Life Cycle of a Trade

Life Cycle of a Trade (Part 1)

Have you ever wonder what happens after you submit your order for your trade? If you have flipped through the papers and come across terms like Front office, Middle office and Back office, what are they and their roles?

In this post, I shall show how an order flows from an investor to an exchange, how it gets converted into a trade, and how it gets settled. Each order that is initiated by an investor follows a defined life cycle from initiation to settlement. The image below illustrates this life cycle. This life cycle is defined worldwide by the existing operational practices of most institutions, and the processes are more or less similar. The emphasis is on getting the orders transacted at the best possible price and on getting trades settled with the least possible risk and at manageable costs. Designated employees in the member’s office ensure that each trade that takes place through them or in their house account gets settled properly. Unsettled trades lead to liability, risk, and unnecessary costs.

The following steps are involved in a trade’s life cycle:

1. Order initiation and delivery
2. Risk management and order routing
3. Order matching and conversion into trade
4. Affirmation and confirmation (this step is relevant for institutional trades only)
5. Clearing and settlement

Steps 1 and 3 are generally called front-office functions, and steps 4–5 are called back-office functions. The risk management part in step 2 is a middle-office function, and the routing part is again a front-office function. In the trading and settlement value chain, steps that take place before the order gets executed are called pre-trade. These include order initiation, order delivery, order management and routing, order-level risk management, and so on. Similarly, steps that take place after the order is matched and converted into a trade are called post-trade. The entire gamut of clearing and settlement is known as post-trade activity.

Though the underlying philosophies of executing orders at the lowest costs and performing risk-free settlements remain the same, the operational steps differ from member to member and also from country to country.

Also, given an institution, the steps followed differ from client to client. This is actually more linked to the client type rather than to the client. An individual person trading is classified as a retail customer and is hence considered risky. Corporate customers, funds, banks, and financial institutions are called institutional investors. For example, risk management before order routing may be a step that takes place compulsorily for a retail client but could be waived for an institutional client, especially if the institution has a sound financial standing in the market. Additional steps are involved in settling an institutional trade in comparison to a retail trade. This difference is because institutions normally outsource their settlement function, and members have to talk to this additional agency. Institutions also have a number of checks and balances that each member has to follow.

Order Initiation and Delivery

This is the first step, and it involves accepting orders from a client and forwarding them to the exchange after doing risk management checks.

Clients keep a close eye on the markets and keep scouting for investment opportunities. They form a view about the market. View alone, however, is not enough to produce profits. Profits come from maintaining a position in the market. Positions are the results of trades that investors execute in the markets. Clients place orders with their brokers through multiple delivery channels. Some popular channels for placing orders include phones, faxes, the Internet, and interactive voice response systems (IVRSs). The majority of brokers have built-in capabilities to allow clients to submit their orders through personal digital assistants (PDAs) and other handheld devices. Institutions usually place a large number of orders. Most institutions submit their orders in soft-copy format through a floppy disk or any other bulk-upload medium.

Those who trade a lot in a particular market may even demand that the broker gives them a dedicated trading terminal. They may also set up their own trading terminal that connects to the broker’s trading terminal/server through a proprietary protocol or industry-standard protocol such as Financial Information Exchange (FIX), which is a technical specification prepared in collaboration with brokers, exchanges, banks, and institutional investors to enable the seamless exchange of trading information between their systems. Systems with broker and trading institutions generate orders automatically depending upon the market conditions. Trading on such automatically generated orders is called program trading and is not allowed in some markets because it is perceived to cause volatility. Regardless of the methodology used for order delivery, the broker carefully records the orders so that there is no ambiguity or mistakes in processing. Almost all brokers record the conversation between clients and brokers, which can be used later for dispute resolution in case any ambiguity exists over what was communicated and what was interpreted and executed.

Institutions normally speak to a sales desk of the broker and get a feel for the market. An institution or the fund manager who places the order may be managing multiple funds. At the time of placing the order, however, the fund manager may not know to which fund he will allocate the securities bought/sold. At the point of placing the order, the fund manager just instructs the sales desk of the broker to execute the order.

An individual order received from a client is tagged with some special conditions such as good till cancelled (GTC), good till date (GTD), limit order, market order, and so on. These conditions dictate the rate and condition at which the customer expects the orders to be executed. The member on a best-effort basis accepts the order. Unless an institution specifically demands it, there is no standard practice of giving back-order confirmation details. This essentially means that the clients work with brokers on good faith that the broker has understood their order terms clearly and will get it executed at the best possible price. It is important that brokers preserve the sanctity of the conditions specified and get the orders executed within the boundaries of specification. Failure to do so will result in the client moving to a different brokerage house.

