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Version 1.1 Financial System, Financial Instruments & Financial Markets: A Guide Wipro BPO – Talent Transformation – Internal and Restricted 1
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Financial System, Financial Instruments & Financial
Markets: A Guide
This Guide belongs to: __________________________________
If found, please call me at (Ph. No.):_______________________
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Financial System
The following chart gives you an overview of the financial system:
(OLD)
(New)
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In finance, the financial system is the system that allows the transfer of money between savers and borrowers. It comprises a set of complex and closely interconnected financial institutions, markets, instruments, services, practices, and transactions.
Financial systems are crucial to the allocation of resources in a modern economy. They channel household savings to the corporate sector and allocate investment funds among firms; they allow inter temporal smoothing of consumption by households and expenditures by firms; and they enable households and firms to share risks. These functions are common to the financial systems of most developed economies.
Financial InstrumentsFinancial Assets can be of the following types:
Shares Equity shares Preference Shares
Debt/ Fixed Income Securities Capital Market Instruments Money Market Instruments
Mutual Funds Derivatives
Equity
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Equity shares or shares of common stock represent ownership in a business enterprise. When an investor subscribes to the issue of shares by a company he becomes a part owner of the business. Ownership of shares entitles an investor to dividends paid by the firm.
The rate of dividends is not fixed neither is it contractually guaranteed. That is, dividends can and do fluctuate from year to year. Secondly a company is under no obligation to declare dividends in a particular year. However, good companies try to keep dividends at steady levels to avoid sending wrong signals to the outside world.
A firm will however not pay out its entire profits for the year as dividends. A fraction of the profits for the year will be reinvested in the company. This is known as `Retained Earnings’.
If a firm is forced to declare bankruptcy, then the shareholders are entitled to the residual value if any of the business, after the claims of the other creditors are fully settled.
Equity shares never mature, in the sense that they have no expiry date. This is because when a firm is created, it comes into existence with the assumption that it will last forever. No one starts a company with the expectation that he will wind it up after a few years.
Shareholders are given voting rights. That is, they can vote on various issues at the Annual General Meetings of companies, including the election of the board of directors.
Not all shares carry voting rights, however. There are non-voting shares. These shareholders are not entitled to vote. This category is created to restrict corporate control to only certain groups of shareholders.
Preferred Shares
They are a hybrid of debt and equity. They are promised a fixed rate of return like debt holders and unlike equity holders.
But if the firm is unable to pay as promised then preferred shareholders cannot seek legal recourse unlike debt holders. However, till their overdue dividends are paid, the firm usually cannot pay dividends to equity holders. Such shares are therefore called cumulative preferred shares.
Dividends on preferred shares can be paid only after a company has made interest payments on its outstanding debt. In the event of liquidation, preferred shareholders get priority over equity shareholders.
Pre-Tax versus Post-Tax Payments
Equity and preferred dividends are paid out of post-tax profits. However interest paid by the company on debt can be deducted from the profits while computing its tax liability. This reduces the tax burden for the firm or in other words gives it a `tax shield’.
Debt Securities
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Debt instruments are financial claims issued by borrowers to the lenders of funds. The ownership of a debt security does not constitute part ownership of a business venture. It is merely an IOU.
Issuers of debt promise to pay interest at periodic intervals, and to repay the
principal at maturity. Long term debt securities (with a time to maturity of one year or more) issued by the government or by corporations, are called Bonds or Debentures.
A debenture in global financial jargon is a bond for which no assets of the firm have been specified as collateral. Thus debentures constitute unsecured debt. Firms also issue debt securities for which specific assets are designated as collateral are called Bonds.
In India, the terms are often used interchangeably. Thus both the terms; bonds as well as debentures, could refer to secured as well as unsecured debt.The Treasury Department issues long term bonds (with a time to maturity of 10-30 years) called Treasury Bonds or T-bonds. The Treasury also issues medium term debt (with maturities ranging from 1 to 10 years) called T-notes. These are otherwise similar to T-bonds.
Companies and governments also issue short term debt instruments (with a time to maturity at the time of issue of one year or less). T-bills are short term debt instruments issued by the Treasury Department and have a maturity of either 13, 26, or 52 weeks. Corporations issue Commercial Paper to meet their Working Capital requirements.
Terminology often differs across countries. T-notes in Australia, for instance, correspond to T-bills in the U.S.
Interest payments on debt securities are contractually guaranteed. That is, they are not a function of the profits made by a firm. In other words a firm is obligated to pay interest on its outstanding debt irrespective of whether or not it has made profits. Consequently all interest payments have to be made, before any payments can be made to equity.
Similarly in the event of bankruptcy, the claims of the bondholders have to be settled first. Consequently if a company defaults on a scheduled interest payment, or principal repayment, the bond holders can stake a claim on its assets. After liquidating the assets of the firm the claims of the bondholders will be settled. Only if something were to remain, would the equity shareholders be entitled to stake a claim.
Debt instruments can be `Negotiable’ or `Non-negotiable’
Negotiable instruments can be freely traded because they can be endorsed by one party to another. A Treasury Bond is an obvious example.
Non negotiable securities cannot be transferred. Examples include bank loans and bank time deposits.
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Govt Bonds & Notes:
A Government/Treasury bond is a bond issued by a national government denominated in the country's own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds.They generally have a maturity of 10 – 30 years.Treasury Notes have a maturity of 1 – 10 years.
Municipal Bonds:
A municipal bond is a bond issued by a city or other local government, or their agencies. Potential issuers of municipal bonds include cities, counties, redevelopment agencies, special-purpose districts and any other governmental entity (or group of governments) below the state level.
State Government Bonds:
A State Government bond is a bond issued by a state government, or their agencies.
Corporate Bonds:
It is a bond that a corporation issues to raise money in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date.
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If the bonds are unsecured (not collateralized) then it is generally called a Debenture.
Treasury Bills:
A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations of $1,000 up to a maximum purchase of $5 million and commonly have maturities of one month (four weeks), three months (13 weeks) or six months (26 weeks). These bills are issued through a competitive bidding process at a discount.
Repurchase Agreement (Repo):
Repo is a form of short-term borrowing for dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day.
Reverse Repurchase Agreement (Reverse Repo):
Purchase of securities with the agreement to sell them at a higher price at a future date.
Bankers' acceptances
A bankers' acceptance is also called as bill of exchange. It was invented to suit the needs of a party requiring temporary finance to facilitate the trading of specific goods. The party needing finance would approach investors for this temporary finance. The investors or lenders would then lend a certain amount to the borrower in exchange for a document called bill of exchange, stating that the debt would be paid back on a certain date in the short-term future. For this arrangement to be attractive to the lender, the amount paid back by the borrower (called the nominal amount) would have to be more than the amount advanced by the lender. The difference between the amount advanced and the amount paid back (the nominal amount) is known as the discount on the nominal amount. A bank would normally bring the two parties together.
The redemption of the loan would have to be guaranteed by a bank, called the acceptance by the bank making the arrangement. Hence it is called "bankers' acceptance".
The bearer of the document may, at the redemption date approach the bank that will pay the nominal amount to the holder. The bank will then claim the nominal amount from the borrower.
A bank acceptance can, in formal terms, can be described as an unconditional order in writing
Addressed and signed by a drawer (the lender)
To a bank which signs the document and becomes the acceptor
Promising to pay a certain amount of money at a fixed date in the future
To the bearer or holder (the borrower) of the document (the acceptance).
When a draft promises immediate payment to the holder of the draft, it is called a sight draft. Buyer does not need to sign the draft.
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When a draft promises a deferred payment to the holder of the draft, it is called a time draft. Buyer needs to sign the draft.
Negotiable Certificates of Deposit (NCD’s):A negotiable certificate of deposit is a certificate issued by a bank for a deposit made at the bank. This deposit attracts a fixed rate of interest, which is normally payable to the holder of the instrument together with the nominal amount invested, at redemption date. NCD’s are a bearer document, which means that the name of the owner (holder or depositor) does not appear on the document. The bearer or holder of the document will receive the maturity value at maturity date.
Certificate of Deposit (CD):
It is a savings certificate entitling the bearer to receive interest. A CD bears a maturity date, a specified fixed interest rate and can be issued in any denomination. CDs are generally issued by commercial banks.
