Part-15: Brokerage

Operations

Micro Issues
Trade Life Cycle

&
Straight Through Processing
TLC
 What do we mean by `trade lifecycle’?
 All the steps involved in a trade from the point of
order receipt to trade execution through to
settlement are referred to as the lifecycle of the
trade.
 The management of all STOs require that
trades are processed in the most efficient
manner.
 This is reflected in their desire to achieve STP.
TLC (Cont…)
 STP is achievable if the lifecycle is begun by
recording the details of each trade in a
timely and accurate fashion within the front
office, and is handled efficiently and cost-
effectively in the operational areas of the
STO.
 A problem created early on in the cycle will
cost more to correct the further it is allowed
to flow uncorrected.
STP
 What is Straight Through Processing?
 It is a term used to describe the objective of
managing trades throughout the lifecycle
automatically and without human intervention.
 Historically there was little or no connectivity
between the various systems within an STO.
 This resulted in manual rekeying of individual
trade details at various points.
 Even where connectivity existed between
internal systems a lack of consistent reference
data prevented automatic passing of trade
details from system to system.
STP (Cont…)
 The objective of STP is the
following.
 Following trade execution

Input the details of individual trades only
once

And from that point until the complete
settlement of the trade. Manage each of
the steps in a fully automated fashion.
Elements of TLC
 Trading Activities
 Trade Execution
 Trade Capture (Front Office)
Elements of TLC (Cont…)
 Operational Activities:
 Trade Capture (Back Office)
 Trade Enrichment
 Trade Validation
 Trade Agreement
 Transaction Reporting
 Settlement Instructions
 The Role of the Custodian
 Pre Value Date Settlement Instruction Statuses
 Settlement Failure
 Trade Settlement
 Reflecting Trade Settlement Internally
Order Flow
 Typical steps in the placement of an
institutional order with an STO.
 The institution decides to buy or sell a specific
security and contacts an STO with whom it
normally trades. The details of the order are
normally conveyed to the relevant salesperson
within the STO.
 The salesperson records the details of the
order either manually or electronically within
an order management system.
Order Flow (Cont…)
 The order details are forwarded by the
salesman or are fed automatically by the
order management system to the
relevant trader or market maker.
 The trader will assess the order in order
to decide whether or not to trade. A
market maker must trade if the order
price is within the quote given by him. If
the trade is executed the details are
recorded in the relevant trading book.
Order Flow (Cont…)
 The trader will respond to the salesperson who placed
the order advising whether or not the trade has been
executed and if so on what terms.
 The salesman records the details of the execution
thereby closing the open order.
 The salesman will contact the client usually by phone
to advise whether the order has been fulfilled. A
formal trade confirmation will be sent later via a
medium of the client’s choice within a prescribed
deadline.
Trade Capture by the Front
Office
 All trades executed by an STO must be recorded
formally within the STO’s books and records.
 The first step is to record the basic details of each trade.
 This is necessary to:
 Update the trading position for the specific security
 Update the average price of the current trading position so that
when the next trade is executed the trader knows whether a
trading profit or loss will be made.
Trade Capture (Cont…)
 Traders normally use trading systems
designed specifically for managing their
positions and applying updated prices to
those positions.
 The basic trade details must be immediately
conveyed to the middle or back office to
allow operational processing to commence.
Components of a Trade
 In the case of a principal trade, the basic
components that are typically recorded by
the trader are:
 Trading book
 Trade date
 Trade time
 Value date
 Operation
 Quantity
 Security
 Price
 Counterparty
Trading Book
 The trading book has only internal implications.
 The purpose of assigning a trade to a specific book is
to assign internal responsibility and ownership for
the trade.
 This results in
 An update to the trading position within the specific
security
 And an update to trading profits within the trading book.
 Incorrect application of a trading book has no
external impact.
Trade Date
 The trade date is the day that the two parties agree to
execute the trade.
 It has internal as well as external implications.
 It has an impact on the following aspects.
 The date that a trading position is updated.
 If a trade is not recorded on the trade date the trading position will
remain incorrect until it is recorded.
 Besides, unless it is recorded the risk exposure with the counterparty
cannot be assessed.
Trade Date (Cont…)
 Trading P&L Calculation
 The P&L impact of a trade cannot be calculated if the
trade is not recorded.
 Calculation of accrued interest
 The trade date is connected to the value date of the
trade and the value date is used in most markets to
calculate the accrued interest.
 If the trade date is incorrect, it can affect the value
date which could affect the accrued interest and
consequently the Net Settlement Value.
Trade Date (Cont…)
 Entitlement to income on equity
 Is most markets entitlement to dividends is related to
the trade date.
 If the trade date is incorrect the buyer or the seller
could lose his entitlement.
 Trading systems typically assume that the trade
date is the same as the trade input date.
 Usually this poses no problems.
 However precautions must be taken if there is a `late
booking’, that is the trade is being recorded a day late
or there is an `as-of’ trade like `as-of’ yesterday.
Trade Time
 In many markets regulators require the
STO to record the exact hour and minute
that the trade was executed.
 This enables:
 Monitoring the STO’s activities to ensure that
the trades have been executed at the `best
execution’ price. This has implications for the
protection of the investor.
Trade Time (Cont…)
 It enables the settling of disputes between
counterparties regarding the basic details of the trade
such as quantity differences.
 It enables market surveillance on the part of the
regulator to identify abnormal trading activity.
 Regulators also insist that all telephone
conversations made by traders are taped.
 When a dispute arises the trade time is used to
quickly identify and retrieve the relevant tape.
Trade Time (Cont…)
 In some cases, the trade time is used as a
measure for trade reporting.
 In the Eurobond market, the regulator
requires that all trades executed by UK
based members of the Eurobond industry
