Investment Banking Operations - Trade life cycle.pptx

Video elaborates about various stages of trade lie cycle

1. Trade Life Cycle

2. Trade Life cycle All steps involved in a trade, from the point of order receipt and trade execution through to settlement of the trade, are commonly referred to as the trade life cycle Trade life cycle Trading activity: Under this activity, it covers all process and procedure to capture trade from the client via front office Trade execution In this logical step we determine trading business channel where sellers and buyers execute trades Quote drive markets: n markets where market makers publicize (quote) prices at which they are prepared to buy and sell with the intention of attracting a counterparty, the market is said to be ‘quote-driven’

3. ii. Order-driven Markets: In markets in which orders from sellers are compared and matched with buyers’ orders electronically, the market is said to be ‘order-driven. Transaction types There are 2 types of transactions – Opening trade & Closing trade. When you are opening trade, you are creating new position & when you are closing trade, you are squatting off or reversing the opened trade . Opening trade: Buy to open : When you buy stock you are creating new position. It is referred to as creating long position. Short Selling : You can also open trade by short selling. It is referred to as creating short position. Short selling means selling stock at current value & buying the same stock later at low price to realize profit. Closing trade: Sell to close : When you sell stock, you are closing a long position that you created with Buy to open Buy to Cover : When you buy to cover, you are closing a short position that you created with Short Selling. Usually, investors will buy to cover at low price to realize profit

4. The Stages of Trade Lifecycle The area of trade processing is gaining momentum with a lot of Investment/ Custodian banks outsourcing the work to countries like India Stage 1: Pre-Trade Client On Boarding : This step refers to onboarding the client to once organization. This is the 1st and most crucial step as it directly impacts the “Customer experience” with the organization. Steps: Due diligence: Customer acceptance policy Customer identification program Monitoring, reporting and record keeping Risk management Master Agreement Account setup

5. Stage 2: Trade The next stage is the trade execution which occurs at a trading venue. The execution is decided by the price discovery mechanism followed by the trading venue. There are different price discovery mechanisms exist in financial markets. They can be grouped into two, which are call auction and continuous auction . Call auction is practiced when there is a situation of “one seller but many buyers” There are two types of call auction , namely, uniform price auction and discriminatory price auction. Continuous auction is practiced when there are multiple buyers and multiple sellers Simultaneously, There are two forms of continuous auction, which are order-matching and quote-matching the order-matching

6. Stage 3: Pre-Settlement When a trade is executed, the agreed transaction does not complete immediately. Once a trade is executed, an extensive clearing and settlement process is implemented to finalize the trade. Trade clearing refers to the process through which the counterparties to the trade and their agents determine and verify the exact details of the transaction and prepare for settlement . Trade settlement refers to the completion of the agreed-upon transaction. Trading Activity: Trade Capture The next stage in the life cycle is the trade capture. After the trade execution, the details of the trade are recorded . For all trades, trade data consists of counterparty, price, quantity and settlement date.

7. Trade Validation The next process is the review, repairs, and validation. This stage applies only to OTC market trades , particularly for derivatives . It does not apply to most Exchange-traded underlying and derivatives trades in debt and equity market. The process is carried out by either back office (in smaller organizations) or by mid office . Trade Enrichment Trade data alone is not sufficient to process the trade further in its life cycle. The reason is that the trade captures only the economic details , which are trade-specific, such as price, quantity, etc. We need additional data about the counterparty and product, such as the counterparty’s agents (e.g., custodian, prime broker), clearing agency, etc. Such data does not change from trade to trade but remains static at counterparty and product level; and are called “static data”.

8. Trade Confirmation/Affirmation The next process is the confirmation, affirmation, and matching , all of which are related to the same process. Confirmation is the legal document for the trade. When both parties agree to the details in the confirmation, the trade has become a legal contract. At this stage , we say the trade reached the “ legal execution ”, which is different from trade execution. Legal execution can take place in two routes. First, one party prepared the confirmation , send it to the other, who agrees to it and gives his consent. This is called “confirmation affirmation”. Second, both parties prepare the confirmation, exchange it and accept each other’s confirmation document. This is called “ confirmation matching”

9. IM – Investment Manager EM – Executing Brokers Trade Allocation & Reporting The next process is allocation and reporting . This is applicable only for institutional trades in Exchange-traded products. At this stage, the trade that is confirmed-affirmed is the ‘block’ or ‘parent’ trade , which is large. The large block trade is split into smaller ‘child’ trades , which are to be allocated to various client accounts of investment manager , or different sub accounts of the same client.

10. A/c #1 A/c #2 A/c #3 A/c #4 Buy Sell Bal Buy Sell Bal Buy Sell Bal Buy Sell Bal #1 (+100) 50 50 #2 (-150) 50 50 50 #3 (+200) 100 +50 50 +100 -50 50 +50 # Buy Sell POS 1 100 100 2 150 -50 3 200 150 Trade Execution : Updated Position Register Post trade : posting/allocation After the first trade, the position is 100 (long); after second trade, the position is 50 (short); and after third trade, the position is 150 (long). After trade execution, the trade is posted or allocated to different accounts or books. Let us say that there are four different accounts or books maintained internally. The first trade is split across a/c #2 and #4; the second trade, across a/c #1 and a/c #3; and the third trade, across a/c #1, a/c #2 and a/c #4. The sum of balance in each account must tally with the running position in Position Register at that point of time. Position reconciliation

11. Mark-to-market and Margining They are tools to mitigate counterparty credit risk , which arises for each party in every trade whenever there is a delay in trade execution and settlement. In OTC market, mark-to-market a nd margining together are called ‘collateral management’. The principle of mark-to-market is that the contract is periodically rewritten at the prevailing market price and not carried at the original historical price. Pre-settlement confirmation It applies to most OTC derivative trades. It applies to all trades that have floating cash flows, contingent cash flows, payments netting provision and cash settlement provision. Floating cash flows would require sending of rate reset advice and translating the benchmark rate into settlement amount.

12. Clearing Clearing is multilateral and conducted by a separate entity called Clearing Corporation (CC). All exchange-traded products are subject to clearing Clearing process consists of three separate sequential functions, namely, receiving and matching trade information from the parties; multilateral netting, post-netting confirmation There is a specified timeline for completing each functioning Novation in Clearing Novation means that one party retires, and a new party takes his place in an existing trade. There are many forms of novation, and the novation practiced in clearing is as follows. To start with, there is a buyer and a seller and a trade between them Clearing corporation enters now and interposes between buyer and seller. To the buyer, it is the seller; and to the seller, it is the buyer. Thus, after novation, there are two trades and three parties. The real trade, of course, continues to be one.

13. Stage 4: Trade Settlement Settlement method can be Physical or Cash method. Physical settlement involves two flows: exchange of cash for security. When we say “settlement”, what we mean is physical settlement. Buyer pays cash and seller delivers security , and this is physical settlement. Cash settlement involves settlement of a single flow , which is in cash. It does not involve any movement of security . Stage 5: Post Settlement Accounting - On the settlement day, accounting entries are posted . They are posted in “mirror” or “ledger”. Mirror/Ledger ‘mirrors’ the entries in the statement of bank/depository received from corresponding banks. Debits/outflows in statement will be credits in Ledger. Credit/inflow s in statement will be debits in Ledger.

14. Account reconciliation - Receive the statement and compare it with Ledger. Debit in one must tally with the credit in other for - Counterparty Amount Value date Equity Trade Life Cycle: The Equity Trade Life cycle is the entire trade order process, including selling, buying and carrying out the exchange of any security in the market. The cycle begins with investors interest in trading the equity The investors approaches an authorized broker who forms an agreement to trade the security Once the agreement is in place, the trade life cycle moves forward to execute the entire trade by the broker and investor systems that communicate in sync

15. Office activities Front office activities The front office usually referred to as the trading floor, is where the trade gets initiated. This is where the pre-trade checks are performed The front office receives the client orders and performs preliminary checks on these orders in the form of trading limit check, daily trading notional etc., Middle office activities The middle office is the department in investment banks that sits in between the front and back office. It typically manages risk and tracks and processes all the deals made by the front office before being reconciled by the back office Middle office personnel are responsible for ensuring that the deal negotiated by the front office is accurately booked, processed and paid for. The middle office activities starts with validating the client’s order , once validated they are booked and send the confirmation of trade booking to investment manager

16. Ongoing position & Risk management Throughout the trade lifecycle, there is requirement for ongoing position and risk management. This refers to the management of the numerous positions that an institution holds in its portfolio, otherwise known as trading book Example activities: Managing corporate actions, managing counterparty credit risk Trade reconciliation Measuring profit and loss (P&L) Measuring risk and sensitivity Preparing internal and external reports Back office activities The back office is the portion of investment bank made up of administration and support personnel who are not client facing. Back office functions include settlements, clearances, record maintenance, regulatory compliance, accounting The back office plays a vital role in clearing, settlement, accounting & regulatory compliance. Back office activities also manage to reconcile the activities of the front office and middle office activities as well. The final report of the entire trade is given to both parties in the process ie ., the investors or clients and the exchange.

17. Parties in trade life cycle Buy side firm (i.e., institutional investors) Sell side firm (i.e., deal or broker dealer) Investment manager (asset manager or portfolio manager) Interdealer broker (voice broker) Custodian Safe keeping of cash and securities Settlement Record keeping Asset servicing (corporate actions) Reporting Valuation Performance measurement Tax reclaims processing Compliance reporting Security lending

18. Fund administrator Prime broker Trading venue Clearing agency Depository Tri- party agents Banks SWIFT (Society for Worldwide Interbank Financial Transmissions) Data Vendors IT Service providers