk.
• Clearing and Netting — verify trade details (price, volume, etc.) and calculate the net obligations of all participants.
• Securities and Funds Transfer — facilitate the actual transfer of funds (through clearing banks) and securities (through depositories such as NSDL and CDSL) on the pre-defined settlement date.
• Market Efficiency and Transparency — by standardizing the settlement process, clearing corporations enhance overall market liquidity, efficiency, and investor confidence.
• Regulatory Compliance and Reporting — responsible for reporting data to regulators.
• Member Oversight and Discipline — they monitor the activities of their members on a daily basis. If a member violates established rules, the clearing corporation has the authority to investigate, hold disciplinary hearings, impose penalties or even revoke membership.

As a central counterparty, the clearing corporation also:

• Participates as counterparty in every transaction, commonly referred to as a "counterparty undertaking".
• Monitors the market and market participants.
• Provides structured procedures, as well as resources for dispute resolution. Buyers and sellers are not forced to take legal action against one another, as the clearing corporation offers independent legal enforcement of contracts.
• Reduces the number of payments due to netting and handles all payments not relating to deliveries on behalf of members.
• Provides possibilities to net deliveries of underlying stocks on a member level compared with netting of payments, which are always netted.
• Provides secure and standardized transaction processing.
• Provides less risk to investors trading on the stock exchanges.
• Calculates and controls the margining mechanism.

In India, in the cash segment there are two clearing corporations, viz., NSE Clearing Limited (NCL) and Indian Clearing Corporation Limited (ICCL).

The corporation also devised mechanisms to handle various exceptional situations like security shortages, bad delivery, company objections, auction settlement, and it takes help of clearing members, clearing banks, custodians and depositories to settle the trades.

Interoperability among clearing corporations

Interoperability among Clearing Corporations enables a Clearing Member to select the Clearing Corporation of its choice to clear and settle trades executed in multiple exchanges. It allows market participants to consolidate their clearing and settlement functions at a single Clearing Corporation, irrespective of the stock exchange on which the trade is executed.

The expected result: efficient allocation of capital for the market participants, thereby saving on costs as well as providing better execution of trades.

What is in and what is out

The framework applies to all recognised clearing corporations excluding those operating in the International Financial Services Centre (IFSC), and all the products available for trading on stock exchanges, except commodity derivatives and Tri-party repo.

Also excluded: order collection mechanisms/schemes such as Offer for Sale, Mutual Funds Service Scheme, Buy back/Tender Offer, Non Competitive bidding, Primary bidding of SGB. The Securities Lending and Borrowing Scheme of the Clearing Corporation is also kept outside Inter-operability.

The designation rules

• Every Clearing Member shall be required to designate a Clearing Corporation for each business segment covering all its Trading Members in that business segment.
• A CM may maintain membership with more than one CC. However, the CM can be active with only one CC per business segment at any point of time.
• A CM may choose a different CC as its designated CC for different business segments, since the choice of designated CC is made at the CM-Segment level.
• Custodians shall have the facility to specify a designated CC separately for each of their CPs, as the choice of designated CC for a Custodian is determined at Custodian-CP Segment level.

How the corporations link to each other

The recognised clearing corporations shall establish a peer-to-peer link for ensuring interoperability. A clearing corporation shall maintain special arrangements with another clearing corporation and shall not be subjected to normal participant (membership) rules.

Risk management between the clearing corporations shall be based on a bilaterally approved framework and shall ensure coverage of inter-clearing corporation exposures. Clearing corporations shall exchange margins and other financial resources on a reciprocal basis based on mutually agreed margining models.

The inter-CC collateral has two components:

• (a) Margins as per the existing Risk Management Framework (initial margin, extreme loss margin, calendar spread margin, etc.) prescribed by SEBI.
• (b) Additional capital, to be determined by each Clearing Corporation, based on the credit risk from the linked Clearing Corporation, on which no exposure shall be granted to the linked Clearing Corporation.

The purpose: so that any default by one Clearing Corporation, in an interoperable arrangement, would be covered without financial loss to the other non-defaulting Clearing Corporation.

The benefits:

• Choice to participants to choose the clearing corporation.
• Better capital utilization.
• Reduce trading disruption.
• Reduce aggregate exposure.
• Reduced operational complexity.
• Enhanced market competition and lower cost of clearing.
• Execution risk can be decoupled from settlement risk as there can be an "arm's length" relationship between the exchange and adjunct clearing corporation.

