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Cashiers

The Cashiers Department, or Cashiering, is responsible for receiving and delivering securities to and from the brokerage firm, and controlling the flow of money related to this movement of securities. Due to the presence of large quantities of physical stock and bond certificates that reside in the firm’s vault – which is located within Cashiers – the department is housed in a secured location and access to the Cashiering Department is restricted.

In post-modern times, the restriction of access to Cashiering was accomplished by enclosing the department behind steel bars – similar to those of a prison cell or animal cage. As a result, the department earned the nickname ‘the Cage’. This term, although still used today, is outdated and draws attention away from the state of the art technology currently utilized to control the flow of securities and money in and out of the broker dealer.

Job functions in Cashiers involve both those activities that control the actual movement of securities and funds and those activities that support or facilitate that movement.

The following departments within Cashiering handle the actual movement of the securities and funds:

The following departments within Cashiering support or facilitate the movement of securities and funds:

Movement of Securities and Funds

Securities can be in the form of:

  • Physical Stock or Bond Certificates
  • Electronic Shares on Deposit
  • Bookshares

Physical Stock or Bond Certificates

Physical Stock or Bond Certificates are negotiable paper documents that represent shares of ownership (stock) or indebtedness (bonds). At a minimum, the physical certificate identifies the issuing company, the number of shares or bonds represented by the certificate and the registered owner of the securities. Certificates also contain a unique Certificate Number that is used to track the certificate once issued.

Issued physical certificates are registered with the company – or more commonly with the company’s stock transfer agent. Through this registration, the transfer agent or registrar maintains the shareholder registry for the issuing company. The agent is also responsible for transferring the registration of shares from one owner to another as shares of the company are bought and sold.

Electronic Shares on Deposit

Electronic Shares on Deposit represent stocks and bonds held in certificate form by a designated central securities depository. The depository tracks ownership of the securities held through the use of an electronic record keeping system. Security movements from one firm to another are facilitated with journal entries within the electronic record keeping system, and do not require the physical movement or re-registration of the actual physical certificates. The most widely used US securities depository is the Depository Trust Company or DTC.

Bookshares

Similar to Electronic Shares on Deposit, ownership of Bookshares or Book Entry Securities is tracked through the use of an electronic record keeping system. The primary difference between Book Entry Systems and Depository Shares is the elimination of the physical stock and bond certificates in the Book Entry System. Unlike Shares on Deposit, electronic Bookshares do not represent actual shares deposited in a holding facility.

The primary securities held in Book Entry Security Systems are Mutual Funds, Options and Government Securities.

The functions performed by the Cashiering Department are either Trade Settlement activities, or activities that support the Trade Settlement process.

Control Locations

A Control Location is an account maintained on the firm’s accounting records that identifies where the firm holds actual securities on behalf of its clients. A credit position in a Control Location signifies shares or bonds held in that location. This credit entry offsets the debit entry in a client’s brokerage account that denotes ownership of the securities by that client.

A credit entry of securities into a Control Location or Control Account denotes actual securities received at the holding location. Similarly, a debit entry of securities in the Control Account signifies securities delivered or removed from that holding location.

For example, electronic shares on deposit at DTC are represented as a credit entry to the firms DTC Control Account. Similarly, physical certificates held in the firm’s vault are represented on the accounting records as a credit entry to the firm’s Vault Control Account.

Trade Settlement

The vast majority of the security movements processed by Cashiering result from the brokerage firm’s trading activities. This movement of securities and funds concludes the trade settlement process. Remember that when a firm sells securities to another firm, the seller must deliver the sold securities to the purchaser on settlement date. In turn, the buy side firm pays the selling firm for the securities purchased.

The flow of securities and funds between firms depends on the type of marketable security traded, the comparison received (CNS, Non-CNS or T-f-T) and the eligibility of the particular stock or bond traded. The following departments within Cashiering handle the actual movement of the securities and funds:

Although the type of securities delivered, and delivery technique for each, may vary from area to area, the terms and concepts leading up to that delivery are the same.

Trade Comparison and Reconciliation is the primary function of the Purchase and Sales Department. The method of Trade Settlement is determined at the time of comparison, and depends on the NSCC eligibility status of the particular security traded. Trade Settlement is accomplished either via CNS Net Settlement, Non-CNS Net Settlement or on a Trade-for-Trade Basis.

The Receive and Deliver Master File

The firm’s Receive and Deliver Master File - or R&D File - is an accounting sub-ledger that maintains the settlement instructions for the firm’s trading activity. The R&D File receives trade data from the firm’s Purchase and Sales System, and instructs the Cashier’s Department to deliver securities (sell trades) or receive securities (buy trades).

The R&D File provides specific information to Cashier’s about the securities to be received or delivered. This information includes the settlement date, the specific security issue to be settled, the quantity to be delivered or received, the settlement amount to be collected or paid and the contra broker to whom the securities are to be delivered or from whom the securities are to be received.

Once securities are delivered or received and the trade is settled, the open deliverable or receivable is removed from the R&D Master File. The removal of the settlement instruction from the R&D File is commonly referred to as a ‘Clean-Up’.

Delivery Methods

By definition, all securities that are eligible for CNS Net Settlement are also eligible for deposit at the Depository Trust Company. This is because DTC eligibility is a mandatory prerequisite for CNS eligibility. Delivery and receipt of securities to and from CNS will be discussed in this section under DTC Settlements.

The delivery methods used for Non-CNS and Trade-for-Trade settlements are the same, and are accomplished by the delivery or receipt of either physical certificates, electronic shares on deposit (generally DTC) or Book Entry securities. Book Entry Settlement is generally associated with the settlement of Mutual Funds, Options and Government Securities, and will be discussed in appropriate sections.

Non-CNS and Trade-for-Trade Settlements

US security trades compared for settlement via Non-CNS or Trade-for-Trade delivery, are concluded with the settlement of funds, and the delivery or receipt of:

Non-CNS and Trade-for-Trade comparisons generate entries to the firm’s R&D Master File. Sell trades create a ‘Fail-to-Deliver’ record on the R&D File, whereas buy trades create a ‘Fail-to-Receive’ record.

