part 15

Part-15: Brokerage Operations

Micro Issues

Trade Life Cycle

&Straight Through Processing

TLC What do we mean by `trade lifecycle’?

All the steps involved in a trade from the point of order receipt to trade execution through to settlement are referred to as the lifecycle of the trade.

The management of all STOs require that trades are processed in the most efficient manner. This is reflected in their desire to achieve

STP.

TLC (Cont…) STP is achievable if the lifecycle is

begun by recording the details of each trade in a timely and accurate fashion within the front office, and is handled efficiently and cost-effectively in the operational areas of the STO.

A problem created early on in the cycle will cost more to correct the further it is allowed to flow uncorrected.

STP What is Straight Through Processing?

It is a term used to describe the objective of managing trades throughout the lifecycle automatically and without human intervention.

Historically there was little or no connectivity between the various systems within an STO.

This resulted in manual rekeying of individual trade details at various points.

Even where connectivity existed between internal systems a lack of consistent reference data prevented automatic passing of trade details from system to system.

STP (Cont…)

The objective of STP is the following. Following trade execution

Input the details of individual trades only once

And from that point until the complete settlement of the trade. Manage each of the steps in a fully automated fashion.

Elements of TLC

Trading Activities Trade Execution Trade Capture (Front Office)

Elements of TLC (Cont…) Operational Activities:

Trade Capture (Back Office) Trade Enrichment Trade Validation Trade Agreement Transaction Reporting Settlement Instructions The Role of the Custodian Pre Value Date Settlement Instruction Statuses Settlement Failure Trade Settlement Reflecting Trade Settlement Internally

Order Flow Typical steps in the placement of an

institutional order with an STO. The institution decides to buy or sell a

specific security and contacts an STO with whom it normally trades. The details of the order are normally conveyed to the relevant salesperson within the STO.

The salesperson records the details of the order either manually or electronically within an order management system.

Order Flow (Cont…) The order details are forwarded by the

salesman or are fed automatically by the order management system to the relevant trader or market maker.

The trader will assess the order in order to decide whether or not to trade. A market maker must trade if the order price is within the quote given by him. If the trade is executed the details are recorded in the relevant trading book.

Order Flow (Cont…) The trader will respond to the salesperson

who placed the order advising whether or not the trade has been executed and if so on what terms.

The salesman records the details of the execution thereby closing the open order.

The salesman will contact the client usually by phone to advise whether the order has been fulfilled. A formal trade confirmation will be sent later via a medium of the client’s choice within a prescribed deadline.

Trade Capture by the Front Office

All trades executed by an STO must be recorded formally within the STO’s books and records.

The first step is to record the basic details of each trade.

This is necessary to: Update the trading position for the specific security Update the average price of the current trading

position so that when the next trade is executed the trader knows whether a trading profit or loss will be made.

Trade Capture (Cont…)

Traders normally use trading systems designed specifically for managing their positions and applying updated prices to those positions.

The basic trade details must be immediately conveyed to the middle or back office to allow operational processing to commence.

Components of a Trade In the case of a principal trade, the basic

components that are typically recorded by the trader are: Trading book Trade date Trade time Value date Operation Quantity Security Price Counterparty

Trading Book The trading book has only internal

implications. The purpose of assigning a trade to a specific

book is to assign internal responsibility and ownership for the trade.

This results in An update to the trading position within the specific

security And an update to trading profits within the trading

book. Incorrect application of a trading book has no

external impact.

Trade Date The trade date is the day that the two parties

agree to execute the trade. It has internal as well as external implications. It has an impact on the following aspects. The date that a trading position is updated.

If a trade is not recorded on the trade date the trading position will remain incorrect until it is recorded.

Besides, unless it is recorded the risk exposure with the counterparty cannot be assessed.

Trade Date (Cont…) Trading P&L Calculation

The P&L impact of a trade cannot be calculated if the trade is not recorded.

Calculation of accrued interest The trade date is connected to the value date of

the trade and the value date is used in most markets to calculate the accrued interest.

If the trade date is incorrect, it can affect the value date which could affect the accrued interest and consequently the Net Settlement Value.

Trade Date (Cont…) Entitlement to income on equity

Is most markets entitlement to dividends is related to the trade date.

If the trade date is incorrect the buyer or the seller could lose his entitlement.

Trading systems typically assume that the trade date is the same as the trade input date. Usually this poses no problems. However precautions must be taken if there is a

`late booking’, that is the trade is being recorded a day late or there is an `as-of’ trade like `as-of’ yesterday.

Trade Time

In many markets regulators require the STO to record the exact hour and minute that the trade was executed.

This enables: Monitoring the STO’s activities to ensure

that the trades have been executed at the `best execution’ price. This has implications for the protection of the investor.

Trade Time (Cont…) It enables the settling of disputes between

counterparties regarding the basic details of the trade such as quantity differences.

It enables market surveillance on the part of the regulator to identify abnormal trading activity.

Regulators also insist that all telephone conversations made by traders are taped.

When a dispute arises the trade time is used to quickly identify and retrieve the relevant tape.

Trade Time (Cont…) In some cases, the trade time is used as a

measure for trade reporting. In the Eurobond market, the regulator

requires that all trades executed by UK based members of the Eurobond industry body – The International Securities Market Association (ISMA) – report details of their trade to ISMA via their system TRAX within 30 minutes of trade execution. Fines are imposed on members who fail to

meet the deadline.

Value Date

The value date is the intended date of securities for cash. This is known as the contractual

settlement date. Note that the actual settlement date could

be different because of settlement failure. The period between the Trade Date

and the Value Date is known as the Settlement Cycle.

Value Date (Cont…)

The longer the settlement cycle the greater is the possibility of one of the parties defaulting. For instance if a buyer is not required

to pay for many days following the trade he may be tempted to default should the market price of the security fall sharply before the value date.

Operation

The term operation refers to the direction of the trade Is the STO a buyer or a seller Or in the case of a securities lending

or borrowing transaction, is the STO a lender or a borrower.

Quantity

The quantity refers to the number of shares or bonds that have been bought or sold.

Standard tradable quantities may apply to both shares and bonds. Shares are often traded in Round Lots or

Board Lots. Bond are traded in multiples of the

minimum denominational values.

Quantity (Cont…)

The quantity will require inputting by the trader.

But the trading system should verify its validity by reference to static data.

Security

When a trade is being executed we must know precisely which security is being traded.

In the case of equities confusion can arise in cases where an original security and a second security with superficial similarity are validly in existence at the same time.

Security (Cont…) An example would be where new shares have

been created in addition to the original shares. The two may need to be identified separately

in a situation where the new shares may not be equal in all respects until a later point in time. For instance the next dividend may be payable only

on the original shares and not on the new shares. Following the payment of the dividend the two

types of shares will become equivalent.

Security (Cont…) In the case of bonds, some issuers

such as the World Bank may have hundreds of bonds with details that are extremely similar such as: Issues with identical coupon and maturity

but with different currencies of issue Issues with identical coupon and currency

but with different maturity dates Issues with identical maturity and

currency but with different coupons.

Security (Cont…) At the time of trade execution the two

parties must be precisely aware of the security that they are dealing in.

To help avoid errors securities identification code numbers such as ISIN and CUSIP are assigned to each security.

The security being traded should have its details held within the static data repository.

Security (Cont…) Trading systems normally display only

those securities which pertain to the particular trading book. The trader only needs to select the

correct security from the list. If the details have not been set up

within the static data trade capture will be held up at the beginning of the TLC causing delays and avoidable costs.

Price

Price is an essential component of a trade It is therefore important that the input

should be exact Equity prices are typically expressed

as a cash amount per share. Bonds are normally traded at a

percentage of the face value.

Counterparty Correct identification of the

counterparty is very important. Confusion can arise if an STO trades

with a group of companies consisting of trading entities in different locations.

Being uncertain of the counterparty and its location can lead to Delays in settlement processing Unmatched settlement instructions

Counterparty (Cont…)

When an STO trades with a mutual fund manager it is common to find that at the point of placing an order and at the time of execution the fund manager is yet to decide to which of its underlying funds the trade should be allocated. It may take a number of hours for the fund

manager to respond with allocation details.

Counterparty (Cont…) Under these conditions the STO has

executed a trade with a counterparty knowing that the final counterparty details will differ from the counterparty known at trade execution.

Normally the trade is recorded as executed with the parent counterparty, and later on, when the allocation details are known, the original trade is replaced.

Counterparty (Cont…) The counterparty with whom the

trade was executed should be held within the static data repository.

The trader only needs to select the correct counterparty inclusive of location from the list.

If the data is not present at the outset, trade capture will be held up at the beginning of the TLC.

Front Office Trade Reference The trading system should perform

validation that all necessary components of a trade are present before assigning a trade reference number to a trade.

Storage of the reference number allows identification and inspection of the details at any time after trade capture.

This is vital if the trade is subsequently amended or cancelled.

