This article is written by Chandana Lakshman, pursuing a Diploma in Companies Act, Corporate Governance and SEBI Regulations from LawSikho.com. Here she discusses “What are clearing corporations and what do they do?”.

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Introduction

Before the establishment of Clearing Corporation, trades were settled by account period settlement. On the introduction of clearing corporations, it has ensured market efficiency, transparency, liquidity and it also helps in reducing settlement and operational risks, savings on settlement cost. The greatest advantage of clearing corporation is now the trades can be settled within three working days which initially took one week to settle trade obligations

Clearing Corporations- Meaning

In general terms, clearing is an arrangement of trade which is done through the exchange of obligations.

For the successful completion of trade clearing corporations is essential. Clearing Corporations are commonly called as a clearinghouse or clearing firm and it is a corporation which is associated with a stock exchange, which is established to handle confirmation, settlement and delivery of transactions. Clearing Corporations helps the stock exchanges and this stock exchanges, in turn, ensures that buying and selling of securities are being correctly dealt with.

Clearing Corporation and Clearing Member- Definition [securities contract(regulation)(Stock exchange and clearing corporation) regulations, 2018]

Section 2(d) of the securities contract(regulation)(Stock exchange and clearing corporation) regulations, 2018 defines clearing corporation as “ entity that is established to undertake the activity of clearing and settlement of trades in securities or other instruments or products that are dealt with or traded on a recognized stock exchange and includes a clearinghouse”.

Section 2(e) of the securities contract(regulation)(Stock exchange and clearing corporation) regulations, 2018 defines Clearing Member as ” a person having clearing rights in any recognised clearing Corporation”.

Clearing and Settlement

Clearing

• The clearing is a process when the organisation acts as intermediary and it also assumes the role of the buyer and seller in order to reconcile the transactions that occur in the trade.
• It also includes all the activities that occur from the moment when the trade starts to till the final stage when the trade is settled.
• The activities that include clearing are reporting, risk management, and tax handling.

Settlement

• The moment clearing comes to an end, settlement begins.
• The settlement agency receives securities from the seller who wants to sell his securities and receives cash from buyers who want to buy securities and then he gives to the buyer the securities and the seller the securities.
• The buyer is obliged to pay the payment within the settlement period and the seller is to deliver the securities within the settlement period.
• The settlement period depends on the type of securities it has exchanged.
• For stocks, the settlement period is three days after the transaction.

Settlement Process

In every successful completion of the trade, there are three processes involved and they are:

• Trading

In this, the buyer who wishes to purchase the securities will give his order and seller who wants to sell his securities goes for the execution of securities.

• Clearing

Clearing determines the obligation of both the parties in relation to the funds and securities.

• Settlement

At the final stage, NSCCL acts as counterparty between the buyer and seller, and it also gives to guarantee to both the party that in case of default by any party NSCCL will take actions against the defaulter.

Clearing Corporation of India Limited

Clearing Corporation of India was first introduced under the ministry of the central counterparty in April 2001. The main objective of this corporation is to provide clearing and settlement for transactions in government securities, foreign exchange and money markets in the economy. The introduction of clearing Corporation came with a lot of benefits like there was a reduction in settlement and operational risk, there were savings on settlement cost. It also introduced various platforms for the electronic execution of deals in various market segments. It is also a trade repository for all over the counter transaction in the forex, Interest rate and credit derivative transaction.

Parties to the clearing corporation

The main parties who assist in the clearing process are:

• Depositories

This ensures in facilitating the electronic transfer of securities in a dematerialized form.

• Clearing banks

Clearing Banks acts as a connecting link between the clearing members and the NSCCL for the settlement of funds.

• Clearing Members

These members are responsible for settling the trade which is done on all the counters.

• Custodians

These members keep the securities in a safe manner and they hold the documentary proof of securities, keeping the title of securities intact in the name of the holder.

Functions of Clearing Corporation of India Limited

1. They act as guarantors in clearing and settlement functions to various parties and they also ensure that transactions occur smoothly.
2. It also acts as an agent to Financial Benchmark India Private Limited. The main role of the FBI is administering government securities.
3. They also ensure all the parties who are involved in the successful completion of transactions follow the due procedures.
4. By ensuring that goods are delivered to the buyer properly it avoids the needs for any post-settlement arbitrations.
5. They also play an active role in settlement of complex transactions at predetermined future price and date.
6. The pivotal functions are improving market efficiency, ensuring transparency, liquidity and risk management.
7. It also helps in trade settlement for wholesale markets entities like banks, insurance companies and mutual funds.

Risk involved in Clearing Corporation

• Replacement cost risk

Whenever a clearing member defaults, the clearinghouse would be liable to pay the replacement cost. It fulfils the replacement obligation by purchasing or selling the contracts identical to those on which the clearing member default. 

• Liquidity risk

By substituting itself as a counterparty to its clearing members, the clearinghouse exposes itself to liquidity risk. It does by fulfilling its payment obligations to non-defaulting members on schedule. On default of the payment, the clearing house looks into the assets of defaulting members and its financial resources to raise the necessary funds.

• Delivery risk

This is one of the biggest risk clearing corporations incurs at the time of expiry of the contracts and when they are to be settled through delivery and delivery versus payment is not achieved. There are two circumstances when this kind of risk is involved and they are:

• When the securities are delivered to the buyer before the payment is made to the seller and seller is at risk losing the value of the payment.
• When the payment is made before the securities are delivered to the buyer.

• Counterparty risk

This risk arises in circumstances when either of the party fails to fulfil their obligations on time.

• Principal risk

When both buyer and seller has fulfilled the obligation of making payments and delivery of shares but has not received the shares or funds and in such circumstances counterparty which is here NSCCL will become the buyer to every seller and the seller to every buyer.

Steps involved in settlement of trade

• Determination of obligations of both parties

These obligations are determined by NSCCL for the traders and it also acts as the central counterparty to the members.

• Pay-In funds and securities

Members after knowing their obligations they  make available funds and securities to NSCCL 

• Pay-out funds and securities

After fulfilling the Pay-In obligations, NSCCL sends out electronic instructions to the clearing banks to pass the required entries.

• Risk management

As there is a considerable time gap between the settlement of trade and execution there is a possibility of arising defaults and to minimise this default NSCCL has framed comprehensive risk management and surveillance system.

List of Clearing Corporation in India

Networth of clearing Corporation

• Securities Contract(Regulations)(stock exchange and clearing Corporation) 2018 Regulation 14(2) states in order to get recognition as a clearing Corporation under Regulation 4 the Corporation shall have a minimum net worth of one hundred crore rupees.
• Regulation 14(2)(b) states in case if the corporation goes for wind-down or recovery of operations the corporation shall have additional capital to cover the cost required.
• Regulation 14(2)(c) states as it is said above in regulation 14(2)(b) every recognised corporation shall maintain a net worth of one hundred crore rupees at all times.
• Regulation 14(4) states unless it meets the threshold limits of one hundred crore rupees it shall not distribute profits to any of its shareholders.
• Regulation 14(5) states that the clearing corporations are also required to submit an audited net worth certificate from the statutory auditor on a yearly basis by the 13 days of September of every year for the preceding financial year.

Conclusion

It is said that Clearing Corporation acts as a protective guide for all the secondary markets transactions with efficient risk management systems.

Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skill.