From trading pits crammed with human beings to markets that exist solely on computer screens – today’s financial markets are as diverse as the people who trade in them.
Let’s start with the stock market. Beginning with an order, all the way through to clearing and settlement, here’s what you need to know about how billions of shares change hands every day. Mastering these fundamentals will help you understand how the financial markets of today operate.
OK, let’s start at the very beginning. What’s a financial market? What’s a trade?
A financial market is where buyers and sellers come together to trade instruments such as stocks, ETFs, bonds, currencies, commodities and derivatives. Trading is the buying and selling of these assets. When opposing buy and sell orders match – then a trade is born.
Some trades are done on-venue (such as over an exchange), others are executed over-the-counter (OTC). Let’s take a closer look at what these terms mean:
- An exchange is a highly-organized marketplace where members get together to trade specific types of instruments. For instance, on the New York Stock Exchange members trade US shares, while members of Euronext buy and sell European stocks and options. It’s important to note that only members are allowed to trade on an exchange. That’s why retail investors and asset managers generally must make their trades via banks and brokers who are exchange members.
- The core function of an exchange is to ensure fair and orderly trading and the efficient publication of price information for all the securities that trade there. Most exchange trades are done “on screen”, where the best price is displayed for all to see.
- Over-the-counter (OTC) trades, in contrast, are negotiated directly between two parties such as a bank and an asset manager and executed between these parties, away from a venue. Unlike an on-exchange trade, the OTC trade price is negotiated between the parties beforehand.
Got it. So who’s involved in making a trade happen?
It all starts with the investor, an individual or organization who wishes to trade a financial asset or instrument. There are two main types of investors:
- Retail investors who use their own money to trade, often through an online broker
- Institutional investors, such as a pension fund, insurance company or hedge fund, that typically invests money on behalf of others
Between the investor and the exchange sits the broker, a middleman who executes trades by virtue of being directly or indirectly connected to the exchange. Brokers have other functions, too. For instance, they perform a series of checks to decide if the investor is eligible to make the trade. These include ensuring the investor has sufficient funds and stays within price or size limits.
Market makers provide liquidity to financial markets by posting quotes (bids to buy and offers to sell) across a range of instruments on the exchange. Without them, market participants would find it harder to transact and trades would become more costly and difficult to execute. Optiver makes markets in multiple asset classes including derivatives like options and futures, stocks, and ETFs.
The central counterparty (CCP) comes into the picture once the trade is completed. It performs all the necessary calculations to determine what is needed from each side and by when. The CCP is responsible for making sure both the parties meet their obligations, so that cash and securities change hands in a timely way. Some firms connect to the CCP directly or use general clearing members (GCMs) to clear on their behalf.
The custodian or depository is responsible for ensuring the safekeeping of the financial assets. After a trade is completed, the custodian receives a notification and then ensures the relevant securities are transferred to the right accounts.
So how does this all come together to make a trade happen?
Step 1: The investor submits an order
It all starts with the investor. They inform the brokerage what security they want to buy or sell, how much and at what price.
Step 2: The order passes through the brokerage firm
Once the sales trader in the front office of the brokerage firm receives the order, it either goes through an automated computer check or gets passed to risk-management experts in the middle office. In both cases, a series of checks are performed to see if the customer’s order falls within acceptable limits. If it does, then the order is sent for execution. If not, it’s rejected.
Step 3: The order arrives at the exchange
Once an order passes these risk management checks, it can be transmitted to the exchange. Trades that arrive at the exchange are placed in the order book. The order book is an electronic ledger that records all the offers to sell (“asks” or “offers”) and bids to buy (“bids”) for a particular instrument. When a bid and an ask match, then the trade is executed. We’ll have more to say about how the order book works in an upcoming explainer.
Step 4: The transaction moves to post-trade
After a trade is confirmed, it moves through to what’s known as the post-trade phase. Here, brokers for the respective parties verify the details of the trade, such as the product, the price and the settlement date. The exchange also sends these details to the client’s custodian, who then forwards a confirmation to the broker. Remember the custodian is the entity responsible for ensuring the safekeeping of its client’s financial assets. Once the transaction is confirmed, the back-office team gets to work and the CCP comes into play.
The role of the CCP is to take legal ownership of the shares during what’s known as the settlement period, when the securities are in the process of actually changing hands. In effect, it becomes a guarantor for the investors. It collects enough money from the buyer and seller (known as margin) to cover any potential losses if the trading parties do not meet their obligations. (In OTC trading, there’s no CCP to collect money from the participants and ensure that the trading parties meet their obligations). Once this is done, the CCP sends settlement instructions to the relevant parties.
Step 5: The trade settles
Settlement, which is when the cash and the securities actually change hands, is the final step in the process. After a trade is executed on the exchange, it generally takes two days to settle. This settlement date is commonly referred to as “T+2”, where “T” stands for the trade date. So if a transaction is marked T+2, securities and cash are exchanged two days after the trade is done. The majority of the markets operate on a T+2 basis. Trades can also be cash-settled, which means just cash changes hands, not securities.
The CCP holds accounts for each trading counterparty and facilitates the transfer. The buyer transfers cash through the CCP, and similarly, the seller hands over the securities. Back-office staff ensure payments are made on time and properly documented. At the end of each trading day, the CCP reports transactions to the exchanges and custodians.
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To discuss this paper – or any other market structure topic – reach out to the Optiver Corporate Strategy team at [email protected]