Part-15: Brokerage

Operations
Micro Issues

Trade Life Cycle

&
Straight Through Processing

TLC

What do we mean by `trade

lifecycle?

All the steps involved in a trade from

the point of order receipt to trade
execution through to settlement are
referred to as the lifecycle of the
trade.

The management of all STOs

require that trades are processed
in the most efficient manner.

This is reflected in their desire to

TLC (Cont)

STP is achievable if the lifecycle is

begun by recording the details of
each trade in a timely and
accurate fashion within the front
office, and is handled efficiently
and cost-effectively in the
operational areas of the STO.
A problem created early on in the
cycle will cost more to correct the
further it is allowed to flow

STP

What is Straight Through Processing?

It is a term used to describe the objective of

managing trades throughout the lifecycle
automatically and without human
intervention.
Historically there was little or no
connectivity between the various systems
within an STO.
This resulted in manual rekeying of
individual trade details at various points.
Even where connectivity existed between
internal systems a lack of consistent
reference data prevented automatic passing

STP (Cont)

The objective of STP is the

following.

Following trade execution

Input the details of individual trades only

once
And from that point until the complete
settlement of the trade. Manage each of
the steps in a fully automated fashion.

Elements of TLC

Trading Activities

Trade Execution
Trade Capture (Front Office)

Elements of TLC (Cont)

Operational Activities:

Trade Capture (Back Office)

Trade Enrichment
Trade Validation
Trade Agreement
Transaction Reporting
Settlement Instructions
The Role of the Custodian
Pre Value Date Settlement Instruction
Statuses
Settlement Failure
Trade Settlement
Reflecting Trade Settlement Internally

Order Flow

Typical steps in the placement of

an institutional order with an STO.

The institution decides to buy or sell a

specific security and contacts an STO
with whom it normally trades. The
details of the order are normally
conveyed to the relevant salesperson
within the STO.
The salesperson records the details of
the order either manually or
electronically within an order

Order Flow (Cont)

The order details are forwarded by

the salesman or are fed automatically
by the order management system to
the relevant trader or market maker.
The trader will assess the order in
order to decide whether or not to
trade. A market maker must trade if
the order price is within the quote
given by him. If the trade is executed
the details are recorded in the
relevant trading book.

Order Flow (Cont)

The trader will respond to the

salesperson who placed the order
advising whether or not the trade has
been executed and if so on what
terms.
The salesman records the details of
the execution thereby closing the
open order.
The salesman will contact the client
usually by phone to advise whether
the order has been fulfilled. A formal
trade confirmation will be sent later

Trade Capture by the Front

Office

All trades executed by an STO must be

recorded formally within the STOs
books and records.
The first step is to record the basic
details of each trade.
This is necessary to:

Update the trading position for the specific

security
Update the average price of the current
trading position so that when the next trade
is executed the trader knows whether a

Trade Capture (Cont)

Traders normally use trading

systems designed specifically for
managing their positions and
applying updated prices to those
positions.
The basic trade details must be
immediately conveyed to the
middle or back office to allow
operational processing to

Components of a Trade

In the case of a principal trade, the

basic components that are typically
recorded by the trader are:

Trading book
Trade date
Trade time
Value date
Operation
Quantity
Security
Price
Counterparty

Trading Book

The trading book has only internal

implications.
The purpose of assigning a trade to a
specific book is to assign internal
responsibility and ownership for the
trade.
This results in

An update to the trading position within the

specific security
And an update to trading profits within the
trading book.

Incorrect application of a trading book

Trade Date

The trade date is the day that the two

parties agree to execute the trade.
It has internal as well as external
implications.
It has an impact on the following
aspects.
The date that a trading position is
updated.

If a trade is not recorded on the trade date

the trading position will remain incorrect
until it is recorded.

Trade Date (Cont)

Trading P&L Calculation

The P&L impact of a trade cannot be

calculated if the trade is not recorded.

Calculation of accrued interest

The trade date is connected to the value

date of the trade and the value date is used
in most markets to calculate the accrued
interest.
If the trade date is incorrect, it can affect
the value date which could affect the
accrued interest and consequently the Net
Settlement Value.

Trade Date (Cont)

Entitlement to income on equity

Is most markets entitlement to dividends is

related to the trade date.
If the trade date is incorrect the buyer or
the seller could lose his entitlement.

Trading systems typically assume that

the trade date is the same as the trade
input date.

Usually this poses no problems.

However precautions must be taken if there
is a `late booking, that is the trade is being
recorded a day late or there is an `as-of

Trade Time

In many markets regulators

require the STO to record the exact
hour and minute that the trade
was executed.
This enables:

Monitoring the STOs activities to

ensure that the trades have been
executed at the `best execution
price. This has implications for the
protection of the investor.

Trade Time (Cont)

It enables the settling of disputes between

counterparties regarding the basic details of
the trade such as quantity differences.
It enables market surveillance on the part of
the regulator to identify abnormal trading
activity.

Regulators also insist that all telephone

conversations made by traders are
taped.
When a dispute arises the trade time is
used to quickly identify and retrieve the

Trade Time (Cont)

In some cases, the trade time is used as

a measure for trade reporting.
In the Eurobond market, the regulator
requires that all trades executed by UK
based members of the Eurobond
industry body The International
Securities Market Association (ISMA)
report details of their trade to ISMA via
their system TRAX within 30 minutes of
trade execution.

Fines are imposed on members who fail to

meet the deadline.

Value Date

The value date is the intended

date of securities for cash.

This is known as the contractual

settlement date.
Note that the actual settlement date
could be different because of
settlement failure.

The period between the Trade

Date and the Value Date is known
as the Settlement Cycle.

Value Date (Cont)

The longer the settlement cycle

the greater is the possibility of one
of the parties defaulting.

For instance if a buyer is not required

to pay for many days following the
trade he may be tempted to default
should the market price of the
security fall sharply before the value
date.

Operation

The term operation refers to the

direction of the trade

Is the STO a buyer or a seller

Or in the case of a securities lending
or borrowing transaction, is the STO a
lender or a borrower.

Quantity

The quantity refers to the number

of shares or bonds that have been
bought or sold.
Standard tradable quantities may
apply to both shares and bonds.

Shares are often traded in Round Lots

or Board Lots.
Bond are traded in multiples of the
minimum denominational values.

Quantity (Cont)

The quantity will require inputting

by the trader.
But the trading system should
verify its validity by reference to
static data.

Security

When a trade is being executed we

must know precisely which
security is being traded.
In the case of equities confusion
can arise in cases where an
original security and a second
security with superficial similarity
are validly in existence at the
same time.

Security (Cont)

An example would be where new shares

have been created in addition to the
original shares.
The two may need to be identified
separately in a situation where the new
shares may not be equal in all respects
until a later point in time.

For instance the next dividend may be

payable only on the original shares and not
on the new shares.
Following the payment of the dividend the

Security (Cont)

In the case of bonds, some issuers

such as the World Bank may have
hundreds of bonds with details that
are extremely similar such as:

Issues with identical coupon and

maturity but with different currencies
of issue
Issues with identical coupon and
currency but with different maturity
dates
Issues with identical maturity and

Security (Cont)

At the time of trade execution the

two parties must be precisely
aware of the security that they are
dealing in.
To help avoid errors securities
identification code numbers such
as ISIN and CUSIP are assigned to
each security.
The security being traded should
have its details held within the

Security (Cont)

Trading systems normally display

only those securities which pertain
to the particular trading book.

The trader only needs to select the

correct security from the list.

If the details have not been set up

within the static data trade capture
will be held up at the beginning of
the TLC causing delays and
avoidable costs.

Price

Price is an essential component of

a trade

It is therefore important that the input

should be exact

Equity prices are typically

expressed as a cash amount per
share.
Bonds are normally traded at a
percentage of the face value.

Counterparty

Correct identification of the

counterparty is very important.
Confusion can arise if an STO
trades with a group of companies
consisting of trading entities in
different locations.
Being uncertain of the
counterparty and its location can
lead to

Delays in settlement processing

Counterparty (Cont)

When an STO trades with a mutual

fund manager it is common to find
that at the point of placing an
order and at the time of execution
the fund manager is yet to decide
to which of its underlying funds the
trade should be allocated.

It may take a number of hours for the

fund manager to respond with
allocation details.

Counterparty (Cont)

Under these conditions the STO

has executed a trade with a
counterparty knowing that the final
counterparty details will differ from
the counterparty known at trade
execution.
Normally the trade is recorded as
executed with the parent
counterparty, and later on, when
the allocation details are known,

Counterparty (Cont)

The counterparty with whom the

trade was executed should be held
within the static data repository.
The trader only needs to select the
correct counterparty inclusive of
location from the list.
If the data is not present at the
outset, trade capture will be held
up at the beginning of the TLC.

Front Office Trade

Reference

The trading system should perform

validation that all necessary
components of a trade are present
before assigning a trade reference
number to a trade.
Storage of the reference number
allows identification and inspection
of the details at any time after
trade capture.
This is vital if the trade is

Subsequent Action

Once the trade is captured within a

trading system the details should
be sent to the back office
immediately for operational
processing.
If the STO does not have a trading
system the details are recorded
manually on a `dealing slip.
This will be collected and delivered
to the middle office or the

Incorrect Capture

Incorrectly recorded trades may lead to:

Inaccurate trade confirmations being sent to

counterparties

This could lead to a loss of business

Inaccurate settlement instructions being

sent to the custodian

This could lead to unmatched instructions with

the counterparty and require a subsequent
amendment.
Or if the instructions nevertheless match and the
trade settles it could lead to a monetary loss.

Sometimes the STO may never even come to know

that there was an error.

Trade Capture within the

Settlement System

In an automated environment, where

the trade has been sent by the trading
system to the back office system
electronically, it is to be expected that
the trade will arrive successfully in the
receiving system.

However it is possible that the trade fails to

arrive in the back office system.
It is therefore recommended that a tradeby-trade reconciliation is conducted to
ensure that the trades sent by the trading
system have in fact been received
successfully by the back office within an

Trade Capture(Cont)

As soon as the back office system receives a

trade validation needs to be performed to
confirm that static data items like

Trading book
Security
Counterparty

are known.
If a check reveals a problem eg.
Counterparty not known the problem should
be highlighted and treated as an exception
requiring corrective action.
This will have the impact of temporarily halting
operational processing.

Trade Capture (Cont)

Once the trade details have been

checked for validity, a settlement
system trade reference number
will be assigned.

This is in addition to the trading

system trade reference number.

The trade has now been accepted

into the settlement system and is
now ready for Enrichment.

Trade Enrichment

Following trade capture within the

settlement system the details of a
trade require enrichment.
What is enrichment?

It involves the selection, calculation,

and attachment to a trade of relevant
information necessary to complete
further essential actions.

Trade Enrichment (Cont)

In an automated environment,
trade enrichment is achieved
through defaulting relevant
information automatically from the
store of information held within
static data.

This is known as Static Data

Defaulting.

Trade Enrichment (Cont)

Steps involved:

The basic trade details are captured

within the settlement system
The basic trade details are compared
with the information held within the
static data repository, and if the
necessary information is present in
the repository, the default information
is selected.
The selected defaults are attached to
the basic trade detail to form the

Trade Enrichment
Components

In general, the trade components

requiring enrichment are:

Calculation of cash values

Counterparty trade confirmation
requirements
Selection of custodian details
Method of transmission of settlement
instructions
Determining the method of
transaction reporting (for regulatory

Trade Enrichment
Components (Cont)

The components pertaining to one

transaction type may be only
partially similar to the components
pertaining to another transaction
type.
We will list the trade enrichment
components of each transaction
type.

Principal Transaction

Required

Cash value calculation

Securities depot details
Trade confirmation
Transaction reporting
Settlement instructions
Securities accounting
Cash accounting

Repo Transaction

Required

Cash value calculation

Securities depot details
Trade confirmation
Transaction reporting
Settlement instructions
Securities accounting
Cash accounting

Securities Lending and

Borrowing

Required

Cash value calculation

Securities depot details
Trade confirmation
Transaction reporting
Settlement instructions
Securities accounting
Cash accounting

Trading Book Transfer

Required

Cash value calculation

Securities accounting
Cash accounting

Not Required

Securities depot details

Trade confirmation
Transaction reporting
Settlement instructions

Depot (Custodian)
Transfer

Required

Securities depot details

Settlement instructions
Securities accounting

Not required

Cash value calculation

Trade confirmation
Transaction reporting
Cash accounting

Unsecured Borrowing and

Lending

Required

Cash value calculation

Trade confirmation
Settlement instructions
Cash accounting

Not required

Securities depot details

Transaction reporting
Securities accounting

Nostro Transfer

Required

Cash value calculation

Settlement instructions
Cash accounting

Not required

Securities depot details

Trade confirmation
Transaction reporting
Securities accounting

Foreign Exchange

Required

Cash value calculation

Trade confirmation
Settlement instructions
Cash accounting

Not required

Securities depot details

Transaction reporting
Securities accounting

Determining Factors in Trade

Enrichment

Before enrichment of individual

trades can occur, consideration
must be given to the choices that
an STO has for deriving the correct
information to attach to a trade.
We will consider issues pertaining
to each component in detail.

Calculation of cash values

In order to calculate all the cash

related components of a trade, it is
necessary to consider the
following.

Operation

That is

Buying or selling/Borrowing or lending

This has implications for cash value

calculations
For instance client purchases of UK equity
attract stamp duty, but sales do not.
Only sellers of US securities are required

Calculation(Cont)

Security group

Stamp duty is payable on Irish equities

but not on Japanese equities
Accrued interest is applicable to coupon
paying bonds but not to ZCBs.

Counterparty Type

Sales credits are normally calculated on

trades with institutional clients, but not
on trades with other STOs.
Sales credits may be calculated
differently for different types of
institutional clients.

Selection of Custodian
Details

The selection of the relevant custodian

details for both the trading company
and the counterparty will be affected by
the following issues.

Trading company

If an STO processes the business of more than

one trading company

Different custodians may be used by each of the

companies, even for the same security group.
The same custodian may be used by both trading
companies, distinguished by different account
numbers for each company at the custodian.

Selection(Cont)

Transaction Type

Security Group

Different transaction types will determine the

settlement location of a trade.
A principal trade will settle at a securities
custodian, whereas a foreign exchange trade is
likely to settle over a main bank account.
The custodian and the bank may not be the same
entity.
US equities will settle at the NEW York Custodian
New Zealand government bonds will settle at the
Wellington custodian.

Counterparty

Where there is a choice of settlement locations, a

counterparty may choose. Some counterparties
may select the settlement location on a trade-bytrade basis.

Counterparty Trade
Confirmation Requirements

An STO will normally issue a trade

confirmation to its institutional
clients, as a part of its service.
But it may not issue confirmations
to other STOs with which it trades.

Determining the method of

Transaction Reporting

The types of security in which an

STO trades may require that the
STO carries out its transaction
reporting via different methods.
For instance, a UK based STO may
be required to report UK equities
via one route, and its international
bond transactions via another
route.

Method of Transmission of
Settlement Instructions

The methods used to transmit

settlement instructions will depend
on the following.

Trading Company

Where an STO processes the business of

more than one trading company each
company may have a preferred but
different method of transmission.
For instance company A may choose to
transmit via telex while company B may
choose to transmit via SWIFT.

Transmission (Cont)

Custodian

Custodians typically have a preference

for the method of communication
between themselves and the STO.

Failure to Apply Static Data

Defaults

In an automated environment,
failure to fully enrich a trade may
be intentional or unintentional.

Intentional Failure

In a situation where the default of a

particular trade component is best
applied manually, the STO may choose
to set no automatic default of static
data.
For instance Italian Government bonds
can settle domestically in Milan or
internationally in Euroclear or
Clearstream.
An STO may choose to settle an
individual trade in or other location
depending upon the circumstances.

If no general rule can be applied then it is

Unintentional Failure

In an automated environment it is
not possible to default static data
automatically if such data is
missing for a particular
component.
For instance a specific
counterparty is set up within both
the trading system and the
settlement system, but no
custodian details are set up within

Enrichment of Counterparty
Custodian Details

An STO needs to calculate its

counterpartys custodian details in
addition to its own custodian details.
When a trade is executed by an STO, it
is necessary to determine where it
wishes to settle the trade.

This is particularly true if it trades in many

markets.

It must also determine how the

counterparty wishes to settle the trade

This information will be required on the

settlement instruction issued by the STO

Example

WSIL an STO has bought 5,000,000

News Corporation shares from PTIF.
WSIL first needs to assess how it wishes
to settle the trade from its own
perspective.

It needs to determine its appropriate

custodian based on the individual security
or security group.
In this case the equity is Australian.
So the decision is taken to settle at
Custodian A in Sydney.

Example (Cont)

A similar decision needs to be

taken by WSIL regarding where it
believes PTIF will settle the trade
according to the information
received from PTIF and held within
WSILs static data.

The custodian to be used by the

counterparty will appear on the
settlement instruction that will be
sent by WSIL to its custodian.

Example (Cont)

This is essential information.

Otherwise WSILs custodian will not

know with whom the trade is to settle.
Merely stating PTIF does not provide
the answer.
The information required to match
and settle the instruction sent by
WSIL is

The account number at the relevant

depository of the Australian custodian
being used by PTIF

Let us assume it is Custodian B in Melbourne.

Example (Cont)

Following trade execution between WSIL

and PTIF the trade would be

In the process WSIL would have

calculated

captured within the trading system

then captured within the settlement system
followed by trade enrichment within the
settlement system.

The custodian that it wishes to use

And PTIFs custodian

The sequence of steps taken would be

as follows.

Example (Cont)

WSIL issues a settlement

instruction to its custodian telling

Custodian A in Sydney to receive

5,000,000 News Corporation ordinary
shares, against payment of the
relevant cash amount
From Custodian B Melbourne whose
depository account number is
5532896.

Example (Cont)

PTIF issues a settlement instruction to

Custodian B asking it to deliver shares
against the relevant cash amount to
Custodian A

Whose account number at the depository is

5023598.

Custodian A should update its records

with the details of the instruction
received from WSIL
Custodian B should update its records
with the details of the instructions

Example (Cont)

Each custodian should aim to

achieve a match of their clients
settlement instructions with the
counterpartys custodian.

If the information does not match the

custodians have no authority to
change any aspect of the clients
settlement instruction.
They must however advise the client
about the status of the instruction.

