Part 5: NISM Series VII SORM - Clearing Process

NISM Series VII SORM – Chapter 5: The Clearing Process (Clearing Corporation, Netting, Depository)

This is Chapter 5 of the NISM Series VII Securities Operations and Risk Management (SORM) short notes. This chapter covers the clearing process — including the role of the clearing agency, clearing banks, multilateral netting, the depository system, and the clearing mechanism for derivatives. These are frequently tested topics in the NISM SORM exam.

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What Is Clearing?

Clearing is the process of determining the obligations of each market participant after a trade is executed. Once these obligations are determined, they are discharged through settlement. Clearing is a critical post-trade activity in the equity trade life cycle.

Role of the Clearing Agency (Clearing Corporation)

The clearing corporation (or clearing house) is the central counterparty that ensures all trades are honoured. Here is how it functions:

• Ensures that all members meet their fund and security obligations
• Acts as the legal counterparty to all trades through a process called Novation
• Through novation, the clearing corporation becomes the buyer to every seller and the seller to every buyer
• In the event of any member default, the clearing corporation is responsible for guaranteeing settlement to both parties

The clearing agency interacts with the Stock Exchange, clearing banks, clearing members, and depositories through electronic connections.

What Is Novation?

Novation is the legal process by which the original contract between buyer and seller is replaced with two new contracts — one between the buyer and the clearing corporation, and one between the seller and the clearing corporation. This eliminates counterparty risk for market participants.

Clearing Banks and Their Functions

Clearing banks handle all fund transactions (pay-in and pay-out of money) in the settlement process. Their role:

• Receive obligation details from the clearing corporation
• Execute pay-in and pay-out of funds based on net obligations
• This process happens on T+2 day

Clients' demat accounts must be linked to their bank accounts to facilitate smooth fund transfers during settlement.

Clearing Members and Custodians

The clearing corporation provides trade details of all members and their clients to each respective clearing member. In the cash market:

• Trades allocated for settlement by custodians are marked with a Custodian Participant (CP) code
• These trades are subject to confirmation by the respective custodian
• After confirmation, the clearing agency determines net obligations through multilateral netting

Depository and Depository Participants (DPs) What Is a Depository?

A depository holds securities in electronic (dematerialised) form and enables transfer of ownership through book entries (without physical share certificates). It maintains records of ownership electronically, making trading paperless, fast, accurate, and safe.

What Are Depository Participants (DPs)?

Depositories provide services to clients through their agents called Depository Participants (DPs). DPs can be banks, brokers, or financial institutions registered with a depository.

Important for NISM SORM exam:

• For trading in the Cash Market, both buyer and seller must have a demat (beneficiary) account with a DP in either NSDL or CDSL
• In the depository system, both the transferor (seller) and transferee (buyer) must give instructions to their respective DPs for delivering and receiving securities

The Clearing Process – Multilateral Netting

Clearing on stock exchanges is done through a process called multilateral netting — performed by the clearing agency (clearing corporation/house). This process determines the net obligation of each member across all their trades.

How Multilateral Netting Works Step 1: Balancing / Netting Off with Clients

At the end of each trading day, each client's position is netted against all their transactions. The final pay-in/pay-out of securities and funds is then carried out through clearing banks and depository participants.

Step 2: Broker Netting with Exchange

The clearing corporation sends each clearing member a list of all trading transactions made by them and their clients for the day. After this, multilateral netting is performed to arrive at the member's net obligation.

Clearing Process for Derivatives (F&O)

In the derivatives segment, the clearing mechanism involves working out open positions and obligations of clearing members:

• Open positions of clearing members are calculated by aggregating the open positions of all brokers/trading members and custodial participants clearing through them
• A trading member's open position = proprietary open positions + client open positions
• These positions are considered for exposure and daily margin purposes

Quick Comparison – Key Clearing Concepts

Quick Revision – Key Points for NISM VII Chapter 5

• Clearing = determination of obligations; Settlement = discharge of obligations
• The clearing corporation becomes the counterparty to all trades through novation
• Clearing banks handle fund pay-in/pay-out on T+2 day
• Demat accounts must be linked to bank accounts for fund transfers
• Custodian-settled trades carry a CP code; subject to custodian confirmation
• Multilateral netting determines the net fund and security obligation of each member
• Both buyer and seller must have demat accounts with a DP for cash market trading
• In F&O clearing, open positions = aggregated positions of all trading members under the clearing member

📌 Next Chapter: NISM Series VII SORM – Chapter 6: The Settlement Process

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Related reads: NISM SORM Clearing and Settlement Notes | Depository System Explained | NISM Series VII Free Mock Test