Commercial Paper and other Discount Instruments
Commercial paper refers to short-term unsecured promissory notes normally issued by corporate companies with a high credit rating. These instruments are also issued on a discount basis such as BAs. Because they are unsecured, the risk involved will be higher than that of BAs, and therefore the issuing institution must be financially strong and sound. Because of the risk attached to these instruments they would normally be issued and traded at a higher discount than the prevailing BA rate.
Finance can be obtained by making use of various alternative kinds of discount instruments. Other discount instruments that have been used are secured promissory notes and asset backed commercial paper. The Central Bank also issue discount bills from time to time. It is thus clear that finance, using money market instruments, can be arranged between parties over the counter, as needs be. Standardised instruments as discussed above are more liquid and tradable.
ASSET CLASS
INSTRUMENT TYPE
Securities Other cash Exchange traded derivatives
OTC derivatives
Debt (Long Term)>1 year
Bonds LoansBond futuresOptions on bond futures
Interest rate swapsInterest rate caps and floorsInterest rate optionsExotic instruments
Debt (Short Term)<=1 year
Bills, e.g. T-BillsCommercial paper
DepositsCertificates of deposit
Short term interest rate futures
Forward rate agreements
Equity Stock N/AStock optionsEquity futures
Stock optionsExotic instruments
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Foreign Exchange
N/A Spot foreign exchange
Currency futures
Foreign exchange optionsOutright forwardsForeign exchange swapsCurrency swaps
Mutual funds
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors and invests typically in investment securities (stocks, bonds, short-term money market instruments, other mutual funds, other securities, and/or commodities such as precious metals).The mutual fund will have a fund manager that trades (buys and sells) the fund's investments in accordance with the fund's investment objective.
Derivatives
These are essentially contracts which are based on, or the demand for which is derived from, the demand for an underlying asset. The underlying assets could be stocks, bonds, physical assets, stock market indices, or foreign currencies.
There are four broad classes of derivative securities
Forward contracts Futures contracts Options contracts Swaps
Required Attributes for an Investor
When an investor invests or trades in a security, he is essentially concerned with the following issues:
What is the rate of return on the security? (The rate of return from a security is known as the Yield from the asset)
How risky is the rate of return? How liquid is the asset? What is the time pattern of returns?
Returns or Yields
In the case of equity shares, returns accrue in the form of:
Dividends And/or capital gains/losses
Dividends are paid out in the form of cash periodically. Capital gains/losses arise when an asset is sold.
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If the subsequent selling price of an asset is greater than the original cost of acquisition, the profit is termed a capital gain. However, if the subsequent selling price is less, it will give rise to a capital loss.
In the case of bonds, the investor gets returns by way of periodic interest payments known as coupon payments. In addition there can be capital gains/losses when the bond is sold.
Risk
The risk associated with investments in financial assets is that they may firstly not pay dividends or interest as anticipated. Secondly the level of capital appreciation may be less than expected, or worse there may be a capital loss. Finally a firm may go into bankruptcy, in which case a part or all of the investment would be lost.
Liquidity
Liquidity may be defined as follows:
It is the ability of market participants to transact quickly at prices that are close to the true or fair value of the asset. It refers to the ability of buyers and sellers to discover each other quickly and without having to induce a transaction by offering a large premium or discount.
In liquid markets there will always be plenty of potential buyers and sellers available. So traders will not be required to spend precious time and money in locating counterparties. If a market is liquid, large trades will not have a significant price impact. In the absence of liquidity, large purchase orders will send prices shooting up, while large sale orders will end up depressing prices substantially. Liquid markets in other words have a lot of depth. Securities which trade in illiquid markets are said to be thinly traded.
Time Pattern of Cash Flows
Cash flows from bonds, at least from those carrying fixed rates of interest, are fairly predictable. However, the dividends received from shares can be substantially volatile, depending on the financial performance of the company, and its dividend policy.
Rational Investors
A rational investor would prefer assets which give a high rate of return and are highly liquid. Everything else remaining the same, he would prefer an asset whose return is less risky.
However, all investors are not identical. A particular investor may be willing to take on a greater degree of risk as compared to another risk-averse investor. He would of course demand adequate compensation by way of higher expected returns.
The requirements in terms of time patterns of cash flows also differ across investors. Young people are more likely to prefer equities, for they may not require regular cash
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flows immediately, and may be content with the possibilities of substantial capital gains. Retired persons usually prefer to invest in bonds. For them, the key issue is the availability of predictable periodic cash flows from the asset.
Financial Markets
Capital Market: A capital market is a market for securities (debt or equity), where business
enterprises (companies) and governments can raise long-term funds. The capital market includes the stock market (equity securities) and the bond
market (debt).
It can be subdivided into Primary Market and Secondary Market.
Primary versus Secondary Markets
A primary market is one where the company offers new financial instruments to the investing public. Thus companies issue shares and bonds in the primary market. The very first issue of shares by a company is called an Initial Public Offering or IPO.
Once an asset has been bought by an investor from the company, subsequent transactions in the instrument take place in the secondary market. Primary markets therefore enable borrowers to raise funds. Secondary markets merely represent the transfer of ownership of an asset from one investor to another.
Illustration
TCS is issuing shares for the first time to the public at Rs 850 per share. Assume that Ravi applies for 1000 shares and is allotted 200 shares at a price of Rs 850.This is a primary market transaction.
Assume that six months later, Ravi sells these shares on the National Stock Exchange for Rs 1250 per share. This represents a secondary market transaction.
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Are Primary Markets Alone Sufficient?
In order to facilitate savings and investment in the economy we need both primary as well as secondary markets. What would be the consequences if we had only primary markets?
If we were to subscribe to a bond in such conditions, we would have no option but to hold it to maturity.
In the case of equity shares the problem would be even more serious. We and our heirs would have to hold on to the shares forever.
This will not be a satisfactory arrangement! In real life we like assets which can be easily liquidated or converted into cash. Since liquidity needs can never be perfectly anticipated, we need developed and active secondary markets, where assets can be bought and sold. Secondly nobody typically invests in a single asset. That is, everyone likes to hold a portfolio of assets.
This is because putting all your eggs in one basket is a very risky proposition. Consequently investors like to spread out or diversify their risk by investing in a basket of securities. Quite obviously, all the companies will not experience difficulties at the same time.
However, our risk propensity will not remain constant during our lifetimes. Young people are more risk taking, while old people are more risk averse. Consequently investors need the freedom to periodically adjust their portfolios over a period of time. Once again, secondary markets are critical.
Money Market:
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Instruments traded in the money market include Treasury bills, commercial paper, bankers' acceptances, certificates of deposit, federal funds, and short-lived mortgage- and asset-backed securities.
Money versus Capital Markets
1. Money market instruments have a time to maturity at the time of issue, of one year or less. Money market instruments by definition have to be debt instruments.
2. Capital markets are markets for medium to long term instruments. Capital market securities include both long and medium term debt as well as equities.
3. The functions of the two markets are fundamentally different Money markets are used to adjust temporary liquidity imbalances. In practice, for any company, inflows and outflows at any point in time will rarely match. Thus money markets help firms to borrow short term and also to deploy surplus funds on a short term basis.
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4. Money markets tend to be wholesale markets. That is, these instruments have high denomination. Consequently small investors usually do not participate in such markets. Small investors can however participate indirectly by investing in Money Market Mutual Funds (MMMF’s).These funds primarily invest in money market securities.
5. These securities carry relatively low default risk. The logic is simple. The odds of a firm getting into financial difficulties in the short run are definitely less than such an event occurring over a longer term horizon
6. Money markets tend to be very liquid. That is, the trading volumes are very high.
Capital markets serve a different economic purpose. They channel funds from those who wish to save to those who seek to make long term productive investments. Thus capital markets are where companies source funds for their long term investment needs.
Foreign Exchange
FOREX markets are characterized by the buying and selling of currencies. A currency is nothing but a financial commodity. Consequently each currency will have a price in terms of another currency. The price of one country’s currency in terms of that of another is known as the exchange rate.
Currencies are traded amongst a network of buyers and sellers linked by phone/fax. Traders do not come face to face on an organized exchange. Major participants are commercial banks and multinational corporations (MNC’s). Physical currency is rarely exchanged. All transfers are done electronically from one bank account to another.