Example (Cont)

If there is a mismatch WSIL would

need to investigate.
If its static data is accurate in all
respects
And if the trade is properly
enriched

The number of unmatched

instructions will be minimized.

However settlement instructions

may be unmatched for other

Trade Validation

Having executed, captured and

enriched a trade it is now complete
and further taskes such as

Issuing a trade confirmation

Reporting the trade to the regulatory
authorities
Issuing settlement instructions can
proceed.

Trade Validation (Cont)

However many STOs adopt a final

check of the data contained within
a fully enriched trade to reduce the
possibility of incorrect information
being sent to the outside world.
This is known as Trade Validation.

Fundamental Risks

The basic risks associated with trades

are that an STO may make a loss
This could happen directly

While buying

While selling

By paying more cash than the market value

By paying the correct amount but without
simultaneous receipt of securities
By receiving less cash than the market value
By delivering securities without simultaneous
receipt of cash

This could happen indirectly

By losing clients due to provision of slow

and inaccurate service.

Reasons

These risks can arise as a result of the

following issues

Trading error: The trader makes a mistake

at the time of execution

He trades at a price that is significantly different

from the market price
Or he agrees to settle on an FoP basis

Trade recording error

The trade has been captured with one or more

components that differ from those that were in
fact executed

Eg.: 10 MM shares were purchased but is has been

recorded as 1 MM.

Reasons (Cont)

Trade enrichment error

The calculation of trade cash values is

incorrect
For instance the number of days of
accrued interest on a bond is incorrect

Trade validation is a task that is

designed to detect such situations
on a trade by trade basis.

Basic Trade Validation

The trade components ought to be

viewed from the following
perspectives.
Trading book

May be restricted to specific

transaction types (eg. Principal only)
May be restricted to specific
instrument groups (eg. Japanese
securities)

Validation (Cont)

Trade Date

Should be `today for a new trade

Cannot be in the future
Should be today or in the recent past
for an amended trade
Should be a business day
Cannot be after the value date

Trade Time

Cannot be in the future

Validation (Cont)

Value Date

Is normally the standard settlement cycle

for the security group eg. T+3 for US
securities
May be shorter or longer than the standard
(if the trader has agreed at the time of
execution and has recorded that date)
Should be a business day in the location of
settlement
Cannot be earlier than the trade date
Cannot be earlier than the primary value
date of a new issue

Validation (Cont)

Operation

This typically cannot be validated

Settlement personnel have no means of knowing

whether the trader should be buying or selling;
borrowing or lending

Quantity

Cannot be less than the minimum

denomination of a bond
Must be in multiples of the minimum
denomination of a bond
Is normally in multiples of a round lot for
equities
May be an odd lot for equities

Validation (Cont)

Security

Cannot be a matured bond

Cannot be an expired warrant
Must be clearly distinguishable from other
securities

Price

Must be expressed according to the security

group

Share price must be an amount per share

Bond price must be either a percentage relevant
to face value or a yield

Validation (Cont)

Counterparty

Must be clearly distinguishable from others

Must include location

Trade cash value

Must be quantity x price plus or minus other

costs such as stamp duty
Accrued days must be relevant to last
coupon payment date and value date
Accrued interest must be relevant to
quantity, accrued days, and coupon rate

Validation (Cont)

Trade confirmation

Should be sent to institutional clients

Should not be sent to STOs if for
instance an electronic trade matching
system is in place

Companys and Counterpartys

Custodian

Must be relevant to the security group

Additional Trade Validation

In order to have the ultimate level of

control regarding the information that is
about to be sent to the outside world,
the following types of validation
measures are taken by some STOs in
addition to the basic trade validation
steps.
Any trade falling within or more of the
following categories should be treated
as an exception and held pending
validation.

Additional Validation
(Cont)

Trades due to settle on an FoP basis

Extreme caution needs to be taken when

settling on an FoP basis
All such trades should be held for validation

Trades with a cash value at or above a

certain figure

To give specific focus to all trades that are

deemed to be large, all trades with a net
settlement values of a given figure or
greater, or the currency equivalent of that
figure or greater, should be held for

Additional Validation
(Cont)

Trades in a Specific Transaction Type

All trades in a specific transaction type may

be required to be held for validation to
ensure correctness before transmission to
the outside world.

Trades with a specific counterparty

This is likely to be required for trades with

institutional clients

May be necessary because the client is new

Or could be because an existing client has
complained about the accuracy of information or
speed of service provided on past trades.

Additional Validation
(Cont)

Trades in a Specific Market or

Security Group

Where an STO is trading in particular

market for the first time it may

Wish to recheck that trade cash values

are accurate
That custodian details are correct for all
trades on securities within a group

This may prove necessary for a

limited period only until it is proved
that new trades are correct routinely.

Additional Validation
(Cont)

Trades Due to Settle at a Specific

Custodian

If an STO has recently changed

custodians at a financial centre it may
wish to verify all trades destined for
settlement at that custodian

Additional Validation
(Cont)

Trade Price Outside of market Price

As a precautionary measure an STO

may decide to validate all trades to
ensure that prices are reasonable.
Because price is a major factor in
deriving the Net Settlement Values,
there is a danger of an STO making
overpayment on purchases or
receiving underpayment on sales.

Additional Validation
(Cont)

If the current market price is accessible and

a tolerance is set against the current market
price (to allow for typical validity) then only
those trades falling outside the set
tolerance should be held for validation.
When such trades are identified
management may need to be informed. The
management should decide as to how tight
the tolerance should be.

Too tight a tolerance may mean that many trades

are being held for validation thereby preventing
STP
Too loose a tolerance may mean that incorrect

Additional Validation
(Cont)

Trades in a Specific Trading Book

The management may wish to

monitor the trading activity of a
particular trading book

Trades with trade dates in the past

Any new trade that has a trade date

in the past may be held for validation
to ensure that it is valid.

Additional Validation
(Cont)

Trades with value dates in the past

Any new trade with a value date in the past

should be held for validation for this is an
indication that something is seriously
wrong.
If settlement should have occurred in the
past this is highly likely to result in a cost to
the STO.

All amended trades

Some STOs may wish to monitor all

amended trades to ensure that trades
recorded with incorrect quantity or price

Additional Validation
(Cont)

All Cancelled Trades

The need for outright cancellation should be

minimum and an STO may wish to check
the detail before issuing information such as
canceling trade confirmations and canceling
settlement instructions to the outside world.

Validation provides the STO with a high

degree of control resulting in reduced
inaccuracies.
But there is a compromise between
sufficient control and STP.

Manual Trade Validation

Due to the number of trade

components manual validation is
likely to result in

A limited number of components

being validated so as not to adversely
affect meeting external deadlines
Occasional human error resulting in
the failure to identify a risk or an error

Manual Validation (Cont)

In order to identify problematic trades

manual validation needs to be
undertaken by the more knowledgeable
members of the middle or back office
using their `experienced eye to scan
the components of a trade and their
knowledge to sense whether or not a
trade is acceptable.
But a significant amount of manpower
would be required to validate all trades
to the fullest extent due to the sheer

Manual Validation (Cont)

In order to meet the combined

demands of

STP
Servicing clients accurately and
speedily
Issuing settlement instructions by the
necessary deadlines
Transaction reporting within required
deadlines

extensive validation is possible only

Automated Trade
Validation

The processing of trades can be highly

automated while achieving satisfactory
levels of STP and control over trades
requiring additional validation.
An STO could decide that all trades
should be handled on an STP basis
unless identified to be held for
validation.
Trades held for validation are referred
to as `exceptions and are therefore
subject to `exception handling.

Automated Validation
(Cont)

The trigger that causes trades to

be treated as exceptions is the
setting of rules within the
settlement system.
All or some of the rules studied
earlier could be set up within the
settlement system.
After each trade has been enriched
the system would compare the
trade details with the relevant

Automated Validation
(Cont)

If the trade passes the validation

check it would be allowed to
continue immediately and can be
regarded as having been
processed on an STP basis.
If the trade fails the validation
check it will be treated as an
exception and will be held for
validation.

Automated Validation
(Cont)

When a trade is held for validation

it is temporarily suspended and no
actions such as

Issuance of a trade confirmation

Or issuance of a settlement
instruction

should occur until the trade has

been released from its exception
state.

Flow

We will summarize the flow of trades

where handled on an STP basis and
where an exception is found.
The trade is captured, enriched and is
now subject to validation.
The details of the trade are compared
with preset validation rules.
If all rules are passed the trade will be
forwarded immediately for actioning of
other operational tasks such as

Trade agreement and

Transaction reporting

Flow (Cont)

If the trade fails the validation check it will be

held for validation and routed for exception
handling
The trade will be forwarded to the appropriate
authorizer depending on the reason for being
withheld
Having been investigated and found to be
correct the trade is authorized.
The trade within the exception handling
system is updated and released to the
settlement system
The trade is now forwarded for actioning of
operational tasks.
If the trade is found to require amendment or
cancellation further action may be required by

Flow (Cont)

Further automation may be

employed where resolution of an
exception has not occurred within
an acceptable timeframe.
The management of an STO may
decide for instance that unresolved
exceptions that are for example 45
minutes old should be escalated to
a more senior staff member.

Trade Agreement

Once a trade has passed validation a

number of tasks can commence.
The action that is regarded as most
urgent is the act of gaining agreement
of the trade details with the
counterparty.
Trade agreement can be achieved
through:

Issuance of outgoing trade confirmation to

the counterparty
Receipt of incoming trade confirmation from
the counterparty
Trade matching

Trade Agreement (Cont)

In a generic sense trade

agreement is achieved by the STO
communicating the details of each
trade to its counterparty
whereupon the counterparty
should check the detail and revert
to the STO if:

It recognizes the trade but the details

differ

Trade Agreement (Cont)

The communication needs to

contain all the basic trade details
as a minimum plus

The cash value calculations and

optionally
The settlement details including

STOs and the counterpartys custodian

details
Their account numbers
And whether the trade is to settle on a

Trade Agreement (Cont)

Matching of buyers and sellers

details is in many cases effected
through two routes

Trade Agreement: Agreement of trade

detail between the two parties
And additionally
Settlement Instruction Matching: The
custodians of the buyer and the seller
attempt to match settlement
instructions prior to delivery of

Trade Agreement (Cont)

These two exercises are similar in that

the trade details are matched prior to
the value date.
But the timing is usually different.

Trade agreement is necessary immediately

after trade execution to ensure that the
correct counterparty has been recorded by
the STO and that the details agree

This is from a risk mitigation perspective

Settlement instruction matching is typically

effected at any time between trade

Reducing the STOs Risk

For each executed trade the STO

remains at risk of its trading P&L
being incorrect if the trade and its
detail has not been agreed or
matched by the counterparty
within a reasonable timeframe.

The P&L remains subject to change

until it is proven that all trades have
been agreed by the counterparties.

Reducing Risk (Cont)

Because of the risk the objective is to

gain agreement of the trade detail as
soon as possible after trade execution.
To reiterate, the situation is as follows:

The trader has just executed a trade with

the counterparty
The trade has been recorded within the
trading system
The trade has been captured within the
settlement system
The trade has been validated internally

Reducing Risk (Cont)

But there is no guarantee that:

The counterparty with whom the

trade has been captured is the same
as the counterparty with whom the
trade was executed
The trade details

Quantity
Price
Net settlement value

Will be agreed to by the counterparty

Risk Reduction (Cont)

From an STOs perspective failing to

seek agreement of trades with its
counterparties soon after trade
execution will inevitably

Result in the identification or errors during

the settlement instruction matching process
Which in a T+3 cycle is unlikely to bring
errors to light until the day following the
trade date at the earliest.

The longer a trade remains unmatched

after execution the greater is the risk of

Risk Reduction (Cont)

Time is an important factor.

Assume that trader believes he sold 15
MM shares at a price of HKD 22.59 on
trade date 15 June for value date 18th
June.
On 17 June it becomes apparent
through the settlement instruction
matching process that the counterparty
believes it bought at HKD 22.55 and
investigation proves that the other
party is correct.

The trade will have to be amended to the

Risk Reduction (Cont)

Take a worse example

On 17 June the counterparty does not
recognize the trade at all.
If this results in the trade being
cancelled outright

The STO will have a positive position of

15MM shares
If the price were to have fallen in the
interim the trader would have failed to
realize a profitable opportunity.

Trade Agreement Methods

The method of agreement of trade

details between the parties to a trade
varies according to

Local regulations
Market practice
Type of counterparty

Generally agreement of trades executed

with other STOs is likely to be handled
differently from trades with institutional
clients .

Method-I

Issuance of outgoing trade

confirmations

It is highly likely that an STO will be

required to issue a trade confirmation
to its institutional clients particularly
where a trade affirmation facility is
not being used
It is likely that an STO will want to
issue a confirmation to other STOs
particularly where a trade matching

Method-II

Receipt of incoming confirmations

from counterparties

The STO may receive confirmations

from other STOs
It is unlikely to receive confirmations
from institutional clients

As such clients are the recipients of

service from the STO.

Method-III
Trade Matching

Trade matching is a term used for the

mandatory electronic matching of trade
details between STOs and other
members of stock exchanges/markets
such as agents for investors (excluding
institutional clients).
Both parties are required to input the
trade details to a central matching
facility.
The matching results are provided to
both parties.

Where trades have been executed

electronically the trade detail is usually

Method-IV
Trade Affirmation

This relates to the optional

electronic matching of trade
details between STOs and
institutional clients.
The trade details are input by the
STO to a trade affirmation facility
and the institutional client agrees
or disagrees.
Both parties must elect to

Outgoing Trade
Confirmations

Trade confirmations to Institutional

Clients

Where an STO has executed a trade with an

institutional client (for instance over the
telephone) the client is likely to require the
receipt of a confirmation within a mutually
agreed time frame such as 1-2 hours.

This timeframe is likely to shrink as settlement

cycles shrink.

The confirmation represents formal

confirmation of trade details which must be
received by the client within an agreed time

Outgoing Confirmations
(Cont)

Under some circumstances it may not

be possible for an STO to issue a
confirmation within the required
timeframe.
Institutional clients like fund managers
usually place an order to buy or sell a
specific quantity of a specific security
within a limited price.

Once the trade is executed the STOs

salesperson will report the details of the
execution to the fund manager informally,
usually via telephone.

Outgoing Confirmations
(Cont)

Following trade execution the fund

manager will allocate the total
trade to one or many of its
underlying funds.
In practice the fund manager will
usually not convey to the STO the
names of the underlying funds
until some time after trade
execution.

Outgoing Confirmations
(Cont)

For example an STO has sold USD

50MM World Bank 6.50% bonds
maturing 1st February 2018 to QRS
Fund Managers at a price of
98.625%.
QRS will require the total quantity
of bonds to be allocated to its
underlying funds as shown below.

Allocation
Fund Name

Quantity

Price

QRS Healthcare
Growth Fund
QRS Global
Bond Growth
Fund
QRS European
Income Fund
QRS Pacific
Income Fund
TOTAL

12,000,000.00

98.625

10,000,000.00

98.625

25,000,000.00

98.625

3,000,000.00

98.625

50,000,000.00

Outgoing Confirmations
(Cont)

The fund manager usually requires the

receipt of trade confirmations for each
of the underlying funds.

For ultimately it is the underlying funds that

have purchased or sold the securities and
not the parent.

The STO needs to decide whether to

record the trade with the parent.

It knows that this will have to be replaced

by one or many trades with the underlying
funds at some point later in the day.

Outgoing Confirmations
(Cont)

If the trade is recorded in the

name of the parent immediately
after execution, the STO would
have reflected the factual
situation.
If not the settlement system will
not reconcile with the trading
system the trading positions will
differ.

Outgoing Confirmations
(Cont)

Some STOs treat these situations as

follows.

The original trade is captured in the trading

system and fed to the settlement system.

Eg. Sold USD 50 MM of bonds to QRS Fund

Managers at a price of 98.625%

The original trade is captured within the

settlement system but is treated as a trade
with the parent, awaiting allocation to the
underlying funds.

The trade is simply held in the knowledge that

allocations will be advised by the fund manager at
the earliest.

No trade confirmation is usually issued to the

parent.

Outgoing Confirmations
(Cont)

The fund manager advises the STO of the

allocations.
The original trade is replaced by one or
more trades.

This may happen both in the trading as well as

the settlement system or only in the settlement
system.

From the settlement system formal trade

confirmations can now be generated and
transmitted to the fund manager at the
underlying fund level.

Outgoing Confirmations
(Cont)

In order to gain agreement of trade

details, the STO normally issues a trade
confirmation to other STOs with which it
has traded.

There could be exceptions if an electronic

trade matching system is being used.

Confirmations to institutional clients are

regarded as a part of the service.
But confirmations to other STOs are
used to confirm that the trade details
are correct as soon as possible after
trade execution.

Outgoing Confirmations
(Cont)

The issuing STO hopes that the

recipient STO will check the detail
upon receipt, and respond without
delay if its is found to be incorrect.

Content of a Confirmation

From the name of the issuing STO

To the name of the counterparty
Attention the relevant
person/department at the counterparty
Subject a heading that states the
purpose of the message, namely `Trade
Confirmation.
Our trade reference the STOs
settlement system trade reference

Content (Cont)

Trading capacity the capacity in which

the STO has traded (principal or agent)
Transaction type principal, repo,
FOREX etc.
Operation Buying/selling;
Lending/borrowing
Trade date date of trade execution
Trade time time of trade execution
Value date contractual settlement
date
Quantity quantity of shares, or
quantity of bonds with currency

Content (Cont)

Security the exact, unmistakable

description of the security
Security reference ISIN, CUSIP etc.
Price quoted according to type of
security (share or bond)
Principal quantity x price
Accrued days relevant number of days
of accrued interest
Accrued interest cash value of accrued
interest

Content (Cont)

NSV the cash value to be

paid/received
Our depot the STOs settlement
location of securities
Our Nostro The STOs settlement
location of cash
Your depot the counterpartys
settlement location of securities
Your NOSTRO the counterpartys
settlement location of cash

Content (Cont)

Settlement basis DVP or FOP

Exchange/market exchange or market
where a trade has been executed
Rules a statement that the trade is
subject to rules of the exchange/market
Signoff by the STO full name and
location of the STO
Transmission time a clear statement
of the date and time of transmission

No. of Copies

Some counterparties typically

institutional clients may require
the receipt of one or more copies
of a confirmation for each trade.
If multiple copies are required

The counterparty may require all

copies to be sent to the same
destination
Or to different destinations via
different transmission methods

No of Copies (Cont)

The different destinations may

include

The counterpartys head office

Its bank
Its accountant

To enable automation of this

service this information needs to
be held within the STOs static data

Incoming Confirmations

Some of the counterparties with whom

an STO trades may issue confirmations.

Usually this is the case if the counterparty is

another STO.
Institutional clients typically expect only to
receive confirmations.

After receiving an incoming

confirmation an STO needs to check
whether to expend resources checking
the details contained in the
confirmation with its own records.

Incoming Confirmations
(Cont)

To gain trade agreement and to

avoid risk, it is better to check the
confirmation on receipt.

This will highlight whether the STO

and the counterparty agree or
disagree.

Risks of failing to check

Decisions are sometimes taken not

to check incoming confirmations.

For trades where agreement will not

be achieved by another means this
could result in monetary loss for the
STO.

Example

A telex confirmation has been received

by an STO from a counterparty on the
afternoon of the trade date.

The trade is due to settle T+3

The STO decides not to check the incoming
confirmation.

However a discrepancy comes to light a

day prior to the value date.

Investigation reveals that the counterpartys

price or quantity was incorrect.

The counterparty has to consequently amend its

detail.

Example (Cont)

It look as if the STO has incurred no

cost.

It was the counterparty that recorded the

trade details erroneously.

But if the counterparty subsequently

realizes that a trade confirmation was
sent and that the receiving STO failed to
highlight the discrepancy

It may seek some form of compensation.

Trade Matching with STOs

Trade matching is a generic term used

to describe an electronic method of
comparing the trade detail of both seller
and buyer.
The process typically includes:

The transmission of trade details by both

parties to central trade matching facility by
a specified deadline
The application by the matching facility of
the current status matched or unmatched.

TRAX

ISMA based in Zurich is a self

regulatory organization and trade
association responsible for
regulating and enforcing rules
governing the orderly functioning
of the international securities
market.
During the 1980s ISMA was
primarily focused on the Eurobond

TRAX (Cont)

In the Eurobond market, prior to

1989, when an STO traded with
another STO, agreement was
attempted but not necessarily
achieved by the issuance of
confirmations, normally in the form
of telexes.

The situation was inefficient and full

of risk.

TRAX (Cont)

In 1989, ISMA introduced TRAX.

It is a real-time trade matching
mechanism covering all
internationally traded debt and
equity securities.

All ISMA members are required to

send a message to TRAX so as to be
received by TRAX within 30 minutes
of trade execution.

TRAX (Cont)

If a message is not received by TRAX

within a 30 minute deadline, a fine is
imposed on the STO.

The fine is on a sliding scale.

The later the message is received, the
larger is the fine.

ISMA also imposes fines for other noncompliance reasons such as

Failure to provide all necessary trade details

Failure to act on a no-matching advice
within a reasonable timeframe.

TRAX (Cont)

A TRAX message conveys the

details of the trade to a central
matching facility that compares
both sellers and buyers trade
details.
After comparison a real-time report
is generated that details the
current status of each trade.

TRAX (Cont)

However a TRAX message is not a

settlement instruction.

There is a need to issue a settlement

instruction to the relevant custodian
independently of the TRAX message.

The TRAX System

An STO executes a trade with a

counterparty both of whom must be
ISMA members or non-member users
of the system.
Both parties send their trade details to
TRAX
TRAX searches for a match and then
applies the status
The trade status is then made available
to both the parties.

The TRAX System (Cont)

The receipt of a status other than

`matched requires immediate
investigation by the STO, resulting in
one of the following actions.

The STO leaves its trade details intact and

the counterparty amends it details
The STO amends its trade details
The STO cancels the trade
The counterparty cancels or denies the
trade

The TRAX System (Cont)

TRAX will apply the following trade

statuses for messages sent by the STO
Matched the STOs and the
counterpartys details have been
compared and found to agree
Unmatched The STO has input its
trade details, but the counterparty has
not input matching trade details.
Denied Advisory The counterparty
does not recognize the trade and has
stated that is denies knowledge of the
trade

The TRAX System (Cont)

The following trade statuses will be

applied to messages not sent by the
STO.
Advisory Trade detail has been input
by the counterparty. The receiving STO
must either input trade details or else
state `denied.
Denied If the STO does not recognize
the advisory trade, it can state `denied.

Other Trade Matching

Services

In the US the National Securities

Clearing Corporation (NSCC) has a
trade comparison service.

Automation

In modern settlement systems the

following aspects of trade matching
messages can usually be automated

The decision to issue the message pre or

post trade validation
The decision whether to issue a message or
not according to the type of security Eurobond versus US T-bond
The decision whether to issue a message or
not depending upon the counterparty
ISMA members as opposed to non-ISMA
members.

Automation (Cont)

The following can also be automated

The transmission of the message to the

trade matching facility
The receipt of the message status from the
facility
The updating of the relevant trade record
(internally with the STOs books and
records) with the trade matching status
The highlighting of trades with a status
other than `matched.

Trade Affirmation with

Institutional Investors

Institutional investors are able to

have trades confirmed to them by
STOs and brokers electronically,
via Omgeos Oasys Global system.
The advantage is that an
institution based in Tokyo can have
its trades confirmed electronically
by an STO based in Toronto.

Trade Affirmation (Cont)

Unlike trade matching for STOs

which is typically regulated by an
exchange or local regulator, the
decision to subscribe to the Oasys
Global system has to be taken by
each institutional investor.

Trade Affirmation (Cont)

Strictly speaking there is a

difference between Trade Matching
and Trade Affirmation.

In trade matching, both parties input

details at the same time to a central
facility.
In trade affirmation, the STO inputs its
trade details to which the institutional
investor affirms or responds.

Trade Affirmation (Cont)

Institutions that choose to

subscribe to Oasys Global usually
encourage STOs to use the system
in order to ensure that as many
trades as possible are affirmed via
this route and to realize the full
vale of the subscription.

Illustration

Step-1: An STO executes a trade

with a fund manager.

At this point he knows only the name

of the fund manager and not the
names of the underlying funds.

Step-2: The basic trade detail for

the counterparty is input to Oasys
Global which forwards the detail to
the fund manager.

Illustration (Cont)

Step-3: The fund manager will check the

trade details with his own records and if
found correct the trade in Oasys Global
will be affirmed as correct and the
details of allocation to the underlying
funds will be input.
Step-4: The STO will replace the original
trade by trades with the underlying
funds.

Illustration (Cont)

Step-5: The individual trades are

input to Oasys Global including the
net settlement value for each
trade.
Step-6: The fund manager checks
the trade detail for each of the
funds, and if found correct each
trade in Oasys Global is affirmed
as `agreed.

Trade Affirmation (Cont)

The receipt of a trade status other than

agreed requires that the STO
investigate without delay.

The salesperson within the STO will have to

be informed.
If the record of the trade detail is found to
be incorrect the STOs books and records
will require amendment.

The revised input will have to be re-input to Oasys

Global.

Trade Affirmation (Cont)

The use of a system like Oasys

Global requires that the history of
each individual trade be recorded
in case of the need to investigate
past events.
Other trade affirmation services in
the U.S. include Omgeos
TradeMatch system.

Automation

The following aspects of trade

affirmation messages can normally
be automated.

The decision whether to issue the

message pre or post trade validation
The decision whether to issue a
message or not.

For example a message need be sent

only if the counterparty is an Oasys
Global subscriber.

Automation (Cont)

Furthermore, the following can also be

automated.

The transmission of the message via Oasys

Global.
The receipt of message statuses from Oasys
Global.
The updating of the relevant internal trade
record.
The highlighting of trades with a status
other than matched.

Transaction Reporting

Following the execution of a trade

the exchange/member is required
to report to the appropriate
regulator the details of each
transaction, within a pre-specified
timeframe after execution.
This is referred to as Supervision or
Surveillance.

Transaction Reporting
(Cont)

There are different methods for

reporting.

The chosen method depends on the

local regulator.

One way is for the computerized

exchange to forward the trade
details to the regulator on behalf of
the stock exchange member.

Transaction Reporting
(Cont)

Or a part of the message sent by a

member may be used for reporting
purposes.

For example if TRAX were to be used the

relevant information would be forwarded by
ISMA to the regulator.
Or else a settlement instruction sent to a
depository may be forwarded to the
regulator

Eg. CREST in the U.K.

Transaction Components

The usual trade information requiring

submission to the regulator is:

Capacity Principal or Agent

Trade date
Trade time
Vale date
Operation Buy or sell
Quantity
Security
Price
Counterparty

Transaction Reporting
(Cont)

Upon receipt, the regulator will

analyze the details and attempt to
identify unusual patterns of trading
which may have been caused by

Market manipulation
Insider trading
Errors on the part of the STO

Transaction Reporting
(Cont)

One objective of surveillance is to

identify trading activity that falls
outside the norm.
Another objective is to identify
breaches of trading rules.
Yet another objective is the
identification of insider trading.

Transaction Reporting

In some markets automation is used to

search for abnormal trading patterns.

On the NYSE a computer system named

StockWatch is used to identify abnormal
trading activity.
At the Australian Stock Exchange a system
called SOMA is set up with limits
representing normal market activity

This enables any reported transactions that fall

outside the limits to be identified automatically.

After Detection

When a regulator detects dubious

activity he will begin an
investigation

Typically all transactions executed by

the member in the specific security
will be examined.
The members books and records will
be examined.
Key personnel may be interviewed.

After Detection (Cont)

The issuing company may be

contacted to establish whether any
company notices are due for
publication.

If so, it is possible that insider trading

may have occurred.

If suspicious trading practices are

uncovered disciplinary action can
be taken this is termed as

After Detection (Cont)

Punishment can be severe

including prison sentences for
insider trading.
Members may be expelled; their
license to trade may be
suspended.
Investors who have suffered
financial losses may be eligible for
compensation.

Settlement Instructions

Settlement instruction is a generic term

used to describe the mechanism by
which trade settlement is initiated
between the seller and the buyer.
The instructions are normally generated
and transmitted from the STOs
settlement system to the appropriate
custodian from the list of the STOs
custodians depending on the security
that has been traded.

Settlement Instructions
(Cont)

Upon receipt of the instruction the

custodian will attempt to match
the detail with the custodian of the
counterparty and apply a status
Matched or Unmatched.
On the value date he will then
attempt to exchange securities
and cash with the counterpartys
custodian.

Risks associated with

settlement instructions

In a manual system the generation of

settlement instructions should be
restricted to a select group.
In an automated environment trade
capture within the STOs trading system
should be restricted to authorized
traders.
If trade validation is through settlement
instructions should be allowed to flow
through in order to achieve STP unless
certain conditions are applicable.

Risks (Cont)

As far as possible the STO should

avoid settling on an FoP basis.
That is, the trades as far as
possible, should settle on a DvP
basis.
FoP settlement may be with or
without risk to the STO.

FoP with Risk

The STO delivers securities prior to

the receipt of cash from the
counterparty.
Or the STO pays the NSV prior to
the receipt of securities from the
counterparty.

FoP without Risk

The STO delivers the securities

only after confirmation of receipt
of cash from the counterparty.
Or the STO pays the NSV only after
confirmation of receipt of
securities from the counterparty.

Risks (Cont)

No back office should take

unilateral decisions that puts the
company at risk.

These decisions are best left to those

with the appropriate level of
authority.

When the back office is advised by

a trader or a salesperson to take
risk, the operations areas of some
STOs insist on written
authorization from the head of

Risks (Cont)

STOs must minimize the possibility of

the transmission channel between itself
and the custodians being accessed by
those who may seek to attempt fraud.
An STO is likely to select a particular
custodian if it feels that the custodians
settlement instruction transmission
system is sufficiently secure where
high levels of encryption are used to
prevent outsiders from deciphering the
coded message.

Risks (Cont)

An instruction that has been issued

but not received by the custodian
is no different from an instruction
that has not been transmitted.

There is a risk of financial loss in such

cases because settlement typically
cannot occur until settlement
instructions are matched with the
counterpartys custodian.

Risks (Cont)

To minimize risk STOs typically

require the relevant custodian to
acknowledge receipt of the
instruction.
In an automated system
instructions issued can be
compared against
acknowledgements received.

If an acknowledgement is missing, it

Risks (Cont)

STOs trade and settle on a global

basis

They will consequently have

custodians in many different time
zones.
Each custodian will impose a
deadline, which will be relevant to the
value date of the trade.
Thus the STO must remain aware of
the appropriate deadlines pertaining
to each custodian.

Settlement Instruction
Types

Settlement of trades occurs in one

of two ways

DvP
Or FoP

DvP

DvP is the simultaneous and

irreversible exchange of securities
and cash
Where DvP is the mode of
settlement

It is normal to issue a single

instruction to the relevant custodian
requesting

Delivery of securities versus payment

Or receipt of securities versus payment

FoP

FoP refers to the non-simultaneous

exchange of securities and cash.
For FoP settlement it is normal for
two settlement instructions to be
generated.

FoP When the STO is

Buying

A settlement instruction needs to be

issued to the STOs custodian to receive
the securities against nil cash value
A separate instruction needs to be
issued to the STOs bank (Nostro) to
make payment.
The second instruction would depend on
whether settlement is to occur with or
without risk.

FoP Without Risk

The instruction will be submitted to

the bank only after receiving
confirmation of receipt of
securities by the custodian.

This is known as `Upon Receipt

FoP With Risk

In this case the instruction will

need to be transmitted in time for
cash to be paid to the counterparty
on the value date, irrespective of
the receipt of securities.

FoP When the STO is

Selling without Risk

In this case a settlement

instruction needs to be issued to
the custodian to deliver the
securities against nil cash value.
If the STO is not to be at risk, this
instruction will be transmitted only
after having received confirmation
of receipt of cash by the Nostro.

FoP- When the STO is

Selling with Risk

In this case the custodian has to be

instructed in time for the securities
to be delivered to the counterparty
on the value date, irrespective of
the receipt of cash.

Pre-Advice

Irrespective of whether the STO is

selling with or without risk, a c ash
pre-advice may need to be issued
to the bank advising it to expect to
receive payment.

Content of Settlement
Instructions

A settlement instruction tells the

custodian to carry out precise
commands such as:

To whom securities have to be

delivered
From whom payment is to be
received
Or
From whom securities have to be
received
To whom payment has to be made

Content(Cont)

The quantity of securities to be

received or delivered
The net settlement value to be paid
or received
The earliest date that the instructions
are to be carried out.

Typical Instruction

From: name of the issuing STO

To: name of the STOs custodian
Depot Account Number
Nostro Account Number
Trade Reference: the STOs
settlement system trade reference
number
Deliver/Receive

Typical Instruction
(Cont)

Settlement Basis: DvP or FoP

Value Date
Quantity
Security Reference: ISIN; CUSIP etc.
Settlement Currency
Net Settlement Value
Counterparty Depot
Counterparty Nostro
Transmission Time: A clear statement of the date and
time of transmission

Other Components

Trade components such as:

Trade date
Price
Accrued days
Are also usually included in a settlement
instruction.
In the event of the instruction being
unmatched this allows the custodian to
communicate with the counterpartys
custodian to identify the discrepancy.

Methods of Transmission

Modern methods of transmitting

settlement instructions include the
following characteristics.

The automatic generation of settlement

instructions by settlement systems
The automatic transmission of instructions
individually or in batches
Electronic exchange of test keys
Settlement instructions in standardized
formats

Methods(Cont)

Secure transmission environment due

to high levels of message encryption
High speed of transmission
Predictable cost of transmission
Enables STP

Methods(Cont)

A widely used electronic

settlement instruction mechanism
is SWIFT.
In order to utilize the SWIFT
network both the STO transmitting
the settlement instruction and the
destination custodian must
subscribe to SWIFT.

Methods(Cont)

For transmission of settlement

instructions to International Central
Securities Depositories such as
Euroclear and Clearstream there is a
choice of:

SWIFT
EUCLID for Euroclear
CEDCOM for Clearstream
Tested Telex
Mail

Format

Cedcom, Euclid, and SWIFT

transmission systems all have
standardized messages
incorporating mandatory fields
that are required to be used
according to the action required of
the custodian by the STO.

Format (Cont)

SWIFT has numerous categories of

settlement instructions and
messages for different purposes

Some relate to securities

Others relate only to cash movements

Format (Cont)

Series 2: cash related

MT200: transfer between two

accounts of the same account holder
MT202: payment of cash to a financial
institution
MT210: receipt of cash from a
financial institution

Format (Cont)

Series 5: Securities Related

MT540: sent to a
FoP
MT541: sent to a
versus payment
MT542: sent to a
FoP
MT543: sent to a
versus payment

custodian to receive
custodian to receive
custodian to deliver
custodian to deliver

Format (Cont)

EUCLID

It uses a numbering convention that

distinguishes between settlement
with another Euroclear participant as
opposed to settlement with a
Clearstream participant.

Format (Cont)

Euclid settlement instructions

E01: Receive free or versus payment

from a Euroclear participant
E02: Deliver free or versus payment
to a Euroclear participant
E03C: Receive free or versus payment
from a Clearstream participant
E07C: Deliver free or versus payment
to a Clearstream participant

Format (Cont)

CEDCOM

Clearstreams proprietary system

CEDCOM has a settlement instruction
numbering method that does not
distinguish the system the
counterparty is using.

Format (Cont)

Example of CEDCOM instructions

41: Receive versus payment from a

Clearstream oe Euroclear participant
41F: Receive free of payment from a
Clearstream or Euroclear participant
51: Deliver versus payment to a
Clearstream or Euroclear participant
51F: Deliver free of payment to a
Clearstream or Euroclear participant

Format (Cont)

CREST

Is the system over which UK and Irish

settlements are effected

Codes used by CREST

ADVN: Delivery Input

ASDN: Stock deposit input
ASWN: Stock withdrawal input

Deadlines

All custodians will quote a deadline

by which settlement instructions
must be received by them relevant
to the value date.

The method of transmission is also

likely to affect the deadline imposed
by the custodian.

Deadlines (Cont)

Assume that the settlement

processing occurs in Bangkok
during daylight hours of the value
date.

A custodian in Bangkok may impose a

deadline of say 8 a.m. Bangkok time
on the value date

Provided the instruction in transmitted in

an electronic form.
This normally allows for matching of
instructions with the counterpartys
custodian.

Deadlines (Cont)

If a NYC based dealer buys shares

in a Thai equity for settlement on a
T+3 basis

He must issue the instructions by

close of business on T+2 (EST) in
order to meet the deadline imposed
by the Bangkok custodian

This is to take into account the time

difference between the two cities.