body – The International Securities Market
Association (ISMA) – report details of their
trade to ISMA via their system TRAX within
30 minutes of trade execution.
 Fines are imposed on members who fail to
meet the deadline.
Value Date
 The value date is the intended date of
securities for cash.
 This is known as the contractual
settlement date.
 Note that the actual settlement date could
be different because of settlement failure.
 The period between the Trade Date
and the Value Date is known as the
Settlement Cycle.
Value Date (Cont…)
 The longer the settlement cycle the
greater is the possibility of one of
the parties defaulting.
 For instance if a buyer is not required
to pay for many days following the
trade he may be tempted to default
should the market price of the security
fall sharply before the value date.
Operation
 The term operation refers to the
direction of the trade
 Is the STO a buyer or a seller
 Or in the case of a securities lending
or borrowing transaction, is the STO a
lender or a borrower.
Quantity
 The quantity refers to the number of
shares or bonds that have been bought
or sold.
 Standard tradable quantities may
apply to both shares and bonds.
 Shares are often traded in Round Lots or
Board Lots.
 Bond are traded in multiples of the
minimum denominational values.
Quantity (Cont…)
 The quantity will require inputting
by the trader.
 But the trading system should
verify its validity by reference to
static data.
Security
 When a trade is being executed we
must know precisely which security is
being traded.
 In the case of equities confusion can
arise in cases where an original security
and a second security with superficial
similarity are validly in existence at the
same time.
Security (Cont…)
 An example would be where new shares have been
created in addition to the original shares.
 The two may need to be identified separately in a
situation where the new shares may not be equal in
all respects until a later point in time.
 For instance the next dividend may be payable only on
the original shares and not on the new shares.
 Following the payment of the dividend the two types of
shares will become equivalent.
Security (Cont…)
 In the case of bonds, some issuers such as
the World Bank may have hundreds of bonds
with details that are extremely similar such
as:
 Issues with identical coupon and maturity but
with different currencies of issue
 Issues with identical coupon and currency but
with different maturity dates
 Issues with identical maturity and currency but
with different coupons.
Security (Cont…)
 At the time of trade execution the two
parties must be precisely aware of the
security that they are dealing in.
 To help avoid errors securities identification
code numbers such as ISIN and CUSIP are
assigned to each security.
 The security being traded should have its
details held within the static data repository.
Security (Cont…)
 Trading systems normally display only
those securities which pertain to the
particular trading book.
 The trader only needs to select the correct
security from the list.
 If the details have not been set up
within the static data trade capture will
be held up at the beginning of the TLC
causing delays and avoidable costs.
Price
 Price is an essential component of a
trade
 It is therefore important that the input
should be exact
 Equity prices are typically expressed as
a cash amount per share.
 Bonds are normally traded at a
percentage of the face value.
Counterparty
 Correct identification of the counterparty
is very important.
 Confusion can arise if an STO trades with
a group of companies consisting of
trading entities in different locations.
 Being uncertain of the counterparty and
its location can lead to
 Delays in settlement processing
 Unmatched settlement instructions
Counterparty (Cont…)
 When an STO trades with a mutual fund
manager it is common to find that at the
point of placing an order and at the time
of execution the fund manager is yet to
decide to which of its underlying funds the
trade should be allocated.
 It may take a number of hours for the fund
manager to respond with allocation details.
Counterparty (Cont…)
 Under these conditions the STO has
executed a trade with a counterparty
knowing that the final counterparty details
will differ from the counterparty known at
trade execution.
 Normally the trade is recorded as executed
with the parent counterparty, and later on,
when the allocation details are known, the
original trade is replaced.
Counterparty (Cont…)
 The counterparty with whom the
trade was executed should be held
within the static data repository.
 The trader only needs to select the
correct counterparty inclusive of
location from the list.
 If the data is not present at the
outset, trade capture will be held up
at the beginning of the TLC.
Front Office Trade
Reference
 The trading system should perform
validation that all necessary components of
a trade are present before assigning a trade
reference number to a trade.
 Storage of the reference number allows
identification and inspection of the details at
any time after trade capture.
 This is vital if the trade is subsequently
amended or cancelled.
Subsequent Action
 Once the trade is captured within a
trading system the details should be
sent to the back office immediately for
operational processing.
 If the STO does not have a trading
system the details are recorded
manually on a `dealing slip’.
 This will be collected and delivered to
the middle office or the settlement
department.
Incorrect Capture
 Incorrectly recorded trades may lead to:
 Inaccurate trade confirmations being sent to
counterparties
 This could lead to a loss of business
 Inaccurate settlement instructions being sent to
the custodian
 This could lead to unmatched instructions with the
counterparty and require a subsequent amendment.
 Or if the instructions nevertheless match and the trade
settles it could lead to a monetary loss.
 Sometimes the STO may never even come to know that
there was an error.
Trade Capture within the
Settlement System
 In an automated environment, where the
trade has been sent by the trading system
to the back office system electronically, it is
to be expected that the trade will arrive
successfully in the receiving system.
 However it is possible that the trade fails to
arrive in the back office system.
 It is therefore recommended that a trade-by-
trade reconciliation is conducted to ensure that
the trades sent by the trading system have in
fact been received successfully by the back
office within an appropriate time frame.
Trade Capture…(Cont…)
 As soon as the back office system receives a trade
validation needs to be performed to confirm that
static data items like
 Trading book
 Security
 Counterparty
are known.
 If a check reveals a problem – eg. Counterparty not

