The Trade Lifecycle

Once the trade has been booked in the front-office system it will need to be sent to the back-office. This can be done manually but is more likely to be automated on a trade feed. The trade will come across to the back office system with only basic details. The first process will be to enrich the trade. Trade Enrichment can be achieved by defaulting the details based on business rules. For example, if the instrument is ABC, the counterparty is DEF and the venue is HIJ then a particular record will be returned and it will be used to populate the remaining trade details. One of the major attributes that needs to be populated in the trade record are the settlement instructions. These are the depot and nostro accounts that the trade will settle across at the National Central Securities Depositary (NCSD). The depot and nostro are the stock and cash accounts respectively. The CSD is a countrys central organisation where securities settlement is affected. For the United Kingdom this is CREST. International securities are settled at one of the two International Central Security Depositaries (ICSD), Euroclear or Clearstream. One problem where a Securities Trading Organisation (STO) maintains its own standing settlement Instruction database is that it will have to keep it up-to-date. An alternative to this is to use the services of a 3rd party vendor. Thompson Financial provides such a service through it ALERT offering. The venue is of particular importance. Recently there has been a big increase in the number of venues where securities can be traded. These Multilateral Trading Facilities (MTF) or Electronic Communication Networks (ECN) offers reduced transactions cost. Furthermore, these venues may issue the settlement instruction automatically to the CSD. Under these circumstances it will be necessary to suppress the settlement instruction that gets generated from the STO settlement system. Otherwise you could end up paying twice. There are a number of providers of back-office settlement services. A provider can differentiate its offering from its competitors by providing value added services. Trade Validation is such an additional service. Trade Validation is an optional risk monitoring step. The idea of Trade Validation is to identify high levels of settlement risk before they become actual events. The most secure form of securities settlement is Delivery versus Payment (DVP). The idea of DVP is that you maintain ownership of either the stock or the cash at all times so that if one side of the deal defaults you still have the other side as collateral. However, a client might wish to settle on a Free-of-Payment basis. This sometime occurs on a trade which also involves a foreign exchange transaction, the payment being at a different location to where the stock is being transferred. FOP trades are subject to higher levels of counterparty risk. This is because once the payment has been made the client will be subject to financial loss in the event that the counterparty defaults. Trade validation identifies areas of settlement risk based on business rules. The business rules can be configured on a number of different parameters including settlement type (DVP vs FOP) or even specific counterparties.

Once the exception has been raised it will be necessary to seek approval before the settlement process can continue. The GLOSS Global settlement has a STP Exception monitor module that performs a similar function. Institutional Investors may want to agree the trade details with the STO before settlement. Such a service is provided by Thompson Financial Oasys Global system. The idea is that both the STO and the Institutional Investor input trade details into Oasys. SWIFT is the mechanism by which these messages are transmitted. SWIFT is a back office communication protocol used by a number of financial services industry participants to send secure messages. When Oasys receives the message they will send back an Ack (Acknowledgement) message. If for any reason they fail to receive the whole message then they will send back a Nack (Nonacknowledgement). Oasys will attempt to match each message. There are four possible outcomes.

In scenario 1 both the STO and the Institutional Investor trade details match and the trade can proceed to settlement. In scenario 2 both the STO and Institutional Investor have input trade details but they have failed to match due to at least one difference. Both parties will be advised what the difference is and what the other counterparty has input. Each party will need to check their records and input amended details so that the trade can then match.

In Scenario 3 the Institutional Investor has input trade details but nothing has been input by the STO. In this scenario the trade will be alleged back to the STO. Scenario 4 is the opposite of Scenario 3 and the trade will be alleged back to the Institutional Investor. Not all the trade parameters need to be exactly the same for the trade to achieve a match. Some of the matching parameters might have a tolerance. For example, for a consideration of 100,000 that one side enters the counterparty might be able to enter any value in the range 99,980 - 100,020 for the trade to still match. As well as Institutional Trade matching the STO will also need to match with its market counterparty. This is achieved through Trax and is similar to how Institutional Trade matching works. It should be pointed out that not all trades will be subject to the same trade lifecycle. For example, for a Non-SETS equity settling in CREST, the settlement instruction is the process by which trade agreement is reached. Any securities transactions will need to be reported to the appropriate authorities. This is for regulatory and tax purposes. Equity trades in the UK need to be reported within 3 minutes. Such a requirement means that it will need to be reported in the Front-Office. However, other security types have a less stringent requirement. Eurobonds need to be reported within 30 minutes. During this period the trade should have filtered through the Front-Office and into the Back-Office. Therefore, it might be more suitable to report it in the Back-Office. Especially, if the same interface can be used for another function i.e. trade matching. After trade reporting the settlement instruction can be transmitted to the NCSD. These can be transmitted via SWIFT or some other proprietary communication link. Settlement Instructions will need to be agreed and go through the same type of matching process as described earlier. Settlement Instructions give the NCSD the authority to move stock and cash on the settlement date. On settlement day if there is enough stock in the sellers depot and there is enough cash in the buyers nostro then a simultaneous and irrevocable transfer of cash and securities will occur. Some CSD arrange for the cash to be moved between Payment Banks outside the system. There are a number of different cash settlement types. Bilateral Netting is where only the net difference is settled between two counterparties. Multilateral Netting is where more than two parties net their obligations. Each party will then pay or receive a single cashflow to cover all its obligations with the other participants. Real Time Gross Settlement (RTGS) is settling the Gross amounts between parties i.e. no netting, and these amounts are settled as and when the stock is transferred in the CSD i.e. intraday.

Simon Brown tmn0004676@yahoo.co.uk

The Trade Lifecycle

Standing Settlement Instructions
Tra Ma de M rke atc t C hin ou nte g wit rpa h rty

Xtrakter TRAX

Regulatory and Tax Authorities

nd obo Eur des Tra

Instrument ABC Counterparty DEF Venue HIJ

Depot Nostro Defaults

Central Securities Depositary i.e. Euroclear

Settlement Trade Reporting Settlement Instruction Matching STO Depot Counterparty Depot

Front Office Trade Feed

DVP
Trade Enrichment

Trade Matching

ing atch ns em io Trad Institut with

Nostro

Nostro

Depot Nostro Details

Trade Validation

FO P

Settlement Instruction

ALERT

OASYS GLOBAL Counterparty

Trade Validation Business Rules Institutional Investors Simon Brown tmn0004676@yahoo.co.uk

Note: Free of Payment should be inspected more closely than Delivery Versus Payment. Therefore FOP should go through an extra trade validation process. Equity Trades are subject to more stringent Trade reporting Requirements so will need to reported in the front Office. Eurobonds, however, have a 30 minute deadline so should have time to filter through the back office system before they need to be reported.