Deadlines (Cont)

Euroclear and Clearstream begin

to operate their overnight
settlement processing during the
evening of the day prior to the
value date.
The deadline for the receipt of
settlement instructions imposed by
Euroclear is 19:45 Central
European Time on the day prior to

Deadlines (Cont)

Deadlines exist so that the dealers

are aware of the time by which
instructions must be received in
order for the trade to settle on the
value date.
If instructions are received after
the deadline, the custodian may
still accept the instruction

However it cannot be processed on

the value date.

Deadlines (Cont)

From the standpoint of the ICSDs

deadlines for transmission via
SWIFT or via the proprietary
systems are identical because the
format is standardized and the
information can be automatically
captured into the custodians
system.

Deadlines (Cont)

However transmission via telex is

not in a standardized format and
requires the custodian to rekey the
information.

Thus a considerably earlier deadline

is imposed for instructions
transmitted by telex.

Deadlines (Cont)

Dealers effecting cross border

trading and settlement must be
conscious of the deadlines of each
custodian.

They would need to take extra care if

using a mixture of electronic and nonelectronic methods of transmission.

Deadlines (Cont)

It is recommended that settlement

instructions be generated and
transmitted as soon as possible
after trade validation on the trade
date.

This gives maximum time to resolve

any discrepancies prior to the value
date.

Deadlines (Cont)

Another reason not to delay

instructions is the possibility that a
software or communication fault
can occur before the deadline,
thereby preventing automatic
transmission.

Validation

As for trade validation, some

dealers wish to review and
authorize certain types of
settlement instructions prior to
transmission to the custodian.

This requires the setting up of

validation rules within the settlement
system.

Validation (Cont)

At the point of transmission the

system would compare the trade
detail with the relevant rules:

If the instruction passes the check it

is allowed to continue immediately,
and can be regarded as having been
processed on an STP basis.
If it fails, it will be held as an
exception, pending authorization by
the relevant staff.

Manually Generated
Instructions

Even in an automated
environment, it may be necessary
to generate settlement instructions
manually in certain cases.
For instance assume that a trader
has executed a trade but has failed
to record it within the trading
system.

Obviously there will be no record

within the settlement system either.

Manually (Cont)

On the value date the dealer finds that

the counterparty has input a settlement
instruction which is unmatched.
If investigation reveals that the trade
was in fact executed, the trader would
need to record it within the trading
system, and feed it to the settlement
system.

This would obviously need to the generation

and transmission of a settlement
instruction.

Manually(Cont)

But at times there may be

insufficient time to follow such a
process.
In such cases the only option is to
input the instruction manually
directly into the transmission
mechanism destined for the
custodian, so as not to incur the
settlement failure costs.

Manually(Cont)

In such a case if the trade has not

been recorded within the
settlement system, the trade
reference number will be unknown.
So a dummy trade reference
number will have to be applied to
the manual settlement instruction.

Manually (Cont)

In such a situation when the trade is

captured within the settlement system,
the automatically generated settlement
instruction would need to be suppressed
to avoid duplication.
When a custodian receives the manually
sent instruction, it will be subject to all
the normal settlement instruction
events.

Manually(Cont)

But there will be no connection

between the instruction and the
trade within the settlement
system.
Thus the trade record within the
settlement system will not be
updated automatically.

Safe Custody

Following the execution of a trade

dealers typically expect to settle
externally with counterparties.

This means issuing settlement

instructions to custodians.
They will undertake the exchange of
securities and cash with the
counterpartys custodian.

Safe Custody (Cont)

But what if the counterparty does

not have a custodian relationship
for external settlement to occur.
In such cases the dealer may offer
to hold the clients securities, and
possibly cash in safe custody.

Safe Custody (Cont)

This means that when the dealer sells

securities to the client, it retains control
but not ownership of the securities.
He will therefore issue a settlement
instruction to remove the securities
from its own account (in which its
securities are held) to a segregated
account at the custodian, in which the
securities owned by its safe custody
clients are kept.
The reverse flow must occur when the
dealer buys securities from a safe
custody client.

Safe Custody (Cont)

Both the main account and the

safe custody account are under the
direct control of the dealer.

By law in many countries a dealers

own securities and those held on
behalf of others must be segregated
and held in different accounts at the
custodian.

But there is no need to hold the accounts

at separate custodians.

Safe Custody (Cont)

In terms of settlement instructions

this can mean the need to
generate and transmit either a
single instruction or two
settlement instructions.
Consider the case of a sale by a
dealer to a safe custody client.

Safe Custody (Cont)

Whether one or two instructions

are required depends on the way
the custodian wishes to operate
movements between the two
accounts owned by the dealer.

The case of two

instructions

One for the removal of securities

from the dealers main account
and delivery to the safe custody
account
One for the receipt of securities
into the safe custody account from
the main account.

The case of a single

instruction

For the removal of the securities

from the main account and
delivery to the safe custody
account

This is known as `Own Account

Transfer.

Instructions under Power

of Attorney

Where trades have been executed

either on a computerized stock
exchange
Or via an electronic communications
network (ECN)

The entity over which the trade has been

executed issues the settlement instruction
on behalf of the dealer.
For this to occur, the dealer must give a
power of attorney to the entity.

Power of Attorney (Cont)

In such cases the dealer would

need to suppress the generation of
settlement instructions by its
settlement system, to avoid
duplication.

Power of Attorney (Cont)

When instructions are directly

issued to the custodian by another
entity, the dealer benefits

This is because instructions are

issued very shortly after trade
execution
And the expense of issuing an
instruction is avoided.
Besides the risk of issuing an
incorrect instruction is avoided.

Link Between a Trade and

its Settlement Instruction

Dealers typically wish to maintain a

history of settlement instruction events
for each individual trade such as:

Transmission to the custodian

Receipt by the custodian
Achieving a status of unmatched
Achieving a status of matched
Settlement failure
Settlement completion

Link(Cont)

To update the trades within the

settlement system automatically
with the information received from
the custodian, there is a need for a
link

Between the settlement instruction

reference and the trade residing
within the settlement system.

Link(Cont)

When the dealer has issued the

settlement instruction, the
settlement system trade reference
number is normally sent as a part
of the content of each settlement
instruction.

Link(Cont)

But if another entity such as an

ECN has issued a settlement
instruction under a power of
attorney

The settlement instruction reference

number may not be the same as the
settlement system trade reference
number.
However there is still a need to
update a trade with the current status
of the settlement instruction.

Link(Cont)

Maintaining a link between the

trade and its settlement instruction
enables the dealer to have a
complete picture of trades that
require no action, such as those
with:

Successful instruction receipt by the

custodian
Matched instructions
Instructions that have settled

Link(Cont)

As well as trades requiring

investigation and action such as
those with:

Unmatched instructions
Instructions that have failed to settle
on the value date

The Role of the Custodian

We have used the term custodian

as a generic term to describe those
organizations that effect
settlement on behalf of dealers.
In reality, a number of organization
types fall within this group.

Custodians (Cont)

Custodians provide services not

only to dealers, but also to

Individual investors
Institutional investors
And brokers

These entities will be described

generically as the custodians
account holders.

Custodians (Cont)

Why is a custodian required?

A custodian is appointed by an
account holder to take care of his
assets

Normally securities and cash

And to carry out his instructions to

Deliver or receive securities

And to pay or receive cash

Holding Securities and

Cash in Safe Custody

Following previous purchases of

securities by the account holder,
once settlement has occurred, the
custodian will hold the securities in
safe custody.
He will provide some or all of the
following services relating to the
holding of securities in safe
custody.

Safe Custody(Cont)

Keep the securities safe from the threat of

theft or loss
Provide daily statements of securities and
cash holdings
Provide current market valuations of
securities holdings
Provide securities lending or borrowing
facilities
Collect income or additional securities
relating to the account holders entitlement.
Advise of optional corporate actions.

Safe Custody(Cont)

Following purchases of securities

and upon settlement the custodian
will debit the cash account of the
account holder.
The custodian may or may not
allow the account holder to hold
cash balances on an overnight
basis.
In case he does, then he will
provide one or more of the

Safe Custody(Cont)

Keep the cash safe

Pay interest on cash balances
Provide daily statements of cash
balances

Movement of Securities
and Cash

When the account holder sells securities

held by the custodian or buys securities
that will be held by the custodian, he
will issue a settlement instruction to
effect the appropriate movement of
securities and cash.
He may also issue settlement
instructions relating to other
transactions like

Repos
Depot transfers

Movement(Cont)

When it comes to the movement of

securities and cash, the custodian will
provide some or all of the following
services.

Acknowledge receipt of the settlement

instruction
Apply the current pre-settlement status

Unmatched
Matched
Failed to settle

Transmit the current status of each

instruction to the account holder

Movement(Cont)

Effect the delivery or receipt of

securities and the receipt or payment
of cash
Upon settlement of each instruction

Apply the status of `settled

Update the account holders securities
holding
Update the account holders cash balance

Movement(Cont)

In addition an account holder may wish

to have cash paid away from its account
at the custodian to another bank
Or else have cash received by the
custodian from an external source
In such cases he will issue an instruction
to pay away or a `pre-advice to receive
cash.

Types of Custodians

Various terms are used to describe

those involved in the provision of
trade settlement and custodial
services on behalf of those who
execute trades.

