July 2001

Central Counterparty for EquitiesSettlement Netting

Service Outline

Important noteRecipients should not construe the contents of this document as investment, tax or legal advice and eachrecipient is urged to consult with his own professional advisers as to these matters. This document doesnot constitute an offer to sell or a solicitation of an offer to buy an investment and does not carry any legalrights. This document sets out the current position regarding the provision of settlement netting serviceswithin the central counterparty services for SETS, which is, as is in the nature of development projects,subject to change.

If you have any general queries relating to this document, or if you require further copies, please contact:

CRESTCo Limited Tel: 020 7849 0029Email: warren.alsop@crestco.co.uk

London Stock Exchange plc Tel: 020 7797 3456Email: businessdevelopment@londonstockexchange.com

The London Clearing House Limited Tel: 020 7426 7089Email: westm@lch.co.uk

Further copies of this document can also be downloaded from the websites at www.lch.com orwww.crestco.co.uk or www.londonstockexchange.com

This document has been produced by CRESTCo Limited, London Stock Exchange and The London Clearing HouseLimited to assist users of their systems. While it has been prepared on the basis of the best information available, theauthors accept no liability for decisions taken, or systems work carried out by any party, based on this document. Thisdocument does not form part of the contractual documentation between any of its authors and their customers.

© June 2001 CRESTCo Limited, registered in England and Wales No 2878738, London Stock Exchange plc, registeredin England and Wales No 2075721 and The London Clearing House Limited, registered in England and Wales No25932.

The CREST logo is a trademark of CRESTCo Limited. SETS, SEAQ and the London Stock Exchange crest and logo aretrademarks of London Stock Exchange plc. The London Clearing House logo is a trademark of The London ClearingHouse Limited.

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Contents

1 Introduction 5

2 Context 72.1 Market Conditions 72.2 Drivers for settlement netting 72.3 Other markets 7

3 Service overview 83.1 What is settlement netting? 83.2 Scope 83.3 Optionality 93.4 Contractual basis of netting 9

4 Implementation 114.1 Approach 114.2 Timescales 114.3 Impact on participants 12

5 Optionality 145.1 Selecting the options 155.2 Enriched transaction 165.3 Treating gross transactions as automatically matched 165.4 Netting 165.5 Treating net transactions as automatically matched 175.6 Changing the options 17

6 The netting process 186.1 The netting algorithm 186.2 Timing of netting 20

7 Legal and regulatory considerations 227.1 Type of netting 227.2 Contractual framework 227.3 Use of settlement agents 247.4 Agency netting 247.5 Protecting clients� safekeeping assets 257.6 Netting across trading participants 267.7 Books and records 267.8 Default 27

8 Settlement 298.1 Splits 298.2 Settlement 298.3 Settlement management 29

9 Corporate events 319.1 Benefits 319.2 Corporate actions 31

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10 Risk management 33

11 Reporting to members 3411.1 Standing data 3411.2 Transaction data and reconciliation 34

12 Stamp duty and regulatory reporting 3512.1 Stamp duty and SDRT 3512.2 Regulatory reporting 35

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Guide to readership

The guide to readership is intended to help readers find the most relevant sections of the document forthem.

Section Scope Readership

Overview

1: Introduction Description of this document

2: Context The reasons why participantswant settlement netting

3: Service overview Overview of the completeservice

4: Implementation How the service will bedelivered

All readers

Detailed description

5: Optionality Description of the choicesavailable in the service

6: Trading and settlement Impact of netting on tradingand settlement

7: Legal and regulatoryconsiderations

Description of the legalapproach to netting and theimpact of this on how firmsstructure their approach tosettlement

8: The netting process Details of the nettingalgorithm

9: Handling late settlementsDescription of the methodsused to handle latesettlements

10: Corporate events Description of the changes tocorporate action processing

11: Risk management Description of the impact ofnetting on risk management

12: Reporting to membersDescription of the newinformation available toCREST participants

13: Stamp duty andregulatory reporting

Description of the proposedchanges to stamp duty andregulatory reporting

All users of the service andother CREST participants,including front, middle andback offices, technical teamsand compliance officers

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1 IntroductionThe London Stock Exchange (�the Exchange�), London Clearing House (�LCH�) and CRESTCojointly introduced a central counterparty service for electronically executed trades on SETS andSEAQ Crosses on 26 February 2001. The objectives of this first phase of the service were tointroduce LCH as the central counterparty, with the associated clearing member relationships,while keeping the trading and settlement process as unchanged as possible.

The first phase delivered full counterparty anonymity and improved counterparty risk protection tothe market. Settlement remained on a �gross� basis, although it was generally recognised bymany market participants that the service should be enhanced to deliver settlement netting,because significant cost savings would result, at least to some participants.

Settlement netting was not included as part of the first phase because it has a significant impacton trade processing, and it was felt introducing netting at the same time would demand too greata degree of change for the market to cope with easily in one step.

Because of this, both CRESTCo and LCH commenced consultations with their members in late2000. LCH established the EquityClear Advisory Group in late 2000 in order to focus on itsmembers� needs, while the CRESTCo consultation was addressed to all interested parties.

The results of CRESTCo�s consultation have now been published (see the CREST newsletter forApril 2001) and the three organisations have now commenced a new programme with theintention of delivering a settlement netting service in early 2002.

This Service Outline provides the first document describing how the initial implementation ofsettlement netting will work and which trades it will apply to. Further documents will develop thedetail of the service. It is also recognised that the scope of settlement netting is likely to expandover time and that some areas of expansion will require enhancements to the service asdescribed in this document. These expansions will be the subject of further documents.

This document describes:

• the market context for the introduction of settlement netting

• an overview of the netting service

• specific detail on those areas where settlement netting will change today�s approach totrading, clearing and settlement

• an outline of the implementation approach.

Further documents will be published by CRESTCo, LCH and the Exchange detailing systemsdevelopments, rule changes, operational and implementation issues before the service goes live.It should be noted that some details within this document must, where necessary, be approvedand ratified by the relevant CRESTCo, LCH and Exchange governance bodies. Alterations todetail are therefore possible. Any significant changes will be notified to recipients in later versionsof this Service Outline or other documents, as appropriate.

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The parameters and timings stated in this document are for illustrative purposes only. Actualvalues will be confirmed before implementation.

In this document, the term �Exchange� refers to the London Stock Exchange, except whereexplicitly noted. The term �member� refers to membership of CREST, the Exchange or LCH,depending on the context. The term �participant� refers to a participant in the services offered byCRESTCo, the Exchange or LCH depending on the context, although �settlement participant�always refers to the CREST system.