Clearing banks

Clearing Bank(s) act as an important intermediary between clearing member(s) and the clearing corporation. Every clearing member needs to maintain an account with any of the empanelled clearing banks at the designated clearing bank branches. The clearing accounts are to be used exclusively for clearing and settlement operations.

It is the function of the clearing members to ensure that the funds are available in his account with the clearing bank on the day of pay-in to meet the funds obligations. In case of a pay-out, the clearing member receives the amount on pay-out day.

How the money actually moves: the pay-in obligation details are passed on to the clearing banks by the clearing corporation, who then debit the clearing member account; and based on pay-out instruction from the clearing corporation the clearing bank will credit the receiving member clearing account.

The clearing banks are required to provide the minimum services as specified by the Clearing Corporation to clearing members.

Clearing members and custodians

There are three types of clearing members who help in clearing of trades, namely professional clearing member (PCM), trading cum clearing member (TCM) and trading cum self-clearing member (SCM). The clearing members need to take membership of the clearing corporation(s). They then get a unique member ID number from the clearing corporation.

Custodians act as clearing members but not trading members. They settle trades in the cash segment on behalf of their institutional clients which are executed through other trading members.

Their four functions:

• Clearing — computing obligations of all his trading members, i.e. determining positions to settle.
• Settlement — performing actual settlement.
• Risk Management — setting limits based on upfront deposits/margins for each trading member/client and monitoring positions on a continuous basis.
• Confirmation of custodian participant trade.

The two mandatory accounts

Demat. It is mandatory for clearing members to open demat accounts with both the depositories, i.e. CDSL and NSDL, through a depository participant. These accounts are known as clearing member settlement pool accounts.

The critical feature: unlike the usual demat accounts, the clearing member does not get any ownership or beneficiary rights over the shares held in these accounts. The benefits related to shares are received in the pool account, from where they are distributed to the beneficiaries.

A pool account is a settlement account of a broker/exchange member from where the broker delivers securities to the exchange's clearing corporation against pay-in obligation and receives pay-out of securities from the clearing corporation. A client can transfer shares directly into the member's pool account.

Bank. It is mandatory for a clearing member to open a separate and distinct clearing bank account with the designated clearing bank, used for settlement of fund obligation, payment of margins, release and enhancement of collateral, EPI of funds, penal charges.

Clearing members shall irrevocably authorize the Clearing Bank for operation of the clearing account — to access their clearing accounts for debiting and crediting as per the instructions of the Clearing Corporation, reporting of balances and other information.

And a one-way rule worth remembering: a clearing member can deposit funds in these accounts in any form but withdraw funds from these accounts only in self-name.

A clearing member can maintain and operate an additional clearing account with the designated clearing bank for the purpose of enhancement of collateral in the form of cash and providing early pay-in of funds.

Confirmation. The clearing corporation provides details of all transactions of members and their clients which are linked to its clearing member. In the cash market, trades which are allocated for settlement by Custodians are indicated with a Custodian Participant (CP) code and the same is subject to confirmation by the respective Custodian. Once this is done, the clearing agency determines the net obligations of the clearing members/custodian through multilateral netting.

Depositories and depository participants

In the clearing and settlement process, the depositories facilitate transfer of securities from one account to another at the instruction of the account holder.

For trading in the Cash Market, it is mandatory for buyer and seller to open a demat (beneficiary) account with a depository participant in either of the depositories.

In the depository system both transferor and transferee have to give instructions to their depository participants for delivering (transferring out) and receiving of securities. The transferee has to submit a Receipt Instruction to receive securities into his account. But for the convenience of the investor, the transferee can give "Standing Instructions" (SI) to its DP for receiving in securities. If SI is not given, then the transferee has to give separate instructions each time.

Three purposes for which securities may be transferred:

• Transfer due to a transaction done on a person-to-person basis, i.e. an "off-market" transaction — a trade which is not done on a recognised stock exchange.
• Transfer arising out of a transaction done on a recognised Stock Exchange.
• Transfer arising out of transmission of securities and account closure.

The Delivery Instruction Slip. A beneficiary account can be debited only if the beneficial owner has given a "Delivery Instruction Slip" (DIS) in the prescribed form. The DIS for an off-market trade or for a market trade has to be clearly indicated in the form by marking appropriately. The form should be complete in all respects. All the holder(s) of the account have to sign the form. If the debit has to be effected on a particular date in future, the account holder may mention such date in the space provided for "execution date".

