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National Clearing and Settlement System

The establishment of the System will improve transparency and efficiency of the equities market

By Shabbir H. Kazmi
Aug  06 - 12 , 2001

As Pakistan enters the second phase of capital markets reforms programme, the National Clearing and Settlement System (NCSS) is being launched. NCSS, an electronic system, will replace the individual clearing houses currently operating in each of Pakistan's three stock exchanges. NCSS will initially be operated by the Central Depository Company (CDC) under a facilities management with the National Clearing Company of Pakistan registered as a separate legal entity with its Board of Directors. The new system is aimed at capping systemic risk and improve efficiency of the settlement process.

NCSS offers Continuous Net Settlement (CNS) in which Clearing Members have the option of carrying over their positions to the next settlement day as opposed to the present system in which settlement of trades has to be done at the designated settlement day. The CNS will be implemented in an environment of 'Rolling Settlement' on a T+3 settlement cycle. In Rolling Settlement all trades executed on a day has to be settled on a designated future day. Therefore, every day is a trading day and a settlement day for the trades made three business days earlier.

Currently, Pakistan mainly uses a 'Fixed Settlement' cycle along with 'Rolling Settlement' cycle for selective securities. In a 'Fixed Settlement' cycle the risk of default increases due to time lag between trading and settlement. This risk arises when market price of scrips change and expose the non-defaulting member to cover the contract at a higher price. Under the CNS, Clearing members will be required to settle only with the Clearing House rather than the counter party. Therefore, the risk of fault is minimized and integrity of the system is enhanced.

At present, if the Clearing Members are short of funds or securities they have to resort to borrowing. Under the CNS, Clearing Members have the option of carrying over their positions to the next settlement day (subject to system allocation if any). This will enable them rolling over their position without the constraint of delivery and payment except for a mark to market charge. Position of each Clearing Member with the Clearing House will be updated every day based on the settling trades and movement of share positions.

The CNS permits an additional level of netting by eliminating the need to actually settle a given day's transactions on settlement day by carrying over positions to net with the settling position on the next settlement day. This is expected to increase trading volume due to 1) reduction of settlement costs because of reduction in actual settlement movement and 2) reduction of carry over costs as Clearing Members will able to trade in and out of their positions without the mandatory requirement for full delivery or payment on settlement day.

Moreover, the CNS also offers an auto loan facility through which Clearing Members will be able to lend their excess shares using a leading account in CDS, which would be accessible by the NCSS to cover withdrawal requests. Cash paid would be then transferred to the Leading Clearing Member as long as the securities are being utilized by the system.

The entities who will be eligible to become Clearing Member in NCSS are: stock brokers, banks, companies falling under section 3A of the banking Companies Ordinance 1969, Investment and asset management companies and any other entity which the National Clearing Company of Pakistan allow from time to time.

The transaction that will be settled by the NCSS will be of two types: 1) Exchange trades and 2) non-exchange transactions. Exchange trades are those trades that come from trading system of the three stock exchanges in Karachi, Lahore and Islamabad. These trade will be settled under the CNS and the Balance Order Settlement (BO). The Balance Order Settlement aims at reducing the number of actual settlements by netting sell and buy transactions. Netting between all parties in the system referred as multilateral netting is in practice. In the BO, settlement has to be done at the designated settlement day. If the Clearing Members are short of funds or securities, they have to resort to borrowing to meet their obligations.

Non-exchange transactions will be generated from the NCSS itself. Institutional Delivery System will record trades between brokers and financial institutions and will allow for netting of deliveries and cash transactions. Broker to Broker Delivery System will facilitate transaction between members of different stock exchanges. Members of same exchange will also be allowed to use this facility. Member to Member Stock Loan Transactions will provide the option of borrowing and lending stocks from and to other Clearing Members. These transactions are expected to replace the current practice of carry over trade. Under Member to Member Money Lending Transactions, Clearing Members will be allowed to lend funds to other Clearing Members in the system.