An insight into various back-office operations activities in Securities Markets

Securities Operations involves various middle office and back office operations of Securities Broking Firms. This tutorial would give you an understanding of the basics of the Indian securities market, the different products traded and the various market participants and the respective roles they play in the Indian securities market. It would also help you know the various functions of the Front Office, Middle Office and Back Office in a Securities Broking Firm, understand the trade life cycle, the steps and participants involved in the trade life cycle and the role of the back office in a securities broking firm as well as understand how the risks are managed in a securities broking firm, the clearing and settlement process.

1. What are the different products that are traded in the Indian Securities Market?

The investors in the Indian securities market have a wide choice of product base to choose depending upon a person’s risk appetite and needs. Broadly, however the products available can be categorized as Debt and Equity. We here discuss the different products available in the different types of market in India.

(a) Equity Markets and its Products

The equity segment of the stock exchange allows trading in shares, debentures, warrants, mutual funds and exchange traded funds (ETFs).

Equity Shares represents the form of fractional ownership in a business venture. Equity shareholders collectively own the company. They bear the risk and enjoy the rewards of ownership.

Debentures are instruments for raising long term debt. Debentures in India are typically secured by tangible assets. There are fully convertible, non-convertible and partly convertible debentures. . Fully convertible debentures will be converted into ordinary shares of the same company under specified terms and conditions. Partly convertible debentures (PCDs) will be partly converted into ordinary shares of the same company under specified terms and conditions. Thus it has features of both debenture as well as equity. Non Convertible Debentures (NCDs) are pure debt instruments without a feature of conversion. The NCDs are repayable on maturity. Partly Convertible debentures have features of convertible and non-convertible debentures. Thus, debentures can be pure debt or quasi-equity, as the case may be.

Warrants entitle an investor to buy equity shares after a specified time period at a given price.

Mutual Funds are investment vehicles where people with similar investment objective come together to pool their money and then invest accordingly. A mutual fund company pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these investments, depending on the objectives of the fund.

Exchange Traded Fund is a fund that can invest in either all of the securities or a representative sample of securities included in the index. Importantly, the ETFs offer a one-stop exposure to a diversified basket of securities that can be traded in real time like individual stock. Recently even ETF units with underlying security of Gold are traded under this segment.

Indian Depository Receipt (IDR): Foreign companies are not allowed to directly list on the Indian stock exchanges. However, they are now allowed to raise capital in Indian currency through an instrument called Indian Depository Receipt (IDR). IDRs are issued by foreign companies to Indian investors. IDRs are depository receipts which have the equity shares of the issuing company as the underlying security. The underlying shares are held by a foreign custodian and the DRs are held in the Indian depository. IDRs are listed in the Indian stock exchanges. The investor can either hold the IDR, trade in them in the stock exchange or request for redemption into the underlying shares. Redemption is permitted after 1 year from the date of listing. SEBI has recently permitted 2 way fungibility of IDRs. 2 way fungibility means the depository receipt can be converted into underlying shares and underlying shares can be converted into depository receipt. However, the number of shares that will be allowed to be converted into depository receipt should be within the headroom available. Headroom shall mean number of IDRs issued less number of IDRs outstanding and IDRs already converted into underlying shares.

(b) Derivative Market and its Products

Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. The derivatives segment in India allows trading in the equities, currency, commodities. There are two types of derivatives instruments viz., Futures and Options that are traded on the Indian stock exchanges.

Index/Stock Future is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. Futures contracts are available on certain specified stocks and indices.

Index / Stock Options are of two types – calls and puts. Calls give the buyer the right, but not the obligation, to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation, to sell a given quantity of the underlying asset at a given price on or before a given date.

Currency Derivatives trading was introduced in the Indian financial markets with the launch of currency futures trading in the USD-INR pair at the National Stock Exchange of India Limited on August 29, 2008. Few more currency pairs have also been introduced thereafter. It was subsequently introduced in the BSE on October 1, 2008, and MCX-SX, On October 7, 2008. Currency futures are traded on the USD-INR, GBP-INR, EUR-INR and JPY-INR at the NSE, MCX-SX and USE.

Commodity Derivatives markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts for a specified future date. Commodity markets facilitate the trading of commodities such as gold, silver, metal, energy and agricultural goods.