Subsequent Action Once the trade is captured within a

trading system the details should be sent to the back office immediately for operational processing.

If the STO does not have a trading system the details are recorded manually on a `dealing slip’.

This will be collected and delivered to the middle office or the settlement department.

Incorrect Capture Incorrectly recorded trades may lead to:

Inaccurate trade confirmations being sent to counterparties

This could lead to a loss of business Inaccurate settlement instructions being sent to

the custodian This could lead to unmatched instructions with the

counterparty and require a subsequent amendment. Or if the instructions nevertheless match and the trade

settles it could lead to a monetary loss. Sometimes the STO may never even come to know that

there was an error.

Trade Capture within the Settlement System

In an automated environment, where the trade has been sent by the trading system to the back office system electronically, it is to be expected that the trade will arrive successfully in the receiving system. However it is possible that the trade fails to

arrive in the back office system. It is therefore recommended that a trade-by-

trade reconciliation is conducted to ensure that the trades sent by the trading system have in fact been received successfully by the back office within an appropriate time frame.

Trade Capture…(Cont…) As soon as the back office system receives a trade

validation needs to be performed to confirm that static data items like

Trading book Security Counterparty

are known. If a check reveals a problem – eg. Counterparty not

known – the problem should be highlighted and treated as an exception requiring corrective action.

This will have the impact of temporarily halting operational processing.

Trade Capture …(Cont…)

Once the trade details have been checked for validity, a settlement system trade reference number will be assigned. This is in addition to the trading system

trade reference number. The trade has now been accepted into

the settlement system and is now ready for Enrichment.

Trade Enrichment

Following trade capture within the settlement system the details of a trade require enrichment.

What is enrichment? It involves the selection, calculation,

and attachment to a trade of relevant information necessary to complete further essential actions.

Trade Enrichment (Cont…)

In an automated environment, trade enrichment is achieved through defaulting relevant information automatically from the store of information held within static data. This is known as Static Data

Defaulting.

Trade Enrichment (Cont…) Steps involved:

The basic trade details are captured within the settlement system

The basic trade details are compared with the information held within the static data repository, and if the necessary information is present in the repository, the default information is selected.

The selected defaults are attached to the basic trade detail to form the enriched trade.

Trade Enrichment Components In general, the trade components

requiring enrichment are: Calculation of cash values Counterparty trade confirmation

requirements Selection of custodian details Method of transmission of settlement

instructions Determining the method of transaction

reporting (for regulatory purposes)

Trade Enrichment Components (Cont…)

The components pertaining to one transaction type may be only partially similar to the components pertaining to another transaction type.

We will list the trade enrichment components of each transaction type.

Principal Transaction

Required Cash value calculation Securities depot details Trade confirmation Transaction reporting Settlement instructions Securities accounting Cash accounting

Repo Transaction


Securities Lending and Borrowing


Trading Book Transfer Required

Cash value calculation Securities accounting Cash accounting

Not Required Securities depot details Trade confirmation Transaction reporting Settlement instructions

Depot (Custodian) Transfer Required

Securities depot details Settlement instructions Securities accounting

Not required Cash value calculation Trade confirmation Transaction reporting Cash accounting

Unsecured Borrowing and Lending

Required Cash value calculation Trade confirmation Settlement instructions Cash accounting

Not required Securities depot details Transaction reporting Securities accounting

Nostro Transfer Required

Cash value calculation Settlement instructions Cash accounting

Not required Securities depot details Trade confirmation Transaction reporting Securities accounting

Foreign Exchange Required

Cash value calculation Trade confirmation Settlement instructions Cash accounting

Not required Securities depot details Transaction reporting Securities accounting

Determining Factors in Trade Enrichment

Before enrichment of individual trades can occur, consideration must be given to the choices that an STO has for deriving the correct information to attach to a trade.

We will consider issues pertaining to each component in detail.

Calculation of cash values In order to calculate all the cash related

components of a trade, it is necessary to consider the following. Operation

That is Buying or selling/Borrowing or lending

This has implications for cash value calculations For instance client purchases of UK equity

attract stamp duty, but sales do not. Only sellers of US securities are required to pay

an SEC fee.

Calculation…(Cont…) Security group

Stamp duty is payable on Irish equities but not on Japanese equities

Accrued interest is applicable to coupon paying bonds but not to ZCBs.

Counterparty Type Sales credits are normally calculated on

trades with institutional clients, but not on trades with other STOs.

Sales credits may be calculated differently for different types of institutional clients.

Selection of Custodian Details The selection of the relevant custodian

details for both the trading company and the counterparty will be affected by the following issues. Trading company

If an STO processes the business of more than one trading company

Different custodians may be used by each of the companies, even for the same security group.

The same custodian may be used by both trading companies, distinguished by different account numbers for each company at the custodian.

Selection…(Cont…) Transaction Type

Different transaction types will determine the settlement location of a trade.

A principal trade will settle at a securities custodian, whereas a foreign exchange trade is likely to settle over a main bank account.

The custodian and the bank may not be the same entity.

Security Group US equities will settle at the NEW York Custodian New Zealand government bonds will settle at the

Wellington custodian. Counterparty

Where there is a choice of settlement locations, a counterparty may choose. Some counterparties may select the settlement location on a trade-by-trade basis.

Counterparty Trade Confirmation Requirements

An STO will normally issue a trade confirmation to its institutional clients, as a part of its service.

But it may not issue confirmations to other STOs with which it trades.

Determining the method of Transaction Reporting

The types of security in which an STO trades may require that the STO carries out its transaction reporting via different methods.

For instance, a UK based STO may be required to report UK equities via one route, and its international bond transactions via another route.

Method of Transmission of Settlement Instructions

The methods used to transmit settlement instructions will depend on the following. Trading Company

Where an STO processes the business of more than one trading company each company may have a preferred but different method of transmission.

For instance company A may choose to transmit via telex while company B may choose to transmit via SWIFT.

Transmission (Cont…) Custodian

Custodians typically have a preference for the method of communication between themselves and the STO.

Failure to Apply Static Data Defaults

In an automated environment, failure to fully enrich a trade may be intentional or unintentional.

Intentional Failure In a situation where the default of a

particular trade component is best applied manually, the STO may choose to set no automatic default of static data.

For instance Italian Government bonds can settle domestically in Milan or internationally in Euroclear or Clearstream.

An STO may choose to settle an individual trade in or other location depending upon the circumstances. If no general rule can be applied then it is not

possible to automate the default.

Unintentional Failure In an automated environment it is not

possible to default static data automatically if such data is missing for a particular component.

For instance a specific counterparty is set up within both the trading system and the settlement system, but no custodian details are set up within the settlement system for that counterparty.

Enrichment of Counterparty Custodian Details An STO needs to calculate its counterparty’s

custodian details in addition to its own custodian details.

When a trade is executed by an STO, it is necessary to determine where it wishes to settle the trade. This is particularly true if it trades in many

markets. It must also determine how the counterparty

wishes to settle the trade This information will be required on the settlement

instruction issued by the STO

Example WSIL an STO has bought 5,000,000 News

Corporation shares from PTIF. WSIL first needs to assess how it wishes to

settle the trade from its own perspective. It needs to determine its appropriate custodian

based on the individual security or security group.

In this case the equity is Australian. So the decision is taken to settle at Custodian

A in Sydney.

Example (Cont…)

A similar decision needs to be taken by WSIL regarding where it believes PTIF will settle the trade according to the information received from PTIF and held within WSIL’s static data. The custodian to be used by the

counterparty will appear on the settlement instruction that will be sent by WSIL to its custodian.

Example (Cont…) This is essential information.

Otherwise WSIL’s custodian will not know with whom the trade is to settle.

Merely stating PTIF does not provide the answer.

The information required to match and settle the instruction sent by WSIL is

The account number at the relevant depository of the Australian custodian being used by PTIF

Let us assume it is Custodian B in Melbourne.

Example (Cont…) Following trade execution between WSIL

and PTIF the trade would be captured within the trading system then captured within the settlement system followed by trade enrichment within the

settlement system. In the process WSIL would have calculated

The custodian that it wishes to use And PTIF’s custodian

The sequence of steps taken would be as follows.

Example (Cont…)

WSIL issues a settlement instruction to its custodian telling Custodian A in Sydney to receive

5,000,000 News Corporation ordinary shares, against payment of the relevant cash amount

From Custodian B Melbourne whose depository account number is 5532896.

Example (Cont…) PTIF issues a settlement instruction to

Custodian B asking it to deliver shares against the relevant cash amount to Custodian A Whose account number at the depository is

5023598. Custodian A should update its records with the

details of the instruction received from WSIL Custodian B should update its records with the

details of the instructions received from PTIF.

Example (Cont…)

Each custodian should aim to achieve a match of their client’s settlement instructions with the counterparty’s custodian. If the information does not match the

custodians have no authority to change any aspect of the client’s settlement instruction.

They must however advise the client about the status of the instruction.

Example (Cont…) If there is a mismatch WSIL would need

to investigate. If its static data is accurate in all

respects And if the trade is properly enriched

The number of unmatched instructions will be minimized.

However settlement instructions may be unmatched for other reasons Such as price or quantity differences

Trade Validation

Having executed, captured and enriched a trade it is now complete and further taskes such as Issuing a trade confirmation Reporting the trade to the regulatory

authorities Issuing settlement instructions can

proceed.

Trade Validation (Cont…)

However many STOs adopt a final check of the data contained within a fully enriched trade to reduce the possibility of incorrect information being sent to the outside world.

This is known as Trade Validation.

Fundamental Risks The basic risks associated with trades are

that an STO may make a loss This could happen directly

While buying By paying more cash than the market value By paying the correct amount but without simultaneous

receipt of securities While selling

By receiving less cash than the market value By delivering securities without simultaneous receipt of

cash This could happen indirectly

By losing clients due to provision of slow and inaccurate service.

Reasons These risks can arise as a result of the

following issues Trading error: The trader makes a mistake at the

time of execution He trades at a price that is significantly different from the

market price Or he agrees to settle on an FoP basis

Trade recording error The trade has been captured with one or more

components that differ from those that were in fact executed

Eg.: 10 MM shares were purchased but is has been recorded as 1 MM.

Reasons (Cont…) Trade enrichment error

The calculation of trade cash values is incorrect

For instance the number of days of accrued interest on a bond is incorrect

Trade validation is a task that is designed to detect such situations on a trade by trade basis.

Basic Trade Validation

The trade components ought to be viewed from the following perspectives.

Trading book May be restricted to specific transaction

types (eg. Principal only) May be restricted to specific instrument

groups (eg. Japanese securities) May be restricted to specific traders

Validation (Cont…) Trade Date

Should be `today’ for a new trade Cannot be in the future Should be today or in the recent past

for an amended trade Should be a business day Cannot be after the value date

Trade Time Cannot be in the future

Validation (Cont…) Value Date

Is normally the standard settlement cycle for the security group eg. T+3 for US securities

May be shorter or longer than the standard (if the trader has agreed at the time of execution and has recorded that date)

Should be a business day in the location of settlement

Cannot be earlier than the trade date Cannot be earlier than the primary value date of

a new issue

Validation (Cont…) Operation

This typically cannot be validated Settlement personnel have no means of knowing

whether the trader should be buying or selling; borrowing or lending

Quantity Cannot be less than the minimum denomination

of a bond Must be in multiples of the minimum

denomination of a bond Is normally in multiples of a round lot for equities May be an odd lot for equities

Validation (Cont…) Security

Cannot be a matured bond Cannot be an expired warrant Must be clearly distinguishable from other

securities Price

Must be expressed according to the security group

Share price must be an amount per share Bond price must be either a percentage relevant to

face value or a yield

Validation (Cont…) Counterparty

Must be clearly distinguishable from others Must include location

Trade cash value Must be quantity x price plus or minus other

costs such as stamp duty Accrued days must be relevant to last coupon

payment date and value date Accrued interest must be relevant to

quantity, accrued days, and coupon rate

Validation (Cont…)

Trade confirmation Should be sent to institutional clients Should not be sent to STOs if for

instance an electronic trade matching system is in place

Company’s and Counterparty’s Custodian Must be relevant to the security group

Additional Trade Validation In order to have the ultimate level of control

regarding the information that is about to be sent to the outside world, the following types of validation measures are taken by some STOs in addition to the basic trade validation steps.

Any trade falling within or more of the following categories should be treated as an exception and held pending validation. This means that such trades will not be handled on

an STP basis.

Additional Validation (Cont…) Trades due to settle on an FoP basis

Extreme caution needs to be taken when settling on an FoP basis

All such trades should be held for validation Trades with a cash value at or above a

certain figure To give specific focus to all trades that are

deemed to be large, all trades with a net settlement values of a given figure or greater, or the currency equivalent of that figure or greater, should be held for validation.

Additional Validation (Cont…) Trades in a Specific Transaction Type

All trades in a specific transaction type may be required to be held for validation to ensure correctness before transmission to the outside world.

Trades with a specific counterparty This is likely to be required for trades with

institutional clients May be necessary because the client is new Or could be because an existing client has complained

about the accuracy of information or speed of service provided on past trades.

Additional Validation (Cont…) Trades in a Specific Market or

Security Group Where an STO is trading in particular

market for the first time it may Wish to recheck that trade cash values are

accurate That custodian details are correct for all

trades on securities within a group This may prove necessary for a limited

period only until it is proved that new trades are correct routinely.

Additional Validation (Cont…)

Trades Due to Settle at a Specific Custodian If an STO has recently changed

custodians at a financial centre it may wish to verify all trades destined for settlement at that custodian


Trade Price Outside of market Price As a precautionary measure an STO

may decide to validate all trades to ensure that prices are reasonable.

Because price is a major factor in deriving the Net Settlement Values, there is a danger of an STO making overpayment on purchases or receiving underpayment on sales.


If the current market price is accessible and a tolerance is set against the current market price (to allow for typical validity) then only those trades falling outside the set tolerance should be held for validation.

When such trades are identified management may need to be informed. The management should decide as to how tight the tolerance should be.

Too tight a tolerance may mean that many trades are being held for validation thereby preventing STP

Too loose a tolerance may mean that incorrect prices are being processed undetected.


Trades in a Specific Trading Book The management may wish to

monitor the trading activity of a particular trading book

Trades with trade dates in the past Any new trade that has a trade date

in the past may be held for validation to ensure that it is valid.

Additional Validation (Cont…) Trades with value dates in the past

Any new trade with a value date in the past should be held for validation for this is an indication that something is seriously wrong.

If settlement should have occurred in the past this is highly likely to result in a cost to the STO.

All amended trades Some STOs may wish to monitor all amended

trades to ensure that trades recorded with incorrect quantity or price have been amended correctly.

Additional Validation (Cont…) All Cancelled Trades

The need for outright cancellation should be minimum and an STO may wish to check the detail before issuing information such as canceling trade confirmations and canceling settlement instructions to the outside world.

Validation provides the STO with a high degree of control resulting in reduced inaccuracies.

But there is a compromise between sufficient control and STP.

Manual Trade Validation

Due to the number of trade components manual validation is likely to result in A limited number of components

being validated so as not to adversely affect meeting external deadlines

Occasional human error resulting in the failure to identify a risk or an error

Manual Validation (Cont…) In order to identify problematic trades manual

validation needs to be undertaken by the more knowledgeable members of the middle or back office using their `experienced eye’ to scan the components of a trade and their knowledge to sense whether or not a trade is acceptable.

But a significant amount of manpower would be required to validate all trades to the fullest extent due to the sheer volume of trades executed by an STO.

Manual Validation (Cont…) In order to meet the combined

demands of STP Servicing clients accurately and speedily Issuing settlement instructions by the

necessary deadlines Transaction reporting within required

deadlines

extensive validation is possible only by using efficient and intelligent systems.

Automated Trade Validation The processing of trades can be highly

automated while achieving satisfactory levels of STP and control over trades requiring additional validation.

An STO could decide that all trades should be handled on an STP basis unless identified to be held for validation.

Trades held for validation are referred to as `exceptions’ and are therefore subject to `exception handling’.

Automated Validation (Cont…) The trigger that causes trades to be

treated as exceptions is the setting of rules within the settlement system.

All or some of the rules studied earlier could be set up within the settlement system.

After each trade has been enriched the system would compare the trade details with the relevant rules.

Automated Validation (Cont…)

If the trade passes the validation check it would be allowed to continue immediately and can be regarded as having been processed on an STP basis.

If the trade fails the validation check it will be treated as an exception and will be held for validation.

Automated Validation (Cont…)

When a trade is held for validation it is temporarily suspended and no actions such as Issuance of a trade confirmation Or issuance of a settlement instruction

should occur until the trade has been released from its exception state.

Flow We will summarize the flow of trades where

handled on an STP basis and where an exception is found.

The trade is captured, enriched and is now subject to validation.

The details of the trade are compared with preset validation rules.

If all rules are passed the trade will be forwarded immediately for actioning of other operational tasks such as Trade agreement and Transaction reporting

Flow (Cont…) If the trade fails the validation check it will be held

for validation and routed for exception handling The trade will be forwarded to the appropriate

authorizer depending on the reason for being withheld

Having been investigated and found to be correct the trade is authorized.

The trade within the exception handling system is updated and released to the settlement system

The trade is now forwarded for actioning of operational tasks.

If the trade is found to require amendment or cancellation further action may be required by the fornt office staff.

Flow (Cont…)

Further automation may be employed where resolution of an exception has not occurred within an acceptable timeframe.

The management of an STO may decide for instance that unresolved exceptions that are for example 45 minutes old should be escalated to a more senior staff member.

Trade Agreement Once a trade has passed validation a

number of tasks can commence. The action that is regarded as most urgent

is the act of gaining agreement of the trade details with the counterparty.

Trade agreement can be achieved through: Issuance of outgoing trade confirmation to the

counterparty Receipt of incoming trade confirmation from

the counterparty Trade matching Trade affirmation

Trade Agreement (Cont…)

In a generic sense trade agreement is achieved by the STO communicating the details of each trade to its counterparty whereupon the counterparty should check the detail and revert to the STO if: It recognizes the trade but the details

differ Or if does not recognize the trade

Trade Agreement (Cont…)

The communication needs to contain all the basic trade details as a minimum plus The cash value calculations and optionally The settlement details including

STOs and the counterparty’s custodian details Their account numbers And whether the trade is to settle on a DvP or

FoP basis

Trade Agreement (Cont…) Matching of buyer’s and seller’s details is

in many cases effected through two routes Trade Agreement: Agreement of trade detail

between the two parties And additionally Settlement Instruction Matching: The

custodians of the buyer and the seller attempt to match settlement instructions prior to delivery of securities and payment of cash.

Trade Agreement (Cont…) These two exercises are similar in that the

trade details are matched prior to the value date.

But the timing is usually different. Trade agreement is necessary immediately after

trade execution to ensure that the correct counterparty has been recorded by the STO and that the details agree

This is from a risk mitigation perspective Settlement instruction matching is typically effected

at any time between trade execution and the value date.

Reducing the STO’s Risk

For each executed trade the STO remains at risk of its trading P&L being incorrect if the trade and its detail has not been agreed or matched by the counterparty within a reasonable timeframe. The P&L remains subject to change

until it is proven that all trades have been agreed by the counterparties.

Reducing Risk (Cont…) Because of the risk the objective is to

gain agreement of the trade detail as soon as possible after trade execution.

To reiterate, the situation is as follows: The trader has just executed a trade with the

counterparty The trade has been recorded within the

trading system The trade has been captured within the

settlement system The trade has been validated internally

Reducing Risk (Cont…) But there is no guarantee that:

The counterparty with whom the trade has been captured is the same as the counterparty with whom the trade was executed

The trade details Quantity Price Net settlement value

Will be agreed to by the counterparty

Risk Reduction (Cont…) From an STO’s perspective failing to seek

agreement of trades with its counterparties soon after trade execution will inevitably Result in the identification or errors during the

settlement instruction matching process Which in a T+3 cycle is unlikely to bring errors to

light until the day following the trade date at the earliest.

The longer a trade remains unmatched after execution the greater is the risk of price movement and subsequent loss.

Risk Reduction (Cont…) Time is an important factor. Assume that trader believes he sold 15 MM

shares at a price of HKD 22.59 on trade date 15 June for value date 18th June.

On 17 June it becomes apparent through the settlement instruction matching process that the counterparty believes it bought at HKD 22.55 and investigation proves that the other party is correct. The trade will have to be amended to the correct

price This will have a negative impact on the P&L

Risk Reduction (Cont…) Take a worse example On 17 June the counterparty does not

recognize the trade at all. If this results in the trade being cancelled

outright The STO will have a positive position of 15MM

shares If the price were to have fallen in the interim

the trader would have failed to realize a profitable opportunity.

Trade Agreement Methods The method of agreement of trade details

between the parties to a trade varies according to Local regulations Market practice Type of counterparty

Generally agreement of trades executed with other STOs is likely to be handled differently from trades with institutional clients .

Method-I

Issuance of outgoing trade confirmations It is highly likely that an STO will be

required to issue a trade confirmation to its institutional clients particularly where a trade affirmation facility is not being used

It is likely that an STO will want to issue a confirmation to other STOs particularly where a trade matching facility is not being used.

Method-II

Receipt of incoming confirmations from counterparties The STO may receive confirmations

from other STOs It is unlikely to receive confirmations

from institutional clients As such clients are the recipients of

service from the STO.

Method-IIITrade Matching Trade matching is a term used for the

mandatory electronic matching of trade details between STOs and other members of stock exchanges/markets such as agents for investors (excluding institutional clients).

Both parties are required to input the trade details to a central matching facility.

The matching results are provided to both parties. Where trades have been executed electronically

the trade detail is usually considered to have been already compared and matched.

Method-IVTrade Affirmation

This relates to the optional electronic matching of trade details between STOs and institutional clients.

The trade details are input by the STO to a trade affirmation facility and the institutional client agrees or disagrees.

Both parties must elect to subscribe to such a service.

Outgoing Trade Confirmations Trade confirmations to Institutional Clients

Where an STO has executed a trade with an institutional client (for instance over the telephone) the client is likely to require the receipt of a confirmation within a mutually agreed time frame such as 1-2 hours.

This timeframe is likely to shrink as settlement cycles shrink.

The confirmation represents formal confirmation of trade details which must be received by the client within an agreed time frame and which must be completely accurate.

Outgoing Confirmations (Cont…) Under some circumstances it may not be

possible for an STO to issue a confirmation within the required timeframe.

Institutional clients like fund managers usually place an order to buy or sell a specific quantity of a specific security within a limited price. Once the trade is executed the STO’s

salesperson will report the details of the execution to the fund manager informally, usually via telephone.

Outgoing Confirmations (Cont…)

Following trade execution the fund manager will allocate the total trade to one or many of its underlying funds.

In practice the fund manager will usually not convey to the STO the names of the underlying funds until some time after trade execution.


For example an STO has sold USD 50MM World Bank 6.50% bonds maturing 1st February 2018 to QRS Fund Managers at a price of 98.625%.

QRS will require the total quantity of bonds to be allocated to its underlying funds as shown below.

Allocation

Fund Name Quantity Price

QRS Healthcare Growth Fund

12,000,000.00 98.625

QRS Global Bond Growth Fund

10,000,000.00 98.625

QRS European Income Fund

25,000,000.00 98.625

QRS Pacific Income Fund

3,000,000.00 98.625

TOTAL 50,000,000.00

Outgoing Confirmations (Cont…) The fund manager usually requires the

receipt of trade confirmations for each of the underlying funds. For ultimately it is the underlying funds that

have purchased or sold the securities and not the parent.

The STO needs to decide whether to record the trade with the parent. It knows that this will have to be replaced

by one or many trades with the underlying funds at some point later in the day.


If the trade is recorded in the name of the parent immediately after execution, the STO would have reflected the factual situation.

If not the settlement system will not reconcile with the trading system – the trading positions will differ.

Outgoing Confirmations (Cont…) Some STOs treat these situations as

follows. The original trade is captured in the trading

system and fed to the settlement system. Eg. Sold USD 50 MM of bonds to QRS Fund Managers

at a price of 98.625% The original trade is captured within the

settlement system but is treated as a trade with the parent, awaiting allocation to the underlying funds.

The trade is simply held in the knowledge that allocations will be advised by the fund manager at the earliest.

No trade confirmation is usually issued to the parent.


The fund manager advises the STO of the allocations.

The original trade is replaced by one or more trades.

This may happen both in the trading as well as the settlement system or only in the settlement system.

From the settlement system formal trade confirmations can now be generated and transmitted to the fund manager at the underlying fund level.

Outgoing Confirmations (Cont…) In order to gain agreement of trade details,

the STO normally issues a trade confirmation to other STOs with which it has traded. There could be exceptions if an electronic trade

matching system is being used. Confirmations to institutional clients are

regarded as a part of the service. But confirmations to other STOs are used to

confirm that the trade details are correct as soon as possible after trade execution.


The issuing STO hopes that the recipient STO will check the detail upon receipt, and respond without delay if its is found to be incorrect.

Content of a Confirmation From – the name of the issuing STO To – the name of the counterparty Attention – the relevant

person/department at the counterparty Subject – a heading that states the

purpose of the message, namely `Trade Confirmation’.

Our trade reference – the STO’s settlement system trade reference

Content (Cont…) Trading capacity – the capacity in which

the STO has traded (principal or agent) Transaction type – principal, repo, FOREX

etc. Operation – Buying/selling;

Lending/borrowing Trade date – date of trade execution Trade time – time of trade execution Value date – contractual settlement date Quantity – quantity of shares, or quantity

of bonds with currency

Content (Cont…) Security – the exact, unmistakable

description of the security Security reference – ISIN, CUSIP etc. Price – quoted according to type of

security (share or bond) Principal – quantity x price Accrued days – relevant number of days

of accrued interest Accrued interest – cash value of accrued

interest

Content (Cont…) NSV – the cash value to be

paid/received Our depot – the STO’s settlement

location of securities Our Nostro – The STO’s settlement

location of cash Your depot – the counterparty’s

settlement location of securities Your NOSTRO – the counterparty’s

settlement location of cash

Content (Cont…) Settlement basis – DVP or FOP Exchange/market – exchange or market

where a trade has been executed Rules – a statement that the trade is

subject to rules of the exchange/market Signoff by the STO – full name and

location of the STO Transmission time – a clear statement

of the date and time of transmission

No. of Copies Some counterparties – typically

institutional clients – may require the receipt of one or more copies of a confirmation for each trade.

If multiple copies are required The counterparty may require all copies

to be sent to the same destination Or to different destinations via different

transmission methods

No of Copies (Cont…)

The different destinations may include The counterparty’s head office Its bank Its accountant

To enable automation of this service this information needs to be held within the STOs static data

Incoming Confirmations Some of the counterparties with whom

an STO trades may issue confirmations. Usually this is the case if the counterparty is

another STO. Institutional clients typically expect only to

receive confirmations. After receiving an incoming confirmation

an STO needs to check whether to expend resources checking the details contained in the confirmation with its own records.

Incoming Confirmations (Cont…)

To gain trade agreement and to avoid risk, it is better to check the confirmation on receipt. This will highlight whether the STO

and the counterparty agree or disagree.

Risks of failing to check

Decisions are sometimes taken not to check incoming confirmations. For trades where agreement will not

be achieved by another means this could result in monetary loss for the STO.

Example A telex confirmation has been received

by an STO from a counterparty on the afternoon of the trade date. The trade is due to settle T+3 The STO decides not to check the incoming

confirmation. However a discrepancy comes to light a

day prior to the value date. Investigation reveals that the counterparty’s

price or quantity was incorrect. The counterparty has to consequently amend its

detail.

Example (Cont…) It look as if the STO has incurred no

cost. It was the counterparty that recorded the

trade details erroneously. But if the counterparty subsequently

realizes that a trade confirmation was sent and that the receiving STO failed to highlight the discrepancy It may seek some form of compensation.

Trade Matching with STOs Trade matching is a generic term used to

describe an electronic method of comparing the trade detail of both seller and buyer.

The process typically includes: The transmission of trade details by both

parties to central trade matching facility by a specified deadline

The application by the matching facility of the current status – matched or unmatched.

TRAX

ISMA based in Zurich is a self regulatory organization and trade association responsible for regulating and enforcing rules governing the orderly functioning of the international securities market.

During the 1980’s ISMA was primarily focused on the Eurobond market.

TRAX (Cont…)

In the Eurobond market, prior to 1989, when an STO traded with another STO, agreement was attempted but not necessarily achieved by the issuance of confirmations, normally in the form of telexes. The situation was inefficient and full of

risk.

TRAX (Cont…)

In 1989, ISMA introduced TRAX. It is a real-time trade matching

mechanism covering all internationally traded debt and equity securities. All ISMA members are required to send

a message to TRAX so as to be received by TRAX within 30 minutes of trade execution.

TRAX (Cont…) If a message is not received by TRAX

within a 30 minute deadline, a fine is imposed on the STO. The fine is on a sliding scale. The later the message is received, the

larger is the fine. ISMA also imposes fines for other non-

compliance reasons such as Failure to provide all necessary trade details Failure to act on a no-matching advice

within a reasonable timeframe.

TRAX (Cont…)

A TRAX message conveys the details of the trade to a central matching facility that compares both seller’s and buyer’s trade details.

After comparison a real-time report is generated that details the current status of each trade.

TRAX (Cont…)

However a TRAX message is not a settlement instruction. There is a need to issue a settlement

instruction to the relevant custodian independently of the TRAX message.

The TRAX System An STO executes a trade with a

counterparty both of whom must be ISMA members – or non-member users of the system.

Both parties send their trade details to TRAX

TRAX searches for a match and then applies the status

The trade status is then made available to both the parties.

The TRAX System (Cont…) The receipt of a status other than

`matched’ requires immediate investigation by the STO, resulting in one of the following actions. The STO leaves its trade details intact and

the counterparty amends it details The STO amends its trade details The STO cancels the trade The counterparty cancels or denies the trade

The TRAX System (Cont…) TRAX will apply the following trade

statuses for messages sent by the STO Matched – the STO’s and the

counterparty’s details have been compared and found to agree

Unmatched – The STO has input its trade details, but the counterparty has not input matching trade details.

Denied Advisory – The counterparty does not recognize the trade and has stated that is denies knowledge of the trade

The TRAX System (Cont…) The following trade statuses will be

applied to messages not sent by the STO.

Advisory – Trade detail has been input by the counterparty. The receiving STO must either input trade details or else state `denied’.

Denied – If the STO does not recognize the advisory trade, it can state `denied’.

Other Trade Matching Services

In the US the National Securities Clearing Corporation (NSCC) has a trade comparison service.

Automation In modern settlement systems the

following aspects of trade matching messages can usually be automated The decision to issue the message pre or

post trade validation The decision whether to issue a message or

not according to the type of security - Eurobond versus US T-bond

The decision whether to issue a message or not depending upon the counterparty – ISMA members as opposed to non-ISMA members.

Automation (Cont…) The following can also be automated

The transmission of the message to the trade matching facility

The receipt of the message status from the facility

The updating of the relevant trade record (internally with the STO’s books and records) with the trade matching status

The highlighting of trades with a status other than `matched’.

Trade Affirmation with Institutional Investors

Institutional investors are able to have trades confirmed to them by STOs and brokers electronically, via Omgeo’s Oasys Global system.

The advantage is that an institution based in Tokyo can have its trades confirmed electronically by an STO based in Toronto.

Trade Affirmation (Cont…)

Unlike trade matching for STOs which is typically regulated by an exchange or local regulator, the decision to subscribe to the Oasys Global system has to be taken by each institutional investor.

Trade Affirmation (Cont…) Strictly speaking there is a

difference between Trade Matching and Trade Affirmation. In trade matching, both parties input

details at the same time to a central facility.

In trade affirmation, the STO inputs its trade details to which the institutional investor affirms or responds.


Institutions that choose to subscribe to Oasys Global usually encourage STOs to use the system in order to ensure that as many trades as possible are affirmed via this route and to realize the full vale of the subscription.

Illustration Step-1: An STO executes a trade

with a fund manager. At this point he knows only the name

of the fund manager and not the names of the underlying funds.

Step-2: The basic trade detail for the counterparty is input to Oasys Global which forwards the detail to the fund manager.

Illustration (Cont…) Step-3: The fund manager will check the

trade details with his own records and if found correct the trade in Oasys Global will be affirmed as correct and the details of allocation to the underlying funds will be input.

Step-4: The STO will replace the original trade by trades with the underlying funds.

Illustration (Cont…)

Step-5: The individual trades are input to Oasys Global including the net settlement value for each trade.

Step-6: The fund manager checks the trade detail for each of the funds, and if found correct each trade in Oasys Global is affirmed as `agreed’.

Trade Affirmation (Cont…) The receipt of a trade status other than

agreed requires that the STO investigate without delay. The salesperson within the STO will have to

be informed. If the record of the trade detail is found to

be incorrect the STO’s books and records will require amendment.

The revised input will have to be re-input to Oasys Global.


The use of a system like Oasys Global requires that the history of each individual trade be recorded in case of the need to investigate past events.

Other trade affirmation services in the U.S. include Omgeo’s TradeMatch system.

Automation The following aspects of trade

affirmation messages can normally be automated. The decision whether to issue the

message pre or post trade validation The decision whether to issue a

message or not. For example a message need be sent

only if the counterparty is an Oasys Global subscriber.

Automation (Cont…) Furthermore, the following can also be

automated. The transmission of the message via Oasys

Global. The receipt of message statuses from Oasys

Global. The updating of the relevant internal trade

record. The highlighting of trades with a status

other than matched.

Transaction Reporting

Following the execution of a trade the exchange/member is required to report to the appropriate regulator the details of each transaction, within a pre-specified timeframe after execution.

This is referred to as Supervision or Surveillance.

Transaction Reporting (Cont…)

There are different methods for reporting. The chosen method depends on the

local regulator. One way is for the computerized

exchange to forward the trade details to the regulator on behalf of the stock exchange member.

Transaction Reporting (Cont…) Or a part of the message sent by a

member may be used for reporting purposes. For example if TRAX were to be used the

relevant information would be forwarded by ISMA to the regulator.

Or else a settlement instruction sent to a depository may be forwarded to the regulator

Eg. CREST in the U.K.

Transaction Components The usual trade information requiring

submission to the regulator is: Capacity – Principal or Agent Trade date Trade time Vale date Operation – Buy or sell Quantity Security Price Counterparty


Upon receipt, the regulator will analyze the details and attempt to identify unusual patterns of trading which may have been caused by Market manipulation Insider trading Errors on the part of the STO


One objective of surveillance is to identify trading activity that falls outside the norm.

Another objective is to identify breaches of trading rules.

Yet another objective is the identification of insider trading.

Transaction Reporting In some markets automation is used to

search for abnormal trading patterns. On the NYSE a computer system named

StockWatch is used to identify abnormal trading activity.

At the Australian Stock Exchange a system called SOMA is set up with limits representing normal market activity

This enables any reported transactions that fall outside the limits to be identified automatically.

After Detection

When a regulator detects dubious activity he will begin an investigation Typically all transactions executed by

the member in the specific security will be examined.

The member’s books and records will be examined.

Key personnel may be interviewed.

After Detection (Cont…)

The issuing company may be contacted to establish whether any company notices are due for publication. If so, it is possible that insider trading may

have occurred. If suspicious trading practices are

uncovered disciplinary action can be taken – this is termed as enforcement.

After Detection (Cont…)

Punishment can be severe – including prison sentences for insider trading.

Members may be expelled; their license to trade may be suspended.

Investors who have suffered financial losses may be eligible for compensation.

Settlement Instructions Settlement instruction is a generic term

used to describe the mechanism by which trade settlement is initiated between the seller and the buyer.

The instructions are normally generated and transmitted from the STO’s settlement system to the appropriate custodian from the list of the STO’s custodians depending on the security that has been traded.

Settlement Instructions (Cont…)

Upon receipt of the instruction the custodian will attempt to match the detail with the custodian of the counterparty and apply a status – Matched or Unmatched.

On the value date he will then attempt to exchange securities and cash with the counterparty’s custodian.

Risks associated with settlement instructions In a manual system the generation of

settlement instructions should be restricted to a select group.

In an automated environment trade capture within the STO’s trading system should be restricted to authorized traders.

If trade validation is through settlement instructions should be allowed to flow through in order to achieve STP unless certain conditions are applicable.

Risks (Cont…)

As far as possible the STO should avoid settling on an FoP basis.

That is, the trades as far as possible, should settle on a DvP basis.

FoP settlement may be with or without risk to the STO.

FoP with Risk

The STO delivers securities prior to the receipt of cash from the counterparty.

Or the STO pays the NSV prior to the receipt of securities from the counterparty.

FoP without Risk

The STO delivers the securities only after confirmation of receipt of cash from the counterparty.

Or the STO pays the NSV only after confirmation of receipt of securities from the counterparty.

Risks (Cont…) No back office should take unilateral

decisions that puts the company at risk. These decisions are best left to those

with the appropriate level of authority. When the back office is advised by a

trader or a salesperson to take risk, the operations areas of some STOs insist on written authorization from the head of trading.

Risks (Cont…) STOs must minimize the possibility of the

transmission channel between itself and the custodians being accessed by those who may seek to attempt fraud.

An STO is likely to select a particular custodian if it feels that the custodian’s settlement instruction transmission system is sufficiently secure – where high levels of encryption are used to prevent outsiders from deciphering the coded message.

Risks (Cont…)

An instruction that has been issued but not received by the custodian is no different from an instruction that has not been transmitted. There is a risk of financial loss in such

cases because settlement typically cannot occur until settlement instructions are matched with the counterparty’s custodian.

Risks (Cont…)

To minimize risk STOs typically require the relevant custodian to acknowledge receipt of the instruction.

In an automated system instructions issued can be compared against acknowledgements received. If an acknowledgement is missing, it will

be highlighted as an exception.

Risks (Cont…) STOs trade and settle on a global

basis They will consequently have custodians

in many different time zones. Each custodian will impose a deadline,

which will be relevant to the value date of the trade.

Thus the STO must remain aware of the appropriate deadlines pertaining to each custodian.

Settlement Instruction Types

Settlement of trades occurs in one of two ways DvP Or FoP

DvP

DvP is the simultaneous and irreversible exchange of securities and cash

Where DvP is the mode of settlement It is normal to issue a single instruction

to the relevant custodian requesting Delivery of securities versus payment Or receipt of securities versus payment

FoP

FoP refers to the non-simultaneous exchange of securities and cash.

For FoP settlement it is normal for two settlement instructions to be generated.

FoP – When the STO is Buying A settlement instruction needs to be

issued to the STO’s custodian to receive the securities against nil cash value

A separate instruction needs to be issued to the STO’s bank (Nostro) to make payment.

The second instruction would depend on whether settlement is to occur with or without risk.

FoP – Without Risk

The instruction will be submitted to the bank only after receiving confirmation of receipt of securities by the custodian. This is known as `Upon Receipt’

FoP – With Risk

In this case the instruction will need to be transmitted in time for cash to be paid to the counterparty on the value date, irrespective of the receipt of securities.

FoP – When the STO is Selling without Risk

In this case a settlement instruction needs to be issued to the custodian to deliver the securities against nil cash value.

If the STO is not to be at risk, this instruction will be transmitted only after having received confirmation of receipt of cash by the Nostro.

FoP- When the STO is Selling with Risk

In this case the custodian has to be instructed in time for the securities to be delivered to the counterparty on the value date, irrespective of the receipt of cash.

Pre-Advice

Irrespective of whether the STO is selling with or without risk, a c ash pre-advice may need to be issued to the bank advising it to expect to receive payment.

Content of Settlement Instructions A settlement instruction tells the

custodian to carry out precise commands such as: To whom securities have to be delivered From whom payment is to be received Or From whom securities have to be

received To whom payment has to be made

Content…(Cont…) The quantity of securities to be

received or delivered The net settlement value to be paid

or received The earliest date that the instructions

are to be carried out.

Typical Instruction

From: name of the issuing STO To: name of the STO’s custodian Depot Account Number Nostro Account Number Trade Reference: the STO’s

settlement system trade reference number

Deliver/Receive

Typical Instruction (Cont…)

Settlement Basis: DvP or FoP Value Date Quantity Security Reference: ISIN; CUSIP etc. Settlement Currency Net Settlement Value Counterparty Depot Counterparty Nostro Transmission Time: A clear statement of the date and

time of transmission

Other Components Trade components such as:

Trade date Price Accrued days Are also usually included in a settlement

instruction. In the event of the instruction being

unmatched this allows the custodian to communicate with the counterparty’s custodian to identify the discrepancy.

Methods of Transmission Modern methods of transmitting

settlement instructions include the following characteristics. The automatic generation of settlement

instructions by settlement systems The automatic transmission of instructions –

individually or in batches Electronic exchange of test keys Settlement instructions in standardized

formats

Methods…(Cont…) Secure transmission environment due

to high levels of message encryption High speed of transmission Predictable cost of transmission Enables STP

Methods…(Cont…)

A widely used electronic settlement instruction mechanism is SWIFT.

In order to utilize the SWIFT network both the STO transmitting the settlement instruction and the destination custodian must subscribe to SWIFT.

Methods…(Cont…) For transmission of settlement

instructions to International Central Securities Depositories such as Euroclear and Clearstream there is a choice of: SWIFT EUCLID for Euroclear CEDCOM for Clearstream Tested Telex Mail

Format

Cedcom, Euclid, and SWIFT transmission systems all have standardized messages incorporating mandatory fields that are required to be used according to the action required of the custodian by the STO.

Format (Cont…)

SWIFT has numerous categories of settlement instructions and messages for different purposes Some relate to securities Others relate only to cash movements

Format (Cont…)

Series 2: cash related MT200: transfer between two

accounts of the same account holder MT202: payment of cash to a financial

institution MT210: receipt of cash from a

financial institution

Format (Cont…)

Series 5: Securities Related MT540: sent to a custodian to receive

FoP MT541: sent to a custodian to receive

versus payment MT542: sent to a custodian to deliver

FoP MT543: sent to a custodian to deliver

versus payment

Format (Cont…)

EUCLID It uses a numbering convention that

distinguishes between settlement with another Euroclear participant as opposed to settlement with a Clearstream participant.

Format (Cont…) Euclid settlement instructions

E01: Receive free or versus payment from a Euroclear participant

E02: Deliver free or versus payment to a Euroclear participant

E03C: Receive free or versus payment from a Clearstream participant

E07C: Deliver free or versus payment to a Clearstream participant

Format (Cont…)

CEDCOM Clearstream’s proprietary system

CEDCOM has a settlement instruction numbering method that does not distinguish the system the counterparty is using.

Format (Cont…) Example of CEDCOM instructions

41: Receive versus payment from a Clearstream oe Euroclear participant

41F: Receive free of payment from a Clearstream or Euroclear participant

51: Deliver versus payment to a Clearstream or Euroclear participant

51F: Deliver free of payment to a Clearstream or Euroclear participant

Format (Cont…)

CREST Is the system over which UK and Irish

settlements are effected Codes used by CREST

ADVN: Delivery Input ASDN: Stock deposit input ASWN: Stock withdrawal input

Deadlines

All custodians will quote a deadline by which settlement instructions must be received by them relevant to the value date. The method of transmission is also

likely to affect the deadline imposed by the custodian.

Deadlines (Cont…) Assume that the settlement

processing occurs in Bangkok during daylight hours of the value date. A custodian in Bangkok may impose a

deadline of say 8 a.m. Bangkok time on the value date

Provided the instruction in transmitted in an electronic form.

This normally allows for matching of instructions with the counterparty’s custodian.

Deadlines (Cont…) If a NYC based dealer buys shares

in a Thai equity for settlement on a T+3 basis He must issue the instructions by

close of business on T+2 (EST) in order to meet the deadline imposed by the Bangkok custodian

This is to take into account the time difference between the two cities.

Deadlines (Cont…)

Euroclear and Clearstream begin to operate their overnight settlement processing during the evening of the day prior to the value date.

The deadline for the receipt of settlement instructions imposed by Euroclear is 19:45 Central European Time on the day prior to the value date.

Deadlines (Cont…) Deadlines exist so that the dealers

are aware of the time by which instructions must be received in order for the trade to settle on the value date.

If instructions are received after the deadline, the custodian may still accept the instruction However it cannot be processed on the

value date.

Deadlines (Cont…)

From the standpoint of the ICSDs deadlines for transmission via SWIFT or via the proprietary systems are identical because the format is standardized and the information can be automatically captured into the custodian’s system.

Deadlines (Cont…)

However transmission via telex is not in a standardized format and requires the custodian to rekey the information. Thus a considerably earlier deadline

is imposed for instructions transmitted by telex.

Deadlines (Cont…)

Dealers effecting cross border trading and settlement must be conscious of the deadlines of each custodian. They would need to take extra care if

using a mixture of electronic and non-electronic methods of transmission.

Deadlines (Cont…)

It is recommended that settlement instructions be generated and transmitted as soon as possible after trade validation on the trade date. This gives maximum time to resolve

any discrepancies prior to the value date.

Deadlines (Cont…)

Another reason not to delay instructions is the possibility that a software or communication fault can occur before the deadline, thereby preventing automatic transmission.

Validation

As for trade validation, some dealers wish to review and authorize certain types of settlement instructions prior to transmission to the custodian. This requires the setting up of

validation rules within the settlement system.

Validation (Cont…) At the point of transmission the

system would compare the trade detail with the relevant rules: If the instruction passes the check it

is allowed to continue immediately, and can be regarded as having been processed on an STP basis.

If it fails, it will be held as an exception, pending authorization by the relevant staff.

Manually Generated Instructions Even in an automated environment, it

may be necessary to generate settlement instructions manually in certain cases.

For instance assume that a trader has executed a trade but has failed to record it within the trading system. Obviously there will be no record within

the settlement system either.

Manually (Cont…) On the value date the dealer finds that

the counterparty has input a settlement instruction which is unmatched.

If investigation reveals that the trade was in fact executed, the trader would need to record it within the trading system, and feed it to the settlement system. This would obviously need to the generation

and transmission of a settlement instruction.

Manually…(Cont…)

But at times there may be insufficient time to follow such a process.

In such cases the only option is to input the instruction manually directly into the transmission mechanism destined for the custodian, so as not to incur the settlement failure costs.


In such a case if the trade has not been recorded within the settlement system, the trade reference number will be unknown.

So a dummy trade reference number will have to be applied to the manual settlement instruction.

Manually …(Cont…) In such a situation when the trade is

captured within the settlement system, the automatically generated settlement instruction would need to be suppressed to avoid duplication.

When a custodian receives the manually sent instruction, it will be subject to all the normal settlement instruction events.


But there will be no connection between the instruction and the trade within the settlement system.

Thus the trade record within the settlement system will not be updated automatically.

Safe Custody

Following the execution of a trade dealers typically expect to settle externally with counterparties. This means issuing settlement

instructions to custodians. They will undertake the exchange of

securities and cash with the counterparty’s custodian.

Safe Custody (Cont…)

But what if the counterparty does not have a custodian relationship for external settlement to occur.

In such cases the dealer may offer to hold the client’s securities, and possibly cash in safe custody.

Safe Custody (Cont…) This means that when the dealer sells

securities to the client, it retains control but not ownership of the securities.

He will therefore issue a settlement instruction to remove the securities from its own account (in which its securities are held) to a segregated account at the custodian, in which the securities owned by its safe custody clients are kept.

The reverse flow must occur when the dealer buys securities from a safe custody client.

Safe Custody (Cont…) Both the main account and the

safe custody account are under the direct control of the dealer. By law in many countries a dealer’s

own securities and those held on behalf of others must be segregated and held in different accounts at the custodian.

But there is no need to hold the accounts at separate custodians.


In terms of settlement instructions this can mean the need to generate and transmit either a single instruction or two settlement instructions.

Consider the case of a sale by a dealer to a safe custody client.


Whether one or two instructions are required depends on the way the custodian wishes to operate movements between the two accounts owned by the dealer.

The case of two instructions

One for the removal of securities from the dealer’s main account and delivery to the safe custody account

One for the receipt of securities into the safe custody account from the main account.

The case of a single instruction

For the removal of the securities from the main account and delivery to the safe custody account This is known as `Own Account

Transfer’.

Instructions under Power of Attorney Where trades have been executed either

on a computerized stock exchange Or via an electronic communications

network (ECN) The entity over which the trade has been

executed issues the settlement instruction on behalf of the dealer.

For this to occur, the dealer must give a power of attorney to the entity.

Power of Attorney (Cont…)

In such cases the dealer would need to suppress the generation of settlement instructions by its settlement system, to avoid duplication.

Power of Attorney (Cont…) When instructions are directly

issued to the custodian by another entity, the dealer benefits This is because instructions are issued

very shortly after trade execution And the expense of issuing an

instruction is avoided. Besides the risk of issuing an incorrect

instruction is avoided.

Link Between a Trade and its Settlement Instruction Dealers typically wish to maintain a

history of settlement instruction events for each individual trade such as: Transmission to the custodian Receipt by the custodian Achieving a status of unmatched Achieving a status of matched Settlement failure Settlement completion

Link…(Cont…)

To update the trades within the settlement system automatically with the information received from the custodian, there is a need for a link Between the settlement instruction

reference and the trade residing within the settlement system.

Link…(Cont…)

When the dealer has issued the settlement instruction, the settlement system trade reference number is normally sent as a part of the content of each settlement instruction.

Link…(Cont…) But if another entity such as an ECN

has issued a settlement instruction under a power of attorney The settlement instruction reference

number may not be the same as the settlement system trade reference number.

However there is still a need to update a trade with the current status of the settlement instruction.

Link…(Cont…) Maintaining a link between the trade

and its settlement instruction enables the dealer to have a complete picture of trades that require no action, such as those with: Successful instruction receipt by the

custodian Matched instructions Instructions that have settled

Link…(Cont…)

As well as trades requiring investigation and action such as those with: Unmatched instructions Instructions that have failed to settle

on the value date

The Role of the Custodian

We have used the term custodian as a generic term to describe those organizations that effect settlement on behalf of dealers.

In reality, a number of organization types fall within this group.

Custodians (Cont…) Custodians provide services not

only to dealers, but also to Individual investors Institutional investors And brokers

These entities will be described generically as the custodian’s account holders.

Custodians (Cont…)

Why is a custodian required? A custodian is appointed by an

account holder to take care of his assets

Normally securities and cash And to carry out his instructions to

Deliver or receive securities And to pay or receive cash

Holding Securities and Cash in Safe Custody

Following previous purchases of securities by the account holder, once settlement has occurred, the custodian will hold the securities in safe custody.

He will provide some or all of the following services relating to the holding of securities in safe custody.

Safe Custody…(Cont…) Keep the securities safe from the threat of theft

or loss Provide daily statements of securities and cash

holdings Provide current market valuations of securities

holdings Provide securities lending or borrowing facilities Collect income or additional securities relating

to the account holder’s entitlement. Advise of optional corporate actions.

Safe Custody…(Cont…) Following purchases of securities and

upon settlement the custodian will debit the cash account of the account holder.

The custodian may or may not allow the account holder to hold cash balances on an overnight basis.

In case he does, then he will provide one or more of the following services.

Safe Custody…(Cont…) Keep the cash safe Pay interest on cash balances Provide daily statements of cash

balances

Movement of Securities and Cash When the account holder sells securities

held by the custodian or buys securities that will be held by the custodian, he will issue a settlement instruction to effect the appropriate movement of securities and cash.

He may also issue settlement instructions relating to other transactions like Repos Depot transfers

Movement…(Cont…) When it comes to the movement of

securities and cash, the custodian will provide some or all of the following services. Acknowledge receipt of the settlement

instruction Apply the current pre-settlement status

Unmatched Matched Failed to settle

Transmit the current status of each instruction to the account holder

Movement…(Cont…) Effect the delivery or receipt of

securities and the receipt or payment of cash

Upon settlement of each instruction Apply the status of `settled’ Update the account holder’s securities

holding Update the account holder’s cash balance

Movement…(Cont…) In addition an account holder may wish

to have cash paid away from its account at the custodian to another bank

Or else have cash received by the custodian from an external source

In such cases he will issue an instruction to pay away or a `pre-advice’ to receive cash.

Types of Custodians

Various terms are used to describe those involved in the provision of trade settlement and custodial services on behalf of those who execute trades.

Types of Custodians (Cont…) These include:

Custodian Global custodian Local custodian Sub-custodian Central Securities Depository (CSD) National Central Securities Depository (NCSD) International Central Securities Depository

(ICSD) Settlement Agent

Custodian

An organization that holds securities and usually cash on its client’s behalf

May effect settlement of trades on its client’s behalf

Global Custodian

Performs the role of a custodian But has a network of local or sub-

custodians that hold securities and cash and effect settlement on behalf of it.

Local Custodian

A custodian that operates within a specific financial centre

Sub-custodian

A custodian within a global custodian’s network of custodians

CSD

An organization that holds securities Normally in book entry form Usually the ultimate place of

settlement effected through book-entry transfer

NCSD

A CSD that handles domestic securities of the country in which it is located

ICSD

A CSD that handles domestic and international securities

Only two organizations are recognized as ICSDs Clearstream in Luxembourg Euroclear in Brussels

Settlement Agent

An organization that effects the exchange of securities and cash on behalf of its clients

Resultant securities and cash balances may or may not be held

Example A trade initiated by an institutional

investor resulted in the following actions. Institution placed an order with a broker Broker forwarded the order to a dealer Dealer executed the order and recorded the

details of the sale to the broker Dealer sent an advice of execution to the

broker Broker recorded a purchase from the dealer

and a sale to the institution Broker sent an advice to the institution Institution recorded a purchase from the

broker

Example (Cont…) Following the trade a settlement

instruction must be issued to effect settlement ultimately at the CSD.

Each instruction will request the recipient to either Deliver securities and receive cash

from a specific account at the CSD Or receive securities and pay cash to

a specific account at the CSD

Example (Cont…) The steps are as follows:

The institution issues a settlement instruction to its global custodian

The global custodian will issue a settlement instruction to its custodian in the relevant financial centre.

Let us call it sub-custodian X X will issue a settlement instruction to

its own account at the CSD.

Example (Cont…) For its sale to the institution the broker will

issue an instruction to its custodian Let us call it local custodian Y

Local custodian Y will issue an instruction to its own account at the CSD

For its purchase from the dealer the broker issues a settlement instruction to custodian Y

Local custodian Y will issue a settlement instruction to its own account at the CSD

For its sale to the broker the dealer issues a settlement instruction to the CSD

Example (Cont…) On the value date

The CSD removes the security from the dealer’s account and adds them to custodian Y’s account

It will simultaneously debit cash from custodian Y’s account and credit the dealer’s account.

This concludes settlement for the sale by the dealer to the broker.

Example (Cont…) On the value date:

The CSD removes securities from the agent’s account and adds them to custodian X’s account

It will simultaneously debit cash from custodian X’s account and credit the agent’s account.

This accounts for the sale by the agent to the institutional investor.

Example (Cont…) Net result of these transactions

Securities are held within custodian X’s account at the CSD

Who is holding on behalf of the global custodian Who is holding on behalf of the institutional

investor There are no securities held in custodian Y’s

account at the CSD on behalf of the agent There are no securities at the dealer’s

account at the CSD

Example (Cont…) The cash has been debited to custodian

X’s account at the CSD On behalf of the global custodian The global custodian will debit the cash cost

to its account with the institution There will be no cash held in custodian

Y’s account at the CSD The sale proceeds would have been

credited to the dealer’s account at the CSD

Perspective Who is a client and who is a custodian? It depends on the specific entity’s view

The institution regards the global custodian as its custodian

The global custodian regards its client as the institution and its custodian as sub-custodian X

Custodian X regards its client as the global custodian and its custodian as the CSD

Perspective (Cont…) The broker regards its custodian as

custodian Y Custodian Y regards its client as the broker

and its custodian as the CSD The dealer regards its custodian as the CSD The CSD regards its account holders as

Custodian X Custodian Y And the Dealer

Perspective (Cont…) An institutional investor, broker or dealer

may choose to set up arrangements for Settlement of trades And holding of securities and cash

With A local custodian in each financial centre CSDs in each financial centre A global custodian Or any combination of the three

Global Custodians

A global custodian is appointed to facilitate trade settlement and the holding of securities and cash By use of its worldwide network of

sub-custodians Each of which is usually a member of its

local CSD

Global Custodians (Cont…)

The client issues settlement instructions to a single destination – the global custodian It will then direct its instructions to

the appropriate sub-custodian Who will effect settlement on its behalf.

Global Custodians (Cont…)

The exchange of securities and cash occurs at the CSD Where accounts of the sub-custodians

representing buyer and seller will be debited or credited with securities and cash.

Illustration

Global Custodian

Sub-custodian V Sub-custodian W Sub-custodian X

Australian CSD Spanish CSD Mexican CSD

NCSDs

An NCSD is typically set up and operated on behalf of the members of the national stock exchange of a country

It is the core repository of securities issued, traded and settled in that country.

NCSDs (Cont…)

Dealers and custodians located in the same country as the NCSD are likely to be direct members of the NCSD.

Non-resident dealers may not be allowed to have direct membership They may be required to use a local

custodian

NCSDs (Cont…)

NCSDs typically provide DvP and FoP capability for their members

They keep securities in safe-keeping for their members

But some NCSDs do not allow cash to be held overnight

ICSDs An ICSD holds both international and

domestic securities Dealers, brokers, institutions and

custodians from round the globe can become members.

Securities are held on behalf of the ICSD by depository banks in numerous financial centres Correspondent banks manage the external

movement of currencies.

ICSDs (Cont…) They provide DvP and FoP trade

settlement capability on a multi-currency basis Securities are held in safe custody Cash balances are held overnight

Only two ICSDs exist Clearstream in Luxembourg Euroclear in Brussels

ICSDs (Cont…) Settlement at the ICSDs falls into three

categories Internal

Between two participants of the same ICSD Bridge

Between a participant of Euroclear and a participant of Clearstream

External Between participants of an ICSD and an NCSD

This is known as Cross Border Settlement

Custodian Selection Dealers have a choice

They may set up relationships with CSDs or local custodians in all markets in which they are active

They may choose to have direct relationships with CSDs or local custodians only in the markets in which they are most active

For less active markets they may use a global custodian

They may use global custodians for all markets

Custodian Selection (Cont…)

One major consideration is cost In certain cases it may be cheaper to

set up relationships with CSDs or local custodians

On the other hand a global custodian may offer a premium service.

Custodian Selection (Cont…) The following criteria are typically used

to select a custodian Its credit rating

It signifies its status and financial stability Past performance

STP rates Ability to process equities Ability to process debt securities Proficiency of cash management

Interest rates on cash balances Overdraft facilities

Methods of processing corporate actions

Custodian Selection (Cont…)

Cost of operating the service Cost of securities holdings Cost per settlement instruction

Ability to process multiple currencies This is provided within the ICSDs This is likely to be provided by the global

custodian It is less likely to be provided by a local

custodian or an NCSD

Settlement Instruction Statuses

An STO needs to know the various statuses applied by the custodian

The frequency of updating the instruction with statuses

Method of communication of the status Electronic or Non-electronic

Statuses (Cont…) The minimum statuses that a dealer

would expect to receive are Unmatched

Including the reason Matched Settlement failure

Including the reason Settlement completion

Including information regarding the quantity of securities delivered/received and cash paid/received

Services Related to Securities and Cash Holdings The following criteria relate to the

custodian’s holdings of securities and cash on behalf of the dealer. Securities lending and borrowing Cash borrowing arrangements Rates of interest on cash balances Statements of securities holdings Statements of cash balances Corporate actions

Securities Lending and Borrowing

Some custodians provide a service whereby an account holder’s securities can be lent to a borrower This service is likely to be offered when

a custodian has access to a large pool of its account holders’ securities.

Some account holders are willing to lend securities for additional income.

Lending and Borrowing (Cont…) When a dealer has sold securities that it

cannot deliver it may be willing to borrow securities. This will enable settlement to go through But there will be an associated cost

The custodian typically acts as an agent between lenders and borrowers The fee collected from the borrower is passed

on to the lender after deduction of the custodian’s fee

Cash Borrowing Arrangements Typically dealers need to borrow to

pay for the purchases of their securities.

Some borrow in anticipation of settlement occurring on the value date They have the cash paid into their

account at the custodian Others borrow after settlement has

occurred at the custodian

Cash…(Cont…)

Generally a custodian will not allow a dealer to incur a cash overdraft unless the dealer has sufficient cash or collateral against which money can be borrowed.

The collateral acts as a safeguard for the custodian.

Cash…(Cont…)

The dealer will have a credit line or O/D limit But the limit is usually usable only to

the extent that the dealer has collateral

Interest on Cash Balances Following settlement of trades a dealer

typically expects to be overdrawn at the custodian – unless it has already borrowed from another source.

Occasionally a dealer may have a credit balance – if the value of sales is greater than the value of purchases.

In either case the dealer needs to know the rate of interest to be charged by or received from the custodian.

part 15

Documents

trade lifecycle

order details

order order flow cont

trade execution input

later trade capture

formal trade confirmation

institutional order

order price