How securities trading and settlement works?

When I started working with my cash equity implementation I had numerous questions in my mind, especially how shares are transferred between two parties, how book keeping works, margining, and also how delivery vs payment works. On working in clearing engine initiative I did few studies on clearing and settlement process that helped me in understanding different players and their roles in Equity trading. Before getting into more details on the different roles in trading I would like to explain the entire system with and without IT system. Actually IT system automation reduces more manual work in trading(proud to say I am part of it) and it actually makes trading more easy and cost effective.  Actually this article is for beginners in IT industry to understand the Equity trading infrastructure and not for the finance experts.

Before the IT system, all the shares were introduced in paper form and if someone wants to buy and sell shares it requires physical transfer of documents between two parties. Today enormous trade volume exist across various exchanges in various countries which makes physical document transfer practically impossible. Just imagine book keeping of these certificates then all exchanges or brokers firm should have multi-storey building only for paper storage. Now in this technology world there is no more physical certificates hence in the beginning stage of my career I always have a question how this electronic certificates are issued and someone has to do book keeping rite and also governing body to check the certificates else people will lose the trust. Who is responsible for this?????? Let me explain this later in this article.

I gave a hint on paper based stocks trading to explain how miserable those days for traders and investors. Let us assume you have share of XYZ Company and now you need to sell this share for best price to seller so that you can make profit. In the olden days it was very difficult because there is no centralized place and because of this reason Stock Exchange was invented. Earlier exchange acts as a place like market where buyers/sellers can meet and do their negotiation (trades). Now a new entity called Exchange is born in this world!!

Stock Exchange acts as a central place for investors to buy/sell their certificates. But it actually not served the exact needs for investors. For each buying/selling, an investor has to travel more than 200 to 1000 km means very tired and non-profitable business. Hence investor needs some middle man to interact with exchange on behalf of them so investors avoid their travel and time. Basically they are middleman between investor and exchange. Hence the concept of broker is born!!

Now as per the current participants trading world will look like below

In olden days, broker premises are nearby to exchange place along with huge number of members with phones/letter pads so that they can take orders from their clients and execute in exchange on behalf of their clients. Do you think all problem is solved? Answer is clearly no because still we need few more participants like Central counter party, book keeping authority etc. Let see in detailed manner.

Next participant I like to introduce is Custodian!! In the earlier days of my career I always try to understand their role but I am able to fully understand when I started my work in Shanghai-Hong Kong Stock Connect program.

Custodian is a person who will take care of your shares. Just assume, if you are in paper based trading world and now someone has to keep your shares safely in a locker to avoid tearing rite. Not only book keeping they also take care of shares during corporate action like dividend. Custodians are not like commercial banks they won’t do lending, personal accounts maintenance.  After introduction of custodians our trading world will look like below

Each and every broker will have link with Custodians for book keeping hereafter before opening account with broker kindly ask them because you need to know where your valuable shares are safely placed. Few institutional clients have their account with custodians because of that reason only in the above diagram I placed a link with buyer and custodian.

So now the trading world is having a place to trade and a place to safely keep the shares. Just assume the paper based world, you have XYZ share now wants to sell so you make a call to your broker and in turn he will go to exchange on behalf of you check the best price and execute the trade with buyers broker. Then seller’s broker will inform the custodian to transfer the shares to buyer’s custodian and in turn buyer has to transfer the cash as well. So now one person is still missing because how seller can trust some third person for timely delivery of the amount and also buyer as well. If anyone (Buyer or Seller) is fraudulent then trade becomes invalid hence someone has to supervise these various entities and acts as central responsible person for delivery versus payment of shares. Hence one more new entity born in this trading world and that person act as a Central counter party for the executed trades. Here only clearing and settlement process will start and in the finance world this is the critical function(back office or post trade activities)

Clearing house will act as a central counter party i.e. once trade gets executed in Stock Exchange trades will be moved into clearing house and they will be responsible for buyers and sellers. Basically they will enter into obligation with buyer side for timely settlement of their shares and also they will enter into obligation with seller for settlement of their money. Now buyer don’t have any risk and also seller because Clearing house is taking the risk on behalf of them. If either buyer or seller not able to proceed the trade means then Clearing house will use his own pool of money/shares for settlement. Hence clearing is always risky business in security world and there are strict rules and regulation for becoming clearing member (more trading members in the world right now but less clearing member). In other words clearing house will becomes like a governing body for settling the trades in a timely manner (T+3 or T+2 depends on the country financial infrastructure).

Now if we see in our trading world there is trading place, book keeping place, risk governing council  but still one important entity is missing. Earlier I told about dividend and its taken care by custodians but how company will come to know these are the persons holding my shares and they are eligible for dividend amount. Will they go and check each and every custodian or they will come to exchange to enquire about this. Answer is strictly no then who is doing this activity?  A new entity needs to be introduced called “Registrar”.

Registrar receives information from  new entity called Central Security Depository (CSD). A central securities depository (CSD) is a specialist financial organization holding securities such as shares either in certificated or non-certificated (de-materialized) form so that ownership can be easily transferred through a book entry rather than the transfer of physical certificates. Earlier we talked about custodians for book keeping if buyer and seller belong to different custodian then there is governing council to monitor the transfer of shares that governing council is CSD. Registrar will get the information from CSD for company’s book keeping.

This marks the end of my post.