Chapter 02.pdf

CHAPTER 2: INTRODUCTION TO TRADING, CLEARING, SETTLEMENT AND RISK MANAGEMENT ON STOCK EXCHANGES Learning Objectives After studying the chapter, you should know about: Trade Life Cycle Process Order Management Different types of orders Order Routing Process through exchange...

CHAPTER 2: INTRODUCTION TO TRADING, CLEARING, SETTLEMENT AND RISK MANAGEMENT ON STOCK EXCHANGES Learning Objectives After studying the chapter, you should know about: Trade Life Cycle Process Order Management Different types of orders Order Routing Process through exchanges Order Modification and Cancellation Clearing and Settlement Process Clearing banks and their functions Role of custodians Settlement Obligations Risk management framework Role of Clearing Corporation Auction of securities 2.1 Trading Mechanism 2.1.1 Trade Life Cycle Process A securities trade life cycle starts with the placing of order on the Exchange, its conversion into a trade and finally the trade being settled after securities/funds pay-in and pay-out. The pictorial representation of the securities trade life cycle from the broker’s point of view is given in the figure 2.1. Figure 2.1: Securities Trade Life Cycle 48 It can be seen that the flow starts from placing orders by the client. The order entered into the system is matched with a specified order type (Order types have been explained in later sections), and the trade is supposed to be executed. The stock market systems are such that once the trade is confirmed, intimation is automatically sent to the depository participant and the clearing banks for pay-in/pay-out of funds and securities. When the investor who has sold securities has received the funds against it and the investor who has bought and vice versa, we say that the particular trade is cleared and settled. The Indian securities market has introduced a T+1 rolling settlement in the equity market. There is a separate settlement cycle for government securities. In the below section, we elaborate on how a client’s order moves in the exchange system and gets converted into a trade: Placing of the Order When a client places a buy order with the broker: When the broker receives a buy order from a client either by phone or through internet banking, the broker’s system first checks whether there are sufficient funds in the client’s account. The order will only be sent to the exchange for execution, if there are sufficient funds in the client’s account. Otherwise, the order will be rejected by the broker’s system. When a client places a sell order with the broker: When the broker receives a sell order from a client, the broker’s system first checks whether there are sufficient securities in the client’s demat account. The order will only be sent to the exchange for execution, if there are sufficient securities in the client’s demat account. Otherwise, the order will be rejected by the broker’s system. In such a scenario, the broker shall verify with the clients as a prudential measure. Order matching and its conversion into trade On receiving the order, the exchange will send an order confirmation to the broker’s system and the order is matched with the suitable counter order. If a counter order is found, the order is executed and the trade confirmation message is sent to the broker’s system. If the order is not matched, then it lies in the order book (in case of limit order) or it is cancelled (in case of immediate-or-cancel order). 2.1.2 Order Management Order management consists of entering orders, order modification, order cancellation and order matching. The main components of an order are: Client identity (UCC) Price Time Quantity / No. of Contract Security/Contract (What to buy and what to sell)) 49  Action (Buy / Sell) A trading member can enter various types of orders depending upon his/her requirements. The order conditions are broadly classified into three categories: price related conditions, time-related conditions, and quantity related conditions which have been discussed in the following section. 2.1.3 Different types of orders 2.1.3.1 Market Order A market order is where a trader purchases or sells security at the best market price available across the market depth to complete the order quantity. In the market order there is no need to specify the price at which a trader wants to purchase or sell. There are two variations on the market order—market order without protection and Market with protection order. The market order without protection means that the trades are executed at the best available price/s in the market at that point in time. The second type of market order i.e. market with protection order wherein It allows the market order to be executed till a specified level mentioned by trader. 2.1.3.2 Limit Order Limit orders is when the trader sets the entry or exit price and then aims to buy at or below the market price or sell at or above it. The trader needs to specify the price. Reaching these limits/targets is not always possible and sometimes the orders do not go through. Limit orders are very common for online traders. 2.1.3.3 Stop order The type of order that allows the Trading Member to place an order which gets activated only when the market price of the relevant security reaches or crosses a threshold price. Until then the order does not enter the market. In stop order, the client enters two prices: one is trigger price and the other is limit/market price. A stop order can best be explained with an example. Suppose a trader has a short term (say, for a day) bullish view on a stock, he may buy the stock at say Rs.100 per share in the early hours of trading session. If the stock price moves upwards as per his expectation, he may sell the stock, say at Rs.110 and close his position. The stock price can also move downwards much against expectations of the trader. It may so happen that the trader may have limited risk appetite and does not want to incur loss of more than Rs. 5 per share. In such a scenario, a trader can give a stop loss sell order with trigger price of Rs.96 and limit price of Rs.95. When the stock price starts moving downwards, as soon as it hits the price of Rs.96, the sell order of Rs.95 will automatically get triggered. Any further downward movement in price will not affect the trader as he has already limited his loss on the position. A buy order in the Stop Loss book gets triggered when the last traded price in the normal market reaches or exceeds the trigger price of the order. 50 2.1.3.4 Immediate Or Cancel (IOC) order IOC - An Immediate or Cancel (IOC) order allows a Trading Member to buy or sell a security as soon as the order is released into the market, failing which the order will be removed from the market. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately. 2.1.4 Order Routing Process through exchanges Once the order is entered and confirmed by the client/dealer at his trading terminal, the order is routed to the Exchange for its execution. The Exchange system allots a unique order number for all orders received in the system. This is given as order confirmation along with the time stamp to the broker system. The order matching in an Exchange is done based on price-time priority. The best price orders are matched first. If more than one order arrives at the same price they are arranged in ascending time order. Best buy price is the highest buy price amongst all orders and similarly best sell price is the lowest price of all sell orders. Let us take an example here to better understand this. A sample of the order book is given below for understanding. Buy Quantity Buy Price Sell quantity Sell Price 50 121.20 50 121.50 100 121.10 200 121.80 25 120.90 3000 122.10 500 120.80 1000 122.20 5000 120.00 200 122.60 These quotes given in the table above are visible to clients. Now if a buy market order comes with an order quantity of 50 it gets executed for a price of Rs. 121.50 and the order book entries on the sell side moves up by one notch i.e. the Rs. 121.80 order comes to top. On the other hand, if a limit order with a sell price of Rs. 121.20 for a quantity of 500, only 50 shares get executed and the order for remaining 450 stays at the top on the sell side at Rs. 121.20. All orders come as active orders into the order book. If they get a match they will be executed immediately, else they will be entered into the order book according to price and time as passive orders. 2.1.5 Order Modification and Cancellation Orders once placed in the system can be modified or cancelled till they are matched. The screen available to a trading member displays icons that represent functions such as order modification and order cancellation. Brokers can modify or cancel orders according to the instructions of the client. Once order matching is complete, no modification or cancellation is possible. 51 Sometimes in a moving market, orders need to be changed in terms of the price and quantity as per the client’s requirement. All the orders can be modified till the time they are not fully executed. Orders which are partially executed, only the open or unexecuted part of the order can be cancelled/modified. 2.2 Clearing, Settlement and Risk management 2.2.1 Clearing and Settlement Process Clearing process The clearing function of the clearing corporation is designed to work out a) what trading members/brokers are due to deliver and b) what trading members/brokers are due to receive on the settlement date. In the clearing corporation this is done by a process called multilateral netting. This process is performed by the clearing agency (clearing corporation). The clearing agency guarantees that all contracts which are traded will be honoured. Clearing is the process of determination of obligations, after which the obligations are discharged by settlement. A multilateral netting procedure is adopted to determine the net settlement obligations (delivery/receipt positions) of the clearing members. Accordingly, a clearing member would have either pay-in or pay-out obligations for funds and securities separately. Settlement is a two-way process which involves transfer of funds and securities on the settlement date. Clearing corporation have also devised mechanism to handle various exceptional situations like security shortages, bad delivery, company objections, auction settlement etc. Settlement process In the Indian equities market SEBI has given options to Exchanges/Clearing Corporations to settle trades on Trade+1 day basis. In case of T+1 rolling settlement, a transaction entered into on Day 0 has to be settled on the Day T+ 1 working day, when funds pay in or securities pay out takes place. For instance, trades taking place on Monday are settled on Tuesday, Tuesday's trades settled on Wednesday and so on. Hence, a settlement cycle is the period within which the settlement is made. For arriving at the settlement day, all intervening holidays -- bank holidays, Exchange/clearing corporation holidays, Saturdays and Sundays are excluded. 