On settlement date, the firm’s Cashiering System identifies whether the transaction will settle via electronic shares or physical certificates. The type of securities delivered - physical vs. DTC – is a factor of the particular security to be settled. Certain securities are not eligible for deposit at DTC. This eligibility is determined by DTC, based on pre-determined eligibility criteria set by the depository.

Physical R&D – Receive and Deliver

The majority of US Domestic Securities are eligible for electronic settlement via an established securities depository (such as DTC) or Book Entry System. Securities that are not eligible require the delivery or receipt of physical stock or bond certificates. Physical R&D is accomplished by the following methods:

Through the House

The majority of physical settlements are processed using the NSCC Envelope System – commonly referred to as ‘Through the House’. To utilize the NSCC Envelope System, both the delivering firm and the receiving firm must be members of the NSCC.

Delivering securities Through the House – the NSCC being the House – is the preferred method for physical security settlements because the NSCC controls the money settlement for the trade. This simplifies the collection process for the delivering firm, and reduces the risk associated with the collection process.

Each morning, selling brokerage firms deliver physical certificates to the NSCC. The securities are delivered to NSCC in large, manila envelopes – hence the name ‘Envelope System’. The selling firm also instructs the NSCC to charge the receiving firm for the settlement amount of the transaction. The information as to which securities to deliver and how much payment to collect is obtained from the open deliverable record on the R&D File.

Around noon, the securities are delivered by NSCC to the receiving firms (in reality, firms actually pick up the securities by sending a messenger to the NSCC). Receiving firms have until 1:30 PM EST to review the securities and determine that all key elements of the delivery are accurate. The key elements are:

  • The Security Description
  • The Quantity Received
  • The Settlement Amount Charged

This review is accomplished by locating the open receivable for the securities on the firm’s R&D file, and examining the certificates received to ensure that the Security Description, Quantity and Settlement Amount - the key elements listed above – are the same as those for that open receivable.

Additionally, the receiving firm must also verify that any certificates received are in good standing and in negotiable form. This is accomplished by reviewing the Registration on the certificate. Certificates should be in ‘Street Name’ or accompanied by a valid Stock Power. Additionally, the certificates must be examined for any legends indicating that the shares might be restricted or non-transferable.

If an open receivable is located on the R&D file, and the receiving firm agrees with the key elements of the delivery, and the certificates are in good form, the delivery is accepted and the receivable is removed from the R&D File. If no open receivable is found, or the key elements do not agree, or the certificates are not in good form, the delivery is rejected – or ‘DK’d’.

The receiving broker approves the delivery by keeping the securities received. Upon approval, the NSCC charges the receiving broker’s NSCC Settlement Account for the value of the delivery and credits the delivering broker’s account for the same. This amount is included in the brokers’ NSCC Settlement Amount as a debit.

To DK or reject the delivery the receiving broker returns the shares to the NSCC by 1:30 PM. As a matter of good practice, the rejecting broker should – but generally doesn’t – provide an explanation as to why the delivery was rejected. The NSCC returns the certificates to the delivering broker with any explanation that was provided. The receiving broker is not charged for securities that are rejected prior to the 1:30 cutoff.

Settling with the NSCC

At the close of business each firm must ‘Settle’ with the NSCC. This NSCC Settlement takes into account all of the firm’s debits (from securities received) and credits (from securities delivered). The firm’s debits and credits are netted to arrive at the net NSCC Settlement Amount. If the firm’s net NSCC Settlement Amount is a credit the firm receives a payment from the NSCC. If the firm’s net NSCC Settlement Amount is a debit the firm must make a payment to the NSCC.

Over the Window

If either the delivering firm and/or the receiving firm are not members of the NSCC, neither firm can utilize the NSCC Envelope System for the physical trade settlement. Under such circumstances, securities are delivered ‘Over the Window’. The selling firm uses a messenger or courier to deliver the securities to the buying firm.

If the receiving firm agrees with all key elements, Security, Quantity and Amount, and the securities are in good order, the receiving firm wires payment for the delivered securities to the delivering broker. If the delivery is not in good order, the securities are returned to the delivering firm with the messenger.

DTC Settlement

If the traded securities are DTC eligible, the securities are delivered or received using DTC’s electronic delivery system. On settlement date, the selling firm instructs DTC to deliver the electronic shares or bonds from its DTC account to the DTC account of the receiving firm. At the same time, the delivering firm instructs DTC to debit (money) the DTC account of the receiving firm and credit (money) its own DTC account for the Settlement Amount of the trade.

It is important to remember that there is no actual movement of physical certificates associated with a DTC delivery. The delivery and receipt are effected by entries to DTC’s electronic record keeping system.

After completing the transfer of securities and funds, DTC electronically notifies the receiving firm of the securities received and the corresponding amount that was charged. Upon receiving notification from DTC, the receiving firm reviews the securities received to determine whether or not all key elements of the delivery are accurate. The key elements are the same ones that were evaluated for physical securities, which are:

  • The Security Description
  • The Quantity Received
  • The Settlement Amount Charged

Similarly, the review of the incoming securities is accomplished by first locating the open receivable for the securities on the firm’s R&D file. If an open record exists on the R&D File, it is compared to the delivery notification received from DTC to ensure that the Security Description, Quantity and Settlement Amount - the key elements listed above – are the same as those for that open receivable.

If an open receivable is located on the R&D file and the receiving firm agrees with the key elements of the delivery, the delivery is accepted and the receivable is removed from the R&D File. If no open receivable is found or the key elements do not agree, the delivery is rejected – or ‘DK’d’.

To reject or DK securities that are received through DTC, the receiving broker uses the DTC electronic delivery system to instruct DTC to return the securities to the delivering firm. Upon receiving a DK instruction from the receiving broker, DTC reverses the previous entries in its record keeping system, and electronically notifies the delivering broker about the rejected delivery.