Interest Rate Futures trading is based on notional 10 year coupon bearing GOI security. These contracts are settled by physical delivery of deliverable grade securities using electronic book entry system of the existing depository’s viz., NSDL and CDSL and the Public Debt Office of the Reserve Bank unlike the cash settlement of the other derivative products.

Derivatives on Foreign Stock Indices: SEBI in January 2011 has permitted the stock exchanges to introduce derivative contracts (futures and options) on the foreign stock indices. The stock exchanges can introduce derivative contracts on the foreign indices subject to certain eligibility criteria as mentioned in the SEBI guidelines like market capitalization, volume of turnover, minimum number of constituent stocks and maximum weight of single constituent in the index.

(c) Debt Market and its Products

Debt market consists of Bond markets, which provide financing through the issuance of Bonds, and enable the subsequent trading thereof. Instruments like bonds/debentures are traded in this market. These instruments can be traded in OTC or Exchange traded markets. In India, the debt market is broadly divided into two parts government securities (G-Sec) market and the corporate bond market.

Government Securities Market: The Government needs enormous amount of money to perform various functions such as maintaining law and order, justice, national defence, central banking, creation of physical infrastructure. For this it generates revenue by various ways including borrowing from banks and other financial institutions. One of the important sources of borrowing funds is the government securities market.

The government raises short term and long term funds by issuing securities. These securities do not carry default risk as the government guarantees the payment of interest and the repayment of principal. They are therefore referred to as gilt edged securities. Government securities are issued by the central government, state government and semi government authorities. The major investors in this market are banks, insurance companies, provident funds, state governments, FIIs. Government securities are of two types- treasury bills and government dated securities. .

Corporate Bond Market: Corporate bonds are bonds issued by firms and are issued to meet needs for expansion, modernization, restructuring operations, mergers and acquisitions. The corporate debt market is a market wherein debt securities of corporates are issued and traded therein. The investors in this market are banks, financial institutions, insurance companies, mutual funds, FIIs etc. Corporates adopt either the public offering route or the private placement route for issuing debentures/bonds.

Other instruments available for trading in the debt segment are money market instruments like Treasury Bills, Commercial Papers and Certificate of Deposits.

2. What is Trade Life Cycle (TLC)?

In financial market, “trade” means to buy and / or sell securities / financial products. To explain it further, a trade is the conversion of an order placed on the exchange which results into pay-in and pay-out of funds and securities. Trade ends with the settlement of the order placed. Every trade has its own cycle and can be broken down into pre-trade and post-trade events. Trading of securities also involves many participants like the investors, brokers, exchange, clearing agency /corporation, clearing banks, depository participants, custodians etc.

The following steps are involved in a trade’s life cycle:

Placing of Order
Risk management and routing of order
Order matching and its conversion into trade
Affirmation and Confirmation (only for institutional deals)
Clearing and settlement

3. How to place order on the trading system?

The Broker accepts orders from the client and sends the same to the Exchange after performing the risk management checks. Clients have the option of placing their orders through various channels like internet, phone etc.

In the year 2008, SEBI permitted the facility of Direct Market Access for institutional clients. DMA is a facility which allows brokers to offer its institutional clients direct access to the exchange trading system through the broker’s infrastructure. This does not involve any manual intervention of the broker. This facility can be extended to the institutional clients provided the broker satisfies the operational specifications; risk management measure and other details as prescribed by SEBI.

Once the orders are received by the broker, it is confirmed with the client and then entered into the trading system of the Exchange. The Exchange gives confirmation of the order and time stamps it. An order generally comes with certain conditions which determine whether it is a market order, limit order etc. These specify the terms and conditions at which the client wants his / her order to get executed.

4. What is Risk Management & Order Routing?

A sound risk management is integral to an efficient system. A broker’s risk management works on the following concepts:

Cash: The broker normally ensures that there is enough balance in the clients account to honor the trade.
In case a buy order is entered by the client/ on behalf of client, the broker’s system queries to find the available balance in the clients bank account and whether it is sufficient to meet the stipulated margin requirements. This is as per the agreed upon terms and conditions of risk management with the client. If the available balance satisfies the risk management parameters then the order is routed to the exchange. In cases where the balance is not sufficient the order gets rejected. A rejection message is shown in the system, which then is conveyed to client. In case there is no direct interface to a banking system, the client is asked to maintain cash and securities deposit in order to ensure adequacy of balance.
In case a client gives a sell order, the broker ensures that the client’s custody/demat account has sufficient balance of securities to honor the sale transaction; this is possible only if the client has his/her demat account with the same broker. In all other cases, wherever the client has his demat account with an outside / third party DP, it’s the duty of the client to ensure that he has/ will have the required securities in the demat account, before selling the same.
Depending upon type of order and the actual prices prevailing in the market, the order gets executed immediately or remains pending in the order book of the exchange.

5. How are Orders Matched and Converted into Trade?

All orders which are entered into the trading system of the Exchange are matched with similar counter orders and are executed. The order matching in an exchange is done on a price time priority. The best price orders are matched first. If more than one order is available at the same price then they are arranged in ascending time order. Best buy price is the highest buy price amongst all orders and the best sell price is the lowest price of all sell orders.

Once the order is matched it results into trade. As soon as the trade is executed, a trade confirmation message is sent to the broker who had entered the order. The broker in turn lets the client know about the trade confirmation. All orders which have not been executed, partly or fully can be modified or cancelled during the trading hours.

Trades done during the day can also be cancelled by mutual consent of both the parties subject to approval of the Exchange. These generally occur due to order entry errors and are not a common practice.

6. How is Affirmation and Confirmation (For Institutional Clients) done?

FIIs trading in the Indian securities market use the services of a custodian to assist them in the clearing and settlement of executed trades. Custodians are clearing members of the exchange and not brokers who trade on behalf of them. On behalf of their clients, they settle trades that have been executed through other brokers. A broker assigns a particular trade to a custodian for settlement. The custodian needs to confirm whether he is going to settle that trade. Upon confirmation the clearing corporations assigns the obligation to the custodian. The overall risk that the custodian is bearing by accepting the trade is constantly measured against the collateral that the institution submits to the custodian for providing this service.

It has been decided by SEBI that all the institutional trades executed on the stock exchanges would be mandatorily processed through the Straight through Processing System (STP) w. e. f. July 01, 2004.

7. What is Straight through Processing (STP) System?

STP is a mechanism that automates the end-to-end processing of transactions of the financial instruments. It involves use of a single system to process or control all elements of the work-flow of a financial transaction, including what is commonly known as the Front, Middle, and Back office, and General Ledger. In other words, STP can be defined as electronically capturing and processing transactions in one pass, from the point of first ‘deal’ to final settlement.

8. What is known as Clearing and Settlement of trades?

Clearing and Settlement is a post trading activity that constitutes the core part of equity trade life cycles. After any security deal is confirmed (when securities are obliged to change hands), the broker who is involved in the transaction issues a contract note to the client which has all the information about the transactions in detail, at the end of the trade day. In response to the contract note issued by broker, the client now has to settle his obligation by either paying money (if his transaction is a buy transaction) or delivering the securities (if it is a sell transaction).

Clearing house / corporation is an entity through which settlement of securities takes place. The details of all transactions performed by the brokers are made available to the Clearing House/ Corporation by the Stock Exchange. The Clearing House/ Corporation gives an obligation report to Brokers and Custodians who are required to settle their money/securities obligations with the specified deadlines, failing which they are required to pay penalties. This obligation report serves as statement of mutual contentment.

9. What is Pay-in and Pay-out?

Pay-In is a process whereby a stock broker and Custodian (in case of Institutional deals) bring in money and/or securities to the Clearing House/ Corporation. This forms the first phase of the settlement activity.

Pay-Out is a process where Clearing House/ Corporation pays money or delivers securities to the brokers and Custodians. This is the second phase of the settlement activity.

In India, the Pay-in of securities and funds happens on T+ 2 by 10.30 AM, and Pay-out of securities and funds happen on T+2 by 1.30 PM.

