Navigating Legal Complexities in Stock Settlement: A Case Study of PSX
Keywords:
Stock Settlement, Novation, Central Counterparty, Margin Financing, Off-Market Settlement.Abstract
The settlement of stocks is a critical component of stock trading activities in the Pakistan Stock Exchange (PSX). This process is facilitated by the National Clearing Company of Pakistan Limited (NCCPL) which acts as a central counterparty to ensure the smooth execution of trades and mitigate counterparty risks. However, the settlement process raises significant legal concerns, particularly regarding the validity of novation and the central counterparty system. These issues question the alignment of traditional contract law principles with modern stock market practices. This article provides an in-depth analysis of the stock settlement mechanisms at PSX, examining the legal intricacies of novation and the central counterparty model. It highlights the roles and responsibilities of NCCPL in managing settlement risks, such as through the T+2 cycle, intraday netting, and collateral requirements in leveraged transactions like margin financing and murabaḥah shares financing. Additionally, it addresses the regulatory framework governing these practices, emphasizing the importance of ensuring fair and transparent stock settlements. By exploring these aspects, the article navigates legal complexities the in stock settlement system and propose measures to enhance compliance and market integrity.
References
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Ibid.
Settlement mitigates counterparty risk by ensuring that both parties in a trade fulfill their obligations promptly and reliably. This reduces the likelihood of defaults and instills confidence in the market participants, contributing to overall market stability. See, International Securities Services Association (ISSA). "Settlement Risk Mitigation." https://www.issanet.org/settlement-risk-mitigation (accessed August 5, 2024.
Efficient settlement processes enhance liquidity by facilitating the timely exchange of securities and funds. This liquidity is essential for stock investors to execute trades with ease, reducing trading costs and promoting market efficiency. See, Lee, Ann. "The Role of Settlement in Enhancing Liquidity." Journal of Financial Markets 25, no. 3 (2020): 45-68.
Settlement contributes to price discovery by finalizing trades and incorporating them into market prices. Accurate and timely settlement ensures that market prices reflect all available information, enhancing transparency and efficiency. See, Financial Times. "The Importance of Settlement in Price Discovery." Last modified May 12, 2023. https://www.ft.com/importance-of-settlement-price-discovery.
Settlement mechanisms enable stock investors and institutions to manage their exposure to various risks, including market risk and liquidity risk. By settling trades promptly, stock investors can mitigate the impact of adverse market movements and ensure that their portfolios align with their risk preferences. See, Green, Robert. "Managing Market and Liquidity Risks through Settlement Mechanisms." Journal of Risk Management 30, no. 4 (2022): 115-134.
Settlement processes uphold market integrity by enforcing rules and regulations governing trading and settlement. Fair and transparent settlement mechanisms bolster trust and credibility in the financial system, fostering stock investor confidence. See, Securities and Exchange Commission (SEC). "Regulations Governing Trading and Settlement." https://www.sec.gov/regulations-trading-settlement (accessed August 5, 2024).
Efficient settlement mechanisms facilitate investment by providing a reliable framework for buying and selling securities. This encourages capital formation and supports economic growth and development. See, Williams, Henry. "The Impact of Settlement Mechanisms on Capital Formation." Economic Growth Journal 15, no. 2 (2021): 75-92.
Streamlined settlement processes reduce transaction costs for market participants, leading to cost savings and improved investment returns. See, World Bank. "Benefits of Streamlined Settlement Processes." <https://www.worldbank.org/benefits-streamlined-settlement> (accessed August 5, 2024).
NCSS is the national clearing and settlement system established by the NCCPL, Pakistan in order to provide clearing facility. See, NCCPL Regulations, 2018, Chapter 2 Definitions.
It is important to note that: “the abbreviations T+2 refer to the settlement date of security transactions that occur on a transaction date plus two days.
Mooney Jr., Charles W. The Law of Securities, Commodities and Bank Accounts: The Rights of Account Holders. (St. Paul, MN: West Academic Publishing, 2018), 55.