Both depositories also facilitate electronic delivery instruction slip facility to clients of DPs over the internet.

The DDPI. SEBI has introduced the concept of "Demat Debit and Pledge Instruction" (DDPI), under which the clients shall explicitly agree to authorize the stock broker / stock broker and depository participant to access their BO account for the limited purpose of meeting pay-in obligations for settlement of trades executed by them. The DDPI shall serve the same purpose as PoA and significantly mitigate the misuse of PoA.

How securities move in a settled trade

• After the trade is executed by the broker on the stock exchange, the seller gives delivery instructions to his DP to move securities from his account to his broker's pool account. Stockbrokers can use a client's DDPI or a valid, existing Power of Attorney to transfer securities from the client's beneficial owner account to the broker's pool account for settlement obligations.
• Securities are transferred from the broker's pool account to the Clearing Agency settlement pool account on the basis of a delivery out instruction. Before the actual transfer of securities takes place, a validation process will be performed between CCs and Depositories.
• On pay-out, historically the securities moved from the CC pool account to the buying broker's pool account. But SEBI vide circular dated June 05, 2024 has decided the securities for pay-out shall be credited directly to the respective client's demat account by the CCs. The direct payout of securities shall not be applicable to clients having arrangements with custodians registered with SEBI for clearing and settlement of trades.

The clearing process itself

The clearing function of the clearing corporation is designed to work out (a) what members are due to deliver and (b) what members are due to receive on the settlement date.

This is done by a process called multilateral netting, performed by the clearing agency, which guarantees that all contracts which are traded will be honoured.

A multilateral netting procedure is adopted to determine the net settlement obligations (delivery/receipt positions) of the clearing members. Accordingly, a clearing member would have either pay-in or pay-out obligations for funds and securities separately.

And the exception: for certain transactions/securities the settlement is done on a Gross basis, i.e. trade for trade basis, and there is no netting of transactions.

The summary sequence

• Trade details are available to Clearing Corporation from the Exchange.
• After the custodial confirmation, Clearing Corporation determines obligations.
• Download of obligation and pay-in advice of funds/securities by Clearing Corporation to clearing members and custodians.
• The delivering member shall complete delivery instructions for transfer of securities to CM Clearing Pool Account on settlement day before the time specified.
• The paying member shall ensure that clear funds are available in his clearing bank settlement account before the time specified.
• Pay-in of securities: Clearing Corporation advises the depository to debit the pool account of custodians/clearing members and credit its own settlement pool account.
• Pay-in of funds: Clearing Corporation advises Clearing Banks to debit the account of custodians/clearing members and credit its account.
• Pay-out of securities: direct pay-out to the respective client's demat account by the CCs, except for clients with custodian arrangements.
• Pay-out of funds: Clearing Corporation advises Clearing Banks to credit the account of custodians/clearing members and debit its account.

And the sentence that explains the whole structure: clearing members for buy order and sell order are different and Clearing Corporation acts as a link here.

Multilateral netting worked

The workbook's example — three brokers trading security ABC on day T:

Netting each broker:

Broker X — bought 200 and 100, sold 300. Net quantity 300 − 300 = 0. On value, paid 2000 + 1050 and received 3300, so net value 250 to receive.

Broker Y — sold 200, bought 50 and 300. Net quantity 350 − 200 = 150 to receive. Net value 1825 to pay.

Broker Z — sold 50 and 100. Net quantity 150 to deliver. Net value 1575 to receive.

Notice what netting achieved: four trades of 650 shares in total reduce to 150 shares actually moving, and Broker X, who traded most, ends up delivering nothing at all.

Within the broking firm too: the stock brokers are allowed to net the clients' accounts within the firm. At the end of the day, the position of each client is netted against all his transactions and the final pay-in/pay-out of securities/funds is carried out through clearing banks and depository participants.

Institutional transactions in the cash segment

Institutional Transaction means a transaction done on behalf of institutional investors. Institutional investors shall include Category I and II Foreign Portfolio Investors (who are not corporate bodies, family offices and individuals) as per SEBI FPI Regulations 2019, Mutual Funds registered with SEBI, Public Financial Institutions, Banks, Insurance Companies and Pension Funds.