To accept a DTC delivery of securities, the receiving firm simply does nothing. By not processing a DK the trade is automatically accepted, and the settlement amount is netted into the DTC Settlement Amount.

Firms have until 3:00 PM EST to initiate deliveries via DTC. Securities received can be rejected or DK’d until 3:20 PM EST.

Settling with DTC

At the close of business each firm must ‘Settle’ with the DTC. This DTC Settlement takes into account all of the firm’s debits (from securities received) and credits (from securities delivered). The firm’s debits and credits are netted to arrive at the net DTC Settlement Amount. If the firm’s net DTC Settlement Amount is a credit the firm receives a payment from the DTC. If the firm’s net DTC Settlement Amount is a debit the firm must make a payment to the DTC.

CNS Settlement via DTC

CNS is the NSCC Continuous Net Settlement System. Compared trades for CNS eligible securities are netted and settled through CNS. To settle a trade through CNS, firms that are net sellers of securities must deliver shares or bonds to CNS. Firms that are net buyers of securities receive shares or bonds from CNS.

By definition, all securities that are eligible for CNS Net Settlement are also eligible for deposit at the Depository Trust Company. This is because DTC eligibility is a mandatory prerequisite for CNS eligibility. Therefore, the CNS settlement process is facilitated because the delivery and receipt of securities to and from CNS is accomplished using DTC’s electronic delivery system.

CNS compared trades are recorded on an R&D File for CNS settlements. This CNS R&D informs the Cashier’s Department what securities to deliver to and what securities to receive from CNS. Just as each brokerage firm has its own account on the DTC electronic record keeping system, so too does CNS. To settle with CNS, a firm delivers shares or bonds from its DTC account to the DTC account set up for CNS. In turn, receiving firms receive shares or bonds from the CNS DTC account.

The DTC account number for CNS is 888. Therefore, to deliver securities to CNS via DTC, the delivering firm initiates a delivery, on the DTC electronic delivery system, from its own DTC account to DTC account #888 – CNS.

Benefits of DTC Settlement

It is easiest to explain the benefits of using a depository such as DTC for trade settlements, by imagining a world where such depositories do not exist. Without the use of a securities depository, all trade settlement would be accomplished with the delivery and receipt of physical securities.

In a physical security environment, brokerage firms need to hold the actual physical certificates in a secured location – such as a vault. Each time the firm sells securities on behalf of one of its clients, the Cashier’s Department needs to remove the physical certificate from the vault and manually send it – probably via runner - to the buy side firm. The buyer then drafts a check, which is returned to the delivering firm and deposited.

Upon receipt of the certificates, the receiving firm must send the securities to the issuer’s Stock Transfer Agent to have the registration changed from the old client to the new client. This process generally takes several days and, in many cases, can take more than a week. After the shares are transferred, they are returned to the new brokerage firm and put in the vault for the new client. If and when the new client decides to sell these shares the process starts again.

This situation is complicated even further when the quantity sold does not match a specific certificate, or combination of certificates, held in the firm’s vault. In this case, before the selling firm can deliver the securities, the certificate(s) must first be sent to the issuer’s Stock Transfer Agent. The agent cancels the larger quantity and issues two or more certificates that equal the amount sold plus the difference from the original certificate.

For example, assume the client sells 100 shares, but the smallest denomination certificate available in the vault is for 150 shares. Before the trade can settle, the firm must send the 150 share certificate to the issuer’s Stock Transfer Agent. The Transfer Agent must cancel the 150 share certificate, and issue two new certificates – one for 100 shares and one for 50 shares. This process generally takes several days and, in many cases, can take more than a week.

The new certificates are then sent back to the selling broker. The 50 share certificate is returned to the vault, and the 100 share certificate is delivered to the buy side firm.

Upon receipt of the certificate, the receiving firm must send the certificate back to the Stock Transfer Agent to have the registration changed from the old client to the new client. Again, this process takes time, perhaps more than a week. After the shares are transferred, they are returned to the new brokerage firm and put in the vault for the new client. If and when the new client decides to sell these shares the process starts again.

From start to finish, this one trade took the better part of two weeks to settle. Now imagine having to go through this routine for each of the security trades in the modern era. Modern brokerage firms can settle in the range of 10,000 – 100,000 trades each day. The backlog of paperwork would be too overwhelming to sustain current trading levels.

Enter the Depository Trust Company. DTC serves its members in many ways, most importantly as a depository for physical securities, and as a settlement service. Physical certificates are deposited in a large securities vault located at DTC. The securities are registered in Nominee Name – that is, all securities held at DTC are registered to DTC.

Each DTC member firm has maintains an account at DTC. DTC account numbers – referred to as a firm’s ‘DTC Number’ – are generally three or four numeric characters – although there are a few noteworthy exceptions – such as broker 05 and 050 (Goldman Sachs and Morgan Stanley Dean Witter). DTC Numbers ranging from 0 – 899 are primarily reserved for those DTC members that are brokerage firms, whereas, Numbers 900 and above, are generally reserved for those DTC members that are banks.

The depository’s electronic record keeping system tracks how many shares each DTC member firm owns. When one account delivers shares or bonds to another – DTC simply credits the delivering account and debits the receiving account within its record system. No physical securities are actually moved because DTC holds the securities for both members.

The elimination of physical security movements eliminates the time and cost associated with transferring and re-registering physical certificates during the settlement process. A trade that might have taken 2 weeks to settle in the physical environment can now settle in literally seconds.

Segregation and Excess

After a trade is processed in the Purchase and Sales System, the trade details are forwarded to the Cashiering System, where a settlement instruction is generated on the firm’s Receive and Deliver Master File. However, before the Cashier’s Department can deliver shares in settlement of a sell trade, it must be determined whether or not Excess securities are available to make that delivery.

