Financial market participants & short selling

The participants in the financial markets are:

• Non-financial lenders = buyers of financial securities.

• Non-financial borrowers = issuers of financial securities.

• Financial intermediaries = issuers and buyers of financial securities.

• Broker-dealers (facilitate trading and trade for own account).

• Fund managers (act of behalf of investors).

• Financial exchanges (facilitate trading).

• Financial regulators (see that the financial markets operate efficiently and safely).

• Hedgers; this is not a separate category; they are part of the above [mainly investors (lenders) and borrowers].

• Speculators and arbitrageurs; this is not a separate category; they are part of the categories:

- financial intermediaries (mainly the banks)

- broker-dealers (some of them).

Speculators play a substantial role in the financial system for two main reasons:

• They increase the activity in the financial markets, adding to the liquidity and efficiency of the markets.

• They take on risk from the shedders of risk (the hedgers).

One of the ways in which speculators take on risk is by selling short (or maintaining a "short position"). Short-selling is the converse of holding a long position, i.e. the holding of an investment. Speculators endeavour to make money by buying a security at a price and selling it at a higher price. Short selling is the converse and involves the selling of a security at a price and buying it back later, hopefully at a lower price.

It will be understood that a short sale must involve the delivery of the security to the buyer. In order to achieve this the speculator has to borrow the security for the period of the short sale. At the end of the period the speculator buys the security and then sells it to the lender. An example of a short sale is portrayed in Figure 16 (term = 20 days).

In this example, the speculator makes a profit ofLCC29 945.

short sale and long purchase and unwinding thereof (shares as collateral)

Figure 16: short sale and long purchase and unwinding thereof (shares as collateral)

Clearing and settlement

Efficient clearing and settlement are essential elements in financial market transactions. Clearing is usually defined as:

"...the process of determining accountability for the exchange of funds and financial assets among the parties to a financial transaction.... Clearing involves reporting details of the trade to counterparties, clients, exchanges, regulatory bodies, and others. It also involves matching or comparing the details of the trade with clients and counterparties to make certain all the parties agree."

Settlement is defined as the fulfillment by each party to a deal of its obligation, in the case of the financial markets by the transfer of funds and scrip certificates.

There are a number of risks inherent in clearing and settlement. They are:

• Credit risk is the risk that a deal will not be fulfilled in full, and is also called default risk. If a party defaults on a deal the counterparty either does not receive scrip of funds. On default, the counterparty faces replacement cost risk or principal risk.

• Replacement cost risk. The counterparty to, for example, a failed bond market transaction (in terms of not receiving the security), and not paying, faces the risk of recreating the deal at a different price which could be worse, involving him/her in a loss. There may also be a settlement timing difference, which could make the counterparty a defaulting party to another transaction. The danger of a domino effect exists.

• Principal risk is the risk that after the transaction is settled a party defaults. In the above example this amounts to the counterparty not receiving scrip after payment has been completed. The opposite case is where one party receives scrip but does not pay. Included in this type of risk is the risk of tainted scrip (which is discovered after settlement).

• Liquidity risk is where a party either delivers scrip or payment after the settlement date. This is called a failed transaction, and may also set in motion a domino effect.

• Operational risk is where there is a failure of some facet of the computer system (hardware) or software or communications system.

• Systemic risk is the risk that large defaults or failed transactions threaten the entire financial system.

• Errors risk is where the deal is different to that intended, for example the wrong scrip, the incorrect amount, buying as opposed to selling, the incorrect order (market order instead of limit order), etc.

• Other risks include one of the entities involved in a deal failing, such as the broking firm, the clearinghouse, the central scrip depository, the exchange, etc. Also in cross-border deals there may be complications in laws or the rules of exchanges.

The procedural methods of dealing with clearing and settlement risk are as follows:

• Netting. Netting involves the offsetting of obligations by trading entities, and is applied to payments and securities transfers. Netting reduces obligations substantially and therefore reduces costs and credit and liquidity risks. Netting can be bilateral (between two parties) or multilateral (between groups of trading entities).

• Settlement day. As noted earlier, the risk of replacement cost exists prior to settlement risk. For this reason markets around the world continue to reduce the time period between deal / transaction date and settlement date.

• Delivery versus payment on settlement day. When settlement day arrives, risk management is focused on the reduction of principal risk. The key here is to secure delivery versus payment, i.e. to ensure that both settling parties exchange assets (money and scrip) at the same time.

• Margin. Here one needs to distinguish between the spot debt and share markets and the derivative markets. In the latter case, all the parties to a deal are obliged to put up margin, which is a performance guarantee. The individual places the margin with the broker-dealer, the broker-dealer places this with the relevant clearing member (which is usually a bank of substance), s/he places this with the exchange, which deposits it at different banks. In the case of the debt and share markets, the individual speculator (not institutions) is required to put up margin, which is a down payment, with the broker-dealer lending the remainder of the purchase price. Margin is based on the volatility of the underlying instrument.

The institutions put in place in many markets to deal with clearing and settlement risk are as follows:

• Clearinghouses. A clearinghouse (CH) is an entity that handles clearing and some aspects of settlement, such as deal matching and netting. In some markets the CH interposes itself between the parties to a deal and itself becomes the counterparty to both these parties. Many CHs have clearing members (as noted above), which usually are the large banks, and all other broker-dealers are obliged to clear through them.

• Common agreements. In many markets of the world, parties to certain transactions use agreements issued by international organizations. This reduces the risk of legal misconstruction. An example is the Master Agreement of the International Swap Dealers Association (ISDA).

• Central scrip depositories (CSDs). CSDs are entities that accept deposits of securities and account for the transfer of these securities among participants. Immobilization and dematerialization is applicable here. In many markets scrip is immobilized in a CSD to eliminate the physical movement of scrip in transfers of ownership. Transfers of ownership become book entries (in accounts that participants have). In the case of dematerialization, scrip no longer exists, and proof of ownership becomes electronic.

• Global custodians. Global custodians are usually banks that hold scrip in safe custody on behalf of clients and ensure that clients' transactions are settled and registered accurately. They are also responsible for the collection of dividends, interest, share splits, etc on behalf of clients.

• Communications networks. Communications networks such as the well-known SWIFT (Society for Worldwide Interbank Financial Telecommunications) assist in clearing and settlement. Participants use SWIFT to send details on transactions and confirmations for the transfer of funds and securities.

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