The pay-in and pay-out days for funds and securities are prescribed as per the Settlement Cycle. A typical Settlement Cycle of Normal Settlement is given below:

	Activity	Day
Trading	Rolling Settlement Trading	T
Clearing	Custodial Confirmation	T +1 working days
	Delivery Generation	T +1 working days
Settlement	Securities and Funds pay in	T+2 working days
	Securities and Funds pay out	T+2 working days
Post Settlement	Valuation Debit	T+2 working days
	Auction	T+2 working days
	Auction settlement	T+3 working days
	Bad Delivery Reporting	T+4 working days
	Rectified bad delivery pay-in and pay-out	T+6 working days
	Re-bad delivery reporting and pickup	T+8 working days
	Close out of re-bad delivery	T+9 working days

10. What is the importance Risk Management in TLC?

A sound risk management system is integral to an efficient clearing and settlement system. The system must ensure that brokers / trading member’s obligations are commensurate with their networth.

Risk containment measures include capital adequacy requirements, margin requirements, position limits based on capital, online monitoring of client positions etc. The main concepts of a Risk Management System are listed below:

There should be a clear balance available in the client’s ledger account in the broker’s books.
The clients are required to provide margins upfront before putting in trade requests with the brokers.
The aggregate exposure of the client’s obligations should commensurate with the capital and networth of the broker.
The clients must settle the debits, if any, arising out of MTM settlements.
In futures and options segment, the positions are allowed based on the margin available to satisfy initial margin requirements of the Exchange. The clients are expected to pay the MTM margin as and when required failing which the client or the broker may square off the trade.

11. What are Margin Requirements?

One of the critical components of risk management for the futures and options segment is the margining system. The Exchange levies daily margin, Mark-to-Market (MTM) margin, Extreme loss margin in the equities segment and initial margin and MTM margin in case of futures and options segment.

The broker needs to maintain upfront capital with the exchange to cover his daily margin at the time of order placement. To ensure this, the broker collects upfront margin by way of funds/ shares from the client and deposits the same with the exchange.

12. On what basis is margin requirements calculated?

On Gross Client Basis

The margin is required to be paid on the gross open position of the stock broker. The gross open position signifies the gross of all net positions across all the clients of a member, including the proprietary position of the member. Thus, it is important for the stock broker at any time to know the position on both gross and net basis for all clients.

Two types of margins are applicable for option writing – initial margin and exposure margin.

The initial margin and the mark-to-market requirements are based on a worst-case scenario calculated by valuing the portfolio under several scenarios of changes in market conditions over a trading day.

The market conditions taken into consideration involve combinations of possible changes in the spot price of the underlying and changes in the volatility of the underlying. Sixteen possible scenarios are considered and thereafter the margin requirements are specified.

The margin requirements change considerably for the various stock options.

13. What is Mark-to-Market Margin?

Mark to market is calculated by marking each transaction in security to the closing price of the security at the end of trading. In case the security has not been traded on a particular day, the latest available closing price is considered as the closing price. In case the net outstanding position in any security is nil, the difference between the buy and sell values shall be is considered as crystallized loss for the purpose of calculating the mark to market margin payable.

The mark to market margin (MTM) is collected from the member before the start of the trading of the next day. The MTM margin is collected/adjusted from/against the cash/cash equivalent component of the liquid net worth deposited with the Exchange. The MTM margin is collected on the gross open position of the member. The gross open position for this purpose means the gross of all net positions across all the clients of a member including broker’s proprietary position. For this purpose, the position of a client is netted across its various securities and the positions of all the clients of a member are grossed.

There is no netting off of the positions and set-off against MTM profits across two rolling settlements i.e. T day and T+1 day. However, for computation of MTM profits/losses for the day, netting or set-off against MTM profits is permitted.

14. What is Value at Risk (VaR) Margining – Equity segment?

All securities are classified into three groups for the purpose of VaR margin.

For the securities listed in Group I, scrip wise daily volatility calculated using the exponentially weighted moving average methodology is applied to daily returns. The scrip wise daily VaR is 3.5 times the volatility so calculated subject to a minimum of 7.5%.
For the securities listed in Group II, the VaR margin is higher of scrip VaR (3.5 sigma) or three times the index VaR, and it is scaled up by root 3.
For the securities listed in Group III the VaR margin is equal to five times the index VaR and scaled up by root 3.

