The Trade Life Cycle

The Trade Life Cycle

There is a lot more to a trade than a trader pressing a button on the computer to execute a transaction. At its core, trading is largely about the skill and instinct of a trader and how he/she manages to navigate market conditions to generate a return for their client. However, there are far more players during the entire life cycle of a single trade than just the trader sitting at the trading desk. The first step that occurs is different between the buy side and the sell side. On the sell side, the clients are wealthy investors or other institutions looking to use the investment bank’s trading desk to execute a transaction that they desire for their portfolio. On the buy side, this is slightly different as the traders don’t deal directly with the clients of the buyside institution. In this scenario, a research analyst will typically conduct due diligence on a security or basket of securities and recommend a directional action. It is then up to the trader to execute that action, providing the portfolio manager with the securities at the lowest possible price. For the sake of simplicity, the details below are from the perspective of a sell side institution.

The investor comes to the trader with an order to be made as well as the custodian (a financial institution that looks after and safeguards the assets). This is called the buy order where the investor informs the trader of the position he/she wants and the price to buy it at. There are two main types of prices here: either the market price which is whatever the stock is trading for on the market at that given point in time, or the limit price which is the upper boundary or maximum that an investor is willing to pay for that security (excluding commissions). Once the trade is received by the trading desk, the trader gets to work making the trade happen by executing it on a trading platform. The trading desk in this scenario is referred to as the front office. However, the information from the investor is also given to the middle office, where risk management works to ensure that the risks inherent in the transaction are within acceptable parameters and that neither the bank nor the investor is exposed to losses at an unacceptable level. The risk management team in this regard will conduct deep analysis into both the market conditions that the trade is being made in as well as the actual customer to ensure that they have sufficient funds to pay for the security.

Once the order has been validated by risk management, the broker firm will send it along to the stock exchange. Now one thing to remember here is that there are two counterparties in every trade. Therefore, when there is a buy order submitted by one counterparty, a sell order also needs to be submitted from the other counterparty. The broker firm representing the seller in this scenario will send a similar order as the buying broker firm to the stock exchange to state that they have securities they would like to sell. The stock exchange then conducts a matching process between the buyer and the seller and once the two are matched, the trade is made official. The stock exchange will then send the information back to the respective brokers for confirmation and the brokers then inform their respective clients of the trade made.

All the above described actions conducted pre-trade and during the trade. The post-trade process begins now wherein the clearing and settlement process begins. For clearing, there is a specialized clearing house that calculates how much is needed from each side of the trade and when. Once the trade has been cleared (usually two days after the trade has been made), it is settled where the two parties exchange cash for the security. This isn’t done directly between the two parties however. The clearing house has accounts for each trading side and will then provide reports on settled trades.

 

Categories: Business

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