In Bursa Malaysia settlement of stocks also works on T+2 rolling system cycle where the ownership of stocks is transferred after two days of the actual trade date. The steps involved in this process are as follows:
The process begins on T+0 stage when a stock investor initiates the order placement with his chosen brokerage firm which executes the trade at the exchange. On T+1 stage settlement instructions are passed on to the counter party for pre-matching. On T+2 two important activities, namely settlement of delivery and settlement of receipt take place. On the stage of settlement of delivery stocks are transferred to the brokerage firm at 11:30 Malaysian time via the CSD, whereby by 16:00 Malaysian time, the custodian receives an inter-bank payment for delivery trades. On the other hand, at the stage of settlement of receipt, the brokerage firm transfers stocks via CSD to the custodian for good value by 15:00 Malaysian time and by 16:00 Malaysian time the custodian credits the brokerage firm via interbank payment. See, Bursa Malaysia. "BMSC Disclosure Report 2020." https://www.bursamalaysia.com/sites/5d809dcf39fba22790cad230/assets/5ec74d2a39fba22eca2ebde4/BMSC_Disclosure_Report_2020.pdf (accessed August 3, 2024).
NCCPL Regulations, Chapter 12-6. s 12.4.3.
National Clearing Company of Pakistan Limited (NCCPL). NCCPL Regulations for Clearing and Settlement of Trades in Pakistan Stock Market, last modified March 2021. https://www.nccpl.com.pk/regulations (accessed September 17, 2024).
Krimminger, Michael H. and Katherine Merrill. "The Role of Central Counterparties in the Trading of Over-the-Counter Derivatives." Journal of Financial Services Research 46, no. 2 (2014): 173-186.
The intraday traders may be required to maintain certain margin levels to cover their positions. Margin requirements ensure that traders have sufficient funds or collateral to cover potential losses.
FSI Papers. "The Importance of Clearing and Settlement Systems for the Smooth Functioning of Financial Markets." FSI Insights 11, no. 3 (2018): 21-38.
MTM loss means an amount payable by a stock’s brokerage firm at any point in time during a trade date on account of trades executed on behalf of its stock investors as well as its proprietary unsettled position in any stock, to the company i.e. NCCPL due to the difference between the trade price, on trade-to-trade basis, of the unsettled position in each stock and the closing price of that stock and the last executed price. See, Tokenist. "Mark to Market Explained: Crucial Profit and Loss Calculations." <https://tokenist.com/mark-to-market-explained-crucial-profit-and-loss-calculations/> (accessed 3-8-2-24).
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See, Securities and Exchange Commission of Pakistan, Savings and Capital Markets, March 2019, 178.
Off-market settlement is a settlement system for transactions occurring directly between two parties outside the regular exchange mechanism. See, Smith, John. "Understanding Off-Market Deals in Stock Trading." Financial Insights, See, <https://www.financialinsights.com/off-market-deals.> (accessed August 5, 2023).
Off-market transaction are also known as negotiated deal or off market deal. See, Smith, John. "Understanding Off-Market Deals in Stock Trading." Financial Insights, See, <https://www.financialinsights.com/off-market-deals.> (accessed August 5, 2023).
These deals are typically executed for bulk trades which may not be possible on stock exchange terminals due to regulatory restrictions. When a company changes its ownership, in that case sponsors prefer to sell stocks through deals outside the market instead of selling on exchange, where selling and buying follows certain price mechanism. In off-market deals, parties are free to deal at any price they want. They have just to report to NCCPL about their deal. The stocks also need to be transferred to CDC. There is no cap on price. A stock of a company X may be sold for five rupees, for instance in off-market whose otherwise price in stock exchange may be thirty rupees. See, Smith, John. "Understanding Off-Market Deals in Stock Trading." Financial Insights, See, <https://www.financialinsights.com/off-market-deals.> (accessed August 5, 2023).
The NCCPL plays a crucial role in settling off-market deals by facilitating the transfer of stocks and funds between parties, providing a centralized platform for reporting and settlement, operating the CDS for electronic transfer of stocks, ensuring settlement guarantee and implementing risk management mechanisms. See, National Clearing Company of Pakistan Limited. "NCCPL: An Overview." NCCPL. <https://www.nccpl.com.pk/overview> (accessed January 15, 2023).
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NCCPL is an important participant of settlement process assuming the role of central counterparties, guaranteeing the completion of trades and mitigating counterparty risk. On settlement date, NCCPL settles money obligations through auto pay and collect system whereby buying brokerage firms’ bank accounts are automatically debited while crediting selling brokerage firms’ bank accounts. The stock delivery obligations are also settled through an automated system whereby stocks are automatically picked from the account of respective seller with central depository system (CDS) and delivered into the CDS account of the buyer. NCCPL also manages the risks involved in settlement employing different strategies for mitigation of risk. See, National Clearing Company of Pakistan Limited. "Settlement Procedures and Risk Management." NCCPL Official Website. https://www.nccpl.com.pk/settlement-process (accessed August 5, 2024).
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