In my previous post, I had mentioned about 5 steps involving in the trade’s life cycle. In this post, I shall discuss about the Risk Management and Order Routing and the Order Matching and Conversion into Trade.

Risk Management and Order Routing

Regardless of how an order gets generated or delivered, it passes through a risk management matrix. This matrix is a series of risk management checks that an order undergoes before it is forwarded to the exchange. The onus of getting the trades settled resides with the broker. Any client default will have to be made good to the clearing corporation by the broker. Credit defaults are thus undesirable from the point of view of the broker who puts money and credibility on the line on behalf of the customer. Hence, these credit and risk management checks are deemed necessary.

Institutions are normally considered less risky than retail customers. That is because they have a large balance sheet compared to the size of orders they want to place. They also maintain a lot of collateral with the members they push their trades through. Their trades are hence subjected to fewer risk management checks than retail clients.

The mechanisms followed when orders are accepted and sent to exchanges for matching are the same for both institutions and retail clients. However, for retail customers the orders are subjected to tighter risk management checks and scrutiny. The underlying assumption in all such risk management checks is that retail clients are less credit worthy and hence more susceptible to defaulting than institutions. A recent extension of retail trading has been trading through the Internet. This exposes brokers to even more risk because the clients become faceless. In the good old days of “call and trade” (receiving orders by phone), most brokers executed transactions of clients they knew. With the advancement in trading channels, the process of account opening became more institutionalized, and the numbers came at the expense of client scrutiny. Most brokers who operate on behalf of retail clients these days operate on the full-covered concept. This means that while accepting orders from retail clients, they cover their risks as much as possible by demanding an equal value of cash or near cash securities.

The steps below show how a retail transaction is conducted and the benefit provided by risk management. The method utilized is more or less the same in call and trade as in Internet trading. The order delivery mechanism changes, but the basic risk management principle implemented remains the same. Here are the steps:

1. The client calls the broker to give the orders for a transaction (in Internet trading the client logs on to the Internet trading site, provides credentials, and enters orders).
2. The broker validates that the order is coming from a correct and reliable source.
3. In case the client gives a buy order, the broker’s system makes a query to ascertain whether the client has enough balance in a bank account or in the account the client maintains with the broker. In case the client does not have enough balance, the order is rejected even before forwarding to the exchange. If the client has the balance, the order is accepted, but the value of the order is deducted from the client’s balance to ensure that he does not send a series of orders for which he cannot make an upfront payment. Many brokers still do not have direct interfaces to a banking system. In such cases, they ask the client to maintain a deposit and collateral in the form of cash and other securities; they keep the ledger balances of a client’s cash and collateral account in their back-office system and query this system while placing the order to ensure that the client has enough money in his account. The figure below illustrates this process.

4.   

5. In case a client gives a sell order, the broker checks the client’s custody/demats account to ensure that he has a sufficient balance of securities to honor the sale transaction. Short selling is prohibited in most countries, and brokers need to ensure that the client is not short of securities at the time of settlement, especially in markets that do not have an adequate stock-lending mechanism in place. Most markets have an auction mechanism in place for bailing out people with short positions, but such bailouts could be very expensive. Once the sale transaction is executed, the broker keeps a record and updates the custody balance’s system if it is in-house or keeps reducing the figures from the figures returned by the depository to reflect the client’s true stock account position. In many countries, brokers have a direct interface with the depository system that lets them query the amount of shares of a particular company in which the client has balances. Wherever a direct interface is absent, the broker maintains the figures in parallel; the broker then does a periodic refresh of this data by uploading the figures provided by the depository and maintains a proper intraday position by debiting figures in his system when the clients give sale orders that are executed on the exchange. The figure below illustrates this step.
   
6. Once the risk management check passes, the client’s order is forwarded to the exchange.
7. On receipt of the order, the exchange immediately sends an order confirmation to the broker’s trading system.
8. Depending upon the order terms and the actual prices prevailing in the market, the order could get executed immediately or remain pending in the order book of the exchange.

You can appreciate the role technology plays when you consider that the entire process of receiving the order, doing risk management checks, forwarding the order to the exchange, and getting back the confirmation is expected to take a few hundredths of a second. Any performance not conforming to this standard is considered unacceptable and could be a serious reason for clients to look for other brokers who can transact faster and get them more aggressive prices.

One of the ways of implementing risk management is through margining. A margin is an amount that clearing corporations levy on the brokers for maintaining positions on the exchange. The amount of margin levied is proportional to the exposure and risk the broker is carrying. Since positions may belong to a broker’s clients, it is the broker’s responsibility to recover margins from clients. Margins make the client stand by trades in case the market goes against the client by the time the trades get settled.

To protect the market from defaulters, clearing corporations levy margins on the date of the trade. Margins are computed and applied to a client’s position in many ways, but the underlying philosophy of levying margins is to tie the customer to a position and preserve the integrity of the market even if a large drop in stock prices occurs.

Order Matching and Conversion into Trade

All orders are aggregated and sent to an exchange for execution. Stock exchanges follow defined rules for matching all the orders they receive. While protecting the interests of each client, the exchange tries to execute orders at the best possible rates. The broker’s trading system communicates with the exchange’s trading system on a real-time basis to know the fate of orders it has submitted.

A broker keeps a record of which orders were entered during the day, by whom, and on behalf of which client. A broker also maintains details of how many orders were transacted and how many are still pending to be executed. Using this system, a broker can modify the order and order terms, cancel the order, and also split the order if required depending upon the behavior of the market and instructions from the clients. Once the order is executed, it gets converted to a trade. The exchange passes the trade numbers to the broker’s system. The broker in turn communicates these trade details to the client either during the day or by the end of the day through a contract note or through an account activity statement. The contract note is a legal document that binds the broker and the client. Contract note delivery is a legal requirement in many countries. Apart from the execution details, the contract note contains brokerage fees and other fees that brokers levy for themselves or collect on behalf of other agencies such as the Clearing Corporation, exchange, or state.

This post is the continuation of the post on life cycle of a trade. In this post, I’m going to discuss the last two steps, namely the Affirmation and Confirmation and Clearing and Settlement.

Affirmation and Confirmation

This step is present only when the trading client is an institution. Every institution engages the services of an agency called a custodian to assist them in clearing and settlement activities. The figure below illustrates this.

 

As the name suggests, a custodian works in the interest of the institution that has engaged its services. Institutions specialize in taking positions and holding. To outsource the activity of getting their trades settled and to protect themselves and their shareholder’s interests, they hire a local custodian in the country where they trade. When they trade in multiple countries, they also have a global custodian who ensures that settlements are taking place seamlessly in local markets using local custodians.

As discussed earlier, while giving the orders for the purchase/sale of a particular security, the fund manager may just be in a hurry to build a position. He may be managing multiple funds or portfolios. At the time of giving the orders, the fund managers may not really have a fund in mind in which to allocate the shares. To avoid a market turning unfavorable, the fund manager will usually give a large order with the intention of splitting the position into multiple funds. This is to ensure that when he makes profits in a large position, it gets divided into multiple funds, and many funds benefit.

The broker accepts this order for execution. On successful execution, the broker sends the trade confirmations to the institution. The fund manager at the institution during the day makes up his mind about how many shares have to be allocated to which fund and by evening sends the broker these details. These details are also called allocation details in market parlance. Brokers then prepare the contract notes in the names of the funds in which the fund manager has requested allocation.

Along with the broker, the institution also has to liaise with the custodian for the orders it has given to the broker. The institution provides allocation details to the custodian as well. It also provides the name of the securities, the price range, and the quantity of shares ordered. This prepares the custodian, who is updated about the information expected to be received from the broker. The custodian also knows the commission structure the broker is expected to charge the institution and the other fees and statutory levies.

Using the allocation details, the broker prepares the contract note and sends it to the custodian and institution. In many countries, communications between broker, custodian, and institutions are now part of an STP process. I’ll talk about STP in another post. This enables the contract to be generated electronically and be sent through the STP network. In countries where STP is still not in place, all this communication is manual through hand delivery, phone, or fax.

On receipt of the trade details, the custodian sends an affirmation to the broker indicating that the trades have been received and are being reviewed. From here onward, the custodian initiates a trade reconciliation process where the custodian examines individual trades that arrive from the broker and the resultant position that gets built for the client. Trades are validated to check the following:

• The trade happened on the desired security.
• The trade is on the correct side (that is, it is actually buy and not sell when buy was specified).
• The price at which the trade happened is within the price range specified by the institution.
• Brokerage and other fees levied are as per the agreement with the institution and are correct.

The custodian usually runs a software back-office system to do this checking. Once the trade details match, the custodian sends a confirmation to the broker and to the clearing corporation that the trade executed is fine and acceptable. A copy of the confirmation also goes to the institutional client. On generation of this confirmation, obligation of getting the trade settled shifts to the custodian (a custodian is also a clearing member of the clearing corporation).

In case the trade details do not match, the custodian rejects the trade, and the trades shift to the broker’s books. It is then the broker’s decision whether to keep the trade (and face the associated price risk) or square it at the prevailing market prices. The overall risk that the custodian is bearing by accepting the trade is constantly measured against the collateral that the institution submits to the custodian for providing this service.