Various customer protection rules exist that prevent a brokerage firm from co-mingling client owned securities with those shares owned by the firm. These rules are designed to protect client assets from the firm’s creditors in the event that the brokerage firm is unable to continue as a going concern. A client is considered to own securities once that client pays for the securities in full.

The firm is required to segregate fully paid for client shares from both the firm’s assets and from client shares that are not fully paid for – ie. purchased on margin. Segregated shares are said to be ‘Locked-Up’ or in ‘SEG’. The number of shares locked up is referred to as the firm’s SEG Position.

These same rules prevent a brokerage firm from using a client’s segregated shares in order to settle a firm delivery. The term ‘Excess’ refers to the difference between the total number of shares of a particular security held by the firm and the firm’s SEG Position in that security. In order for Excess to exist, the firm’s total position must be greater than its SEG Position.

Before each and every delivery, the Cashier’s Department must calculate Excess. If Excess securities are available for delivery the delivery is said to be ‘Makeable’. If no Excess securities are available the delivery is said to be ‘Unmakeable’ – that is, it cannot be made.

For example, assume that a firm holds 100,000 shares of XYZ Co. common stock. Additionally, 95,000 of those shares are fully paid for client shares and are therefore segregated or locked up. The firm has 5,000 Excess shares of XYZ Co., which is calculated as follows:

Shares Held

100,000

SEG Position

- 95,000

Excess

5,000

If the firm sold 3,000 shares of XYZ Co. the delivery would be makeable on settlement date from Excess securities. After the delivery, the firm would have Excess of 2,000 shares:

New Position

97,000

SEG Position

- 95,000

Excess

2,000

If the firm instead sells 7,000 shares the delivery will be unmakeable on settlement date because insufficient Excess is available:

Delivery

7,000

Excess

-5,000

Deficit

2,000

Using fully paid for client shares to satisfy a firm delivery is a violation of SEC rules and procedures. This violation, commonly referred to as a SEG Violation, must be resolved immediately. SEG Violations are resolved by borrowing Excess shares from another brokerage firm or purchasing sufficient shares on the open market to cover any shortfall.

SEG Deficits

A SEG Deficit results when a firm’s SEG Position is greater than the quantity held by the firm. For example:

Shares Held

90,000

SEG Position

-95,000

SEG Deficit

5,000

SEG Deficits can result for different reasons, and the rules governing these deficits vary depending on the cause of the deficit. SEG Deficits generally result from:

  • Short Sales
  • Customer Sales Not Long
  • Open Fails
  • SEG Violations

Procedures for identifying and resolving SEG Deficits are covered in the discussion about Operations Control.

Deliver and Receive Support Functions

From time to time the delivery or receipt of securities related to the trade settlement process requires support from other departments within Cashiers. Situations may arise where insufficient Excess is available to make a delivery or physical certificates require transfer and/or re-registration. In other instances, shares expected from another firm in settlement of a buy trade might not be received in a timely manner.

These and other situations arise that delay - or prevent - the trade delivery process from occurring. Depending on the nature of the impasse the transaction might require support from one of the more specialized areas within Cashiering.

The following departments within Cashiering support or facilitate the movement of securities and funds:

  • Stock Borrow and Loan
  • Stock Transfer
  • Vault
  • Buy-In’s
  • Bank Loan

Stock Borrow and Loan

The Stock Loan Department performs three overall functions relating to the trade delivery and settlement process:

  • Loaning Excess securities to raise short term funding
  • Borrowing securities for trade settlement
  • Regulatory Borrow Situations

Loaning Excess Securities to Raise Short Term Funding

Stock Loan enables firms with Excess securities to obtain short term financing – at very reasonable rates – by lending those Excess securities to other firms. The borrowing firm transfers to the lending firm an amount of money equal to the market value of the loaned securities as collateral for the securities. This amount is the Contract Amount of the loan. In essence, the transfer of money is a short-term loan collateralized by the loaned securities.

In addition, the borrowing firm pays a moderate fee – known as a ‘Rebate’ – to the lending firm. The payment of the rebate is essentially the interest component of the loan. Through Stock Loan, the borrowing firm benefits from of the use of the securities while the lending firm benefits form obtains short-term financing at a reasonable cost.

Borrowing Securities for Trade Settlement

More important to the firm’s delivery settlement activities, the Stock Loan Department borrows Excess securities from other brokerage firms that are then utilized by the Cashiering Department to satisfy a previously ‘Unmakeable Delivery’.

Each evening, the firm’s Cashiering System identifies the delivery requirements for all settling trades, and performs Excess calculations for each settling security to determine whether or not sufficient Excess shares are available for those deliveries.

When sufficient Excess is available, the system makes a delivery recommendation. The Deliver area within Cashiers then determines the method or mode of delivery – Physical, DTC or Bookshare – and delivers the securities to the appropriate contra broker.

If sufficient Excess is not available the system generates an exception report. This exception report is commonly referred to as the ‘Unmakeable Report’. The Unmakeable Report indicates both the securities needed for settlement and the quantity of each required. The report instructs the Stock Loan Department to borrow the needed securities.

The firm’s Stock Loan personnel contact their respective counterparts in the Stock Loan Departments of other brokerage houses, banks and large financial institutions to ascertain whether or not those firms have Excess shares of a required security.

If Excess shares are available, a Stock Loan Contract is executed. The lending firm delivers the securities to the borrowing firm. The borrowing firm in turn transfers to the lender a cash amount equal to the market value of the borrowed securities – the Contract Amount. This is generally done via DTC although certain types of securities, such as Government Bonds, and International securities are not DTC eligible and are delivered through another delivery system.

Regulatory Borrow Situations

SEC and NYSE regulations require a brokerage firm to borrow securities – or attempt to borrow securities – under the following situations:

  • SEG Deficit
  • Short Sales

The firm’s ability to borrow securities is positively correlated to the number of outstanding shares or bonds of the particular security. The more securities issued the more likely the Stock Loan Department will be able to locate Excess shares to borrow.