Commodity Market:
A physical or virtual marketplace for buying, selling and trading raw or primary products is called Commodity Market. For investors' purposes there are currently about 50 major commodity markets worldwide that facilitate investment trade in nearly 100 primary commodities. Commodities are split into two types: hard and soft commodities. Hard commodities are typically natural resources that must be mined or extracted (gold, rubber, oil, etc.), whereas soft commodities are agricultural products or livestock (corn, wheat, coffee, sugar, soybeans, pork, etc.)
Financial Intermediaries /Market Participants
The structure of the financial intermediaries is depicted below:
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Why do we need intermediaries?
When an investor seeks to trade, the issue is essentially one of identifying a counter party. A potential buyer has to find a seller and vice versa. Not only should a counter party be available, there should be compatibility in terms of price expectations and quantities sought to be traded.
Price Compatibility
Every trader seeks to trade at a `good’ price. What is a good price?
Buyers are on the lookout for sellers who are willing to offer securities at a price which is less than or equal to what they are willing to pay.Sellers seek buyers willing to offer prices greater than or equal to what they expect.
Quantity Compatibility
The quantity being offered should match the quantity being demanded. Often a large sell order may require more than one buyer to take the opposite position before getting fully executed. The same is true for large buy orders.
Intermediaries are important because they:
Reduce transaction costs Help in achieving Economies of scale Helps in overcoming Asymmetry in information Helps to Overcome Moral hazards
Central Bank:
It is an autonomous or semi-autonomous organization entrusted by a government to; administer certain key monetary functions, such as to
issue, manage, and preserve value of the country's currency regulate the amount of money supply supervise the operations of commercial banks Serve as a banker's bank and the local lender of last resort.
Commercial Bank
Commercial banks comprise of public sector banks, foreign banks, and private sector banks and represent the most important financial intermediary in any financial system. These institutions have a wide geographical spread and deep penetration and strong deposit mobilizing ability. Bank credit is provided to all sectors of the economy and the rural sector is accorded priority. They play very important role in the money market and play a vital role in the call money market.
Investment / Developmental Financial Institutions
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The developmental financial institutions provide the long-term financial needs of corporations. These institutions have been responsive to the growing and varied long term capital needs of economy. Their wide range of activities may be divided into five broad categories, (i) direct financing, (ii) indirect financing, (iii) assistance financing, (iv) promotional work, and (v) miscellaneous activities. Examples of investment financial intermediaries are: UBS, Credit Suisse, Citi Bank etc.
In banking, a merchant bank is a traditional term for an Investment Bank. It can also be used to describe the private equity activities of banking.
Investment Bankers
They are people who specialize in helping companies bring issues to the primary market. They help issuers comply with legal and procedural requirements.
These include preparing a prospectus or offer document. Such a document gives full details about the issue and the potential risk factors for investors to take into account. They also provide advice on compliance with the listing requirements of the stock exchange where the shares are proposed to be listed for trading. Finally, they usually underwrite the issue.
Market Intermediaries
We will look at three types of market intermediaries:
Brokers Dealers
Brokers
Brokers are intermediaries who buy and sell securities on behalf of their clients. Their job is to arrange trades by helping their clients to locate suitable counter parties. They receive a processing fee or commission for performing this task. A broker does not finance the transaction. He merely enables others to execute their trades. However he has to have a license to carry on the above mentioned function.
There are various types of brokerage firms:
Full ServiceFull service brokerage firms offer clients professional research reports and advice on what/when to buy or sell other than their regular function of trading in securities on behalf of their clients.
They charge higher commissions and sometimes even the account maintenance fees to cover the cost of their services.e.g.: Merrill Lynch (now part of Bank of America), Morgan Stanley Smith Barney, and Wells Fargo Securities. (*Note: Many of these companies offer both full service and discount options based on your needs and personality.)
Discount Broker
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A broker who executes buy and sell orders at commission rates lower than a full service broker, but typically provides less services such as research and advice. They were originally order takers and charged commissions as much as 80% lower than their full service counterparts. Today however some of them do provide research inputs but these are taken from outside agencies like Bloomberg.e.g.: E-Trade, TD Ameritrade, and Scot trade
Prime BrokerA broker who acts as settlement agent, provides custody for assets, provides financing for leverage, and prepares daily account statements for its clients, who are money managers, hedge funds, market makers, arbitrageurs, specialists and other professional investors.The Prime Broker also operates many other activities such as:
Clearing and settlement of trades in global markets Support trade strategies through stock borrowing Hedge Fund consulting services Facilitate communication between sales, trading and research.
EG: UBS, Goldman Sachs, Morgan Stanley
Broker Dealer
Any individual or firm in the business of buying and selling securities for itself and others. Broker/dealers must register with the SEC. When acting as a broker, a broker/dealer executes orders on behalf of his/her client. When acting as a dealer, a broker/dealer executes trades for his/her firm's own account. Securities bought for the firm's own account may be sold to clients or other firms, or become a part of the firm's holdings.
Dealers
Dealers maintain an inventory of assets and stand ready to buy and sell at any point in time. Thus dealers unlike brokers have funds that are tied up in the asset. A dealer effectively takes over the trading problem of the client.
If a client is seeking to sell, the dealer will buy the asset from him in the hope of selling it later at a higher price. If a client is seeking to buy, the dealer will sell the asset in the hope of being able to replenish his inventory at a lower price. Dealers have to be expert traders. Some dealers may act in the capacity of a dealer as well as that of a broker. They are called Dual Traders.
Primary Dealers
Who is a primary dealer?
A pre-approved bank, broker/dealer or other financial institution that is able to make business deals with the Central Bank, such as underwriting new
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government debt. These dealers must meet certain liquidity and quality requirements These primary dealers purchase the majority of Treasuries at auction and then redistribute them to their clients, creating the initial market in the process.
A PD is a bank or securities broker-dealer that directly deals in U.S. government securities with the Federal Reserve Bank of New York. As of August 2004 there were 22 primary dealers, down from a number of 46 in 1988. The most important reason is consolidation. That is many firms have merged or refocused their core lines of business.
A firm wishing to become a primary dealer must notify the Central Bank of the country in writing. The Central Bank will then consult the applicant’s principal regulator to verify that the applicant complies with relevant capital standards. Applicants must either be commercial banks or broker-dealers registered with the SEC. They may be foreign owned.
The Central Bank requires primary dealers to participate meaningfully in both open market operations as well as Treasury Auctions. The current list of primary dealers is as follows:
List of Primary Dealers
1. Citigroup Global Markets2. Deutsche Bank Securities3. Goldman Sachs 4. HSBC Securities 5. Nomura Securities6. Barclays Capital7. J.P. Morgan Securities8. UBS Securities
Underwriting
What is underwriting?
An underwriter undertakes to buy that part of the issue which remains unsubscribed if the issue is under subscribed. Underwriting helps in two ways:
Firstly it reduces the risk for the issuer. Secondly it sends a positive signal to potential investors.
This is because, in the case of an underwritten issue, a potential investor knows that the banker is willing to take whatever portion of the issue is left unsubscribed. An investment banker may not however like to take on the entire risk. Sometimes a group of investment bankers may underwrite an issue. This is called Syndicated Underwriting.
Underwriters:
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As an underwriter, a person (or firm) bears the risk of selling the securities to the public and guarantees the proceeds from a sale, essentially taking ownership of the securities. If the underwriter can't sell the securities at the asking price, the underwriter may have to sell them for less than they paid or retain the securities themselves.
The Role of Intermediaries in Indirect Markets
1. Banks, mutual funds etc. have access to large pools of money. They also accept deposits ranging from a few dollars to a few million dollars. They can therefore easily subscribe to large denomination assets.
2. Secondly, they can also accept short term deposits and lend long term. This is because deposits keep getting rolled over, either due to renewals, or due to new clients.
3. Financial institutions also facilitate risk diversification. Diversification means ‘don’t put all your eggs in one basket’. It is costly for an individual investor to diversify across assets because of transactions costs. In practice, each time a security is bought or sold, the trader incurs transactions costs. Banks however indirectly diversify because every deposit is invested across a spectrum of projects.
4. Banks can also afford to employ professionals who can assess risk related issues.
5. Finally financial institutions are able to take advantage of `economies of scale’. That is, the fixed costs of their operations tend to get spread over a vast pool of transactions and assets. This leads to cost efficiency as compared to an individual borrower/lender.
Insurance Company:
The act of insuring, or assuring, against loss or damage by a contingent event; a contract whereby, for a stipulated consideration, called premium, one party undertakes to indemnify or guarantee another against loss by certain specified risks. Any organization which provides this service is known as an Insurance company.
Exchange:
Financial assets are usually traded on exchanges. What is an exchange?
It is a trading system where traders can interact to buy and sell securities. In order for a trader to trade he has to be a member of the exchange. Non members have to consequently route their orders through a member. For instance if you want to trade on the National Stock Exchange, you have to approach a registered broker or a sub-broker. He will then feed your order into the system.
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Historically trading on exchanges has taken place on trading rings or floors. This is called the Open-Outcry method of trading. The BSE used to have this system until it introduced online trading. Many older exchanges, for instance the NYSE, have a combination of floor based and electronic trading. These days most exchanges are essentially electronic communications networks. Consequently most traders no longer interact face to face.
Traditionally exchanges have been owned by the member brokers and dealers. Of late many exchanges are characterized by corporate ownership. Such exchanges are said to be Demutualized. For instance the NSE is owned by a number of institutions such as IDBI, LIC etc.
Examples of Demutualized Exchanges1. The NASDAQ2. The Stockholm Stock Exchange3. The Toronto Stock Exchange4. The Deutsche Borse5. The National Stock Exchange6. The Chicago Mercantile Exchange
Stock Exchanges
It’s a place where securities are bought and sold by the investors with or without the help of brokers or dealers. Investors can be individuals, institutional investors, funds etc. In the U.S. about 8,250 stocks are listed on the major exchanges. However, only a small fraction is actively traded. On the NYSE the 250 most active stocks accounted for 62% of the reported trading volume and an even larger percentage of the dollar volume in 2000.
When a corporation desires that its shares be admitted for trading, it has to first apply to have its shares listed.
All exchanges are governed by certain rules and regulations. Some of them are:Securities Exchange Commission (SEC) USA.Financial Conduct Authority (FCA) in London.Securities and Exchange Board of India (SEBI) in India.
EG: New York Stock Exchange (NYSE) USA American Stock Exchange (AMEX) USA National Association of Securities Dealers Automated Quotation system (NASDAQ)
USA
National Stock Exchange (NSE) India Bombay Stock Exchange (BSE) India
Deutsche Borse Europe FTSE 100 Europe
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International Stock Exchanges
Over the past two decades exchanges have mushroomed across the globe. This has happened due to the increasing acceptance of the free market economic mechanism which has manifested itself by the LPG process: Liberalization, Privatization, and Globalization. Not all emerging market exchanges have been success stories. Successful exchange development requires the following:
Strong property rights Strong contract laws and securities regulation laws Successful privatization programs Regulatory authorities with teeth
Major Global Exchanges
1. Deutsche Borse2. Euronext3. London4. Madrid5. Italy6. Stockholm7. Switzerland8. Australian9. Hong Kong10. Korea11. Osaka12. Taiwan13. Tokyo
Traders in the market can be divided into two categories. There are those who trade on their own account and those that arrange trades for others. Proprietary traders trade on their own account. Agency traders act on behalf of or as agents of others who wish to trade. They are also known as brokers, commission traders, or commission merchants (in futures markets).
Regulatory infrastructure
A regulatory mechanism is needed to regulate the working of the financial system. Its main function is to control compliance according to the regulations of the Central Bank, commercial banks, financial institutions, insurance companies, non banking financial institutions, exchange houses and official credit institutions. It is also responsible for their supervision. It also inspects and supervises issuers registered in the Public Stock Registry. It also supervises compliance with the dispositions applicable to the Pension Savings System and Public Pension System, and especially administrative institutions for Pension Funds, the Public Employee Pension Institute and the Social Security's Disability, Old Age and Death Program. The specific aims of financial regulators are usually:
1. To minimize financial loss of depositors in banks or policy holders of insurance companies
2. To enforce applicable laws3. To prosecute cases of market misconduct, such as insider trading4. To license providers of financial services
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5. To protect clients, and investigate complaints
Some of the important agencies, responsible for regulating the money and capital markets by country are:
1. Federal bank, USA2. U.S. Securities and Exchange Commission (SEC), USA3. Investment Dealers Association of Canada (IDA), Canada4. Financial Conduct Authority (FCA), UK5. Authorité des Marchés Financiers (AMF), France6. Financial Supervisory Authority, Sweden7. The Australian Prudential Regulation Authority (APRA), Australia
International Organization of Securities CommissionsThe International Organization of Securities Commissions (IOSCO) is an international organization that brings together the regulators of the world’s securities and futures markets. It, along with its sister organizations, the Basel Committee on Banking Supervision and the International Association of Insurance Supervisors, together make up the Joint Forum of international financial regulators. Currently, IOSCO members regulate more than 90 percent of the world's securities markets.IOSCO currently has 177 members.
Investor
Investor is an Individual or a company that regularly purchases and sells securities from stock exchanges for financial gains. They focus on increasing the market value of their investments or regular income through the receipt of dividends on shares, or coupons on bonds.
Buying and selling will happen between two parties:
Buyer - who purchase securities from the marketSeller – who sells securities in the market.
Counterparty refers to the party to whom we sell or the party from whom we buy securities
Types of investors:
1. Retail investors: Also called as individual or small investors buy/sell securities for their personal account and not for any company or organization usually in small quantities.
2. Institutional investors: Institutional investors are a non-bank person or an organization that trades securities in large quantities. Example: life Insurance companies, pension funds etc.
3. High Net-worth individual: A high net-worth individual is a person with large personal financial holdings. Their financial assets are worth more than $1 million excluding their primary residence.
4. Private equity investors: Private equity investors invest in securities that are not traded in stock exchanges. The securities are directly sold to companies as private offering.
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Agent
An agent is an individual or firm that places securities transactions for clients. Agent acts as an intermediary capacity for buying and selling securities on behalf of its client. An agent, besides providing trading services to their clients, may also operate as custodian of theirs client securities for which the client may be charged a fee.
STO
Securities Trading Organization (STO) is collective term used to describe a trader or market maker who sells or buys securities for agents, individuals and institutional investors.
Traders: Traders are professionals or individuals (employed by the STO) who buy and sell securities in a market place in order to generate profit for the STO.
May decide to trade only some securities and not all of them. Mat trade or may not trade according to the price at which a prospective
counterparty wishes to trade.
Market maker: Individuals who trade securities over-the-counter are called market makers. They are responsible for shareholders, clients and brokers with whom they enter into a contract.
Publicizes the price with which trade of specific securities will be done. The market maker chooses the securities to be traded.
Custodian
An agent, bank, trust company, or other organization which holds and safeguards an individual's or firms, securities, mutual funds, or investment company's assets for them.
Functions:- Holding of securities and cash in safe custody on behalf of the client.- Movement of securities and/or cash on behalf of the client.- Collection of income arising from the portfolios of the clients.- Notification and dealing with corporate actions.
Global Custodians typically operate as a network of sub custodians that hold securities and cash, settlement of trades and collection of corporate actions. They provide custody
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services for cross-border securities transactions. This is more important for institutional investors.
Local Custodian is one who runs a specific financial center/geographic location.
EG: JP Morgan Chase, Citibank
Clearing House
Clearing house is an external organization that helps in clearing of a trade by acting as a single point of contact for financial institutions. They act a central counterparty between buyer and seller. They guarantee a safe and secure transaction which reduces the risk of defaulting from both the parties. They may also provide settlement services. Clearing and Settlement process calculates the mutual obligation of the participants (buyer and seller) and makes payments, deliveries or both, in connection with transactions.
EG: NSCC- National Securities Clearing Corporation (US) LCHClearnet in London.
Depository
In simple words depository can be defined as a bank or company which holds funds or securities deposited by others, and where exchanges of these securities take place. A depository holds securities of investors in electronic form. The investors are members of this depository and they transfer the securities electronically.
EG: DTCC – Depository Trust Clearing Corporation Euroclear and Clearstream in Europe NSDL and CDSL in India.
INTERACTION BETWEEN MARKET PARTICIPANTS
The initial stages of trading are depicted in the following graphic:
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An investor places an order to an agent to buy securities. The agent forwards the order to an STO. STO executes the order by purchasing the stock from a stock exchange. STO then forwards the record of the sale to the agent. The agent records a purchase from the STO and confirms the sale to the investor. In fact
this step is known as confirmation. It is a step which is mandatory as per ISDA guidelines.
If the investor is an individual investor, instructions are issued to the clearing house to clear and settle the trade matched between the investors and the agent.
If the investor is an institutional investor, information is given to its custodian regarding the purchase of the securities.
The custodian then issues instructions to the clearing house to clear and settle the trade matched between its client (that is, the institutional investor) and agent.
Agent issues instructions to clearing house to clear and settle the trade matched between themselves and the investor.
STO issues instructions to clearing house to clear and settle the trade matched between themselves and the agent
Clearing house then authorizes the settlement of trade through the security depository. The custodian, agent and STO must be members of this security depository.
On the day of exchange the depository transfers the ownership of securities for cash from the STO’s account to agent’s account.
At the same time the depository transfers the ownership of securities for cash from agent’s account to the custodian’s account.
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Derivatives
In finance, a derivative is a financial instrument (or, more simply, an agreement between two parties) that has a value, based on the expected future price movements of the asset to which it is linked - called the underlying asset.
There are two groups of Derivative contracts:
Over-the-counter derivatives (OTC)Contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary
Exchange-traded derivative contracts (ETD )Instruments that are traded via specialized derivatives exchanges or other exchanges.
These are essentially contracts which are based on, or the demand for which is derived from, the demand for an underlying asset. The underlying assets could be stocks, bonds, physical assets, stock market indices, foreign currencies or exotic non tradeable (weather, temperature).
There are four broad classes of derivative securities
Forward contracts Futures contracts Options contracts Swaps
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Forward Contracts
These are agreements for the future delivery of an asset at the end of a pre-specified time period, based on a price that is fixed at the outset. Unlike a conventional transaction, no money changes hands when a forward contract is negotiated. The goods will be delivered and the money will be paid in return only at the end of a pre-specified period.
Example:
Assume that today is 1 November, 2003.
Consider a contract between a farmer Ajay, and a merchant Vijay, according to which Vijay agrees to buy 100 kg of rice from Ajay on 15 December 2003 at Rs 14 per kg.
This is an illustration of a forward contract.
Notice the following features:
The contract is negotiated individually between Ajay and Vijay. Such contracts are called OTC (Over-the-Counter) or customized contracts.
No money changes hand on 1 November. The actual transaction will take place only on 15 December. However, the terms, including the transaction price are set on 1 November. Both the parties have an obligation to perform.
o Ajay is obligated to deliver the rice on 15 December.o Vijay is obligated to accept the rice and pay the money on 15
December.
Futures Contracts
They are similar to forward contracts in the sense that they too are agreements for the future delivery of an asset at terms decided upon in advance. But forward contracts are customized or Over-The-Counter Contracts (OTC) which are negotiated individually between the buyer and the seller, whereas Futures contracts are traded on organized exchanges like stocks and bonds. These exchanges are called futures exchanges.
Notice the following features of Future contracts:1. Contracts are standardized.2. In equity market, futures can be stock future or index future.3. Initial margin money needs to be paid initially
Example:
A Cigarette company requires Tobacco 6 months down the line. The company can go to exchange and buy a Future contract on tobacco with 6 months maturity.
1. Initial margin needs to be paid to the cigarette company
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2. Agrees with exchange for Mark to Market (daily settlement)3. The daily cash flows between buyer and seller are equal to the change in
the future price.The Cigarette Company (buyer) will hold long position on tobacco.
Future Margins:
It can be cash or marketable securities deposited with the broker. It takes care of the adverse price movement in market.
Options Contracts
In Options contract the owner/buyer has the right but not the obligation to exercise a feature of contract (buy or sell asset) on or before expiry date. For this right buyer pays premium to the seller. The seller of an option has the duty to buy or sell at the strike price, if the buyer exercises his right. These are both exchange and OTC traded.
They can be of two types – Calls and Puts.
A call option gives the buyer the right to buy an underlying asset on or before a pre-specified date, at a price decided upon in advance.
A put option gives the buyer the right to sell an underlying asset on or before a pre-specified date, at a price decided upon in advance.
Notice the difference between an option and a forward/futures contract.
Call options give the holder the right to buy the underlying asset. Futures/forward contracts impose an obligation to buy the underlying asset,
on the buyer of the contract.
The difference between rights and obligations is that rights need be exercised only if such action is beneficial. If the holder of a call option decides to exercise his right to buy, the seller of the option has an obligation to deliver/sell the underlying asset. He does not have the right to refuse.
The same is true for put options. That is, if a put holder were to exercise his right, the seller of the put has an obligation to buy the asset. In life rights are never given free. So the buyer of both call and put options has to pay a price to acquire the option from the sellers. This is called the option price or premium.
If the right is subsequently exercised the call/put holder will pay/receive a price per unit of the underlying asset. This is called the Strike or Exercise Price.
Futures/forward contracts however impose equivalent obligations on both parties. Consequently neither party has to pay the other to enter into the agreement. Payments are required only when the underlying asset is delivered.
Example of a Put Option:
Ajay buys a put option from Vijay that gives him the right to sell 100 kg of rice to Vijay at Rs 14 per kg on 15 December. Vijay will not give this right for free.
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Let us assume that Ajay pays Rs 0.25 per kg or Rs 25 in all to acquire this right. This amount has to be paid at the outset and is called the Option Price or Premium.
Assume that the price of rice on 15 December is Rs 12 per kg. Ajay will most certainly exercise his option and ask Vijay to pay Rs 1400. This price of Rs 14 per kg is called the Strike Price or Exercise Price. Vijay cannot refuse since he has an obligation to perform.
What if the price on 15 December is Rs 16 per kg? Ajay will simply forget the option and sell the rice in the market for Rs 16 per kg. He is in a position to do so since an option is a right and not an obligation.
Assume that Vijay acquires the right to buy 100 kg of rice from Ajay on 15 December at an exercise price of Rs 14 per kg. Let us assume that the premium is Rs .40 per kg. Consequently Vijay will pay Rs 40 to Ajay at the outset.
Assume that the price of the asset on December 15 is Rs 16 per kg. Vijay will happily exercise his option and take delivery at the exercise price of Rs 14. Ajay cannot refuse since he has an obligation.
What if the price of rice on 15 December is Rs 12? Vijay will simply forget the option and buy from the market at Rs 12.
Swaps
These are contractual arrangements between two parties to exchange specified cash flows at pre-specified points in time. These are traded Over-The-Counter (OTC).
There are two categories:
Interest-Rate Swaps Currency Swaps.
Interest Rate Swaps
A principal amount called the Notional Principal will be specified in such cases. The principal amount never changes hands and consequently the name Notional Principal. Each party will calculate interest on this notional amount based on a pre-decided method.
For instance one party (Buyer) may be obliged to pay interest at a fixed rate of 10% with an aim to transform the variable rate of its liabilities into fixed rate liabilities to better match the fixed returns earned on its assets. The other (Seller) may be required to pay at the going interest rate on Treasury Bonds with an aim to transform the fixed nature of its liabilities to variable rate liabilities to better match the variable return on its assets. Both the cash flows will be denominated in the same currency. Consequently they can be netted and one party will pay the difference to the other. This is an example of a fixed rate-variable rate swap.
In practice one can also have a variable rate – variable rate swap.
Cross Currency Swaps
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An agreement between two parties to exchange interest payments and principal on loans denominated in two different currencies. In a cross currency swap, a loan's interest payments and principal in one currency would be exchanged for an equally valued loan and interest payments in a different currency. Consequently it is exchanged both at inception and at the end of the contract.
The reason companies use cross-currency swaps is to take advantage of comparative advantages. For example, if a U.S. company is looking to acquire some yen, and a Japanese company is looking to acquire U.S. dollars, these two companies could perform a swap. The Japanese company likely has better access to Japanese debt markets and could get more favorable terms on a yen loan than if the U.S. company went in directly to the Japanese debt market itself, and vice versa in the U.S. for the Japanese company.
One party will pay a fixed/variable rate in one currency while the other will pay a fixed/variable rate in the other. At the end the principal amounts will be swapped back. Since two different currencies are involved, we can have:
Fixed rate – Variable rate swaps: In a fixed-for-Variable cross currency swap, the interest rate on one leg is floating, and the interest rate on the other leg is fixed. Such swaps are usually used for a minor currency against USD.
Variable rate – Variable rate swaps: In a variable-for-variable cross currency swap, the interest rates on both legs are floating rates. Such swaps are also called cross currency basis swap. Variable-for-Variable swaps are commonly used for major currency pairs, such as EUR/USD and USD/JPY.
Fixed rate – Fixed rate swaps: In a fixed-for-fixed cross currency swap, the interest rate on one leg is fixed.
Use of Derivative products
Derivatives are used by investors to:
– provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative;
– speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level);
– hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out;
– obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives);
– Create option ability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a specific price level).
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Difference between Exchange traded derivatives and Over the counter.
Exchange Traded Derivatives (ETD) Over The Counter (OTC)1. Standardized products with smaller
notional Values2. Reach to various segments of
economy3. Safety of margins and settlement
guarantee funds4. Better price discovery mechanism 5. Generally higher transparency than
OTC markets6. Lower transaction costs7. Ignoring margins and special
situations like early exercise, the cash flows in exchange traded contracts generally arise at the maturity of contract.
1. Customized products2. Credit risk differentiation – high
rated counterparties get better pricing
3. Innovation – Newer and more exotic nature of products are easy to adopt.
4. Longer maturities are easy to transact
5. OTC contracts can have multiple cash flows which can be structured to suit any situation.
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Corporate Actions
A corporate action is an event which changes the structure of a company’s capital or when a company wants to distribute its profits.Corporate actions are events which bring material change to a company and affect its stakeholders.
A corporate action is an event initiated by a public company that affects the securities (equity or debt) issued by the company. The primary reasons for companies to declare corporate actions are:
Return profits to shareholders : When a company wants to distribute profits to its shareholders they declare Cash dividends, Bonus issue
Influence the share price: Corporate actions such as stock splits or reverse stock splits increase or decrease the number of outstanding shares to decrease or increase the stock price respectively.
Corporate Restructuring: Corporations re-structure in order to increase their profitability. Mergers, Spinoffs are an example of a corporate action where a company breaks itself up in order to focus on its core competencies.
Types of eventsThere are two types of events:
Mandatory
- A corporate event which is compulsory to all share holders
Voluntary
- A corporate event on which all shareholders have to make a decision
Mandatory with Choice Corporate Action
- This corporate action is a mandatory corporate action where shareholders are given a chance to choose among several options.
Mandatory Events
Cash Dividend – cash payment by a company to its shareholders
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Name change - e.g. Horizon Education & Technology Ltd to Global Voice
Exchange/merger – 2 or more companies elect to combine their assets or liabilities e.g. Poh Lian to Unifiber
Redemption – existing security must be surrendered for cash
Bonus issue – extra shares distribute by a company to its shareholders
Spin off - separation of a subsidiary /division from its parent company. New shares & entity.
Stock split/change of par value - division of outstanding shares into larger/smaller shares. Proportionate equity remains the same.
An n:1 split means that n new shares will be issued to an existing shareholder for every old share that he is holding. For instance an 11:10 split means that a holder of 10 existing shares will receive 11 shares. This is exactly analogous to a 10% stock dividend. Thus theoretically, stock splits and stock dividends are mathematically equivalent.
Differences
Stock dividends entail the capitalization of reserves. Stock splits do not. What happens in the case of a split is that the par value of an existing share is reduced. The number of shares will increase proportionately. The product of the par value and the number of shares outstanding or the Issued Capital will remain unchanged.
Why Split Shares?
Companies generally go in for a split when the share price becomes too high. If so the scrip is considered to be out of reach for small and medium investors. What is high is subjective. But the belief is that most managers have a feel of the popular price range for the stock. That is, they know the range in which the stock should trade in order to attract enough investor attention.
Investors normally prefer to trade in round lots. A round lot is usually defined as 100 shares. Anything less than a 100 is considered to be an odd lot. At very high prices, small and medium investors may be unable to afford odd lots.
Voluntary Events
Rights issue - a right gives the shareholder an opportunity to purchase additional shares in the company for a specific price & time. Generally short term. Offered below current market price.
Pre-emptive Rights
The laws governing companies usually require that existing shareholders be given pre-emptive rights to new shares that are being issued for a monetary consideration, as and when they are issued. This is to enable them to maintain their proportionate ownership in the company.
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Often, rights issues are made at a price that is lower than the prevailing market price of the share. When this happens, the rights acquire a value of their own. In such cases an existing shareholder can either exercise his rights or else sell them to someone else.
Exchange offer - an offer to exchange a specific security for another security at a specified rate. The offer is made by the company itself or another company.
Tender offer - an offer to purchase shares at a specific price. The offer can be made by the company it’s or by another company.
Buy back offer – an offer to repurchase share at a specific price. The offer is made by the company to its shareholders.
Takeover – one company obtains control of another company.
Optional stock dividends – gives the shareholder an option to elect Cash/Stock when a company pays to its shareholders.
Mandatory with Choice Corporate Action
Cash/Stock dividend option with one of the options as default.
Shareholders may or may not submit their elections.
In case a shareholder does not submit the election, the default option will be applied.
Dividend Entitlement – Dates
Dividend-related Dates
In the context of a dividend payment, there are four dates that are important:
1. The Declaration Date2. The Record Date3. The Ex-dividend Date4. The Distribution Date
Declaration Date
It is the date on which the decision to pay a dividend is declared by the directors and the amount of the dividend is announced.
The Record Date
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The dividend announcement will mention the Record Date. Only those shareholders, whose names appear on the register of shareholders as of the record date, will be eligible to receive the forthcoming dividend.
The Ex-Dividend Date
This is specified by the exchange on which the stocks are traded. An investor who purchases the stock on or after the ex-dividend date will not be eligible for the dividend.
Obviously the ex-dividend date will be such that share transactions prior to that date will be reflected in the register of shareholders as on the record date, whereas transactions on or after that date will be reflected on the register only after the record date. This date will therefore be set a few days before the share transfer book is scheduled to be closed. This is to enable the registrar to complete all the administrative formalities.
This date is a function of the settlement cycle followed by the exchange. For instance the NYSE follows a T+3 cycle. That is, if a trade occurs on day T, then delivery of shares to the buyer and payment of funds to the seller will take place on day T+3. Thus a transfer of shares two days before the record date or later will not be reflected in the books on the record date. Thus on the NYSE the ex-dividend date is specified as two business days prior to the record date announced by the firm.
Cum-Dividend and Ex-Dividend
Prior to the ex-dividend date, the shares will be trade cum-dividend. This implies that the buyer of the share is eligible for the forthcoming dividend. On the ex-dividend date the shares will begin to trade ex-dividend. Thus buyers of the share on or after this date will not be eligible for the approaching dividend.
Ex-Dividend Prices
On the ex-dividend date the share price ought to, in theory, decline by the amount of the dividend. For instance if the cum-dividend price is $50 per share and the quantum of the dividend is $2 per share, then theoretically the share should trade at $48 ex-dividend. In practice however, the price decline may not be exactly equal to the amount of the dividend.
The Distribution Date
This is the date on which the dividends are actually paid or distributed.
Stock Dividends
These are called Bonus Shares in India. It is a dividend that is paid in the form of shares of stock rather than in the form of cash. This entails the issue of additional shares without monetary consideration.
What happens is that funds are transferred from the Reserves & Surplus account to the Share Capital account. This is called the Capitalization of Reserves
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From a theoretical standpoint, stock dividends do not create any value for their shareholders. We will illustrate this using a numerical example.
Ex-Bonus Price Declines
In practice, the ex-bonus price may not fall to its theoretically predicted value. This is because the market may interpret the bonus issue as a signal of enhanced future profitability.
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Trade Life Cycle
TRADE
What is a trade?
A Trade is a transaction done between two parties – buying/selling a particular securities product.
ExampleInvestco, a pension fund in Hong Kong, call a CSFB Sales Trader, and ask CSFB to buy 100,000 HSBC shares, at a limit price of $112.00. CSFB execute the order on the Hong Kong Stock Exchange on Investco’s behalf, at an average price of $111.50. The trades are cleared through the exchange clearing house the same day, and settlement takes place within three days.CSFB receive a commission for providing the brokerage service, and Invesco increase their position in HSBC.
Attributes of A Trade.
Attribute NotesProduct / Security Stock Code – Internally, these are represented
using either Reuters Instrument Codes (RIC) or International Security Identification Numbers(ISIN)
Side / Direction Buy, SellQuantity / Nominal The number of shares bought or soldPrice Price of the tradeProceeds/ consideration Dollar value of the tradeBooking account Defines the book to which the trade will be
creditedBooking Entity Legal entity which contains many accounts,
typically represents a branch officeCommissions The fee charged for providing the trading
serviceMarket Charges Charges associated with trading on a particular
Exchange.Trade Date Date on which the trade is executedValue date / Settlement date/ Contract date Date on which the trade is settledTrade time Time at which trade is executedCounterparty The other party which bought or sold the
securities.
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TRADE LIFE CYCLE
The Trade Life Cycle involves a series of steps that include both internal and external management of trades. Every trade has its own life cycle. It tracks the activities associated with an equity trade, from order initiation through execution to settlement. The entire Life Cycle of a trade can be broken down into pre-trade and post-trade events. During its lifecycle a trade generally passes through the three departments in the brokerage firm:
Front OfficeMiddle OfficeBack Office
The various steps in the Trade Life Cycle are:
Client On-Boarding
Client Onboarding is a one-time set of processes executed when the relationship with the client is established involving 3 steps as mentioned below.
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1. Due Diligence: Cornerstone for Due diligence is Know your customer (KYC), activities that financial institutions and other regulated companies must perform to ascertain relevant information from their clients for the purpose of doing business with them. KYC program has the following four key elements
a. Customer Identifications Program (CIP)b. Customer acceptance policyc. Risk managementd. Monitoring, reporting and record-keeping.
2. Documentation: Depending on the counterparty type and market type, different legal agreements are required among different parties. There is considerable progress and standardization and automation of documentation.
3. Account Setup: The provisions in legal agreement are translated into operative provisions and summarized into account setup. It is for the operation staff to refer the legal document in an easy-to-read format without reading the legal language of the agreements.
Below are Front Office activities which happens on T+0.
Pre Trade analytics and Order management
Pre trade is the first step in the Trade Life cycle that serves the function of order management, order routing and related activities. This step takes place in the Front Office where the order gets initiated.
There are entities that specialize and operate in the Pre Trade arena to facilitate these activities known as broker dealer.
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Trade Execution
When you call your broker to buy or sell a stock – or hit "enter" when placing an order through your online brokerage account – that's only the beginning of the transaction. Your broker's firm must then send your order to a market to be filled. This process of filling your order is known as "trade execution."
Trade execution can happen on a face to face basis, on the trading floor of a stock exchange via telephone or computerized exchanges. It is the process in which the trade booked by the broker is placed in the exchange and a successful match is found for it.
Trade capture and allocation
Trade capture is the process of recording of related trade information in the organizations transactional service processing systems. This function is done on Trade Date (T+0). While doing it utmost care needs to be taken to ensure that the data entered matches the used during execution. Traditionally, trade captures occurs twice: first by the front office in its own systems and later by back office or middle office in its own systems.
Data entered as part of trade capture is used by the operations team mainly for confirmation creation, other instruction generation and Cash & Depot account reconciliation. It’s also used by other teams for preparation of financial statements P&L reporting etc.
Trade Allocation is a process of allocating parent trade into multiple child trades is called allocation. The following is the process of the trade allocation:
1. Investment manager gives allocation instructions to executing broker.2. Executing broker splits and allocates it and informs investment manager with
copy to custodian3. Investment managers affirm allocation to executive broker with copy to
custodian.
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Below are Middle Office activities which happens on T+0 and T+1.
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Trade Enrichment
Trade Enrichment is performed automatically after each trade execution. In this step, all necessary details for the clearing or the settlement of cash securities are added. Trade enrichment involves the selection, calculation and attachment of relevant information to a trade, necessary to complete a number of essential actions. It is achieved through incorporating relevant information from the store of information; commonly known as static data defaulting. The information or data that is added is of two types:
Trade Data – This is trade specific data. It keeps changing from trade to trade. In fact the data entered as part of trade execution is generally trade data.EG: Buy/sell, counterparty, quantity, price etc.
Static Data – Data that does not keep changing from trade to trade i.e. it remains constant.EG: client account details, client contact details, global calendars and holidays
Components that require enrichment are:
Calculation of cash values Counterparty trade confirmation requirements Selection of custodian details Methods of transmission of settlement instruction
Trade Validation
This is probably the most important step in the entire Trade Life Cycle. This is a step which ensures data accuracy i.e. accuracy of data that has been ‘captured’ into the system for the trading purpose. This is the last step before settlement where we can identify an error if any at all. This step is undertaken by many STO’s to reduce the possibility of sending erroneous information to the outside world by checking the data contained in a fully enriched trade. Successful settlement of a trade is directly and almost entirely dependent on the result of Trade Validation. Trade Validation can be automatic or manual.
Some of the basic Trade Validations are as follows:
Trading Book – It may be restricted to specific transaction types, instrument groups or traders.
Trade Date – The date should be at least the current date or a future date for a new trade. Also it should be a business day.
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Trade Time – The time should be at least the current time or a future time.
Value date – The Value Date should be a business day in the location of settlement. It cannot be earlier than Trade Date. In fact it will always be a function of the settlement cycle of the settlement location in consideration.
Quantity – The quantity may not be less than a particular amount or there may be restriction on trading in odd lots.
Security – The security cannot be a matured bond or an expired warrant. It shouldn’t be scrip which has been delisted.
Price – The price must be expressed according to the security group.
Counterparty – The counterparty must be distinguishable from any other counterparty.
SSI – The appropriate standard settlement instructions have to be applied.
Trade Agreement
This step is also referred to as Confirmations. The action that is typically regarded as the most urgent is the act of gaining agreement of the trade details with the counterparty.
Once a trade deal is finalized the information needs to be sent to the clients regarding the details of the trade that has just been booked and executed. Confirmation is mandatory as per ISDA (The International Swaps and Derivatives Association) guidelines. It includes all the details of the trade like
- trade date,- quantity, - price, - settlement date and location, - Commission charged etc.
These details are sent to both the counterparties. Why this step assumes extreme importance is that this step allows the counterparties (investors) to identify any errors in trade booking or execution. If both counterparties agree on all the economic details of the confirmation then it is said to be an affirmed trade and can be taken forward for settlement. If there is any discrepancy then that needs to be corrected and that may require editing an existing order or placing a completely new order depending on the existing rules in the market in which the trade is taking place.
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On successful completion of this step all required reports needs to be sent to the regulatory bodies.
Transaction Reporting
It is an obligation to submit regulatory reports when conducting trading activity to the respective regulatory body. There are two types:
1. Trade reporting2. Transaction reporting.
The reports enable the regulatory body to monitor the market to protect investors, monitor conduct and produce market statistics. Penalty for failure to meet requirements is subjective and dependent on the nature of the breach, responsiveness to failure, control framework and historic track record
The regulator has the power to impose trading restrictions, imprison responsible persons, demand unlimited fines, publicize failure and impose further regulatory scrutiny
- TRAX is one example of transaction reporting that is relevant to all functions- Some functions will also produce Client reports. E.g. Custody- Internal reporting requirements e.g. SAR
------------------------------------------------------------------------------------------------------------Clearing and Settlement
Clearing
Once a trade is done, Exchange sends the trade information to its clearing corporation for clearing the trades at the end of the day. Clearing Corporation acts as legal counter party to all the trades and guarantees settlement for all members. Clearing corporation sends a message for confirmation to all clearing firm/brokerage house/ custodian involved in trading for that day. Once the custodian/clearing member agrees to settle a trade they confirm the same to Clearing Corporation through a confirmatory message.Clearing Corporation then sends obligations to clearing banks & custodian for settling the trade. If positive confirmatory message is received for settlement from clearing bank & custodian it’s known as clearing is done & settlement will take place successfully.
Funding
Funding is a commonly used term to describe the financing of investments through the borrowing of cash on a secured and/or unsecured basis, and the act of minimizing the cost of borrowing cash, and maximizing the benefit of lending cash. In short, the efficient management of our cash positions is important to ensure we have cash positions to satisfy settlement obligations
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STO will move cash in/out of our accounts to avoid a shortfall or surplus amount of cashThere are differing deadlines for currencies, but the majority of funding will be done either the day before Settlement (T+2 / S-1) or on Settlement date (S)
Settlement
Once clearing is done, Clearing Corporation asks Depository to debit securities from sell-side clients (depository participants) account. Depository does the same. Clearing corporation sends the similar instructions to Clearing Bank to transfer cash from buyer, to its account & Clearing Bank does the same. This completes the settlement process & investors receive the securities & cash. If any of the buyer or the seller fails to deliver the securities or cash the trade doesn’t settle and it’s known as a fail trade. In that case the process of fails management is put into operation to try and determine the cause of the fail trade.
