Clearing and Settling Financial Transactions, Circa 2000
by Edward J. Green, senior policy adviser, Federal Reserve Bank of Chicago
In order for a market to exist there must be a mechanism to convey whatever is traded conveniently and safely between the trading parties. Particularly in large markets, formal, institutionalized safeguards must support the integrity of the market so that traders can remain confident that payments or assets transfers will be made.
The convenience, safety, and trust required for national and global financial markets to function are largely provided by clearing and settlement arrangements. These arrangements play a crucial role in enabling such developments as the invention of financial derivatives, the explosive growth of trading volume, and the use of telecommunications networks to conduct financial trading.
Green’s paper provides a broad introductory survey of how clearing and settlement are typically accomplished in financial markets today. While the discussion occurs primarily in the context of U.S. laws, institutions, and practices, the focus is understanding clearing and settlement processes as risk-management techniques for financial trading. Using economic logic rather than historical sequence as a guiding principle, Green introduces a hypothetical delivery-versus-payment settlement arrangement as the basic risk-control technique and then discusses ancillary measures that can be successively employed.
Arrangements for the clearing and settlement of financial transactions have improved dramatically and continuously during the past several decades. A quantum leap in the capacity to clear and settle financial transactions and in the integrity with which those operations are accomplished has been part of a radical restructuring of the operation of financial markets in the industrialized countries.
This restructuring has contributed to financial markets’ responsiveness to three major challenges and opportunities: the invention of financial derivatives (for example, futures, options, and swaps) and the establishment of exchanges to trade many of them; the availability of computing and telecommunication technology that can simultaneously link a large, geographically dispersed group of traders and the consequent feasibility of conducting trading by means other than open outcry on a trading floor; and the explosive growth of transaction volume on a number of exchanges.
None of these innovations would have been commercially feasible by itself, Green argues. In particular, the high fixed infrastructure costs for the way that transactions are cleared and settled today would probably have been uneconomical at the transaction volumes typical until the 1970s. By the same token, the development of this way of clearing and settling transactions was a prerequisite for exchanges to handle a volume of transactions beyond those traditional levels.
To the extent that the financial markets transformation has been among the causes of improvement in the macroeconomic performance of the United States and other economies, the dramatic advances in clearing and settlement deserve a full share of the credit.