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2 Context

2.1 Market ConditionsThe primary trading service for the Exchange is SETS. Launched in October 1997, SETS is anelectronic order book that facilitates central price formation and trade execution for securitiescomprising the FTSE 100 index and other liquid securities. SETS regularly executes more than50,000 trades per day. In addition, the percentage of transactions executed in order booksecurities on SETS has steadily risen since its inception to 58 per cent.

The impact of the increase in trade volumes (and value) on SETS is an ever-increasing numberof settlements: in the current gross settlement world there is at least one settlement for eachtrade1.

2.2 Drivers for settlement nettingThis increasing volume of settlements creates strain in market participants� back offices,potentially impeding their ability to cope with more trading, and leading to an increase in theirback office costs. This leads to the main drivers for settlement netting:

• Reducing back office costs and operational risk by reducing the number of settlements andassociated CREST inputs.

• Reducing future investment by capping the number of settlements.

The market consultations earlier in 2001 confirmed these drivers and stated that they were mostimportant for SETS trades.

2.3 Other marketsOther major markets either already use settlement netting or are moving towards it.

• The US markets have had settlement netting since the mid-1970s. Netting in the US coversall market-side trades and regularly achieves netting efficiencies (ie a reduction in the numberof settlements required) of around 97%. It also caps the total number of settlements perparticipant per day.

• The Euronext markets also use settlement netting.

1 For example because of client-side settlements in addition to the market-side settlement.

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3 Service overviewThis chapter gives an overview of the settlement netting service while later chapters provide moredetail on areas specifically impacted by netting. However, this document does not describe theentire service at a detailed level � this will be covered in subsequent publications, especially theCREST White Book on settlement netting, due to be published in July 2001. Areas of trading,clearing and settlement not described in this document should generally be assumed to remainunchanged by the introduction of settlement netting.

3.1 What is settlement netting?The objective is to allow participants to have just one net settlement per security per day withLCH, irrespective of the number of trades they had dealt on SETS. Participants will sometimeshave more than one net settlement per security per day. This depends on various factors,including whether they trade as both agent and principal, how they choose to use the optionalparts of the service, and as a result of some types of corporate event. The reasons are set out inmore detail later in this document, particularly chapter 5.

For example, if a firm had executed two trades on SETS in the same security on the same day,with one being a purchase of 100 shares at £4 each and the other being a sale of 50 shares at £3each, then today each of these transactions would have to be settled separately. If the firm wasusing settlement netting (and providing certain other conditions were met), then it could do justone settlement � a net purchase of 50 shares for a net consideration of £250 � that would meetall of its market-side settlement obligations.

The type of settlement netting being applied is multi-lateral netting with LCH as the centralcounterparty. In this service therefore, the settlement of one (net) transaction may settle severalunderlying (gross) transactions.

The settlement netting algorithm is explained in more detail in section 6.1.

3.2 ScopeIn the longer term, it is clearly in the market�s interest for as many trades as possible to beincluded in the settlement netting service. However, in line with preferences expressed byparticipants during the market consultations, the service will initially only deliver netting forautomated trades on SETS or SEAQ Crosses, but is expected to be expanded later2. The nettingservice only applies to market-side settlements with LCH and not, for example, to client-sidesettlements.

Any participant involved in settlement of SETS trades will be able to take part in the service, butthe netting functionality will be optional, for reasons explained in the next section.

2 In the rest of this document, the term �SETS� is generally used to cover automated executions on bothSETS and in SEAQ Crosses for simplicity. There is no difference to the nature of the netting servicebetween executions on SETS and SEAQ Crosses.

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It is possible that some securities will have to be excluded from the netting service, at least atfirst. A possible example of this is Irish securities, because of the way that Irish Stamp Dutyworks (see section 12.1.2).

3.3 OptionalityA key feature of the netting service is that participation will be optional. The optionality isdesigned to ensure that participants opting in to the service receive the expected benefits, whilstthose opting out do not suffer any disruption to existing processes; in particular, it allows for oneside of a market trade (eg the seller) to use net settlement with LCH, while the other side (eg thebuyer) settles gross � the two sides do not need to know what each other are doing because LCHstands between them. Making netting optional also avoids the need to have a �big bang�implementation with all the difficulties this causes.

Netting will be particularly advantageous for high-volume participants, particularly proprietarytraders. However, there is a cost involved in changing from gross to net settlement. There arelikely to be some SETS users whose SETS trading volume is too small to justify moving tosettlement netting at first. This picture could of course change if SETS volumes continue to growor if settlement netting was extended beyond SETS trades.

In fact, there are three different optional components of the service designed to provide completeflexibility for participants; one of these options may be attractive to participants that do not want tonet their settlements. Service optionality is explained in more detail in section 5.

3.4 Contractual basis of netting

3.4.1 Type of netting

The netting service is designed so that the underlying gross contractual obligations relating todelivery and payment still remain, with settlement of the net transaction performing thoseobligations. In practice, the continuing existence of the underlying gross obligations should haveno material impact except in the event of a default when processing will still be based on the(gross) contractual obligations, although principal positions are still subject to close-out netting ina default (see section 7.8).

3.4.2 Agency and principal netting

Netting can only take place between sufficiently similar contracts (eg same settlementparticipants etc) as defined in section 6.1. In order to avoid problems in default management,agency and principal business can only be netted as follows:

• principal business can only be netted with other principal business

• agency business can only be netted with other agency business.

It is not possible to net between these categories. For the avoidance of doubt, it should be notedthat, for the purpose of this document, the definition of principal business includes client businesstransacted by broker-dealers as a riskless principal, where the broker-dealer contracts with their

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client as legal counterparty, but executes the client order immediately on SETS and takes nomarket price risk.

Firms that propose to net agency business will have to consider whether their settlementarrangements continue to achieve sufficient effective protection amongst their clients to meettheir regulatory requirements. For example, if market-side settlements are netted, it will no longerbe possible to freeze individual clients� market-side settlements in order to achieve effectiveprotection.

3.4.3 Who decides to take part in netting?

It is the principals to the contracts involved in the net settlement that need to give effectiveconsent to the performance of their contracts by way of settlement netting.

General Clearing Members may have to accommodate situations where some of their Non-Clearing Members opt in to components of the netting service while others do not.

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4 Implementation

4.1 ApproachThe implementation of settlement netting will be managed as a collaborative project betweenCRESTCo, LCH and the Exchange, as was the case for the introduction of the initial centralcounterparty service.

