The Real DTCC Discussion

[BigBake1]

Accounting Broker to Broker Trades

I thought I would piece together some info on how trades are accounted for after either investors initiates a trade and how the DTCC may or may not play a roll in that trade. One method involves no human intervention in the process and results in trade clearing and settlement on T+0 with 98% to 99% of all trades processed through it and is the primary OTC method of trade clearing and settlement.

So here is the infamous chart that shows a diagram of how trades flow:



Just a basic trade explanation here of this chart, I am investor “A” and I have 1000 shares of XYZQ on the Ask and I am the best offer at the time. Investor “B” says well I would like some shares at the price from the offer and places an order in for 500 shares at the Ask. In this scenario we will assume we are both from different brokers. Investor “B” sends his order in to his Broker, now the broker has two options available possibly, but in this case we eliminated one which is an in house process. Since we are not in the same brokerage the order gets pushed to an ECN to match a trade. Mind you this is all electronic no human intervention period so far, unless of course someone phoned in their order.

So off the order goes to the ECN to match a trade, on the diagram that would be going to the market and we are dealing with the OTC strictly here. So the ECN for the OTC market receives all these orders and places them in order to their particular security. It attempts to match trades, obviously the best orders are those of the same size and price. If an ECN matches a trade it is a straight forward long position trade and involves no further marking and goes right on the consolidated tape.

Now if a Market Maker gets involved the process is slightly different, once again no human intervention involved, the MM programs seek out such opportunities to make a market. In this case the immediately see Investor “B” order for 500 shares and it already knows I have 1000 shares available on the Ask. So it immediately sells “short” 500 shares to Investors “B” broker, this goes onto the consolidated tape and also shows up on the Daily Reg SHO. On a separate leg of the very same trade transaction the MM purchases 500 shares from my ask to close their open position, that gets reported to the NON TAPE report. All of this trade execution information flows through FINRA.

No matter which method is used here the accounting of the trade for clearing and settlement is the same process. First we will discuss the CNS eligible securities and I will not even try to butcher this on my own as there is a perfect explanantion on Brokerage101 site explaining how the accounting process works:

Trade Balancing and Reconciliation

Trade Balancing and Reconciliation is the core function performed by the Purchase and Sales Department. Balancing and Reconciliation provides assurance that all trades processed on the firm’s books and records are in fact legitimate trades and not data input or trading errors. Balancing and Reconciliation helps limit the firm’s exposure to potential monetary loss resulting from an erroneous transaction on the firm’s trading records.

Balancing and Reconciliation commences on Trade Date + 1 (T+1) and concludes on Settlement Date + 1 (S+1). Trade Date (T) is the business day on which the trade is executed on a securities exchange or market, or between the client a the firm’s inventory account. T+1 is the first business day immediately following Trade Date. Settlement Date (S) is the 3rd business day after Trade Date or T+3, and Settlement Date + 1 is the business day after S. If this is unclear, please take a moment to review the concepts in the section titled The Trade Cycle.

The logic behind Trade Balancing and Reconciliation is rooted in basic accounting principles. Every entry must be a balanced entry. This means that for every debit entry there must be a credit entry of equal value. In the stock brokerage world, this applies to entries for both securities (the quantity of shares, bonds, options etc.) and entries for currency (the Net Amount of money, a.k.a. dinero).

For each buy trade processed (Debit Entry) there must be an offsetting credit entry. Conversely, for each sell trade processed (Credit Entry) there must be an offsetting debit entry. Therefore, to keep the firm’s accounting records balanced, for every buy trade processed there must be an offsetting sell trade and visa versa.

Simply stated, Trade Balancing and Reconciliation is knowing where to find the offsetting entry for each and every trade processed – and then verifying that that offsetting entry was processed correctly. If the offsetting entry is not processed correctly, an out-of-balance will result on S+1. Therefore, the P&S staff has 3 business days – T+1, T+2 and T+3 - to resolve any trade differences that are identified.

The use of electronic trading, comparison and settlement systems ensures that, on average, 98% - 99% of all securities transactions are processed correctly on Trade Date and do not require additional attention nor human intervention throughout the comparison and settlement process.

I love this last paragraph as it explains why the DTCC, Brokers, Broker Dealers and Clearing Houses want this T+1 at a minimum. But as you can see with electronic settlement they are achieving pretty high rate on T+0.

So once again I will hand it off to Brokerage101 and describe where it goes from there and the available processes:

The process used to balance and reconcile street side transactions depends on the type of comparison generated, and the settlement method for the particular trade.