Types of Custodians
(Cont)

These include:

Custodian
Global custodian
Local custodian
Sub-custodian
Central Securities Depository (CSD)
National Central Securities Depository
(NCSD)
International Central Securities Depository
(ICSD)
Settlement Agent

Custodian

An organization that holds

securities and usually cash on its
clients behalf
May effect settlement of trades on
its clients behalf

Global Custodian

Performs the role of a custodian

But has a network of local or subcustodians that hold securities and
cash and effect settlement on
behalf of it.

Local Custodian

A custodian that operates within a

specific financial centre

Sub-custodian

A custodian within a global

custodians network of custodians

CSD

An organization that holds

securities

Normally in book entry form

Usually the ultimate place of
settlement effected through bookentry transfer

NCSD

A CSD that handles domestic

securities of the country in which it
is located

ICSD

A CSD that handles domestic and

international securities
Only two organizations are
recognized as ICSDs

Clearstream in Luxembourg
Euroclear in Brussels

Settlement Agent

An organization that effects the

exchange of securities and cash on
behalf of its clients
Resultant securities and cash
balances may or may not be held

Example

A trade initiated by an institutional

investor resulted in the following
actions.

Institution placed an order with a broker

Broker forwarded the order to a dealer
Dealer executed the order and recorded the
details of the sale to the broker
Dealer sent an advice of execution to the
broker
Broker recorded a purchase from the dealer
and a sale to the institution
Broker sent an advice to the institution
Institution recorded a purchase from the
broker

Example (Cont)

Following the trade a settlement

instruction must be issued to effect
settlement ultimately at the CSD.
Each instruction will request the
recipient to either

Deliver securities and receive cash

from a specific account at the CSD
Or receive securities and pay cash to
a specific account at the CSD

Example (Cont)

The steps are as follows:

The institution issues a settlement

instruction to its global custodian
The global custodian will issue a
settlement instruction to its custodian
in the relevant financial centre.

Let us call it sub-custodian X

X will issue a settlement instruction to

its own account at the CSD.

Example (Cont)

For its sale to the institution the broker will

issue an instruction to its custodian

Let us call it local custodian Y

Local custodian Y will issue an instruction to

its own account at the CSD
For its purchase from the dealer the broker
issues a settlement instruction to custodian
Y
Local custodian Y will issue a settlement
instruction to its own account at the CSD
For its sale to the broker the dealer issues a
settlement instruction to the CSD

Example (Cont)

On the value date

The CSD removes the security from

the dealers account and adds them
to custodian Ys account
It will simultaneously debit cash from
custodian Ys account and credit the
dealers account.
This concludes settlement for the sale
by the dealer to the broker.

Example (Cont)

On the value date:

The CSD removes securities from the

agents account and adds them to
custodian Xs account
It will simultaneously debit cash from
custodian Xs account and credit the
agents account.
This accounts for the sale by the
agent to the institutional investor.

Example (Cont)

Net result of these transactions

Securities are held within custodian Xs

account at the CSD

Who is holding on behalf of the global custodian

Who is holding on behalf of the institutional
investor

There are no securities held in custodian Ys

account at the CSD on behalf of the agent
There are no securities at the dealers
account at the CSD

Example (Cont)

The cash has been debited to

custodian Xs account at the CSD

On behalf of the global custodian

The global custodian will debit the cash
cost to its account with the institution

There will be no cash held in

custodian Ys account at the CSD
The sale proceeds would have been
credited to the dealers account at
the CSD

Perspective

Who is a client and who is a

custodian?
It depends on the specific entitys
view

The institution regards the global

custodian as its custodian
The global custodian regards its client
as the institution and its custodian as
sub-custodian X
Custodian X regards its client as the
global custodian and its custodian as

Perspective (Cont)

The broker regards its custodian as

custodian Y
Custodian Y regards its client as the broker
and its custodian as the CSD
The dealer regards its custodian as the CSD
The CSD regards its account holders as

Custodian X
Custodian Y
And the Dealer

Perspective (Cont)

An institutional investor, broker or

dealer may choose to set up
arrangements for

Settlement of trades
And holding of securities and cash

With

A local custodian in each financial centre

CSDs in each financial centre
A global custodian
Or any combination of the three

Global Custodians

A global custodian is appointed to

facilitate trade settlement and the
holding of securities and cash

By use of its worldwide network of

sub-custodians

Each of which is usually a member of its

local CSD

Global Custodians (Cont)

The client issues settlement

instructions to a single destination
the global custodian

It will then direct its instructions to

the appropriate sub-custodian

Who will effect settlement on its behalf.

Global Custodians (Cont)

The exchange of securities and

cash occurs at the CSD

Where accounts of the sub-custodians

representing buyer and seller will be
debited or credited with securities
and cash.

Illustration
Global Custodian

Sub-custodian V

Australian CSD

Sub-custodian W

Sub-custodian X

Spanish CSD

Mexican CSD

NCSDs

An NCSD is typically set up and

operated on behalf of the
members of the national stock
exchange of a country
It is the core repository of
securities issued, traded and
settled in that country.

NCSDs (Cont)

Dealers and custodians located in

the same country as the NCSD are
likely to be direct members of the
NCSD.
Non-resident dealers may not be
allowed to have direct membership

They may be required to use a local

custodian

NCSDs (Cont)

NCSDs typically provide DvP and

FoP capability for their members
They keep securities in safekeeping for their members
But some NCSDs do not allow cash
to be held overnight

ICSDs

An ICSD holds both international and

domestic securities
Dealers, brokers, institutions and
custodians from round the globe can
become members.
Securities are held on behalf of the ICSD
by depository banks in numerous
financial centres

Correspondent banks manage the external

movement of currencies.

ICSDs (Cont)

They provide DvP and FoP trade

settlement capability on a multicurrency basis

Securities are held in safe custody

Cash balances are held overnight

Only two ICSDs exist

Clearstream in Luxembourg
Euroclear in Brussels

ICSDs (Cont)

Settlement at the ICSDs falls into three

categories

Internal

Bridge

Between two participants of the same ICSD

Between a participant of Euroclear and a
participant of Clearstream

External

Between participants of an ICSD and an NCSD

This is known as Cross Border Settlement

Custodian Selection

Dealers have a choice

They may set up relationships with CSDs or

local custodians in all markets in which they
are active
They may choose to have direct
relationships with CSDs or local custodians
only in the markets in which they are most
active

For less active markets they may use a global

custodian

They may use global custodians for all

markets

Custodian Selection
(Cont)

One major consideration is cost

In certain cases it may be cheaper to

set up relationships with CSDs or local
custodians
On the other hand a global custodian
may offer a premium service.

Custodian Selection
(Cont)

The following criteria are typically used

to select a custodian

Its credit rating

It signifies its status and financial stability

Past performance

STP rates
Ability to process equities
Ability to process debt securities
Proficiency of cash management

Interest rates on cash balances

Overdraft facilities

Methods of processing corporate actions

Custodian Selection
(Cont)

Cost of operating the service

Cost of securities holdings

Cost per settlement instruction

Ability to process multiple currencies

This is provided within the ICSDs

This is likely to be provided by the global
custodian
It is less likely to be provided by a local
custodian or an NCSD

Settlement Instruction
Statuses

An STO needs to know the various

statuses applied by the custodian
The frequency of updating the
instruction with statuses
Method of communication of the
status

Electronic or
Non-electronic

Statuses (Cont)

The minimum statuses that a dealer

would expect to receive are

Unmatched

Matched
Settlement failure

Including the reason

Including the reason

Settlement completion

Including information regarding the quantity of

securities delivered/received and cash
paid/received

Services Related to
Securities and Cash
Holdings

The following criteria relate to the

custodians holdings of securities and
cash on behalf of the dealer.

Securities lending and borrowing

Cash borrowing arrangements
Rates of interest on cash balances
Statements of securities holdings
Statements of cash balances
Corporate actions

Securities Lending and

Borrowing

Some custodians provide a service

whereby an account holders
securities can be lent to a
borrower

This service is likely to be offered

when a custodian has access to a
large pool of its account holders
securities.

Some account holders are willing to lend

securities for additional income.

Lending and Borrowing

(Cont)

When a dealer has sold securities that it

cannot deliver it may be willing to
borrow securities.

This will enable settlement to go through

But there will be an associated cost

The custodian typically acts as an agent

between lenders and borrowers

The fee collected from the borrower is

passed on to the lender after deduction of
the custodians fee

Cash Borrowing
Arrangements

Typically dealers need to borrow to

pay for the purchases of their
securities.
Some borrow in anticipation of
settlement occurring on the value
date

They have the cash paid into their

account at the custodian

Others borrow after settlement has

occurred at the custodian

Cash(Cont)

Generally a custodian will not allow

a dealer to incur a cash overdraft
unless the dealer has sufficient
cash or collateral against which
money can be borrowed.
The collateral acts as a safeguard
for the custodian.

Cash(Cont)

The dealer will have a credit line or

O/D limit

But the limit is usually usable only to

the extent that the dealer has
collateral

Interest on Cash Balances

Following settlement of trades a dealer

typically expects to be overdrawn at the
custodian unless it has already
borrowed from another source.
Occasionally a dealer may have a credit
balance if the value of sales is greater
than the value of purchases.
In either case the dealer needs to know
the rate of interest to be charged by or
received from the custodian.