Elements of the service are being developed by each of the Exchange, LCH and CRESTCo.Each organisation also has some system and rule-book development of its own to do. Oncethese are complete, there will be a period of integration testing between the three organisations,followed by testing with market participants. As with the initial implementation of the centralcounterparty, the LCH regulations will be adapted to cover changes to the relationship betweenLCH and its clearing members, while the Exchange rules cover other areas such as therelationship (particularly on default) between General and Non-Clearing Members.

Because the service is optional, the implementation approach for participants will be differentfrom the first phase of the central counterparty for equities. Before any participant can go livewith settlement netting, they will have to go through a period of testing. The testing servicesrequired for this will be made available, probably every two months, depending on demand.

Documentation will be produced, as appropriate, throughout this period. This will include:

• a detailed description of the CREST changes required to implement settlement netting3

• rule changes

• testing specifications

• updates to existing documents and guidance notes as necessary.

Customers will also be supported by business and technical seminars and by the client supportteams in each organisation.

4.2 TimescalesThe indicative timescales for optional settlement netting are shown in the chart below. Actualdates will be confirmed later. The target live date for the settlement netting service is Q1 2002but this will not be confirmed until a more detailed assessment of the size of the development iscompleted by CREST. Testing facilities will be made available to market participants, both beforeand after the live date, allowing flexibility when planning development schedules and projecttimetables. Progress updates will be published to the market by various means, including theCREST monthly newsletters.

3 CREST will publish details of the enhancements to CREST as a White Book due in July 2001 and anupdated Data Exchange Manual due in September 2001.

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Q2 2001 Q3 2001 Q4 2001 Q1 2002 Q2 2002

Service Outline

First participant live

Development

Participant testing

More detaileddocumentation and seminars

Draft rule changes published

Rule changes published

4.3 Impact on participantsOne of the objectives of settlement netting is to have as little functional or system impact aspossible on trading and settlement participants that do not choose to opt in to the service4.However, participants that opt in to the service will clearly have to change their systems, andthere will be some impacts on other parts of the industry as well. All participants will have to takenote of changes to various rules and regulations to underpin the effectiveness of settlementnetting. An overview of the impacts is outlined below.

4.3.1 Trading participants

There is no direct impact of settlement netting on trading activities, although the anticipatedreduction in the marginal cost of trading is expected to lead to greater trading volumes,particularly from proprietary trading organisations.

4.3.2 Members of LCH

There is no direct impact on clearing and there will be no change to the margin model or thecollection of margin, however the parameters relating to assumed settlement will be reviewed inthe light of settlement performance.

However, GCMs that wish to track the settlement of individual (NCM) trades will need to establishhow they will handle this when the resulting settlement obligations are netted together.

4.3.3 CREST settlement participants

The biggest operational impact is on CREST settlement participants, if they opt in to the service.The impact is in several areas, all described in more detail later in this document. Because someelements of the service are optional, the impact will vary between firms. The areas impacted are:

4 There may be new data items and status values relating to netting on CREST transaction records,although CREST will also support the previous version of the messages for a limited period of time in orderto provide backwards compatibility.

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• Specification of the desired options, including the CREST member account to be used ifrelevant options are chosen

• Settling a net amount instead of the gross transactions together with any associatedreconciliation requirements (this component is optional)

• Consequential changes to the handling of optional stock events

• Removal of the requirement to match settlements with LCH in CREST (this component isoptional)

• Removal of the requirement for Exchange members to input market-side transaction reports,but some possible increase in the requirement for client-side transaction reports, see section12.2.

4.3.4 CREST settlement banks

There is no functional impact on settlement banks, but the use of netting will change settlementflows to some extent, and this may change the liquidity and credit demands of equity settlement.

4.3.5 Registrars

Where net settlement is used, registrars will receive information about the settlement of the nettransaction via the Register Update Request (RUR) and will not receive information about theunderlying trades due to statutory restrictions on providing confidential customer information.Anonymous details of gross trades will continue to be available on the Exchange�s market datafeed.

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5 OptionalityThere are three separate optional areas of the settlement netting service and settlementparticipants can choose which of these they want to make use of in any combination. They are:

• Whether the participant wishes to make use of settlement netting for the relevant business.

• Whether the settlement participant wishes to match the gross transactions (as today) or tohave them automatically matched (irrespective of whether settling net).

• If opted in to netting, whether the settlement participant wishes to match the net transactions,or to have them automatically matched and thereby undertake the minimum possible CRESTinput.

The relationships between these three options are shown in the flowchart below. The flowchart isexplained in more detail in the following sections.

Enrichedtransaction

Treat grosstransactionsas matched?

Treat nettransactionsas matched?

Net thistransaction?

Settlementparticipantmust matchtransaction

Transactiontreated asmatched

Add transactionto net

Settlementparticipantmust match

net settlement

Transactionsready for

settlement

yesno

yes

no

no

yes

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5.1 Selecting the optionsIt should be noted that each of these options apply to all relevant business � ie a participantcannot select on a trade-by-trade basis which of these options are used.

Although settlement participants will select the options they will need to secure any necessarypermissions from clearing members and other affected participants.

It is possible that not all of a settlement participant�s business will be netted together. Thesettlement participant can select different options for different trading participants (ie different BICcodes � this may be particularly relevant to settlement agents acting on behalf of several tradingfirms) and trading capacities. For example, a participant could choose to net their principalbusiness, but not their agency business. Legal and regulatory constraints on the choice ofoptions are discussed in chapter 7.

As noted above, each individual option can be selected separately, although obviously selectingthe ability to treat netted transactions as automatically matched is meaningless if netting has notbeen selected in the first place. Thus there are six overall choices in practice:

Treat gross asmatched?

Net the grosstransactions?

Treat net asmatched?

1 No No No

2 No Yes No

3 No Yes Yes

4 Yes No No

5 Yes Yes No

6 Yes Yes Yes

Choice 1 corresponds to today�s position, and will be the choice of participants that do not want totake part in settlement netting. Participants that do not express any decisions will be deemed tohave chosen choice 1.

Choice 4 allows a participant to reduce their CREST input without actually taking part insettlement netting itself and allows for straight through processing (STP) of gross trades.

Choice 6 provides the greatest STP and settlement efficiency both for market participants and forLCH.

Over time, it is anticipated that the industry will move towards choice 6. However, there is nocurrent intention to mandate use of any of the options. It is recognised that matching rates forSETS business currently are very high and that some firms will want to continue to use matchingas a control mechanism and to allocate their own references to transactions in CREST.

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5.2 Enriched transactionAn �enriched transaction� (as shown on the flowchart above) is one that has been fed from SETSinto CREST and has been enriched with standard information required for settlement as part ofthe automated processing of these transactions. There will be two transactions resulting fromeach execution on SETS, one with LCH buying and one with LCH selling. This process isunchanged from the initial implementation of the central counterparty. In particular, the followinginformation will have been derived from the trade:

• Intended settlement date

• Settlement participant

• Clearing member.

It is important to note that this basic enrichment does not include the CREST Member Accountthat the participant wants to use to settle the transaction or any extra information required intoday�s transaction reporting or stamp duty regimes. All of this information is added to thetransaction when the participant matches it.

5.3 Treating gross transactions as automatically matchedOne option for settlement participants is to treat gross transactions as if they were matched. Thisreduces the participant�s CREST inputs and hence their network usage. It only applies to themarket side of SETS trades, not to other business settled by the participant.

The way that this option works is that � in effect � the SETS trade generates the CREST inputsfor both LCH and the settlement participant and matches them.

In order to make use of this option, the participant must specify the Member Account (andnationality for transactions in relevant securities) to be applied to the resulting transactions.CREST will hold this in standing data and then add it automatically to the relevant transactions.

For participants that do not take part in settlement netting, the gross settlement transaction willproceed directly to a status of being ready for settlement without further participant input.

Clearly, participants will not gain the full benefit of not having to match transactions for settlementunless the other reasons for CREST input and matching are also removed: transaction reportingand specifying the accounting treatment for stamp duty. The way in which this is achieved andthe consequential impact on participants are described in chapter 12.

5.4 NettingParticipants can opt into settlement netting for their SETS trades. Where netting is in use, theoriginal (gross) transactions are not settleable items. Details of the netting process and the timeat which it occurs are described in chapter 6.

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5.5 Treating net transactions as automatically matchedParticipants that have opted into netting can also choose whether they want explicitly to match theresulting net settlement or to have it treated as automatically matched. If the participant choosesto match the net settlements, then the net settlement transaction will not settle unless theparticipant has matched it.

There are no transaction reporting or stamp duty issues with net transactions apart from oneissue with Irish stamp duty, described in section 12.1.2.

5.6 Changing the optionsParticipants will be able to change their selections. Changes will normally only be permitted totake effect overnight (unless a participant�s options have been incorrectly set up, in which case anintra-day change may be permitted). A notice period may be required for planned changes.

Changes to selections are not retrospective but apply only from the time at which they areeffective. This is interpreted in the following ways.

• Changing the option to treat gross transactions as automatically matched takes effect fromthe moment the change is made. Transactions that were entered into CREST before thechange of this option do not have their status changed.

• Changing the option to have gross transactions netted takes effect from the moment thechange is made. If the change is made intra-day, then some of the day�s transactions will benetted and some will not.

• Changing the option to treat net transactions as automatically matched takes effect from thepoint at which the net settlement transactions are deemed to be generated (see section 6.2),thus it cannot change the status of net settlements that already exist when the option ischanged.

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6 The netting process

6.1 The netting algorithm

6.1.1 What can be netted together?

This service only provides netting for settlements where LCH is one of the settlement participants.The detailed parameters for netting are described in the following section and some contractualissues in chapter 7.

6.1.2 Netting parameters in detail

The netting algorithm will combine gross transactions together if the two participants have bothopted into netting (LCH, as one of the two participants, can be assumed to have opted in) and ifthe security concerned is eligible for netting. A net transaction will be created combining grosstransactions where the following characteristics are the same:

• Clearing member

• LCH Account (ie �House� or �Client�)

• Settlement participant

• CREST member account

• Dealing capacity (ie �Agent� or �Principal�)

• Security (ISIN code)

• Country of register, where applicable, ie for securities which have more than one register butthe same ISIN code5

• Currency

• Trade date

• Intended settlement date (for SETS business, this is always implied by the trade date andsecurity type)

• Benefit status (ie �Cum� or �Ex�, for SETS business, this is always implied by the trade date).

Note that this approach allows for netting of transactions dealt under different BIC codes onSETS. However, it is not always possible to do so. This is described further in section 7.6.

5 Note that this situation does not arise on SETS at the time of writing this document as SETS only tradesone of the relevant �versions� of the security for securities with more than one version.

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6.1.3 How is the net calculated?

The quantity of stock and consideration are the two items that are netted. These are both thesimple sums of the underlying transactions, taking purchases and sales into accountappropriately.

For example, if a participant had the following trades that were capable of being netted together:

Type Quantity Price Consideration

Purchase 100 £2.50 £250

Purchase 80 £2.40 £192

Sale (170) £2.30 (£391)

The net position would be

Purchase 10 £51

Note that the �price� of the net position is no longer meaningful, although an �effective price� canstill be calculated in this case by dividing the net consideration by the net quantity.

However, the nature of this netting algorithm is that there are a number of possible outcomes.Essentially, the different outcomes result from different combinations of trades of varying sizesand prices. Scenarios 1 and 2 are the mostly likely outcomes, but the others could occur withparticular trading patterns or price changes during the day. The complete list of the possible netoutcomes is as follows.

Stock movement Cash movement

1 �Normal� purchase Receive Deliver

2 �Normal� sale Deliver Receive

3 Delivery with payment Deliver Deliver

4 Receive with payment Receive Receive

5 Deliver stock with no cash Deliver 0

6 Receive stock with no cash Receive 0

7 Deliver cash but no stock 0 Deliver

8 Receive cash but no stock 0 Receive

9 No stock or cash movement 0 0

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It should be noted that net settlement transactions will be generated for all of these outcomes,including case 9, which will settle on its due date6. This is to aid reconciliation.

An example of how case 4 could arise is shown below, using an adapted version of the previousnetting example, in which the price of the stock has risen significantly between the purchases andthe sale.

Type Quantity Price Consideration

Purchase 100 £2.50 £250

Purchase 80 £2.40 £192

Sale (170) £3.00 (£510)

The net position would be

Purchase 10 (£68)

In this example, the participant would be receiving both stock and money.

6.1.4 Impact of contras

If a SETS trade is contra�d on the day of trade for a participant that has opted into settlementnetting, then both the original trade and the contra will be fed into the net position, where they willcancel each other out. If these are the only trades, then they will form a net trade with zeromovement of stock and cash as in 9 above.

Contras done after trade date will continue to be handled according to the current process � ieagreed contras are settled bilaterally between the trading participants without the involvement ofLCH. This type of contra is not included in the netting process.

6.2 Timing of netting

6.2.1 CREST diary event

The net settlement transactions will be generated at a new CREST diary event which will betimed for early evening, after the last SETS trade or contra, but before the end of CREST inputfor the day. This is so that a participant that wishes to take part in netting, but elects to matchboth the gross and net transactions, has time to do so on the day of trade.

The net settlement transactions will not be visible in CREST before this diary event.

6.2.2 Nets not re-opened

Once the net settlement transaction has been created, it will not be changed by having newtransactions added to it, or existing transactions removed from it7.

6 CREST will not create �null� net transactions if there are no relevant gross transactions, so this is the onlyexample in which a �null� net transaction can be created.

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For a participant that opts to match the gross transactions, this can mean that more than one netsettlement transaction is created with the same basic netting attributes � ie the parameters of twonet transactions (as described in section 6.1.1) could be the same. This situation would arisewhen the participant matched some gross transactions before the CREST netting diary event andsome afterwards. The transactions matched afterwards would be carried forward to the nextday�s netting calculation. On that next day, the carried forward transactions can be netted witheach other, but not with new transactions dealt on that next day, because the trade dates (andhence the intended settlement dates) would be different.

6.2.3 Single transactions

A net settlement will be created if there is only one gross transaction, ie the net and grosstransactions are effectively the same. This is for reconciliation purposes so that participants cansee that netting has taken place and can match the net, if that is their requirement.

7 It should be noted that the following events � some corporate events, see chapter 9, splits, see section8.3.3, or default, see section 7.8 � could modify a net settlement in the same way as they do today, but thisdoes not change the underlying set of transactions that were used to construct the net settlement.

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7 Legal and regulatory considerationsThis chapter provides an overview of the legal and regulatory considerations for settlementnetting. It does not attempt to be a definitive or complete description of the legal structure or therules, regulations or contractual issues that will arise. The complete description with regard to theExchange, CRESTCo and LCH will be supplied by the changes to the various rules. Where legalchanges require consultation, it is intended that the proposed changes will be published forconsultation in Q3 2001. Participants are advised to contact their regulators to confirm anyconduct of business or prudential supervision implications.

7.1 Type of nettingThe legal approach to netting will be �administrative netting� (which is sometimes referred to as�settlement netting�).

In this approach, the underlying contractual obligations remain in existence, however settlementof the net transaction is agreed between the contracting parties as providing performance of theunderlying obligations. The implications of this are described in more detail in the rest of thischapter.

7.2 Contractual frameworkSettlement netting in this service is only supplied for transactions resulting from SETS tradeswhere LCH is one of the settlement participants, ie for the market-side settlements. There aretwo different models of settlement that are used and different issues arise in the two of them.

1. Settlement between LCH and a Clearing Member.

2. Direct settlement between LCH and a Non-Clearing Member.

These are described further below. In either case, participants could be making use ofsettlement agents. In the interests of simplicity, this situation is ignored in the description below,except where it is significant. LCH and its clearing members will continue to be acting asprincipals to all the relevant contracts.

7.2.1 Settlement with a clearing member

Here the settlement chain replicates the contractual chain as shown in the diagram below. Thediagram shows the most complex case, where the clearing member is a GCM and there is aclient of an NCM involved in the trade. The �contracts� on the diagram (and on the diagrams insections 7.2.2 and 7.4 are the contracts for purchase or sale of securities that result from a tradeon SETS. There are other contracts between the participants relating to the supply of the centralcounterparty service, but these are not shown on the diagrams.

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LCH GCM Client

Contract Settlement

NCM

The service provides (optional) netting of the settlement between LCH and the clearing member.The settlements between the clearing member and further participants in the contractual chainare not created by this service but must be entered by the participants.

7.2.2 Direct settlement with a non-clearing member

Here the settlement chain bypasses part of the contractual chain, ie where the clearing memberonly provides risk management services and does not wish to provide settlement services aswell. This is shown in the diagram below. The diagram shows the more complex case, wherethe clearing member is a GCM and there is a client of an NCM involved in the trade, in thisexample as principal counterparty to the NCM.

LCH GCM Client

Contract Settlement

NCM

Where there is direct settlement between LCH and the participant beyond the clearing member inthe contractual chain (eg the NCM in the diagram above), then in legal terms: (1) the NCM issettling its own contract(s) with the GCM; and (2)the NCM is also acting as a settlement agent forthe clearing member (GCM) and settling the GCM�s contracts with LCH.

This is nothing to do with whether the NCM is acting in an agent or principal capacity whentrading, although in this case the contractual structure shown in the diagram is one where theNCM is acting as what is known as a �riskless principal�. For a description of the analogoussituation where the NCM is acting as an agent, see section 7.4.

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The service will provide (optional) netting of the settlement between LCH and its settlementcounterparty, ie the NCM in the example.

7.3 Use of settlement agentsA trading participant can make use of a CREST participant as a settlement agent. It should benoted that where an Exchange member firm enters orders into SETS under its own BIC code butuses a �Model B� settlement agent, it is the settlement agent that is actually the NCM and is thecontracting counterparty to the GCM, not the Exchange member firm. In other words, for thepurpose of the diagram in section 7.2.2, the NCM (as the Model B settlement agent) is actuallydoing its own settlement and not making use of a separate settlement agent. This situation willnot change as a result of the introduction of settlement netting, but there will be some relatedimpacts that affect the ability of settlement agents to have one net settlement with LCH on behalfof multiple clients, see section 7.6.

7.4 Agency nettingWithin the clearing structure, only NCMs can act as agents in effecting trades, and this does notchange as a result of settlement netting. GCMs always act as the principal counterparty to LCHand, if an NCM is trading as agent, the GCM is also acting as the principal counterparty to theunderlying clients of the NCM. Agency trades can be netted with each other, although not withprincipal trades of that NCM.

However, in order to achieve the netting of agency trades, the consent of the underlying clients isrequired. This is because the net settlement fulfils the GCM�s obligations to the NCM�s clients,as the contracting principals in respect of the underlying gross transactions. The legalbackground to this is described in more detail in the CREST Green Book on Settlement Nettingdated January 2001. The mechanism for achieving client consent is still being reviewed.

As described in section 7.2, the service does not net the settlement between an agent NCM andits client. The client�s contractual counterparty is actually the GCM (the NCM acted as an agentin creating this contract on behalf of its client). If settlement occurs directly from LCH to the NCM(as described in section 7.2.2) and this settlement is netted, the net settlement is performing theGCM�s part of the client-GCM contract, as well as the LCH-GCM contract.

It is up to the NCM to allocate any stock or money due to each of its clients, whether delivered byLCH in the net settlement or by other clients. If the NCM defaults between settlement with LCHand with its clients, then the clients have claims against the liquidator of the NCM, not against theGCM (provided the client has given effective consent to the performance of the client-GCMcontract by way of settlement netting in this way). This approach is similar to the current situationwithout settlement netting, where the client consents to the use of his assets for the account ofanother client of the NCM.

The contractual and settlement structure where LCH settles directly with an NCM is shown in thediagram below where the contract lines are between the principals to each contract.

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LCH GCM Client

Contract Settlement

NCM

7.5 Protecting clients� safekeeping assetsAs set out above, participants acting as agents may be required to ensure effective protection oftheir clients� safekeeping assets under SFA or IMRO, or, after N2, FSA rules8. These rulesprevent firms using the safekeeping assets for one client account for another client accountexcept where the appropriate consents described in the rule have been obtained.

There are three core settlement structures that agents typically use in CREST, although it shouldbe noted that some agents combine components of these structures when setting up theirsettlement model. These raise different issues for ensuring the protection of clients� safekeepingassets if net settlement is adopted.

1. Wash-through settlement account. In this case, the agent always settles its market-sidesettlements into one settlement account and the agent�s own accounting records will identifythe account of which client particular stock or cash are held for and should be allocated. Thisis typically supported by separate allocating settlements within CREST to its clients (eg byown account transfers - OATs) or outside CREST (eg stock withdrawals - STWs). Withgross settlement, effective protection of client safekeeping assets can be achieved bymanaging the priorities of the market-side gross settlements and the client-side settlements.If the market-side settlement is netted, then effective protection of client assets may have tobe achieved by managing the client-side settlements only.

2. Direct settlement to a pool nominee. In this case, the market-side settlements are directlyinto a pool nominee containing client stock. Netting of the market-side settlements could beregarded as effectively using one client's stock for another client's settlement.

3. Direct settlement to a designated nominee. In this case, the market-side settlements aredirectly into accounts in the nominee designated by customer. Settlement netting can beused in this case without mixing different clients� stock or other assets, but is unlikely to bebeneficial as netting between clients will not occur, thereby reducing the resultant nettingefficiency. In this case, the participant would not be able to opt into automatic matching ofgross transactions either, because the participant would have to specify the CREST memberaccount on each transaction (see section 5.3).

8 See proposed Rule 9.173 in the FSA Conduct of Business Sourcebook (policy statement issued inFebruary 2001) and SFA Rule 4-102(2).

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7.5.1 Partial settlement

Where net settlements are split (see section 8.1) it will be important to understand how underlyingclients� transactions are allocated to each split. This is essentially so that the agent knows howmuch of each client�s transactions have settled.

7.6 Netting across trading participantsIt is possible in some circumstances to net across business that was dealt under different BICcodes. This is likely to benefit three types of participant:

1. Those that use multiple BIC codes within an organisation (often for historic reasons), butwhere all the BICs represent a single legal entity. In this instance it will be possible to net allthis business into a single settlement provided the participant wishes to settle the nettransactions through a single CREST participant and member account.

2. Model B settlement agents that wish to net all the SETS business that they are transacting,irrespective of the underlying Exchange member firm. It should be noted that the settlementparticipant can control which transactions are netted together in this sort of situation by usingtheir CREST member accounts appropriately � settlement can only be across BIC codes ifthe resulting transactions are settling (on the market side) via the same member account.Similar client protection issues may arise here to those described in section 7.4.

3. GCMs that wish to settle back-to-back with LCH and their NCMs so that the settlement chainreplicates the contractual chain (see section 7.2.1).

Netting across BIC codes is not possible in other situations, such as use of a Model A settlementagent for multiple NCMs via a pooled settlement account and where settlement is direct to LCH(as described in section 7.2.2). This is because of the risk of not being able to insulate oneExchange member from the default of another. In this case the pooled settlement accountcannot be used.

7.7 Books and recordsA key benefit of settlement netting for many market participants is the ability to close down tradesin their front office systems and reduce the scale of their downstream processing. This requirespassing only the net transactions to their accounting systems supporting their balance sheet.

Although equity contracts are on balance sheet items, advice received so far indicates that,assuming the conditions of FRS 5 �Reporting the Substance of Transactions� are met, it shouldbe possible to apply the net transactions only to balance sheets, although this will depend on theopinions of firms� own individual advisers. Similar treatment should also be available underGAAP. Participants should take their own advice in this area as there may be particularcircumstances that mean that this advice is not correct in some cases. However, the followingparagraphs provide some general background information.

FRS5 includes the requirement that debit and credit balances should be aggregated into a singlenet item, only where conditions are met which ensure that the records represent the close-outposition of the entity, in the event of the default of its counterparty. In fact the default rules of bothLCH and the Exchange support the close-out netting of principal contracts, although some of the

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technicalities of the close-out differ eg the price at which contracts are valued. In the LCH defaultrules, regulation 39A defines the rights of clearing members to net their open contracts with LCH,if LCH were to default. The Exchange default rules define similar rights in relation to principalcontracts between GCMs and NCMs.

When calculating regulatory capital, for credit risk relating to delivery against payment cash equitytransactions, there is no impact on Counterparty Risk Requirement (CRR) until five days afterintended settlement date9. (Position Risk requirement PRR does apply from trade date but isindependent of the nature of settlement.) FSA rules allow offset in the calculation of CRR onfailed trades with the same counterparty as long as certain requirements are met in the event ofdefault of that counterparty, including the contractual rights to close-out net10. Consequently theintroduction of settlement netting is not anticipated to change the basis of calculating CRR, sincethe default rules of LCH and the Exchange in relation to principal contracts already support theserights of offset.

FSA also have a series of rules relating to the keeping of financial and accounting records11.These require regulated market participants to have an audit trail that allows any balancepotentially to be dis-aggregated into each of the individual underlying transactions. In other wordsmarket participants will have to keep records of the individual trades, although this need not be abalance sheet accounting record, but could be for example a back office or front office record.Put another way, if participants do not wish to process every trade through their downstreamsystems, then, subject to the advice of their own advisers, it would appear that the existingaccounting and regulatory standards would support this approach.

7.8 DefaultMore details on default handling will be published as part of the Exchange draft rule andregulation changes in Q3 2001 and LCH rule and regulation changes in Q4 2001.

7.8.1 Default of a clearing member

There is no proposed change to the handling of the default of a clearing member as the result ofintroducing settlement netting. This is covered by LCH�s default rules in relation to the contractsbetween the clearing member and LCH; and is covered by the Exchange�s rules in relation to thecontracts between the clearing members and the NCM (or its clients).

7.8.2 Default of a Non-Clearing Member

If a Non-Clearing Member (NCM) that was taking part in settlement netting defaulted, thenunsettled net agency settlements would not be settled net. Instead, the default process wouldwork from the

underlying gross transactions. In other ways, there is no proposed change to the Exchange�shandling of default of an NCM and if the NCM is acting as principal the Exchange�s close-outdefault rules apply.

9 SFA Rule 10-171(1)10 SFA Rules 10-170(10) and 10-171(4)11 SFA Rules 3-10 to 3-13

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7.8.3 Default of a client

There is no proposed change to the handling of the default of a client as the result of introducingsettlement netting.

7.8.4 Impact of splits of net settlements

If a net settlement has been split and one split has settled while another has not, new Exchangeallocation rules will determine the proportions of underlying transactions that have settled. Thesewill apply where the net settlement includes trades dealt under different BIC codes see section7.6) and where agency trades have been netted together for settlement (see section 7.4). Theallowable approaches to netting across BIC codes described in section 7.6 are intended tominimise the possibility that the default of one participant will affect other participants.

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8 SettlementSettlement is not materially changed except as specifically noted in this chapter.

8.1 SplitsParticipants will be able to split net settlements in the same way as gross settlements. There aretwo obvious reasons why a participant might want to do this, although the use of splits is notrestricted to these two reasons.

1. To enable partial settlement if there has been a fail, see section 8.3.3.

2. To allow more than one option when electing in a corporate event, see chapter 9.

Whichever reason applies, one issue for participants is the allocation of underlying gross tradesto the resulting shapes, although this may only be an issue in practice for agency trades12. It isnot necessary (and indeed there are no facilities) for participants to inform CREST of thisallocation, which only becomes important if the participant defaults in a situation where some, butnot all, of the shapes have settled; see section 7.8.

8.2 SettlementThe basic process of settlement remains unchanged for settlement netting. It should be notedthat net settlements are still stock and cash movements consistent with final and irrevocabledelivery vs payment in CREST, eliminating settlement risk. See section 6.1.3 for examples ofhow the net settlement is calculated and the resulting stock and cash movements.

8.3 Settlement managementSettlements efficiency is very important in a net settlement environment. The intended approachto managing late settlements will be to use a combination of the following methods.

• CREST settlement discipline regime

• Buying-in

• Splitting net settlements if only a partial delivery is possible

• Stock borrowing

• Interest claims.

These are described in more detail below.

12 The Exchange intends to provide an allocation algorithm in its rules to define which underlyingtransactions are included in which split in situations, such as participant default, where this becomesimportant.

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8.3.1 CREST settlement discipline regime

This will operate in the same way for all participants, whether they take part in netting or not.However, the impact of settlement netting means that participants that opt in to one or more partsof the service could find that this changes the impact of the regime on their business.

• If a participant opts not to have to match transactions (either at gross or net level), then thesepre-matched instructions will be ignored for the purpose of calculating the participant�smatching performance � ie only those transactions that are (or should be) explicitly matchedcount towards the participant�s performance.

• A participant that opts into netting will settle fewer transactions than otherwise. Thesettlement performance measure for such a participant will thus be weighted more towardsnon-SETS business.

It is possible that changes to this regime will be introduced for central counterparty settlements.Any such changes will require approval by the CREST Settlement Discipline Committee. Marketparticipants will be notified of any changes.

8.3.2 Buying-in

Exchange member firms will continue to be able to request buying-in irrespective of whether theytake part in netting or not. Because, under netting, there is no longer a direct link between boughtand sold settlements across LCH, the Exchange will generally buy in against the oldest unsettledsale to LCH in order to meet the buying-in request. If the buying-in request proceeds through toan actual buy-in, then LCH will ensure onward delivery on the intended settlement date of thebuy-in to the purchaser.

8.3.3 Splitting

Market participants with outstanding net sales holding only some of the stock should split the netsettlement to allow as much to settle as possible. This will use the standard CREST splittingfunctionality.

LCH will also make use of splits if they hold some stock but not enough to be able to deliver anoutstanding settlement in full. It is intended that LCH would only use this facility at defined pointsin the settlement day. However, LCH may split large positions at any time if, in their judgement,this would improve their or the market�s settlement efficiency.

8.3.4 Stock borrowing

Market participants are encouraged to borrow stock to meet outstanding settlements just as theydo today.

8.3.5 Interest claims

LCH will continue to make use of the CREST interest claim facility to recover the cost of fundingstock positions that are not delivered on as a result of the buyer being in technical default (ie nothaving sufficient cash to take delivery).

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9 Corporate eventsMost corporate event processing remains unchanged by the introduction of settlement netting.This chapter describes some specific changes that are required and describes the impact ofnetting.

The basic principle is that the introduction of netting should not change the entitlement of theowners of stock to benefits nor their ability to elect in optional events.

9.1 BenefitsThere is no change to the basic process of distributing benefits, however there will be somechanges to claims handling.

Claims will be raised as soon as possible so that LCH can manage the resulting risk properly.Claims will be raised on gross settlement transactions unless these transactions have alreadybeen netted, in which case the claim will be raised on the net transaction. Claims will also beraised on unmatched transactions where LCH is one of the participants.

Netting only occurs on gross settlement transactions that are matched. If a participant haselected to match the gross settlement transactions explicitly, then it is possible that matching willonly be achieved after the daily netting event but before the end of CREST input for the day (asdescribed in section 6.2.1). In this case, the net transactions would not yet have been createdwhen the claim generation process is run overnight. The consequence of this is that the resultingclaims will be generated at the gross level instead of the net level. This is one reason why it isadvantageous for participants to opt to treat their gross transactions as automatically matched (asdescribed in sections 5.3 and 5.5) because this means that their claims will always be raised at anet level.

Neither stock nor cash claims will be netted with each other or with other transaction types.However, for participants using settlement netting, the number of claims will be lower becauseclaims will normally be generated from their net settlements.

CREST is also intending to introduce new processing for handling the optionality in some scripdividend distributions at the same time as the introduction of the settlement netting service. Moredetails on this area will be made available by CREST in a forthcoming consultation.

9.2 Corporate actionsThere is no change to the basic processing of corporate actions, however some of the actions willbe performed at the net level. It should be noted that the central systems will not �explode out�the net transactions back to the gross level if a corporate event arises. The impact of netting ontransformations and elections is described below.

