Dodd-Frank: Debt Instrument Transaction Processing

An article by New York Institute of Finance instructor David Weiss.

The staid debt market has become a hotbed of activity over the last few years.  Some of the products representing this segment of the market have been blamed for the financial crises.  Two states are being investigated by federal authorities for mishandling municipal securities in their state pension plans. Two grand old financial institutions are gone.  Banks have already paid over $61 billion to settle mortgage claims and the amount continues to grow. People involved with the LIBOR scandal face prison terms.  The list goes on and on...

As most are aware, congress passed the Dodd-Frank Act in 2010 to remedy some of the problems with the debt market.  Among the issues that the Dodd Frank Act addresses is the need for transparency and accountability in the clearing and settlement of derivatives, namely credit default swaps.  With the trading of these instruments and other types of derivatives, settlement is required for both sides of the derivative transaction. One side of the transaction is the security, underlying issue, or product side.  The other side is the cash or money side. The range of processes used to settle derivative transactions spans from custom made (one-off) exercises to mass transaction processing. This article is a quick reference that explains the relevance and differences of the terms used to explain settlement procedures.  I will demonstrate the following terms: Trade for Trade, Bi-lateral Netting, and Unilateral Netting as well as Central Counter Party and CCP Guaranteed transaction.

Trade for Trade

Let’s assume Giant Reckor and Crane (GRC), a broker dealer, buys two lots of an issue for Client #1.  One lot is purchased from Dealer A and one lot is purchased from Dealer B.  Later in the day, GRC sells one lot of the same product for a different client; Client #2, to Dealer B. Near the close of business that day, GRC sells one lot of the same issue for Client #3 to Dealer C.  GRC must settle one trade each with Client #1(buyer of 2 lots) and Client #2 (seller of 1 lot) and Client #3 (seller of 1 lot). CRC must then settle the contra side of the trades with the dealers. GRC must settle one trade with Dealer A (the buy for Client #1), two trades, independently of each other, with Dealer B (the buy of 1 lot for Client #1 as well as the sale of one  lot for Client #2) and finally, settle one trade with Dealer C (the sale of one lot for Client #3). In summation, GRC settles three transactions with their clients and four trades with the contra side dealers.

Bi-Lateral Netting

Using the above example; the client side remains the same but the contra side changes as GRC bought and sold one lot of the same issue against Dealer B. The two firms will “net out” the issue side of the trades and settle any money difference that may exist between the buy and sell transactions. GRC must settle the buy trade against Dealer A, the sell trade against Dealer C and only the money difference (if one exists) with Dealer B, thereby eliminating the receive and deliver of the netted transactions with Dealer B.

Unilateral Netting

Again, using the above example, the client side stays the same but the contra side changes drastically. As GRC bought 1 lot from Dealer A and 1 lot from Dealer B as well as selling 1 lot to Dealer B and 1 Lot to Dealer C; GRC nets out from receiving or delivering any lots and simply settles any money differences that may remain. Dealer A (which originally sold 1 lot to GRC) now delivers one lot to Dealer C (who originally bought 1 lot from GRC) and any money differences are addressed.  

Unilateral netting is performed with the assistance of a clearing corporation, which becomes a CCP (Central Counter Party) to the trades entered into by CRC, Dealer A, Dealer B and Dealer C. As it inserts itself as the “other side” to each transaction, it can facilitate the netting and settlement processes. In the case of the clearing corporations that guarantee settlement, they step in and become the contra side to any transaction that turns out to be against a defunct contra party, thereby protecting the broker dealers that traded with the defunct firm from any exposure to loss . Those clearing corporation that do not offer the guarantee, leave the firms that traded with the defunct firm, after applying netting, to settle those transactions as best they can.

I hope this brief explanation and examples are helpful in understanding the various debt products processes. 

About New York Institute of Finance

With a history dating back more than 90 years, the New York Institute of Finance is a global leader in training for the financial services and related industries with course topics covering investment banking, securities, retirement income planning, insurance, mutual funds, financial planning, finance and accounting, and lending.  The New York Institute of Finance has a faculty of industry leaders and offers a range of program delivery options including self-study, online and in classroom.

For more information on the New York Institute of Finance, visit the homepage or view in-person and online finance courses below: