Have you placed stock market orders? If yes, you must have noticed that the order takes two days to settle, even after it is executed. But why does the settlement take longer? How are execution and settlement different from each other? What happens in the two days between execution and settlement?
Do you have these questions, too? Think no further because this blog on the trade life cycle will answer all of them for you. Learn the stages that stocks go through between placing an order and its settlement.
What is the trade life cycle?
The trade life cycle is a process consisting of various steps, from placing an order to settling the trade, ensuring a seamless and convenient stock exchange between two traders.
Investment banks, brokerage firms, stock exchanges and other institutions involved in the trade have their functions divided into front office, middle office and back office, encompassing all the steps related to a trade’s execution and settlement.
Also read: Market cycles: Riding the rollercoaster of stocks
Trade life cycle stages
The trade life cycle in capital markets begins with traders deciding to buy or sell a stock. The first requirement is registering with a broker and opening demat and trading accounts.
Pre-trade requirements
Once the trader analyses the market and decides on the trading position, an order is placed using the trading account. The front office of the brokerage firm passes the order to the exchange. The exchange then conducts various checks and performs a risk assessment on the order to ensure it satisfies all the requirements of a valid order. Once cleared for safety and risk, the order becomes active on the exchange.
Trade execution
Once the order is active and open on the exchange platform, it looks for a counter order to match trades.
For example, if Trader A places an order to buy 100 stocks of ABC Ltd, the exchange looks for a seller who wants to sell 100 stocks of ABC Ltd. The two orders are then matched.
Execution of an order stops at two traders agreeing to the terms of the trade. It does not indicate the completion of the trade. The date on which the trades match/execute is called the trade date.
Most stocks follow a T+2 settlement, meaning the final settlement happens two days after the execution.
Also read: Take trading positions with low investments through synthetic trading.
Trade clearing
The next step is trade clearing. It is broken down into smaller steps, like trade capturing, trade enrichment, trade validation, trade confirmation and trade reporting.
Trade capturing and enrichment deal with recording all the relevant data with respect to a trade. It includes the name of the stock, quantity, price, currency, identifiers and more. Further, all the data recorded go through a trade validation. This process ensures that the data is enriched and all the risk is managed before the trade details are out to the public.
Trade confirmation involves the agreement of both parties involved in trade. The final step in the clearing stage is to report the trade through reporting mechanisms. This step is essential to ensure transparency and fairness across all trades.
Settlement
The settlement process is the most significant process of the trade life cycle as this is where the trade is completed. It usually happens two days after the trade date. This is where the actual exchange of stocks and money takes place.
Following the settlement, securities are debited from the seller’s demat account and credited to the buyer’s demat account. Similarly, cash is debited from the buyer’s account and credited to the seller’s account.
The two popular ways of settlement are:
- Delivery vs Payment (DvP) – This is a settlement method where the delivery happens only after receiving the payment. The seller transfers securities only after receiving money from the buyer.
Also read:The hidden power of DvP: Trading’s best-kept secret
- Free of Payment (FoP) – This is another settlement method where payment and delivery of securities happen at different times. The probability of counterparty default is higher here.
Reconciliation
The back office handles this process after the settlement of trades. Once the exchange of securities and cash is complete, the details of the trade are reconciled to reflect accurate balances in the company’s book of accounts.
Bottomline
Understanding the trade life cycle is crucial while entering stock market transactions. It helps traders learn how their stocks reach them once the order is placed. It is also helpful in analysing the various parties involved and their roles in executing a trade.
FAQs
The various stages involved in trading on Over-The-Counter (OTC) markets are called the OTC trade life cycle. It usually involves similar processes, though the entities responsible might differ since these trades settle outside the stock exchange.
RvP stands for Receive versus Payment. Conceptually, it is the same as Delivery versus Payment. However, RvP is from the seller’s perspective, while DvP is from the buyer’s point of view. RvP is where the delivery takes place only after the funds are received.
The front, middle and back office are all critical for a successful settlement of a trade. While the front office deals with receiving orders and matching them with counter orders, the middle office handles tasks related to trade validation, reporting and enrichment. The back office deals with settlement activities.
Trade enrichment is the process of updating the trade order with all the necessary details. While trade capturing records basic details, trade enrichment captures further details required for the order to move to the next stage. It includes legal data, identifiers and other important data about the security.
The settlement risk in trading is also called the delivery risk. It is where either of the parties defaults in fulfilling their obligation to settle a trade at the right time. Such instances most often occur in foreign exchange transactions.