Settlement is the transfer of cash and or securities to complete a trade on an agreed date which is called as settlement date or value date.
The number of days between Trade Date and Settlement Date is called as settlement cycle and vary according to the market and Instrument, many markets trade on a T+3 basis but there is a move to reduce this.
This is a back office activity.
Settlement Types
We have 2 types of settlement instructions, they are DVP and FOP.
Delivery Versus Payment (DVP)In this type of settlement securities and cash is exchanged simultaneously and only one instruction to be issued for settlement.
Free of Payment (FOP)Securities and cash are settled separately requiring two instructions to be issued for settlement, to different agents. We need to send one instruction for stock settlement and send another instruction only when we need to make payment (i.e. on our “buy” trades, client delivered securities to us and when we have to make payment to them).
Normally occurs where currency of the cash consideration is different to that of the Security’s originating country. For example: When we are trading in Russian stock, payment of cash is in USD currency instead of RUB currency.
Free of Payment is more risky when compared to DVP as on our sell trades we deliver stock first and later receive cash from the counterparty. There is risk of counterparty defaulting the payment in the case of FOP.
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Client Custodian / Agent Bank– A custodian is a company that effects settlements and holds securities in safe
custody on behalf of another company
Settlement Instruction Data
Each Settlement Instruction includes the Standard Settlement Instructions (SSIs) or Standard Payment Instructions (SPIs). UBS hold SSIs and SPIs for us and for our clientsEach SSI will include account details where the securities will be transferred / received from/to - known as a depot and account details where the cash will be transferred/received from/to - known as a Nostro
It is very important that our static information about SSIs, SPIs are up to date and accurate to ensure timely settlement.
Settlement Instructions are sent for each trade to the local agents and should be sent by authenticated message.
Majority of UBS settlement instructions are transmitted using the global SWIFT system. The Society for Worldwide Interbank Financial Telecommunications
Some of the message types which we use to send settlement instructions are MT540, MT542, MT541, and MT543.
SWIFT messages need to comply with ISO 15022 standards Messages are also sent and received (mostly by SWIFT) to confirm
settlement has taken place and it is called as settlement confirmation. After the settlement confirmation hits our systems, cash and asset
positions get updated and postings are done.
Various Types of SSI
Cash Settlement Instructions - Details of the payment or receipt of funds between organizations. Securities Settlement Instructions- Instructions for security settlements. Consists of settlement agent, Custodian a/c, name and BICClearing Instructions - Instructions sent to a clearing house for undertaking the settlement of indebtedness between members and is used to rationalize securities trading and bank transfers.
Netting
Settling mutual obligations at the net value of a contract as opposed to its gross currency value is called Netting. It reduces the transfer of funds between subsidiaries to a net amount.
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Bilateral Netting is operated by 2 counterparties netting off their respective positions regarding payables and receivables
Central Counterparty Netting (CCP)A central clearing organization can also act as counterparty to all its members
Advantages Credit risk for each counterparty becomes minimal Therefore firms do not have to maintain credit lines Collateral is reduced
Custody
This is the last step in the trade life cycle. This is the step after settlement where the securities will be handed over to the investor account. It will be held with the custodian until the investor decides to sell off the securities. The functions of a custodian have already been defined in an earlier section.
The financial assets covered by custodians are:- Equities,- Debts such as govt. bonds, corporate bonds- Derivatives- Mutual Funds- Warrants.
Entities that use custodian services are:- Institutional Investors- Mutual Funds- Hedge Funds- Pension Funds- Broker Dealer- Insurance Companies- Individual investors
This concludes the discussion on the Trade Life Cycle.
Post Settlement
Settlement Accounting
Settlement accounting is different from financial accounting. On settlement date, accounting/ledger entries are posted assuming all settlements are successful. The entries are posted in a document called Ledgers. Later these ledger entries are reconciled with actual Nostro and Depot entries posted by the custodian.
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Account & P&L reconciliation
All trade / transaction related postings must be recorded in the financial records (General Ledger) of the organization
1. Need to ensure that postings reflect what has actually happened e.g. date and quantity/consideration settled and importance of Nostro/Depot reconciliations to maintain data integrity for financial reporting
2. Prepare & produce P&L, Balance Sheet and Cash Flow statements to meet financial reporting obligations
3. They actively reconcile the P&L versus the general ledger (what happens in Risk Management Vs the real world).
Settlement fails: A trade is said to be a fail when it is not settled on the value date or contractual settlement date. Common causes for trade failure are:
1. Insufficient securities or cash2. Mismatching or Non matching of settlement instructions.
All settlement fails are logged in exception register and followed up for corrective actions such as compensation claims, back valuations, etc.
Buy-in Auctions: A buy-in is the practice whereby a lender of securities enters the open market to buy securities to replace those that have not been returned by a borrower. Strict market prices govern buy-ins.
Brokerage: Brokerage is paid to the intermediaries at defined intervals for the trades successfully settled in that interval.
Interest Claims: A request by a seller to the buyer for reimbursement of lost cash interest, where the seller was able to deliver securities (on or after value date) but the buyer was unable to pay/settle.
The following is a pictorial representation of the functions of a full service brokerage firm, the various departments in it, and the respective functions of those departments.
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Life cycle and Persistent Events
Certain process are monitored and managed throughout on a continued and presidents basis. Such processes are exceptions and escalations, corporate actions and data management. The first arises only during the life cycle of the trade while others are persistent even after the trade is settled.
Exceptions and escalations: Exception is a deviation from the established procedure anytime during the trade life cycle. Such events are logged, analyzed and rectified. They are also reported to the next level, which is called escalation. When the exception is failed to be rectified within the stipulated time, it needs to be escalated immediately to the supervisor. (Detailed notes on escalation procedure are covered in the escalation training e-learning module.
Corporate Actions: Corporate actions are actions that affect investor’s cash balance or securities holding or both. In parallel to settlement of trade, an STO should have complete control of processing and management of corporate actions which means:
Being aware of each corporate action that may affect a position or outstanding trades. Understanding the nature of each corporate action Operating within the necessary deadlines Knowing the cost or benefit of each corporate action Ensuring receipt of entitled assets at the appropriate time Ensuring cost is charged at the appropriate time.
Failure to adequately control corporate actions may result in entitled assets due to STO. A detailed note on corporations is discussed in corporate actions e-learning module.
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Data management
What is a data?
Data generally speaking refers to “Collection of Organized Information” and can be anything numbers, words or images.Generally speaking data can be of two types
The Data that does not change over a period of time or static data The data that changes very frequently or Market Data
Types of Data
We have two types of data:
1. Static Data (Also known as Reference data) is the fundamental data underlying and defining the customers, securities and transactions that flow through the world's financial systems.
2. Market Data (also known as Streaming data) generally refers to the quotes and trade related data that changes on a real time basis.
Usage of Data:
Reference data is used in the processing of transactions, in compliance measurement, analytics, risk management, and client reporting. Without this common data trading, clearing and settling securities transactions would not be possible.
Market data is useful in Analysis, Trading and Dealing, Risk Management, Back Office and Settlement processes.
Static DataStatic/Reference Data is the fundamental data underlying and defining the customers, securities and transactions that is used for trade and acts as a reference entity for all transactions.Static data is critical to Straight-Through Processing (STP) [STP enables the entire trade process for capital markets and payment transactions to be conducted electronically without the need for re-keying or manual intervention].Although stable, static data is prone to periodic updates.
Reference data constitutes:
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• Instrument Data• Client Related information • Counterparty related information• Standing Settlement Instructions (SSI)• Holiday Master• Corporate Action Data• Fee, Tax and Commission Rates
Examples of static data
Market Data
Market Data generally refers to quotes and trade related data that changes on a real time basis. It is associated with equity, fixed income, financial derivatives, currency, and other investment instruments. The term traditionally refers to numerical price data, reported from trading venues such as stock exchanges.
Market data constitutes:
• Real time data: (Quotes, Indices, News, Economic Indicators)• Historic data: (Intra-day Prices, End-of-day prices, News Archive, Economic data
Archived)• Interpretative data: (Earnings, Economic Commentary, Internal and External
Research, Flow of funds)
Examples of Market data:
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