Cash Settlement Procedure

1. Introduction

The CCP for Equities (EquityClear®) service for London Stock Exchange business was launched in February 2001.  At the time of launch the London Stock Exchange was solely responsible for operating the buying in service, which could be initiated by a buyer requesting delivery of unsettled securities.  However, this service is rarely used as the CREST settlement algorithm prioritises the oldest transactions for settlement. This has meant that there are very few outstanding buy transactions, which are eligible for buyer instigation. This service continues to operate, however, due to there being a number of sold transactions still remaining for more than thirty business days after their Intended Settlement Date (ISD), LCH.Clearnet Ltd (LCH.C) introduced its own buying in process in an attempt to create a model in the UK market that ensured settlement finality.

This process has worked well, however, with the recent increase in traded volumes, and the extension of CCP clearing to less liquid securities, there has been a substantial increase in the number of sold transactions that are still outstanding at thirty business days after their ISD.  Corporate events in illiquid securities often cause settlement problems and settlement finality is not being achieved in all circumstances with the buying in process failing to achieve settlement.

This particular problem has been highlighted recently in a number of examples and LCH.C has found that members are cancelling outstanding transactions in their back office systems due to the length of time that they have been failing.

To achieve settlement, where buying in fails, LCH.C currently seeks acceptance from all parties on a fair means of settlement.  This process does not always work due to counterparties disagreeing with the proposed means of settlement and takes up valuable amounts of time and resource by all organisations involved.  Although LCH.C does have an invoicing back rule within its Rules and Regulations, which means that LCH.C sets a fair price to cash settle the outstanding positions, LCH.C proposes to introduce a further step in the buying in process rather than using invoicing back.

The purpose of this circular is to put forward a proposal for improving the fails management model currently employed in the UK market by introducing a standard cash settlement process, which will supplement buying in to achieve final settlement¹.

Members are invited to provide feedback by 10 July 2008 on the proposed cash settlement procedure, which LCH.C intends to implement as soon as possible after that date (subject to regulatory approval).  In the event that no response is received then LCH.C will assume that members accept the new procedure.

Note 1. If an alternative course of action can be agreed between counterparties then LCH.C will use its discretion before imposing the cash settlement procedure.

2. Current Buying In Process

London Stock Exchange

The buying in process is initiated by the requesting party (i.e. the buyer) by submitting a request to the London Stock Exchange.  The London Stock Exchange will then issue the liable party (i.e. the seller) with a Buying In Notice.  The current timescales for the buying in process are detailed in the table below:

LCH.Clearnet

In the event that there are outstanding sell settlement transactions at ISD + 30, LCH.C will instigate the buying in process on its own accord.  LCH.C will issue the liable party with a Buying In Notice.  The table below details the current timescales for buying in.

3. Cash Settlement Procedure

It is proposed that the current buying in regimes operated by the London Stock Exchange and LCH.C (as described in section 2) remain unchanged with the exception that LCH.C will attempt to buy in for a 3rd time before invoking cash settlement.  However, where buying in is not achieved after ISD + 60, then LCH.C will cash settle any outstanding transactions at 120% of the last available closing price².

For example:

Seller A has an outstanding transaction for 10,000 shares against payment of £30,000. Buyer B also has an outstanding transaction for 10,000 shares against payment of £30,000.

Note 2. Members will be advised through e-mail and a follow up phone call where LCH.C invokes the cash settlement procedure.

The last available closing price was £3.50.  Cash settlement will take place at a price of £4.20 (£3.50 x 120%).   Therefore the following cash movement will take place in order to close out the outstanding positions.

The net effect of the cash settlement will be a movement of £12,000 (£42,000 - £30,000) from Seller A to Buyer B.   The cash movement will be settled in the relevant Central Securities Depository as a cash only delivery with the settlement party for which the failed delivery occurred.  In the event that the settlement party fails to match the cash only delivery then LCH.C may settle the cash though the PPS account of the relevant Clearing Member.

4. Sellers Profit

Where the share price of a security drops substantially below the original traded price at the time the cash settlement occurs, the seller can benefit from the drop in price.  This means that the seller is not penalised for failing to deliver the underlying securities.

It is proposed that with the introduction of the standard cash settlement process as described in section 3 of this circular, LCH.C confiscates any profit that the sellers may make as a result of a the cash settlement process and passes the amounts onto the buying member.   This will act as an added incentive for sellers to ensure that they settle any outstanding transactions before the cash settlement process is initiated.

5. Further Information

Please provide any feedback to Ian Mackenzie on 020 7426 7265 or e-mail ian.mackenzie@lchclearnet.com, who will also be able to provide further information if required.

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