It stands to reason then, that, depending on the number of outstanding shares or bonds in regulatory borrow situation, the firm might not always be able to locate excess securities to borrow. Under these circumstances, the firm must be able to demonstrate that a valid attempt was made to borrow the required securities.

SEG Deficits

As mentioned previously, a SEG Deficit results when the firms SEG Position (paid in-full client shares) is greater than the quantity of that security currently possessed by the firm. In the event of a SEG Deficit, the brokerage firm is required to borrow – or attempt to borrow – a sufficient quantity of the deficit security so that the firm’s position in that security is made to equal its SEG Position.

Short Sales

A firm (or client) enters into a Short Sale when the firm (or client) sells shares of a security it does not own. Because the shares are not owned, the firm does not have shares to deliver to the buyer on settlement date. To protect the buyer in a short sale situation, the Stock Loan department must be notified prior to any short sale execution.

The Stock Loan Department must locate Excess shares of the security to be sold at another firm before the short sale can be executed. If shares are located the Stock Loan Department authorizes the short sale. On the trade settlement date, the Stock Loan Department must borrow the sold securities for delivery to the buyer.

If the Stock Loan Department cannot locate Excess shares the request for the short sale is denied.

Termination of the Loan Contract

Upon termination of the Loan, the borrowing firm returns the borrowed securities and the lending firm returns the collateral or Contract Amount. The lender keeps the rebate initially paid by the borrower.

The Stock Loan Contract File

Open Stock Loan Contracts are recorded on an accounting sub-ledger - – the Open Stock Loan Contract File. This sub-ledger provides the Stock Loan Department with detailed information regarding the nature of the contract (Stock Loan vs. Stock Borrow), the security loaned or borrowed, the number of shares or bonds outstanding and the contract or dollar amount received (Stock Loan) or paid (Stock Borrow). Functionally, the Stock Loan Contract File is very similar to the firm’s Receive and Deliver Master File.

Upon termination of the loan the Contract is removed from the Open Stock Loan Contract File.

Mark-to-Market

The contract amount of Open Stock Loan Contracts is frequently adjusted as the market value of the loaned securities fluctuates.

This adjustment, called a ‘Mark-to-Market’, is generally processed as a cash adjustment through the Depository Trust Company. A money only SPO (Special Payment Order) charge is processed which transfers cash from one firm’s DTC account to the other firm’s DTC account.

If the market value of the loaned securities decreases the lending firm returns some of the collateral to the borrower so that the Contract Amount remains equal to the market value of the securities. The contract amount on the Open Contract File is then reduced to reflect the new market value.

Similarly, if the market value of the loaned securities increases the borrowing firm must transfer additional funds to the lender. Again, the Open Contract File is adjusted to reflect the new Contract Amount.

The Mark-to-Market adjustment protects the lender when the market value of loaned securities increases above the value of the collateral received at the time of the contract. For Example, assume that Firm A lends 20,000 shares of XYZ Co. stock to Firm B when the market value of XYZ Co. is $35 per share. The contract amount is $700,000:

Quantity Loaned

20,000

Market Value

x 35

Contract Value

700,000

The lender, Firm A, delivers 20,000 shares of XYZ Co. to FIRM B in exchange for $700,000.

Now assume that the price per share of XYZ Co. increases to $45 per share. The new market value of the loaned shares is $900,000:

Quantity Loaned

20,000

Market Value

x 45

New Market Value

900,000

Firm A is now exposed because it has only $700,000 collateralizing the $900,000 worth of XYZ Co. stock lent to Firm B. In this scenario, Firm A would initiate an SPO through the Depository Trust Company charging Firm B an additional $200,000. Both firms would then reset the Contract Amount of the Open Loan to $900,000.

Original Contract Amount

700,000

SPO Charge

+200,000

New Contract Amount

900,000

At the termination of the loan Firm B will return the 20,000 shares of XYZ Co. to Firm A, and will receive back from Firm A the new Contract Amount of $900,000.

The borrower is protected when the market value of borrowed securities falls below the collateral amount paid at the time of the contract.

For example, now assume that the price per share of XYZ Co. decreases to $30 per share. The new market value of the loaned shares is $900,000:

Quantity Loaned

20,000

Market Value

x 30

New Market Value

600,000

Firm B is now exposed because it has paid collateral of $700,000 for securities that are now only worth $600,000. In this scenario, Firm B would initiate an SPO through the Depository Trust Company charging Firm A $100,000 – which returns part of the collateral initially paid. Both firms would then reset the Contract Amount of the Open Loan to $600,000.

Original Contract Amount

700,000

SPO Charge

-100,000

New Contract Amount

600,000

At the termination of the loan Firm B will return the 20,000 shares of XYZ Co. to Firm A, and will receive back from Firm A the new Contract Amount of $600,000.

Mark-to-Market Thresholds

At the time a Stock Loan Contract is executed the lender and borrower set a mark-to-market threshold which determines how often the market value of the open contract is adjusted. The threshold outlines the necessary price movement of a given security before a mark-to-market adjustment is processed.

For example, the firms might establish a $1 threshold. The open contract will be marked-to-the market only if the market price of the loaned security increases or decrease $1 above or below the market price at the time the contract was entered into.

Stock Loan Recalls and Buy-In’s

Stock Loan Recalls

The lending firm has the right to issue a loan recall at anytime as long as sufficient notice of the recall is provided to the borrower. Upon receiving a recall, the borrower generally has 5 business days to return the borrowed securities to the lending firm.

However, because the borrowing firm often uses the shares to satisfy an open trade deliverable, the borrower does not always have the securities to return.

Stock Loan Buy-In’s

If the borrowing firm does not return the recalled shares within the stipulated 5 business days, the lender has the right to issue a Stock Loan Buy-In Notice. This notice is written communication of the lender’s intention to take ‘Market Action’ against the borrower should the securities remain outstanding. Upon receiving a Stock Loan Buy-In Notice, the borrower has 2 business days to return the borrowed securities.