The rules that make institutional settlement different:

• It is mandatory for institutions to settle their trades through a Custodian. Institutions, through the custodian, apply to the clearing corporation for the Custodial Participant (CP) Code, and it is mandatory to enter the CP code at the time of order entry. The CP code allows institutions to trade with multiple brokers and settle deals with a single custodian.
• All institutional trades executed on stock exchanges would be processed through the Straight Through Processing (STP) system. A contract note in electronic form in the format prescribed by SEBI shall be issued by the broker and sent to the custodian and/or to the institutional investor.
• Trading members may also enter "INST" code in the custodial participant code at the time of entering orders on behalf of institutional clients, and must allocate the INST trades only to the above mentioned categories within the time specified.
• For FPIs that are corporate bodies, individuals or family offices, INST facility is not available in the same manner — for FPIs, allocation for INST trades is allowed only to related FPIs.
• No institutional investor shall be allowed to do day trading, i.e. square off their transaction intra-day. All transactions would be grossed for institutional investors at the custodian level and the institutional investor is required to fulfil their obligation on gross basis. The custodian, however, continues to settle their deliveries on net basis with the stock exchanges.
• Institutional investors shall be permitted to short sell. However naked short selling shall not be permitted in the Indian stock market, and accordingly all investors would be required to mandatorily honour their obligation of delivering the securities at the time of settlement.
• Institutional transactions do not attract margin on an upfront basis. The margin is applicable on T+1 day subsequent to confirmation of trade by the custodian. Trades of Category II FPIs who are corporate bodies, individuals or family offices, and domestic entities who may choose to settle trades through a Custodian, shall be margined on an upfront basis as per the margining framework of non-institutional trades.
• In the event of rejection of institutional trades by the custodian, the trade will be settled through Delivery Versus Payment (DVP) basis. Such trades will be subjected to penalties as may be imposed by the SEs/CCs.

The institutional T+1 timeline

Non-institutional investors may also have a CP code in the Capital Market segment. If they choose to use a professional clearing member/custodian, trades confirmed by the clearing members shall form part of that clearing member's obligation. The clearing members shall be responsible for all obligations arising from such trades including the payment of margins, penalties, any other levies, and settlement of obligations.

The block mechanism

When the client intends to make a sale transaction, shares will be blocked in the demat account of the client in favour of the Clearing Corporation. If the sale transaction is not executed, shares shall continue to remain in the client's demat account and will be unblocked at the end of the T day.

The benefit: this mechanism will do away with the movement of shares from the client's demat account for early pay-in and back to the client's demat account if the trade is not executed. The shares never leave.

How it works:

• The securities lying in the client's demat account will be blocked either by the client himself using the depository's online system or e-DIS mandate, or through the depository participant based on physical DIS given by the client or Power of Attorney holder.
• Depositories may keep a block on the securities in respect of Intra or Inter depository transfer instructions till pay-in day. The blocked securities will be transferred only after checking against the client level net delivery obligation received from CCs.
• Depositories will provide the details of transfer instructions — UCC, TM ID, Exchange ID etc. — to CCs for clients to avail EPI benefit.
• CC will match the client level net obligations with the block details provided by depositories and will provide EPI benefit to the client if the client level net obligation exists for that client.
• In case of unmatched orders, CCs shall upload cancellation of the block instruction on T day so that securities are unblocked and become free in the client's demat account on T day itself.
• Broker or client shall not be allowed to unblock securities if EPI benefit is provided by CC to the client for the same.

Two scope rules: the facility of block mechanism shall be mandatory for all Early Pay-In transactions, and the block mechanism shall not be applicable to clients having arrangements with custodians registered with SEBI for clearing and settlement of trades.

Validation of pay-in instructions

In order to further mitigate the risk for clients' securities, particularly those given towards delivery/settlement obligations, instructions for pay-in of securities from a client demat account to a TM pool account against obligations received from the CCs shall be validated.

The process:

• Depositories, prior to executing actual transfer of the securities for Pay-In from client demat account to TM Pool account, shall validate the transfer instruction received through any of the available channels — whether initiated by clients themselves or by the POA/DDPI holder — against the client-wise net delivery obligation received from CCs.
• CCs shall provide client-wise net delivery obligations on T day to the depositories.
• Depositories shall validate the depository transfer instruction details with CC obligation details based on UCC, TM ID, CM ID, Exchange ID, ISIN, quantity, settlement details.

The four outcomes:

This process shall not be applicable to clients having arrangements with custodians registered with SEBI for clearing and settlement of trades.

Clearing in derivatives

The clearing mechanism in derivatives essentially involves working out open positions and obligations of clearing members. This position is considered for exposure and daily margin purposes.