9.2.1 Transformations

In general, transformations will be generated as described below.

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• Gross settlements not due for netting will be transformed as normal.

• Net settlements will be transformed like other settlements, but see note below on roundingissues. Transforming a net settlement does not make it eligible for further netting. There willbe some timing issues where participants have not opted for automatic matching; these willbe described in detail in the CREST white book.

Transformations sometimes involve rounding and fractions, eg �three outcome shares for everytwo underlying�. Therefore where a transformation is carried out on a net transaction, the resultcould be different from if the transformation had been carried out on the underlying grosstransactions. This could cause issues for participants where they have related gross settlementswith clients which have also been transformed13. This arises because even where participantshave flat settlement positions, due to the shapes of different open settlements, out-turnsettlements after transformation and rounding may not themselves result in a flat settlementposition. This issue will be dealt with under LCH and Exchange rules which will ensure that LCHdoes not acquire principal positions as a result of transformations.

9.2.2 Optional events

Buyer instructions in optional corporate events can be made on net settlements, just like othersettlements.

If the corporate event has options, then there will be instances where a participant wishes to electin different ways on different parts of the net settlement because of instructions from underlyingclients or proprietary trading decisions. In this case, it is proposed that the participant splits thenet settlement into appropriate shapes to allow this.

However, if the net settlement has both purchases and sales within it, it can be lessstraightforward to generate suitable shapes. Participants will have to ensure that client sales arealso delivered to it in such a way as to ensure that purchasers (including LCH) will be satisfied.

More detail on this area will be published along with the draft rule changes in Q3 2001.

13 Similar issues will result from some claims as well.

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10 Risk managementThere will be no change to the calculation of margin as a result of the introduction of settlementnetting. This is because LCH already margins based on the net positions of its members, relyingon its ability to perform close-out netting in the event of their default. It makes no difference toLCH in this calculation whether the participant is actually settling net or not.

LCH will keep the margin parameters under review, in particular the assumption that transactionssettle early on their due date. If the settlement performance of net transactions is materiallyworse than that for gross transactions, then the margin parameters might have to be changed tocover the resulting increase in risk.

There will be no change to either the change to the process of making margin calls or themethods by which LCH members provide collateral as cover.

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11 Reporting to membersExchange and LCH reporting to participants relating to SETS trades and the use of the centralcounterparty is not changing as a result of settlement netting. The only changes are to CRESTinformation.

The CREST changes will be described in more detail in the CREST White Book on SettlementNetting. This chapter provides an overview.

11.1 Standing dataCREST will hold additional standing data to show which participants are taking up which options,as described in chapter 5. This data will be visible to participants to enable them to check theiroptions.

11.2 Transaction data and reconciliationThe result of the optionality described in chapter 5 is that, for participants that make use of any ofthe optional components of the service, the lifecycle of their transactions changes to a greater orlesser extent. The CREST White Book will explain the actual status values etc that will beapplied in each case.

CREST provides the following reconciliation facilities, which can be used in combination. Thesefacilities will be available to both settlement and clearing participants.

• The ability for the participant to calculate the net settlement themselves and reconcile with theCREST calculation using the Net Transaction Id and the underlying Trade Codes (UTIs) fromSETS on the gross transactions.

• Links from the underlying gross transaction to the resulting net transaction: in particular, thegross transaction will have the transaction id of the net transaction added to it. This will bevisible on enquiries from CREST. If a net transaction is split, then the standard CRESTfunctionality will retain an audit trail from the resulting transactions to the one that was split.

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12 Stamp duty and regulatory reportingThis chapter outlines the impact of settlement netting on stamp duty and transaction reporting.More detail will be published in the CREST White Book on settlement netting.

12.1 Stamp duty and SDRT

12.1.1 UK � stamp duty and SDRT

Stamp Duty Reserve Tax (�SDRT�) is calculated based on matched transactions in CREST. Withthe introduction of the settlement netting service, this will be assessed on the gross transactions.SDRT will be applied to the gross transactions irrespective of whether they are automaticallymatched or not.

Intermediary reliefs will continue to be applied as now and CREST will populate SDRT fields onthe gross transactions using the trade information received from SETS. The fields will becompleted according to existing market practice and the gross transactions will then be assessedfor SDRT by the Stamp Processing Unit. CREST will send transaction reports to the InlandRevenue for every transaction assessed by the Stamp Processing Unit irrespective of whether itwas automatically matched or not.

For participants that opt for automatic matching of gross transactions, this will remove the abilityto specify reliefs or exemptions on a transaction-by-transaction basis, eg for charities. Thesereliefs will have to be applied for separately. CREST will publish more details about this in duecourse.

The calculation and collection of stamp duty will not change as it is only SDRT that is impacted bysettlement netting.

12.1.2 Ireland � stamp duty

Discussions are being held with the Irish Revenue Commissioners regarding how Irish stampduty might operate in a netted environment. The relevant legislation was not written with a netsettlement environment in mind. It is possible that Irish securities would have to be initiallyexcluded from settlement netting. More detail on this will be published when it is available.

The same issues about transaction-by-transaction reliefs and exemptions also apply to Irishstamp duty as for SDRT.

12.2 Regulatory reportingBoth the Exchange and FSA collect data known as �transaction reports� and this is usually done(for SETS trades) as part of participants� inputs into CREST. A participant that opted not tomatch the gross transactions would no longer have the ability to provide this data by this means.

However, the existence of the link from SETS to CREST put in place as part of the initial centralcounterparty project allows for a re-examination of the means and necessity of certain elementsof transaction reporting. The conclusions of this are as follows.

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• Exchange member firms will no longer have to enter market-side transaction reports to theExchange or FSA for trades fed directly from SETS to CREST. CREST will have sufficientinformation to supply the Exchange and FSA without further participant input. However,participants can still choose to enter transaction report information on their market-side inputsif they choose to match the gross transactions in CREST.

• Where participants would have used the market-side transaction report to supply a clientreference (ie where they had one and only one client), but are treating the market-sidetransaction as automatically matched, then the client reference should be supplied on aclient-side transaction report. Participants will be unable to input additional information toautomatically matched trades and the Exchange is still considering how participants shouldlink their client-side reports to these.

• Where there is more than one client, there is already a requirement to provide client-sidetransaction reports with the client references on them � this requirement will not change.

It should also be noted that there is no requirement to transaction report net settlements, althoughthey are still classified as on-Exchange business.

Further guidance will be published by the Exchange during Q3 2001.