Trades Comparison is accomplished in one of two ways:

1. Electronically through the use of an automated clearing house such as the NSCC
2. Manually via Ex-Clearing

Trade Settlement is accomplished by one of four methods:
1. CNS
2. Non-CNS
3. Trade-for-Trade
4. Ex-Clearing

The following comparison and settlement combinations are possible:
1. NSCC Eligible – CNS Settlement
2. NSCC Eligible – Non-CNS Settlement
3. NSCC Eligible – Trade-for-Trade Settlement
4. Ex-Clearing – Comparison and Settlement

Now there a few things that will stick out, CNS eligibility is a big deal. It is a streamlined process that requires no human intervention and if the entire order process required no human intervention then the whole trade from inception to settlement really has no human intervention at all, just all computers running the show.

CNS Settlement

In order to settle via CNS, a securities transaction must be both successfully matched during the NSCC Comparison Process and properly designated as a CNS settling trade. Therefore, trades that settle via CNS by definition are necessarily eligible for the NSCC Comparison System.

The vast majority of all domestic securities transactions settle through the CNS Settlement System. It is the role of the Purchase and Sales Department to ensure that all trades booked on a CNS Settlement Trade Blotter – for each domestic exchange and market - are properly matched by NSCC as CNS Compared Trades.

This is accomplished by matching each compared trade on the NSCC CNS trade comparison file with its corresponding trade on the firm’s CNS Trade Blotter. Trades are matched to comparisons based on the following key elements:
· Side – Buy or Sell
· Market of Execution
· Quantity
· Security
· Price
· Principal Amount
· Contra Broker

For CNS settling trades, an offsetting entry is booked in the firm’s CNS clearance account prior to settlement date. For each buy trade (Debit) processed on a CNS trade blotter, an offsetting sell trade (Credit) is booked in the CNS account. For each sell trade (Credit) processed on a CNS trade blotter, an offsetting buy trade (Debit) is booked in the CNS account.

Comparisons and/or trades on the firm’s records that are not successfully matched during the balancing and reconciliation process will be output to an exception report. The P&S staff must work with the firm’s traders to resolve all exceptions before settlement date.

In the event that a CNS comparison is received from NSCC that cannot be matched against a trade on the CNS trade blotter – a client trade or "House Ticket" must be processed. If a trade on the CNS trade blotter cannot be matched to a CNS comparison – a comparison must be generated.

If a comparison and/or trade is not successfully matched by settlement date, a difference will result in the firm’s CNS Account on S+1.

So what if you are a security that lost DTCC eligibility and are no longer in CNS, well trade for trade designations really bring out the manual process..lol

Non-CNS, Trade-for-Trade and Ex-Clearing Settlement
Transactions that do not settle through CNS may or may not be eligible for the NSCC Trade Comparison System. Non-CNS and Trade-for-Trade Settlement are both products of the NSCC trade comparison process. Ex-Clearing transactions, on the other hand, do not utilize the NSCC matching cycle.

Non-CNS and Trade-for-Trade (T-f-T)

The comparison process for Non-CNS and Trade-for-Trade Settlement is very similar to that for CNS Settlement. Both utilize the NSCC automated comparison system. However, Non-CNS trades are processed on Non-CNS trade blotters and Trade-for-Trade transactions are booked on T-f-T trade blotters.

Further, Non-CNS and Trade-for-Trade transactions are not forwarded to CNS for settlement. Instead, the NSCC generates a balance order – which instructs the firm to deliver (sells) or receive (buys) securities to another brokerage firm. The balance order also identifies the net amount or settlement amount to be received (sells) or paid (buys) by each firm.

The brokerage firm uses the NSCC balance order as an instruction to manually settle Non-CNS and Trade-for-Trade transactions. This is either done by delivering or receiving securities through an electronic depository (such as DTC), or by delivering or receiving actual physical (paper) certificates.

Because the trade balancing and reconciliation process is the same for both Non-CNS and Trade-for-Trade settlements, both will be covered in one section. Because neither settles through CNS – Non-CNS and Trade-for-Trade will be used interchangeably in this section.

And finally we have Ex Clearing which is the very last resort for use, but the key point is if ex clearing is used it automatically generates an FTD, so one way or another the trade settlement is publicly tracked through one of these systems by regulators.

Ex-Clearing Trades

Trades in securities that are not eligible for the NSCC trade comparison process are booked on an Ex-Clearing Trade Blotter and are compared manually by the P&S Department.

Prior to settlement date, a "Fail Record" is automatically generated for all Ex-Clearing trades. A Fail Record is an entry to the firm’s Receive and Deliver (R&D) File. The R&D File is an accounting sub-ledger which contains settlement details such as the security traded, the quantity bought or sold, the net amount to be settled, and the contra broker with which to settle the trade. In basic accounting terminology, the "Fail" is either an open deliverable (securities are sold) or an open receivable (securities are purchased).

When the firm sells securities to another brokerage firm for Ex-Clearing settlement, a Fail-to-Deliver is automatically generated prior to settlement date. For accounting purposes, the actual sell trade is a credit entry. The Fail-to-Deliver is a debit entry.

I highly recommend reading the Brokerage101 website it provides excellent information on the trading process and brings to light how things work with our trades.

http://brokerage101.com/pns.html