By taking market action the lender purchases the outstanding securities on a stock exchange or market. Any gain or loss incurred on the transaction is passed to the borrowing firm. Both firms then remove the loan contract from the Stock Loan Contract File.

After the allotted 2 business days, the lending firm can:

  • Cancel the Buy-In Notice
  • Extend the Buy-In Notice
  • Take Market Action

Upon cancellation of the Buy-In Notice the lending firm loses its right to take market action. In order to take market action, a cancelled Buy-In must be reissued, and the issuing firm must again wait the proscribed period of time.

At the lender’s discretion, additional time can be extended to the borrower to return the outstanding securities. This extension does not invalidate the issued Buy-In Notice, however, and the lender is free to take market action as soon as the additional time is expired.

Loan Termination

A lending firm might instead issue a Loan Termination, which is a combination Recall and Buy-In. The Loan Termination gives the borrowing firm 5 business days to return the loaned securities. After 5 business days the lender is permitted to take immediate market action – without any further Buy-In notification.

Stock Loan Service Bureau

A brokerage firm can contract the services of a Stock Loan Service Bureau to handle its Stock Loan processing. The Service Bureau performs the following necessary functions for the firm:

  • Maintaining the Stock Loan Open Contract File
  • Interfacing with the Depository Trust Company
  • Calculating and executing Mark-to-Markets
  • Stock Loan Rebate Billing

Stock Transfer Department

When dealing with physical stock and bond certificates it often becomes necessary to validate the negotiability of the certificates, transfer the registration of the certificates from one client or firm to another, or to have trading restrictions removed – cleared - from the certificates. In doing so, the Cashiering Department must deal directly with the issuing company’s Stock Transfer Agent. Dealing with the Stock Transfer Agent is - no surprise here - the responsibility of the Stock Transfer Department.

Street Name vs. Customer Name

When dealing with physical securities it is preferable to the broker dealer to register those securities in ‘Street Name’. Securities registered in Street Name are registered in the name of the broker dealer – not in the name of the underlying client. Street Name registration is preferred because the certificates are readily negotiable for transfer and delivery thereby benefiting the brokerage firm. Although registered to the brokerage firm, the client still enjoys all the benefits of ownership.

Securities are similar to bank checks in that they must be endorsed to be negotiable. Similar to bank checks, physical certificates are endorsed by signing the back of the certificate. Securities that are registered to the brokerage firm easily endorsed by an authorized employee of the firm.

On the other hand, securities that are registered in the name of a client can only be endorsed by that particular client. Obtaining a client’s endorsement is often very time consuming which is why firms prefer to hold securities in Street Name only.

Stock Powers

In order to obtain a client’s signature to endorse a physical certificate it would be necessary to send the actual certificate to the client. The client would then sign the certificate and return it to the brokerage firm. This process is both time consuming and risky, as the certificate might be lost or stolen in the mail.

To reduce this risk, unsigned certificates are negotiable when accompanied by a signed Stock Power. A Stock Power is a standard document that contains the name of the security, the quantity of the certificate, the certificate number and the client’s signature.

Upon receiving physical certificates registered in the name of a client, the firm can send or fax the Stock Power for the client to sign. Signed Stock Powers might also be kept on file by the client’s broker so that they are available when needed.

Signature Medallion Program

Certificates in Street Name must also be endorsed in order to be in negotiable form. The certificate must by signed an employee authorized and empowered to do so. The designated employee must therefore always be available to the Stock Transfer Department to sign certificates as required.

Of course no employee is always available. As a result, firms participate in the New York Stock Exchange Signature Guaranty Medallion Program. The Stock Transfer Department uses an ink stamp issued by the NYSE. The stamp had the company name, the authorized signature and a Medallion Program inscription.

The Signature Medallion Program provides two benefits to the brokerage community:

  1. The Signature Medallion Stamp issued by the NYSE has the authorized employee’s signature. The employee no longer needs to be accessible, because the firm’s endorsement is made – on the certificate or Stock Power - with the rubber stamp.
  2. Firms and Transfer Agents receiving certificates or Stock Powers stamped with the Medallion Guaranty are provided a reasonable level of assurance as to the authenticity of the endorsement.

The primary roles of the Stock Transfer Department are:

  • Customer Transfers
  • Firm Transfers
  • Legal Transfers
  • Clearing Restricted and 144A Securities
  • Transfer and Ship

Customer Transfers

A customer transfer is a transfer of certificate ownership (or registration) into the name of a customer. Customer Transfer includes transfers from one customer to another customer as well as transfers from Street Name (or Nominee Name) to customer.

Firm Transfers

A Firm Transfer is a transfer of certificate registration into Street Name (the name of a brokerage firm or Nominee Name). Firm Transfer includes registration transfers from one firm to another firm as well as transfers from customer name into Street Name (or Nominee Name).

Legal Transfer

A Legal Transfer is a change of registration that requires certain additional legal documents be acquired, in addition to the standard endorsement, before the transfer agent will process the transfer request. The most frequent Legal Transfers involve re-registration of certificates registered to non-individuals – such as Corporations, Partnerships and Estates. Corporate Resolutions and Partnership Agreements are examples of legal documents required to transfer securities registered to non-individuals.


Clearing Restricted and 144A Securities

Certain physical securities often contain Restrictions or Legends that prohibit the client from selling the securities. Although the restriction cannot prevent the holder from selling shares on the open market, the sale is thwarted because the Transfer Agent will not re-register the restricted securities into the new owner’s name. The seller of restricted securities is therefore unable to use the restricted certificates for settlement and is therefore unable to collect payment for the sale.

At such time that the stipulated restriction period has ended, the Transfer Department presents the certificates to the issuing company’s Transfer Agent. The Transfer Agent cancels the legend bearing certificates, and issues certificates without the restrictive legend. This process is commonly referred to as ‘Clearing the Restriction’.

