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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