Third-party clearing in Australia – what it is, how it works and why it’s important
Clearing is the second-last part of the trading process where a ‘clearing house’ acts as intermediary between buyers and sellers. During clearing, it’s confirmed that the seller of a financial instrument has the money to buy the assets they have agreed to buy, and that the seller actually owns the instruments they have sold. Once this has taken place the trade is ‘settled’ – the buyer receives the assets and the seller receives the cash.
Central clearing is a very important part of the plumbing of financial markets. Using a central counterparty reduces risk to both buyers and sellers who would otherwise be exposed to the potentially poor or fraudulent business dealings of their counterparties (see breakout box – How Clearing Works).
Clearing is not new to financial markets by any means. The first clearing house appeared in 1818 in Boston, opened by Suffolk Bank to net payments in commodity futures markets. For equities, exchanges began using clearing houses in the latter part of the 19th century – the Philadelphia Stock Exchange led the way in 1870.
Australia was very late indeed to this party. Up until 1987, there was no central clearing in this country. That year, as global stockmarkets melted down and Australian retail losses were exacerbated by the lack of central clearing and settlement, a national broker-to-broker system, BBS, was introduced. However, there was still no minimum requirement for the time between making a trade and receiving the cash or shares (settlement). It would be another five years before T+5 legislation was introduced, meaning trades must be settled on the fifth day after being made.
In September of 1994, Australia at last began to meet global market standards with the introduction of the Australian Clearing House (ACH), ASX Settlement and Transfer Corporation (ASTC), and Clearing House Electronic Sub-register System (CHESS) by the Australian Securities Exchange (ASX). Like all clearing houses, CHESS was now the intermediary for trades in the (initially limited) securities available within it. By August 1996, all 1600 ASX listed companied were available in CHESS and central clearing in Australia had begun.
What third party?
Registered market participants who wish to be direct counterparties to the central clearing house need to hold significant amounts of capital to be allowed to do so – this is to protect the central clearing house from default. In Australia, the amount required is $5 million. For big stockbrokers it makes sense – self-clearing, as this is known, is more cost effective when you are managing high volumes of trades.
But for smaller brokers, ring-fencing $5 million in capital, buying an expensive back-office system and hiring the people to run it is a prohibitively expensive process when you are only executing small numbers of trades for your clients. Enter the third-party clearer. For a fee, the third-party clearer acts as the counterparty in the broker’s place, holding the required capital and managing the processes between the making of the trade and the receipt of shares or cash.
A healthy third-party clearing landscape supports a healthy financial market overall, allowing for a thriving industry of boutique firms servicing retail investors. Without third-party clearers, many small and medium-sized brokers would be forced to close and investors would have very limited choices in investment management.
How Does Clearing Work?
All buying and selling of securities in Australia must take place via a market participant registered with ASX. These participants are known as stockbrokers or brokers.
- A broker places a buy or sell order for a share.
- A buyer or seller takes up the offer, becoming the counterparty to the trade.
- The trade information is sent to the Australian Clearing House, which becomes the central clearing counterparty to both buyer and seller. The receipt of cash by the seller and shares by the buyer are now guaranteed by the National Guarantee Fund (in the case of broker fraud) or the Clearing Guarantee Fund (in the case of broker default).
- The information is received electronically by the ClearingHouse Electronic Sub-register System (CHESS). CHESS identifies the old and new holders of the shares by their Holder Identifying Codes (HIN).
- On settlement day, which is two working days after the trade takes place, ASX Settlement and Transfer facilitates the simultaneous debiting and crediting of Exchange Settlement Accounts held at the Reserve Bank of Australia. The shares are transferred from the old HIN to the new one, and cash is sent to the seller’s nominated bank account.
Clearing in Australia
- Up until 1987: no Australian central counterparty exists
- 1987: CENSAS, a 10-day settlement system, is planned for introduction but fails.
- 20 October 1987: loss of Australian money in the global stockmarket crash is exacerbated by the lack of central clearing.
- Late October 1987: a national broker-to-broker settlement system introduced for floor and SEATS trades designed for a T+5 settlement cycle. There is still no legislated settlement period under Australian law.
- 1992: T+5 legislation is introduced.
- September 1994: ACH, ASTC and CHESS are introduced by ASX for a limited number of Australian securities.
- August 1996: CHESS Phase II launches with all 1,600 Australian stocks available.
- 1996: Merrill Lynch buys Berndale Securities and begins third-party clearing
- 1999: T+5 is reduced to T+3
- 2010: Berndale Securities ceases third-party clearing
- 2011: ASX lifts capital requirements for firms to self-clear from $100,000 to $5 million
- November 2011: Penson Financial Services is acquired by BNY Mellon-owned Pershing Securities, creating an effective monopoly for third-party clearing in Australia.
- 2013: a planned rise in capital requirements for firms to self-clear from $5 million to $10 million is put on hold, partly due to limited development of the third-party clearing market.
- 2016: T+3 is reduced to T+2
- October 2017: ASX proposes an uplift for certain self-clearing organisation’s core capital requirements from $5 million to up to $20 million. Proposal sent to ASIC for approval for implementation in 2018.
- October 2017: FinClear launches to offer choice in third-party clearing.