The index VaR, for the purpose, is the higher of the daily Index VaR based on S&P CNX NIFTY or BSE SENSEX, subject to a minimum of 5%.

The VaR margin rate computed as mentioned above is charged on the net outstanding position (buy value-sell value) of the respective clients on the respective securities across all open settlements. There is no netting off of positions across different settlements. The net position at a client level for a member is arrived at and thereafter, it is grossed across all the clients including proprietary position to arrive at the gross open position.

The VaR margin is collected on an upfront basis by adjusting against the total liquid assets of the member at the time of trade.

The VaR margin so collected is released on completion of pay-in of the settlement or on individual completion of full obligations of funds and securities by the respective member/custodians after crystallization of the final obligations on T+1 day.

15. What is Extreme Loss Margin?

The Extreme Loss Margin for any security is higher of 5%, or 1.5 times the standard deviation of daily logarithmic returns of the security price in the last six months. This computation is done at the end of each month by taking the price data on a rolling basis for the past six months and the resulting value is applicable for the next month.

The Extreme Loss Margin is collected/ adjusted against the total liquid assets of the member on a real time basis.

The Extreme Loss Margin is collected on the gross open position of the stock broker. The gross open position for this purpose means the gross of all net positions across all the clients of a member including its proprietary position.

There is no netting off of positions across different settlements. The Extreme Loss Margin collected is released on completion of pay-in of the settlement or on individual completion of full obligations of funds and securities by the respective broker/custodians after crystallization of the final obligations on T+1 day.

The risk management practices undertaken by members for currency derivatives trading, is similar to those for derivatives trading in equities.

16. What is clearing Process of trades?

At the end of the trading day, the transactions entered into by the brokers are tallied to determine the total amount of funds and/or securities that the stock broker needs either to receive or to pay. This process is called clearing. In the stock exchanges this is done by a process called multilateral netting. This process is performed by clearing corporation.

The clearing agency guarantees that all contracts which are traded will be honoured. Clearing therefore serves to create a more efficient market, since all the players involved need not include the original counterparty risk in the price calculation. Generally, the clearing and settlement process can be classified into: Matching, Central counterparty, Cash settlement and Delivery.

Matching means that the parties agree on the conditions of the transaction, i.e. what has been bought or sold, price, quantity, etc. ‘Central counterparty clearing’ is when the clearing organization becomes the legal counterparty in a transaction. Cash settlement refers to settlement of premiums, fees, mark-to-market and other cash settlements, and delivery of the underlying instrument or cash settlement occurs after expiration or premature exercise.

17. What is Settlement Process?

(a) How is settlement obligations in Equity segment determined?

Clearing Corporation receives the details of trades and prices from the exchange. Settlement obligations are computed using predefined methodology specified for the segment/product. Some of the methods of determining obligations are listed below:

a) Netted obligation: All purchase & sell transactions will be netted to determine the obligations. Member will have obligation to deliver a security in a settlement only if the sell quantity is more than buy quantity. Similarly, in case buy quantity is more than sell quantity, the member will receive a pay-out of the security. Fund obligations will also be computed on a netted basis across all securities under netted settlement.

b) Trade to trade or Gross obligations: Transactions will not be netted to determine obligations. Member’s security pay-in obligation will be equivalent to cumulative sell quantity and security pay-out will be equivalent to cumulative buy quantity. Funds pay-in will be equivalent to cumulative value of buy transactions and funds pay-out will be equivalent to cumulative sell value.

c) Daily mark to market settlement of futures contract: Daily settlement prices will computed for futures contracts based on specified methodology. All open positions will be marked to market at the settlement prices to determine mark to market obligations to be settled in cash. All open positions will be carried forward at the latest daily settlement prices.

(b) What are the timings for Settlement of Funds?

The Clearing Bank debits the settlement accounts of the members maintained with the bank within 10.30 a.m. on the last date of settlement period. This appears in the Member’s Balance Sheet.

The Clearing Bank credits the settlement accounts of the members maintained with the bank by 1:30 p.m. on the last date of Settlement period. This appears as net receivable in the Members Balance Sheet.

end faq

{accordionfaq faqid=accordion3 faqclass=”lightnessfaq defaulticon headerbackground headerborder contentbackground contentborder round5″