An "Open Position" is an outstanding or unsettled either long (buy) or short (sell) position in various derivative contracts.

How the open position is built up, from the bottom:

• Proprietary positions are calculated on a net basis (buy − sell) for each contract.
• Clients' positions are arrived at by summing together net (buy − sell) positions of each individual client. The crucial qualifier: positions are only netted for each client at contract level and not netted across clients, and are rather added up across clients.
• A TM's open position is the sum of proprietary open position, client open long position and client open short position.
• The open positions of clearing members are arrived at by aggregating the open positions of all the brokers/trading members and all custodial participants clearing through them.

A "contract" for this purpose is distinguished based on futures and option, underlying instrument, expiry date, option type and strike price.

The worked example

Clearing member A has two trading members clearing through him, PQR and XYZ, in an INDEX May Future contract:

PQR: proprietary buy 5000, sell 3000 → net 2000 long. Client 1 buy 3000, sell 2000 → net 1000 long. Client 2 buy 3000, sell 1000 → net 2000 long. So PQR is long 5000.

XYZ: proprietary buy 1000, sell 2000 → net 1000 short. Client 1 buy 2000, sell 1000 → net 1000 long. Client 2 buy 3000, sell 4000 → net 1000 short. So XYZ is long 1000 and short 2000.

Note that A's long and short do not net against each other — the longs and shorts are aggregated separately, precisely because positions are not netted across clients.

All derivatives contracts — whether index futures, stock futures, index options, stock options, currency futures and options, or interest rate futures and options — are settled either through cash settlement or physical settlement.

Custodial participants are constituents who are eligible to trade through trading members and clear and settle their deals through clearing members. Such custodial participants shall register themselves with the Clearing Corporation through their clearing members, and clearing members of the custodial participants shall confirm trades executed on their behalf. All trades confirmed by the clearing members shall form part of the obligations of the concerned clearing members, who shall be responsible for all obligations arising from such trades including the payment of margins, penalties, any other levies, and settlement of obligations.

Net settlement of cash and F&O on expiry

With a view to provide better alignment of cash and derivatives segments, mitigation of price risk and bringing in netting efficiencies for market participants, SEBI has introduced the mechanism of Net Settlement of cash segment and F&O segment upon expiry of stock derivatives.

The rules:

• The obligations arising out of cash segment settlement and physical settlement of the F&O segment, upon expiry of stock derivatives, shall be settled on a net basis.
• The benefit of netting shall be available to investors whose trading member clears trades in F&O segment and cash segment through the same clearing member — i.e. the benefit shall be available to investors who trade and clear through the same TM-CM combination in Cash and F&O segment. However, investors whose TM clears trades through different CM/CC will not be able to avail the benefit of netting.
• Netting shall not be available for the institutional investors (including all categories of FPIs), since the extant regulatory framework specifies that all transactions by institutional investors in cash market should be backed by delivery.
• Under the Net Settlement mechanism, netting of delivery obligations shall be only for the purpose of settlement. Therefore, Securities Transaction Tax and Stamp Duty shall continue to be computed, levied and reported on a segment wise level.

The workbook's illustration. An investor holds a long In The Money put option of strike price ₹110, with underlying settlement price ₹100, and a cash market trade done on the expiry day, with the security purchased at ₹101.

Under the existing separate settlement:

• The investor will make funds pay-in of ₹101 in the cash segment.
• Will receive pay-out of the stock in the cash segment.
• Will deliver the stock in F&O settlement.
• Will receive ₹110.

And margin would be applicable on delivery obligations in cash segment and F&O segment separately.

Under Net Settlement: there would be no need for the investor to arrange for funds of ₹101 — the investor would have a net pay-out of ₹9 and would not have any requirement of securities pay-in or pay-out. Further, there would be no margin requirement, after expiry, since there would be only cash receivable and no delivery obligation.

The optional T+0 cycle

SEBI vide Circular dated March 21, 2024 introduced the beta version of the T+0 rolling settlement cycle on an optional basis in addition to the existing T+1 settlement cycle in Equity Cash Markets, for a limited set of 25 scrips and with a limited number of brokers.

SEBI vide circular dated December 10, 2024 increased the number of scrips under optional T+0 settlement and also allowed all stock brokers to participate. MIIs and custodians are advised to extend the T+0 settlement facility to Institutional investors as well. Further, SEBI has advised that a mechanism for the Block Deal window shall be put in place by the Stock Exchanges under the optional T+0 settlement cycle.

The operational details: