Thursday, January 8, 2015

Trade Life cycle or Security Trade life cycle or Treasury Trade life cycle

Investment Banking Trade life cycle.

Below are the important steps involved in trade life cycle:
1. Order initiation and delivery. (Front office function)
2. Risk management and order routing.(middle office function)
3. Order matching and conversion into trade.(front office function)
4. Affirmation and confirmation.(back office function)
5. Clearing and Settlement.(back office function)

Trade lifecycle can be broadly divided into two parts:
Pre-trade activities and post trade activities,
  1. Pre-trade activities consists of all those steps that take place before order gets executed,
  2. Post trade activities involve order matching, order conversion to trade and clearing & settlement activity.
Pre-trade activities:
Step 1: Order initiation and delivery. (Front office function)

Order is initiated by Retail client like me and you or institutional clients like any Mutual fund company.
Clients place orders with brokers through telephone, fax, online trading and hand held devices. Orders can be placed by either market orders or limit orders.
Market orders means order to buy or sell is placed at the market price of the share/equity/stock that the investor/client wants to buy/sell
Limit orders means order placed to buy or sell at a price that investor/client wants to buy/sell.

When Broker receives these orders, he records these orders carefully so that there is no ambiguity/mistakes in processing.
Note: Institutional investor/ fund manager at this stage would not have decided on the allocation of the funds so he will just contact its sales desk and place the order, so that once order is executed by broker then later Fund Manager can decide the mutual fund in which the investment has to be placed (irrespective whether it is buy/sell).

Step 2: Risk management and order routing. (Middle office function)

In case of any trade default by the client, it becomes the responsibility of the broker to make sure that the trade is made good by the broker to the clearing corporation.
When orders are accepted and sent to exchange these orders go through various risk management checks set differently for the different type of client: institutions and retails clients.
Since it is assumed that retail investors are less credit worthy, the risk management checks are more for retail investors.
It is not same for institutional investors because they have a large balance sheet compared to the size of orders they want to place. They also maintain collateral with the members they push their trades through. Their trades are hence subjected to fewer risk management checks than retail clients.

Below are the steps how risk management is conducted for retail transactions:

•Client logs into the trading portal with the provided credential and places orders.
• The broker validates that the order is coming from a reliable source (KYC checks)
• If the client places buy order, in this case the broker places query to verify whether the client has sufficient balance (margin money), in case the client does not have sufficient margin then order is rejected. If client has the margin money then the order is accepted and margin money is reduced from the available margin
•Once the above risk management check passes then the order is passed to the exchange.
•On receipt of the order, the exchange immediately sends an order confirmation to the broker's trading system.
•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.

Step 3: Order matching and conversion into trade.(front office function)

Below are the steps:
• All the orders placed by clients are collated and sent to the exchange for execution, exchange tries to allot the shares in the best price available to the investors.
• Broker has the record of all the orders that were received from whom, at what time, against which stock, type of order and quantity. Broker maintains these records against client ID.
• Brokers are in real time conversation with exchange so that they have details of how many orders are still pending and how many have been executed in the exchange.
• Once the order is executed it turns into trade and exchange then sends notification of the trade to the broker. The broker in turn communicates these trades to the client either immediately or at the end of day.
• Official communication from broker is done to the client through contract note, which contains details of the trade executed along with taxes being charged and commission being charged by the broker and other institutions like clearing corporation, custodian etc...

Post-trade activities:
Step 4: Affirmation and confirmation.(back office function)

Every institution engages the services of an agency called a custodian to assist them in clearing and settlement activities. Custodian specializes in taking positions and holding.
Institution clients 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.
While initiating 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. So to make more profit and avoid unfavorable market conditions he/she places the order.

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 these details to broker.
Brokers does a cross verification whether all the allocation details match the trade details and then prepares 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 send trade details to 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.
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. Trades are validated to check the following:

• Whether trade has happened on the desired security.
• Whether the trade is correct i.e. buy or sell.
• The price at which rate it was executed.
• Whether the charges are as per the agreement.

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.

Step 5: Clearing and Settlement.(back office function)

There are hundreds and thousands of trades being executed every day and all these trades’ needs to be cleared and settled. Normally all these trades gets settled in T+2 days, which means the trade will gets allotted to the investor to his/her demat account in 2 days from trade date.

The clearing corporation has obligation to every investor in form of
• Funds (for all buy transactions and also to those transactions that are not squared for the sale positions).
• Securities(for all the sale transactions done)

Clearing corporation 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.

Example:

Let’s say broker purchased 1000 shares of SBI for client A and sold 600 shares of SBI for client B which means the obligation of the clearing corporation to the broker is only for 400 shares.

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.
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.
Once these obligations are done the balance of payments takes place and all the investors will have their stocks/financial instruments/shares in their demat account

On every end of day basis the clearing corporation generates various reports that need to be circulated to exchanges and custodians.



24 comments:

  1. Very helpful blog... thanks for its creation

    ReplyDelete
  2. Thanks for the explanation!
    This was a very helpful info on trading

    Shares to Buy

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  3. excellent and very help ful. Is it possible to have something similar for wealth manager.

    ReplyDelete
    Replies
    1. Sure..will create one for Asset Management life cycle and post soon.. :)

      Delete
    2. Hi. First of i would like to thank you for creating such an informative blog. Can you please let me know if any blog you have created for AM life cycle.

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