2.2.2 Clearing banks and their functions Clearing Banks acts as an important intermediary between a clearing member and the clearing corporation. Every clearing member needs to maintain an account with any of the empanelled clearing banks at the designated clearing bank branches. The clearing accounts are to be used exclusively for clearing & settlement operations. It’s the function of the clearing members to ensure that the funds are available in his account with the clearing bank on the 52 day of pay-in to meet the funds obligations. In case of a pay-out clearing member receives the amount on pay-out day. All transactions of pay-in/pay-out of funds are carried out by these clearing banks. The pay-in obligation details are passed on to the clearing banks by clearing corporation, who then debit the clearing member account and based on pay-out instruction from clearing corporation the clearing bank will credit the receiving member clearing account. In the case of the cash market this happens on T+1 day. The clearing banks are required to provide the minimum services as specified by Clearing Corporation to clearing members. 2.2.3 Role of Custodians Custodians are institutional intermediaries, who are authorised to hold funds and securities on behalf of large institutional investors such as banks, insurance companies, mutual funds, and foreign portfolio investors (FPIs). They settle the secondary market trades for institutional investors. Several custodians are also clearing members and clearing banks of the exchange and manage both funds and securities settlement. 2.2.4 Settlement Obligations Clearing Corporation receives the details of trades and prices from the Exchange. Settlement obligations are computed using predefined methodology specified for the segment/product. 2.2.5 Risk management framework A comprehensive Risk Management framework is the backbone of the Clearing Corporation. A clearing corporation provides settlement guarantee i.e., the settlement of securities and funds will take place even if there is a failure by a broker/clearing member to fulfil their obligation. In order to safeguard against such failures, the clearing agency is required to carry out the risk management measures as specified by SEBI through its various circulars. In the Equity Market segment, brokers should have a prudent system of risk management to protect themselves from client default. Margins are an important element of such a system. The ‘margins’ for this purpose shall mean VaR margin, extreme loss margin (ELM), mark to market margin (MTM), delivery margin, special/additional margin or any other margin as prescribed by the Exchange to be collected by TM/CM from their clients. Clearing Corporations, Risk containment measures include capital adequacy requirements of members, monitoring of member performance and their track record, stringent margin requirements, position limits based on capital, online monitoring of member positions and automatic disablement from trading when limits are breached, etc. 53 2.2.6 Role of clearing corporation When a trade occurs on the Stock Exchange it is a legal contract between the buyer and seller. If there is a default by either the buyer or the seller the counterparty to the trade will have to bear the loss. Clearing Corporation ensures that members meet their fund/security obligations. It acts as a legal counterparty to all trades through the process called novation. Thus, Clearing Corporation becomes the buyer to every seller and seller to every buyer. If there is a default in this scenario, Clearing Corporation being counterparty, is responsible for ensuring the settlement, thus managing risk and guaranteeing settlement to both the parties. In a multi- lateral netting scenario, when a default occurs, it is difficult to unwind the trade to find the original counter party who will have to bear the loss. The process of “novation” addresses this risk. In India, in the equity segment there are three clearing corporations, viz., the NSE Clearing Limited (NCL), Indian Clearing Corporation Limited (ICCL) and Metropolitan Clearing Corporation of India Ltd. (MCCIL). 2.2.7 Auction of Securities An auction is resorted to when there are shortages in delivery by a seller broker. This mechanism is utilized by the clearing corporation to fulfil its obligation towards the buying trading members. Thus, when the selling broker fails to deliver the shares, the clearing corporation through the stock exchanges system conducts an open market purchase by way of an open auction and the shares bought through the auction are delivered to the buying broker and adequate penalties are levied on selling brokers. 54 Chapter 2: Sample Questions 1. Market orders are of how many types? a. 3 b. 2 c. 5 d. 4 2. In case of______, the trader needs to specify the price at which the trade needs to be executed. a. limit order b. Stop order c. IOC order d. Market Order 3. _______are institutional intermediaries, who are authorised to hold funds and securities on behalf of large institutional investors. a. Insurance companies b. Registrar and Transfer Agents c. Custodians d. Stock Exchanges 4. An auction is resorted to when there are shortages in delivery by a/an______. a. custodian b. seller broker c. investor d. bank 55