Clearing and Settlement

With hundreds of thousands of trades being executed every day and thousands of members getting involved in the entire trading process, clearing and settling these trades seamlessly becomes a humungous task. The beauty of this entire trading and settlement process is that it has been taking place on a daily basis without a glitch happening at any major clearing corporation for decades.

After the trades are executed on the exchange, the exchange passes the trade details to the clearing corporation for initiating settlement. Clearing is the activity of determining the answers to who owes the following:

• What?
• To whom?
• When?
• Where?

The entire process of clearing is directed toward answering these questions unambiguously. Getting these questions answered and moving assets in response to these findings to settle obligations toward each other is known as settlement. This is illustrates with the figure below.

Thus, clearing is the process of determining obligations, after which the obligations are discharged by settlement. It provides a clean slate for members to start a new day and transact with each other.

When members trade with each other, they generate obligations toward each other. These obligations are in the form of the following:

• Funds (for all buy transactions done and that are not squared by existing sale positions)
• Securities (for all sale transactions done)

Normally, in a T+2 environment, members are expected to settle their transactions after two days of executing them. The terms T+2, T+3, and so on, are the standard market nomenclature used to indicate the number of days after which the transactions will get settled after being executed. A trade done on Monday, for example, has to be settled on Wednesday in a T+2 environment.

As a first step toward settlement, the clearing corporation tries to answer the “what?” portion of the clearing problem. It calculates and informs the members of what their obligations are on the funds side (cash) and on the securities side. These obligations are net obligations with respect to the clearing corporation. Since the clearing corporation identifies only the members, the obligations of all the customers of the members are netted across each other, and the final obligation is at the member level. This means if a member sold 5,000 shares of Microsoft for client A and purchased 1,000 shares for client B, the member’s net obligation will be 4,000 shares to be delivered to the clearing corporation. Because most clearing corporations provide novation (splitting of trades), these obligations are broken into obligations from members toward the clearing corporation and from the clearing corporation toward the members. The clearing corporation communicates obligations though it’s clearing system that members can access. The member will normally reconcile these figures using data available from its own back-office system. This reconciliation is necessary so that both the broker and the clearing corporation are in agreement with what is to be exchanged and when.

In an exchange-traded scenario, answers to “whom?” and “where?” are normally known to all and are a given. “Whom?” in all such settlement obligations is the clearing corporation itself. Of course, the clearing corporation also has to work out its own obligations toward the members. Clearing members are expected to open clearing accounts with certain banks specified by the clearing corporation as clearing banks. They are also expected to open clearing accounts with the depository. They are expected to keep a ready balance for their fund obligations in the bank account and similarly maintain stock balances in their clearing demat account. In the questions on clearing, the answer to “where?” is the funds settlement account and the securities settlement account.

The answers to “what?” and “when?” can change dramatically. The answer to “when?” is provided by the pay-in and pay-out dates. Since the clearing corporation takes responsibility for settling all transactions, it first takes all that is due to it from the market (members) and then distributes what it owes to the members. Note that the clearing corporation just acts as a conduit and agent for settling transactions and does not have a position of its own. This means all it gets must normally match all it has to distribute.

Two dates play an important role of determining when the obligation needs to be settled. These are called the pay-in date and the pay-out date. Once the clearing corporation informs all members of their obligations, it is the responsibility of the clearing members to ensure that they make available their obligations (shares and money) in the clearing corporation’s account on the date of pay-in, before the pay-in time. At a designated time, the clearing corporation debits the funds and securities account of the member in order to discharge an obligation toward the clearing corporation. The clearing corporation takes some time in processing the pay-in it has received and then delivers the obligation it has toward clearing members at a designated time on the date of pay-out. It is generally desired that there should be minimal gap between pay-in and pay-out to avoid risk to the market. Earlier this difference used to be as large as three days in some markets. With advancement in technology, the processing time has come down, and now it normally takes a few hours from pay-in to pay-out. Less time means less risk and more effective fund allocation by members and investors. The answer to “when?” is satisfied by the pay-in and pay-out calendar of the clearing corporation, which in turn is calculated depending upon the settlement cycle (T+1, T+2, or T+3).

Answers to “what?” depend on the transactions of each member and their final positions with respect to the exchange. Suppose a member has done a net of buy transactions; he will owe money to the clearing corporation in contrast to members who have done net sell transactions, who will owe securities to the clearing corporation. To effect settlements, the clearing corporation hooks up with banks (which it normally calls clearing banks) and depositories. It has a clearing account with the clearing bank and a clearing account with the depository as well. A clearing bank account is used to settle cash obligations, and a clearing account with a depository is used to settle securities obligations.

That is a very long post on the last two steps of the life cycle of a trade. Have a nice weekend my readers and have a happy new year.