Behind the Scenes of Trade Execution

Trade Life Cycle (Behind the scenes of Trade Execution)

“After discussing different entities such as Broker, Depositories, Depository Participant, Exchanges required for a trade execution of stock, last time we ended on a note where in you mentioned that a trade executed today takes 2 days settle, why is der a delay of 2 days”, asked Apurva over the weekly skype session.  “India has come a long way in terms of a trade execution, the trade required more than 2 days to execute earlier but now India is at par with the international standards of trade settlement of 2 days”, I started explaining her.

We have seen the functioning of different entities such as Broker, Depositories, Depository Participant, and Exchanges in isolation in our previous conversations, let us see the linkage between these entities and their logical sequence. This trade life cycle is popularly known as “T+2” settlement process, which means it takes 2 days for a trade to settle after it has been executed. “This means the trade life cycle has two stages, execution and settlement, correct?” Apurva looked confused. “Execution and settlement are part of the trade life cycle but apart from them we also of a stage of “Clearance” about which we have not talked much”. So the three stages of trade executions are

1.      Trade Execution

2.      Trade Clearance

3.      Trade Settlement

 Let us discuss them one by one

Trade Execution

The trade execution starts with buyer and seller of the securities sending their buy and sell instruction to the exchange via a broker.  As discussed last time, investor needs to maintain a Demat account with the depository participant and trading account with a broker. Since the broker usually also acts as a DP, user maintains both account the same entity with linked savings account. Broker forwards the buying and selling instructions given by investor to the exchange (NSE or BSE or MCX-SX).

The job of the exchange is of a match maker. If exchange finds matching buy and sell instruction, it confirms the same to respective brokers which gives confirmation to the investors. This concludes trade execution and trade is said to be executed.

Sometime a investor, especially institutional investors, gives the custody of their securities to a third party. This third party is known as a “Custodian”. If this is the case then the custodian sets aside the required Cash/Securities for the transaction. The trade execution day is referred as Day “T”.

Trade Clearance.

The entire process of the stock buying/selling could be risky. What if after the trade is matched and the buyer does not have the required balance in his linked savings account or the seller does not have the required securities in his Demat account? After all the seller and buyer don’t know each other and it is the exchange who acts as a mediator for both. So it is the responsibility of exchanges in a way to restore confidence in the investors Hence to guarantee the trade after its execution, we have an entity called as “Clearing House” which are generally subsidiary of these exchanges.

The capital market regulator SEBI has said that National Securities Clearing Corporation Ltd (NSCCL- subsidiary of NSE), Indian Clearing Corporation Ltd (ICCL- subsidiary of BSE) and MCX-SX Clearing Corporation Ltd (MCX-SXCCL – subsidiary of MCX-SX) are the only qualified central counterparties (QCCPs) in the Indian securities market.

The clearing house typically breaks the trade in 2 parts. This means clearance house acts as seller for buyer investor and buyer for the investor selling the security. So in case the seller of the security does not have the required securities the clearing house will buy the securities in the open market and gives it to the buyer. In case buyer does not have required cash available for buying the security then the clearing house will payout cash to the seller.

Apart from acting as a counterparty to each side of the trade, the clearing house also performs operation of “Netting”. E.g. Between investor A and Investor there are multiple buy and sell on given day, A owes B ₹ 10,000 and B owes A ₹ 15,000; after netting B owes ₹ 5,000. Netting reduces settlement risk.

So after Day T, the exchange forwards the matched instructions to clearing house which performs netting, splits the trade into two trades and gets custodial confirmation on T+1.

Trade Settlement

This is the final phase of the trade life cycle. On T+2 days the Seller sends the security to the Clearing House and Buyer sends the cash to the clearing house. This is known as “Pay In”. After receiving the Pay In, the clearing cooperation performs a “Pay Out” i.e. transfers the cash to seller and security to the Buyer.

“It was interesting to know the behind the scenes of the trade life cycle, I now know why it takes 2 days for a trade to settle”, said Apurva and we ended the conversation on that note.