Rule 114A Securities are ……

Transfer and Ship

From time to time clients will purchase securities that are traditionally held as electronic shares on deposit. At the time of purchase, however, the client stipulates that the securities are to be issued in certificate form and mailed to the client. This scenario is commonly referred to as a ‘Transfer and Ship’, and is handled by the Stock Transfer Department.

On settlement date, once the purchased securities are fully paid for, the Transfer Department instructs the electronic depository – generally DTC – to issue physical certificates registered in the client’s name and return those securities to the broker dealer. Upon receiving the certificates, the Transfer Department sends the securities to the client.

Security Information Center

To assist the broker dealer in identifying fraudulent physical certificates the SEC established the Security Information Center. This SEC program enables the Stock Transfer Department to perform electronic inquiries concerning the validity or status of physical securities received from clients during the course of business. Inquires are made against SIC "Lost and Stolen" database.

The brokerage firm generally sets a dollar driven threshold for all physical securities received. Certificates representing a market value above the threshold are generally submitted to SIC for review. This review process is PC based and requires the Transfer Department to input both the security description and the certificate number or numbers.

Vault

Most self-clearing brokerage firms have, on site, a securities vault for physical certificates and other important documents. The vault is a large safe that is required to be both fireproof and alarm protected. Every evening, the vault is locked and the alarm is set, generally with a time release mechanism that prevents unauthorized overnight entry.

The securities inventory in the vault is tracked through the firm’s Stock Record. On the firm’s accounting records, client shares held in the firm’s securities vault are debited to the client’s brokerage account (a debit denotes ownership of securities in a client account). An offsetting credit entry is made to a ‘Control’ account or ‘Location’ that represents the vault (a credit in a control location denotes shares held by the firm).

A Control Location is an account maintained on the firm’s accounting records that identifies where the firm holds actual securities on behalf of its clients. For example, electronic shares on deposit at DTC are represented as a credit entry to the firms DTC Control Account. Similarly, physical certificates held in the firm’s vault are represented on the accounting records as a credit entry to the firm’s Vault Control Account.

Vault personnel control the orderly movement of physical securities into and out of the firm’s securities vault. Vault personnel credit the Vault Control Account for securities booked into the vault and debit the Vault Control Account for securities removed from the vault.

Buy-In Department

If the selling firm does not deliver securities to the buying firm in a timely manner, the buyer has the right to issue a Buy-In Notice. This notice is formal communication of the buyer’s intention to take ‘Market Action’ against the seller should the delivery of securities remain outstanding.

By taking market action the buyer purchases the outstanding securities on a stock exchange or market. Any gain or loss incurred on the transaction is passed to the selling firm. Both firms then remove the fail contract from the respective Receive and Deliver Master Files.

Upon receiving a Buy-In Notice, the seller has specified number of business days to make delivery of the sold securities. The number of days in this grace period depends on the type of Buy-In issued:

  • Fail Buy-In
  • CNS Buy-In
  • Stock Loan Buy-In

Fail Buy-In

A Fail Buy-In is issued when the selling firm in a Trade-for-Trade Settlement does not deliver the sold securities to the buying firm in a timely manner. The buyer issues the selling firm a Buy-In notice. This is primarily done using the Depository Trust Company’s electronic Buy-In Communication system. It is important to not that the DTC function is utilized as a communication method only. DTC does not have any liability for a Buy-In Notice issued through its communication system. Additionally, use of the DTC application neither implies nor requires that the trade be settled through DTC delivery.

A standard Fail Buy-In can be issued at anytime prior to the shares being received. However, the general practice is to issue a Fail Buy-In notice on the 5th business day after settlement date. The standard Fail Buy-In gives the selling broker 5 business days from the date of issue to deliver the sold securities.

If the sold securities are not received within 5 business days of issuing the Buy-In, the receiving broker can either take market action or grant the delivering broker an extension of time. This extension typically grants the seller an additional 5 business days. Unless extraordinary circumstances exist, no more than two Buy-In extensions are granted.

CNS Buy-In

CNS – Continuous Net Settlement – is an NSCC Settlement System that enables a brokerage firm to consolidate its trading activity in a particular security into one settlement transaction. Firms that are net buyers of securities have a long CNS Position, and deliver securities to CNS. Firms that are net sellers of securities have a short CNS Position, and receive securities from CNS.

When a firm does not have sufficient Excess securities to deliver to CNS in settlement of a long CNS Position, the firm, or firms, with the corresponding short CNS position does not receive its purchased securities from CNS. Firms that do not receive securities from CNS have the right to issue a CNS Buy-In through the settlement system.

Because firms settle trades through CNS and not directly with CNS, it follows that firms transact Buy-In’s through CNS as well. A Firm with a short CNS Position in a particular security can issue a CNS Buy-In. CNS, in turn, passes that Buy-In to the firm, or firm’s, with long CNS positions in that security. Therefore, a CNS Buy-In is executed through CNS – not against CNS.

For Example, Firm A has a short CNS Position for 200,000 shares of XYZ Co. – or, CNS owes Firm A 200,000 shares. Firms B and C each have long CNS Positions in XYZ Co. of 100,000 shares each - that is, each firm owes CNS 100,000 shares.

Firm A issues a CNS Buy-In for the full 200,000 shares of XYZ Co. CNS notifies both Firm B and Firm C of the pending Buy-In. Should the Buy-In be executed any gain or loss on the transaction is passed through CNS to Firms B and C. Consequently, the CNS Positions are removed and the firms are released from any further liability.

A CNS Buy-In can be issued at any time and gives the selling firm - or firms – 48 hours to deliver the sold securities to CNS. After 48 hours the buyer has the option of either killing or executing the Buy-In.

Stock Loan Buy-In

As mentioned previously, in a Stock Loan situation, the lending firm has the right to recall loaned shares at any time during the loan contract. If the borrowing firm does not return the recalled shares within the stipulated 5 business days, the lender has the right to issue a Stock Loan Buy-In Notice. This notice is written communication of the lender’s intention to take ‘Market Action’ against the borrower should the securities remain outstanding. Upon receiving a Stock Loan Buy-In Notice, the borrower has 2 business days to return the borrowed securities.

