CISI – Financial Products, Markets & Services Topic – Equities (4.1.11, 4.1.12 and 4.1.13) Trading and Settlement

Trading Clearing Settlement Process overview Before an investor finally owns or relinquishes securities, there is a 3-stage process they must go through: Trading Investors need to find a buyer or seller for securities they want to relinquish or own The obligations of the buyer and seller to a trade are defined and legally formalised. It establishes what each of the counterparties expects to receive when the trade is settled and defines the obligations each must fulfil, in terms of delivering securities or funds, for the trade to settle successfully. Clearing The ownership of a security is transferred from seller to buyer in exchange for the equivalent value in cash. Ideally, these two transfers should occur simultaneously. Settlement

Trading Trading (buying and selling) shares and bonds is done either: On-exchange Off-exchange On-exchange Off-exchange Takes place through a recognised stock exchange, using a trading system Takes place directly between market counterparties away from an exchange. Also known as “Over the Counter” Quote driven system Order driven system OR

Trading on-exchange – Quote Driven Quote driven system e.g. NASDAQ or SEAQ Market makers: Work throughout the trading day Provide continuous two-way (bid and offer) prices for particular securities A trading system employing market makers Make a profit through the price spread Perform their function regardless of market conditions Provide liquidity to a market which may have dried up without them

Trading on-exchange – Order Driven Order driven system matches buyers and sellers by Electronic Order Book e.g. LSE’s SETS Auction Process e.g. NYSE floor OR Both match buyers and sellers in strict chronological order: By Price then By the quantity of shares being traded

Trading on-exchange – Order Driven - SETS The London Stock Exchange’s main trading platform is SETS, which is used to trade shares that are contained within the FTSE All Share Index. LSE member firms (Investment banks and brokers) ‘Deep’ Order Book This is used for liquid stock e.g. Vodafone the term ‘deep’ implies that there are lots of orders waiting to be dealt on either side. These firms input orders for themselves or on behalf of client into SETS via computer terminals SETS system WITH Electronic Order Book Integrated market makers Orders added to one of 3 lists in the system Buy queue sell queue Executed immediately Investors who add their order to these queues are prepared to hold out for the price they want Here, investors trade against the queue of buyers (if they are selling) or against the sellers’ queue (if they are buying).

Other trading systems on the LSE The London Stock Exchange does not just use SETS. Due to the varying liquidity of shares and the need to trade fixed interest securities (corporate and government bonds), alternative systems are used: SETSqx SEAQ ORB Trading Systems Stock Exchange Automated Quotation For fixed interest securities and AIM stocks not traded on SETS or SETSqx One of the last examples of quote-driven equity trading systems along with the NASDAQ SETS - quotes and crosses Not all shares are liquid enough to trade via SETS. SETSqx is for shares where the volume of shares traded is low. It combines periodic auctions with quotes from market makers Order Book for Retail Bonds Offers continuous two-way pricing Used for trading in UK gilts and retail-size corporate bonds

Trading Clearing Settlement Process overview Before an investor finally owns or relinquishes securities, there is a 3-stage process they must go through: Trading Investors need to find a buyer or seller for securities they want to relinquish or own The obligations of the buyer and seller to a trade are defined and legally formalised. It establishes what each of the counterparties expects to receive when the trade is settled and defines the obligations each must fulfil, in terms of delivering securities or funds, for the trade to settle successfully. Clearing The ownership of a security is transferred from seller to buyer in exchange for the equivalent value in cash. Ideally, these two transfers should occur simultaneously. Settlement

Trading Clearing Settlement Process overview Before an investor finally owns or relinquishes securities, there is a 3-stage process they must go through: Trading Investors need to find a buyer or seller for securities they want to relinquish or own The obligations of the buyer and seller to a trade are defined and legally formalised. It establishes what each of the counterparties expects to receive when the trade is settled and defines the obligations each must fulfil, in terms of delivering securities or funds, for the trade to settle successfully. Clearing The ownership of a security is transferred from seller to buyer in exchange for the equivalent value in cash. Ideally, these two transfers should occur simultaneously. (Delivery versus Payment or DvP) Settlement

Methods of Holding Title Before exploring how purchases and sales of shares are settled – ie, how the seller gets his money and the buyer gets her shares. It is important to consider how ownership of a share is evidenced. Shares can be issued in either registered or bearer form, with the former (registered) being a lot more common than the latter (bearer).

Holding shares in registered form Methods of Holding Title Holding title - How do you show that you own particular shares? Holding shares in registered form The investor’s name is recorded on the company share register, and, often they are issued with a share certificate. Many companies have ‘dematerialised’ their shares (They do not use physical share certificates) and use electronic records of ownership. This is known as issuing shares on a non-certified basis. Methods of Holding Title (Evidencing share ownership) Holding bearer shares The person who physically holds the share certificate is the owner or ‘bearer’. Ownership passes through transfer of the certificate to the new owner. Risky – the certificate could be lost and so could the investment. Provides opportunity for money laundering and tax evasion.

‘Immobilised’ Often have no register Authorised depositaries Settlement – Registered and Bearer Shares Shares in registered form Bearer Shares UK Companies Often have no register Required to keep and maintain a Authorised depositaries Share register They are usually kept safe in authorised depositories. These can be international organisations like Euroclear, or country based depositories like Singapore’s central depository. a record of all current shareholders in that company, and how many shares they each hold. Company registrar Bearer shares kept in this way are said to be ‘Immobilised’ keeps and maintains the company share register - might be an employee of the or a specialist firm of registrars ‘Certificated settlement’ Historically, when selling these shares, the seller sent their share certificate and a stock transfer form, providing details of the new owner, to the company registrar. The registrar would delete the seller’s name and insert the name of the buyer into the register. The registrar then issued a new certificate to the buyer. An electronic register is also kept by CREST so that trades can be settled electronically.

Shares in registered form Settlement – Registered and Bearer Shares Shares in registered form Bearer Shares Over the past decade most UK settlement has moved to a paperless, dematerialised (or uncertificated) form of settlement through a system called CREST. Certificated settlement is cumbersome and inefficient Some investors still hold physical share certificates and they have been unable to benefit from shorter settlement periods. Settlement of these trades usually takes place at: This allows all of the paperwork to be completed. As part of the changes to settlement periods, there are separate proposals to phase out the use of paper share certificates. European markets to move to a standardised T+2 settlement period: This reduction in the settlement period is intended to harmonise practices across Europe and help to reduce risk T + 2 T + 10