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All you wanted to know before you start investing in Stock Markets

Starting Investment in Stock Markets

It was time to for yet another skype session. After understanding the need for companies to go public it was time to discuss; who, when and how can one invest in the stock market. “Can I start investing in stock markets, it’s still some months before I turn 18”, asked Apurva.  Ideally the law requires you to be 18 years old to start investing in the stock market on your own, but there is a provision under which your parents can open account for you acting as a custodian. How does a share look like? Is it similar to the currency we carry for monetary transaction? Where can one open account for investing stocks, if one already has a savings account can he store his shares in the same account?  Apurva had some many questions in her mind and we decided to tackle all the questions one by one.

Let us start with the question “how does a share look like”. With the advent of technology, it is no longer needed to hold a share in a physical format. Before the technology took over, share of a company used to be in the form of physical form i.e. physical certificate. But there had been many scams where in people involved in the scam came up with fake physical certificates and started trading them in the stock market. This created fake demand for the shares and resulted in the value of these shares which were not in synch with their business fundamentals. No one new why the price of those share kept rising before the scam unfolded and it was decided to convert these share certificate in electronic format. Also since the share certificates were in the physical format there was possibility of them getting lost or getting spoiled with time. Converting these certificate to electronic format resolved all these issues and made it possible for the regulators of the share market to monitor them centrally and avoid any activity that would possibility manipulate the stock market in an illegal manner. The electronic format of the share is also called as dematerialized format. Now we will come to the next point as to where can one store the dematerialized format of the shares. Like you need to have savings account with the bank, we need to have “Demat” account to store the electronic shares. There are 2 central depositories that offer this facility of Demat account. National Securities Depository Limited (NSDL) and the other is the Central Depository Service (India) Limited (CDSL). 

It is difficult for these two depositories to provide the service of depositories in the form of a Demat Account centrally all across India. Hence to facilitate this, these depositories have their agents known as the depository participants, popularly known as “DPs”. These depositary participants need to register with the depositories. The depositories charge the DPs and the DPs intern charge the customers. Apart from one time account opening charge, the DPs can charge only for debit transactions. I.e. a DP can only charge for share transaction in which you buy a share, it cannot charge you for holding a share or transaction when you sell the share. The fee for a debit transaction is based independent of the number of shares traded in that transactions. E.g. irrespective of you sell 1 share or 1000 shares of a company A, the charge will be considered as a single charge since the charge for the entire transaction for the shares of company A. These DPs can be Banks, NBFCs (Non-Banking Financial Companies) or a Broker. Let us try and understand functionalities of a Broker.

Apart from providing the DP service in the form a Demat account, brokers provide service of trading account. Remember that Demat account only allows you to keep the share, acting as a depository. If you want to sell or buy a share you need to have a trading account provided by the broker. The regulator of share market, SEBI (Security Exchange Board of India) allows individual to trade in the share market via brokers only. The brokers need to register with the stock exchanges in order to facilitate stock trading. In India, BSE and NSE are most popular stock exchanges. It’s for a company to decide whether it wants to get listed on NSE or BSE or Both. The price of share on the two exchanges will almost be same but may not be exactly same. These exchanges charge brokers for their service and the brokers in turn charge the customer for trading through the trading account. The charge that brokers charge is known as “Brokerage”. Different brokers can charge different brokerage. Unlike the Demat charges which are based on the per debit transactions, brokerage depends upon the size of the total transaction. The brokerage is a two way affair which means that you will be charged for both Debit and Credit transactions (i.e. Brokerage will be charge both at the time of selling and buying the shares.). Also the brokerage for selling/buying one share will be lesser than that of buying/selling 1000 shares. Apart from the account opening charges, brokers can charge an Annual Maintenance fees for a trading account.

When you buy a share, broker has the responsibility of debiting money from the savings account linked to a trading account and providing it to exchange and putting the shares into your debit account facilitated by the DP. Ideally one can opt for Dmat and trading account from different entity providing the service. And the savings account linked can be a different entity all together. I.e. you could have trading account of ICICI (icicidirect), Demat account from HDFC (HDFC securities) and savings account of SBI. But ideally you would want to have these opened with the single entity. This is because doing this would save some charges for you. Broker/DP and banking from same entity can offer you discount on initial opening charges/maintenance charges, transaction charges. The role of the exchange in this entire transaction is of a Match Maker i.e. matching a buyer’s requirement with that of a seller.

It takes two days for a transaction to be completed. Which means it takes two days for shares to be credited in the account in case you bought the shares or money to be deposited into your account in case you sold shares. We will discuss what happens in these two days some other day. We ended a skype call on this note.