By taking market action the lender purchases the outstanding securities on a stock exchange or market. Any gain or loss incurred on the transaction is passed to the borrowing firm. Both firms then remove the loan contract from the Stock Loan Contract File.

After the allotted business days, the buy firm can:

  • Cancel the Buy-In Notice
  • Extend the Buy-In Notice
  • Take Market Action

Upon cancellation of the Buy-In Notice the receiving firm loses its right to take market action. In order to take market action, a cancelled Buy-In must be reissued, and the issuing firm must again wait the proscribed period of time.

At the buyer’s discretion, additional time can be extended to the seller to deliver the outstanding securities. This extension does not invalidate the issued Buy-In Notice, however, and the buyer is free to take market action as soon as the additional time is expired.

Bank Loan

Bank Loan enables firms with Excess securities to obtain short term financing – at very reasonable rates – by using the Excess securities as loan collateral. The Excess securities are ‘Pledged’ to the lending institution in exchange for a short-term loan. Pledging is accomplished by delivery of securities to the lending institution’s DTC account using the depository’s collateral pledging function.

At such time that the firm needs the pledged securities, the Cashiers Department again uses the DTC collateral pledging function to release the shares from Bank Loan. Once released, the shares are available for use by the broker dealer.

Institutional Delivery

The Cashiers Department generally handles the trade settlement for clients that are Institutional Investors. An Institutional Investor is an organization that trades large volumes of securities, such as a mutual fund, pension fund, insurance company, bank etc.

Institutional Investors are a major player in the investment community and generally account for more than 50% - 60% - or even more - of the trading volume on a given day. To facilitate the account maintenance process, the Institutional Investor usually holds – or custody’s – its securities portfolio with one broker dealer or bank. However, in order to obtain the best securities prices and lowest costs for its investors, an Institution generally trades securities through several different brokerage firms throughout the trading day.

Delivery vs. Payment

On settlement date, the various firms that executed securities trades on behalf of the financial institution must settle those trades with the Institution’s custodian. The trade settlement process for institutional securities transactions is controlled and monitored by the Cashiers Department. The specialized area within Cashiers that processes institutional deliveries is the Institutional Custody or DVP – Delivery vs. Payment - Department. The brokerage firm classifies an institutional trade as either a COR or a COD.

COR – Cash on Receive

A COR – or Cash on Receive – transaction occurs when the institutional client sells securities through the brokerage firm. On settlement date, the custodian – or agent – will deliver the sold securities to the selling broker dealer. In turn, the broker dealer renders payment to the custodian for the received securities.

COD – Cash on Delivery

A COD – or Cash on Delivery – transaction occurs when the institutional client buys securities through the brokerage firm. On settlement date, the brokerage firm – or executing broker – will deliver the purchased securities to the institutional client’s custodian. In turn, the custodian renders payment to the brokerage firm for the delivered securities.

The ID System

To facilitate the settlement of Institutional transactions, the Depository Trust Company created the Institutional Delivery – or ID – System. The ID System is an electronic communication network created to assist institutional clients, broker dealers and institutional custodians with the institutional trading process.

Understanding the following terms will assist the discussion of the ID process.

Institution

The Institution is the client on whose behalf the securities transaction is executed.

Institution Number

Each Institution participating in the DTC ID System is issued an Institution Number. The Institution Number consists of five digits - all numeric, no alphabetical characters. The number is a unique electronic identifier within the ID System.

Executing Broker

The Executing Broker is the brokerage firm that executes the securities transaction on behalf of the institutional client.

Executing Broker Number

Each brokerage firm participating in the DTC ID System is issued a unique Executing Broker Number. The Executing Broker Number is generally the same as the firm’s DTC Number.

The Brokerage Account Number

The institutional client’s DVP account number at the executing broker.

Agent Bank

The Agent Bank is the securities custodian that maintains the brokerage account for the institutional client.

Agent Bank Number

Each Agent Bank participating in the DTC ID System is issued an Agent Bank Number. The Agent Bank Number consists of five digits - all numeric, no alphabetical characters. The number is a unique electronic identifier within the ID System.

Internal Account Number

The institutional client’s account number at its agent or custodian.

ID Confirm

An electronic trade confirmation generated by the DTC ID System for each institutional security trade.

Affirmation

The process through which an Institutional Investor – or its designated custodian or agent – used the ID System to electronically approves an ID Confirm generated by the ID System. The affirmation signifies that the investor agrees with all the specific trade details contained on the electronic confirm.

The ID Process

The ID Process is initiated when the Institutional Client places an order with the brokerage firm to buy or sell securities for or from its portfolio. Once the order is executed on a securities exchange or market, the executing broker submits the trade details to the Depository Trust Company’s ID System.

The ID System generates an electronic ID Confirm, and transmits that confirm to the Institution, the Agent Bank, the Executing Broker and any interested parties.

Upon receiving an electronic ID Confirm, the Institution – or its designated custodian or agent – reviews all the pertinent trade details, including, but not limit to:

  • The security traded
  • The trade quantity
  • The execution price
  • The agent Internal Account Number

If the Institution agrees with the trade details on the ID Confirm it must affirm the trade. Trade affirmation is an electronic acknowledgment of the trade, processed by the Institution, through the ID System. The Institution can – if so desired - appoint an agent or interested party to affirm trades on its behalf.

On the trade settlement date, the Agent Bank delivers any sold securities to the executing broker and receives the sell proceeds for that sale. Similarly, on settlement date, the executing broker delivers any securities purchased by the Institution to the Agent Bank and receives payment for the purchased securities. Although the vast majority of Institutional trades are settled via DTC settlement, DVP transactions might also be settled by the delivery of physical securities or via book entry.

Government Securities Settlement

International Securities Settlement





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