Domain Knowledge

Trade Lifecycle

We'll be seeing all the steps involved in trade, from where trade begins, what steps it goes through, and finally how it gets settled.

Imagine an investor getting in touch with his research team. This happens at the pre-trade stage, also called the trade initiation stage. The investor will get in touch with his research team, get an idea about which market to trade in, decide on the quantity and which stock to trade, and then decide whether to be a buyer or a seller on that day. Let's say, for this example, the investor has decided to buy some shares.

Similarly, on the other side, another investor also got in touch with his research team and was advised to be a seller for a specific stock, such as Facebook. Both have decided to buy and sell Facebook at a particular price.

Once they decide to be a buyer and a seller, the investor informs all the details to the broker, which is called the order placement stage. The broker then places the order. This is the order placement stage.

The broker will punch in all the details into the system, and his platform will check with the stock exchange if there is any matching order. Once a match is found, the trade moves to the trade execution stage.

The first step happens on T+0 at the front office level. Front office refers to where client data is pulled and used for the request given by the client. This also happens on T+0 at the front office level.

Once the trade gets executed, the broker will pass on the trade details to the custodian.

A custodian, derived from the word custody, means taking care of or safeguarding the investor's financial assets. For example, big investment banks like JP Morgan, Goldman Sachs, and BNY Mellon play the role of custodians. In India, they are also called depository participants. The custodian is responsible for making the required changes in the client's account after the trade is executed.

Within the custodian, there is a team called the trade capture team, which captures all the trade details and keys them into the system. This also happens on T+0 at the middle office level.

After the trade is captured, it goes through trade enrichment. Under trade enrichment, data is segregated between trade data and static data. Trade data refers to information specific to the particular trade, such as the name of the stock, quantity, price, date, and direction (buy or sell). Static data includes information that remains the same across trades, such as the client's name, contact details, standard settlement instructions (SSI), which include bank details, currency of settlement, and so on.

After this data enrichment, the trade goes to the trade validation stage, also known as the trade verification stage, where all the data is cross-checked to avoid any mistakes. This also happens on T+0 at the middle office level.

Once this is done, a confirmation is sent to the investor. In India, this confirmation is called a contract note. This also happens on T+0 at the middle office level.

At the end of the day, the stock exchange will pull all the trade details and pass them on to a clearinghouse. The clearinghouse finds the net obligations for the counterparties involved in the trade, determining who owes how much. In India, the National Securities Clearing Corporation Limited (NSCCL) acts as the clearinghouse. The clearinghouse guarantees the counterparty's performance in the trade. This step is called the transaction reporting step, and it also happens on T+0 at the middle office level.

On T+1, there is only one step: the affirmation stage. The buyer checks whether he is okay with all the trade details. If everything is fine, he informs the custodian. This is called the affirmation stage and is part of the trade agreement. Together, confirmation and affirmation form the trade agreement.

On T+2, clearing work begins at the back office level. The clearinghouse gets in touch with the clearing member, who in turn connects with the custodian to confirm the trade details. The custodian confirms the details to the clearing member, who passes them on to the clearinghouse. This happens at the back office level.

Once the clearinghouse has all the details, it passes them on to the depository. The depository maintains the pooled accounts of the custodian. This step is called the settlement instructions stage, and it happens on T+2 at the back office level.

Finally, on T+3, settlement takes place. Settlement refers to the transfer of ownership. The buyer's custodian credits the shares to the buyer's account, while the seller's custodian debits the shares from the seller's account. This is the final settlement stage, which happens at the back office level.

After the settlement, reconciliation work begins to ensure all records are accurate.

Given below are the roles of different departments (Front Office, Middle Office, Core Operations, and Control) and how they interact across different stages of the trade process.

Let’s break it down and simplify each part:

1. Trade Date (Day of Trade Execution):

• Front Office:

  • Trade Execution: The Front Office (traders) initiates and executes the trade.

  • Trade Capture: The executed trade details are captured into the trading system.

  • Hedging: Any necessary hedging actions are taken to mitigate risk.

• Middle Office:

  • Trade Enrichment: Additional details (e.g., reference data) are added to the trade record to ensure accuracy.

  • Trade Verification: The trade is verified for correctness, ensuring all details match expectations.

  • Trade Approval: After verification, the trade is approved for further processing.

  • Position/P&L Control: Updates positions and calculates profit/loss from the trade.

• Core Ops (Operations):

  • Lifecycle Management: Begins managing the lifecycle of the trade, coordinating the various steps that follow.

2. Trade Date + 1 (Next Day after Trade):

• Middle Office:

  • Trade Amendment: If there are any errors, amendments can be requested and made to the trade details.

  • Error Identification/Request for Amendment: Any errors identified in the trade are flagged and requests for amendments are made.

  • Affirmation/Confirmation: Trade details are confirmed with the counterparty to ensure both sides agree on the terms.

• Core Ops:

  • Cash Reconciliation/Settlement Amount Calculation: Calculates the cash amounts required to settle the trade.

3. Pre Value Date (Before Settlement Date):

• Core Ops:

  • Pre-Settlements: Preparation for the settlement process, ensuring everything is in place for a smooth transfer.

  • Margin and Collateral: Ensuring sufficient margin and collateral are available to secure the trade.

4. Value Date (Settlement Date):

• Core Ops:

  • Advice Generation: Generating settlement instructions or advice for the parties involved.

  • Cash Management Settlement: Actual settlement occurs, where the securities are delivered, and payment is made.

5. Post Value Date (After Settlement):

• Control:

  • End-to-End Reconciliation: Ensuring that the entire process (trade, position, cash, and nostro reconciliation) is accurate and complete.

  • Valuation Validation: Validating the valuation of the trade to ensure everything is properly accounted for.

  • Regulatory Reporting: Reporting trade details to regulatory bodies as required by law.

Summary:

• Front Office focuses on executing and capturing the trade.

• Middle Office enriches, verifies, and manages trade approvals and amendments.

• Core Ops handles the settlement process, cash management, and reconciliation.

• Control ensures everything is properly validated, reconciled, and reported to regulators.

This lifecycle ensures that from the moment a trade is executed to the time it is settled, every detail is captured, verified, settled, and reported accurately. Each department has a specific role, ensuring the trade is processed smoothly and in compliance with all regulations.

Executing Broker

• The broker or dealer that finalizes and processes an order on behalf of a client. The orders sent to executing brokers are assessed for appropriateness, and if the order is deemed practical, the executing broker will then carry out the order. If the order is rejected, the customer is notified and the stock is not traded.

• Once the executing broker has assessed the validity of the order, it is then submitted onto the clearing broker who clears the trade. However, since executing brokers are paid through commission, the possibility exists that this incentive may encourage numerous trades even though they may not be suitable.

or

• An executing broker is a type of financial dealer or broker that is responsible for the finalization and processing of an order that is entered by a client. As part of the process, brokers of this type will evaluate the order to make sure it is in line with current policies and procedures and in compliance with any regulations set by the market in which the order will be traded. Only after the executing broker is satisfied that the order is appropriate does he or she move on to actually execute the order on behalf of the client, and place it for trade in the marketplace.

• Executing brokers just execute the order of a client on a trading venue and charges some commission for the service.

Prime Brokers

Prime brokers are specialized financial institutions or divisions within large banks that provide a range of services to hedge funds, institutional investors, and other large-scale clients. These services are designed to support the trading activities and operational needs of these clients, particularly those involved in complex, high-volume trading strategies.

Key Services Provided by Prime Brokers:

1. Securities Lending:

   • Short Selling: Prime brokers lend securities to clients who wish to sell them short. This is a key service for hedge funds that employ short-selling strategies.

   • Collateral Management: They handle the collateral required for borrowing securities, ensuring that the client maintains the necessary margin.

2. Leverage and Margin Financing:

   • Prime brokers offer clients leverage, allowing them to borrow funds to amplify their trading positions. This is often done on margin, where the client only needs to provide a fraction of the total value of the trade as collateral.

3. Trade Execution and Clearing:

   • Execution Services: Prime brokers can execute trades on behalf of their clients across various asset classes, including equities, fixed income, derivatives, and foreign exchange.

   • Clearing and Settlement: They also handle the clearing and settlement of trades, ensuring that all transactions are properly processed and recorded.

4. Custody Services:

   • Prime brokers provide custody services, holding clients' assets (like stocks, bonds, and other securities) in safekeeping. This reduces operational complexity for clients by consolidating their assets with one provider.

5. Capital Introduction:

   • Prime brokers often assist hedge funds in raising capital by introducing them to potential investors, such as institutional investors or high-net-worth individuals.

6. Risk Management and Reporting:

   • They provide sophisticated risk management tools and reporting services to help clients monitor and manage their trading activities and overall portfolio risk.

7. Technology and Operational Support:

   • Prime brokers offer access to advanced trading platforms, research, and market data, as well as back-office operational support. This includes portfolio management tools, performance analytics, and compliance reporting.

8. Derivatives and Structured Products:

   • Prime brokers may offer derivative products and structured financial instruments to help clients hedge risks or create customized investment strategies.

Importance of Prime Brokers:

• Hedge Funds: Prime brokers are particularly important for hedge funds, which rely on their services to execute complex trading strategies, manage risks, and leverage their positions.

• Consolidation of Services: By using a prime broker, clients can consolidate many of their trading and operational needs under one roof, simplifying their operations and often reducing costs.

• Liquidity and Access: Prime brokers provide access to a broad range of markets and liquidity, which is essential for executing large trades without significantly impacting market prices.

Risks and Challenges:

• Counterparty Risk: Clients are exposed to the financial health of their prime broker. If the prime broker faces financial difficulties, it could impact the client’s ability to access their assets or execute trades.

• Concentration Risk: Relying heavily on a single prime broker can create risks if that broker faces operational or financial challenges.

Example of Prime Brokers:

• Goldman Sachs, Morgan Stanley, JP Morgan, and Bank of America Merrill Lynch are some of the major players in the prime brokerage industry.

Prime brokers play a critical role in the financial ecosystem, particularly for hedge funds and large institutional investors, by providing the infrastructure and services necessary to support sophisticated trading strategies.

EMS

Execution Management System (EMS). The EMS can be broker-owned or an independent software vendor. The EMS provides the buy-side trader with the power and speed to deal with today’s challenging trading environment. Functionality such as smart order routing, connectivity to multiple and a large array of trading venues, market data and real-time pricing, pre-trade transaction cost analysis (TCA) and algorithms are provided by these solutions.

OMS

Order Management System (OMS) An electronic system developed to execute securities orders in an efficient and cost effective manner. Brokers and dealers use OMSs when filling orders for various types of securities and are able to track the progress of each order throughout the system.OMSs are an important development in the securities industry because of the significant cost savings they provide to investment firms. Many versions of OMSs have been developed by various firms looking to capitalize on the increased spending made on these systems.

Securities lending

The act of loaning a stock, derivative, other security to an investor or firm. Securities lending requires the borrower to put up collateral, whether cash, security or a letter of credit. When a security is loaned, the title and the ownership is also transferred to the borrower. Securities lending is important to short selling, in which an investor borrows securities in order to immediately sell them. The borrower hopes to profit by selling the security and buying it back at a lower price. Since ownership has been transferred temporarily to the borrower, the borrower is liable to pay any dividends out to the lender

Primary Exchange

The most important stock exchange in a given country. Common characteristics of a primary exchange include a long history, primary listings of the country's top companies, listings of many important foreign corporations, large total market capitalization and a large trade value. A country may have other important stock exchanges in addition to its primary exchange. For example, the United Kingdom's primary exchange is the London Stock Exchange. It was founded in

1801 and has a daily volume of approximately $2 trillion. The NYSE is, of course, the primary exchange of the United States. Other primary exchanges include the following:

Canada – Toronto Stock Exchange

Japan – Tokyo Stock Exchange

China – Shanghai Stock Exchange

India – Bombay Stock Exchange16) Security Id's:

Security identifier types are the various methods by which a security product or issue is identified. They

are each managed and distributed by different organizations.

Dark Pools

• Dark Pools are private trading venues (Alternative Trading Systems - ATSs) where institutional investors, such as mutual funds, hedge funds, or large brokerages, can trade large quantities of securities anonymously without exposing their intentions to the public markets.

Key Features of Dark Pools

• Anonymity: Orders placed in dark pools are not visible to the public until after the trade is executed. This prevents market participants from reacting to large orders and causing price swings.

• No Pre-Trade Transparency: Unlike public exchanges (e.g., NYSE, NASDAQ) where the order book (bids and asks) is visible, dark pools operate without pre-trade transparency.

• Designed for Large Trades: They are mainly used for block trades — trades involving significant volumes of shares.

• Market Impact: Dark pools reduce market impact, which occurs when large orders move stock prices unfavorably.

• Lower Transaction Costs: Dark pools typically charge lower fees than public exchanges, making them more attractive for institutional investors.

Why Dark Pools Exist

• Price Impact: If an institutional investor wants to sell 1 million shares of a stock, revealing this intention on a public exchange would push the price down.

• Front-Running: Traders or algorithms might exploit the information of large trades by "front-running" — executing trades ahead of large orders to profit from anticipated price changes.

• Liquidity: Dark pools provide a private venue where large buyers and sellers can find each other without affecting the broader market.

Types of Dark Pools

• Broker-Dealer-Owned Pools: Operated by large investment banks for their clients (e.g., Goldman Sachs' "Sigma X").

• Independent Dark Pools: Operated by private companies or trading networks (e.g., Liquidnet, Instinet).

• Exchange-Owned Dark Pools: Operated by traditional exchanges as a supplement to their public markets (e.g., NYSE’s "Arca").

How Dark Pools Work

• A trader places a large buy or sell order in the dark pool.

• The order is matched internally within the pool against other orders at the midpoint price between the bid and ask in public markets.

• Once the trade is executed, it is reported to regulatory authorities and included in market data feeds, but the trade’s origin and order size remain undisclosed until execution.

• Benefits of Dark Pools

• Reduced Price Impact: Large trades can be executed without moving the market price significantly.

• Cost Efficiency: Dark pools often charge lower trading fees than public exchanges.

• Improved Liquidity: They provide liquidity for institutional investors without disturbing public market order flow.

Risks and Criticisms

• Lack of Transparency:

• Dark pools have been criticized for their opaque nature, which can disadvantage smaller investors.

• Market Fragmentation:

• Dark pools split trading activity away from public exchanges, reducing transparency in price discovery.

• Potential for Manipulation:

• High-frequency trading (HFT) algorithms can exploit dark pools by sniffing out large orders and taking advantage of the information.

• Regulatory Scrutiny:

• Regulators monitor dark pools closely to ensure fair trading and prevent manipulation.

Conclusion

• Dark pools serve a valuable purpose for institutional investors by providing privacy and minimizing market impact for large trades. However, their lack of transparency raises concerns about fairness and price discovery. As such, they remain a critical, yet controversial, part of modern financial markets.Let me know if you want to dive deeper into high-frequency trading, midpoint pricing, or other related concepts!

Multilateral_trading_facility (MTF'S).

A multilateral trading facility (MTF) is a European regulatory term for a non-exchange financial trading venue. These are alternatives to the traditional stock exchanges where a market is made in securities, typically using electronic systems. The operation of a MTF is considered an investment service. The concept was introduced within the Markets in Financial Instruments Directive (MiFID),[1] a European Directive designed to harmonise retail investors protection and allow investment firms to provide services throughout the EU. Article 4 (15) of MiFID describes MTF as a multilateral system, operated by an investment firm or a market operator, which brings together multiple third-party buying and selling interests in financial instruments – in the system and in accordance with non-discretionary rules – in a way that results in a contract. The term 'non-discretionary rules' means that the investment firm operating an MTF has no discretion as to how interests may interact. Interests are brought together by forming a contract and the execution takes place under the system's rules or by means of the system's protocols or internal operating procedures. The MTF can be operated by a market operator or an investment firm whereas the operation of a regulated market is not considered an investment service and is carried out exclusively by market operators that are authorised to do so. The United States equivalent is an alternative trading system. https://en.wikipedia.org/wiki/Multilateral_trading_facility.

BID & ASK

A two-way price quotation that indicates the best price at which a security can be sold and bought at a given point in time.The bid price represents the maximum price that a buyer or buyers are willing to pay for a security. The ask price represents the minimum price that a seller or sellers are willing to receive for the security. A trade or transaction occurs when the buyer and seller agree on a price for the security. The difference between the bid and asked prices, or the spread, is a key indicator of the liquidity of the asset - generally speaking, the smaller the spread, the better the liquidity.

Fix Drop Copy

The Drop Copy service is a risk management service designed to facilitate real-time monitoring of trading activity done over an EMS.. The Drop Copy service sends carbon copies of execution reports through FIX protocol based messaging interface.