known – the problem should be highlighted and

treated as an exception requiring corrective action.
 This will have the impact of temporarily halting

operational processing.
Trade Capture …(Cont…)
 Once the trade details have been
checked for validity, a settlement
system trade reference number will be
assigned.
 This is in addition to the trading system
trade reference number.
 The trade has now been accepted into
the settlement system and is now
ready for Enrichment.
Trade Enrichment
 Following trade capture within the
settlement system the details of a
trade require enrichment.
 What is enrichment?
 It involves the selection, calculation,
and attachment to a trade of relevant
information necessary to complete
further essential actions.
Trade Enrichment (Cont…)
 In an automated environment,
trade enrichment is achieved
through defaulting relevant
information automatically from the
store of information held within
static data.
 This is known as Static Data
Defaulting.
Trade Enrichment (Cont…)
 Steps involved:
 The basic trade details are captured within the
settlement system
 The basic trade details are compared with the
information held within the static data
repository, and if the necessary information is
present in the repository, the default
information is selected.
 The selected defaults are attached to the basic
trade detail to form the enriched trade.
Trade Enrichment
Components
 In general, the trade components requiring
enrichment are:
 Calculation of cash values
 Counterparty trade confirmation requirements
 Selection of custodian details
 Method of transmission of settlement instructions
 Determining the method of transaction reporting
(for regulatory purposes)
Trade Enrichment
Components (Cont…)
 The components pertaining to one
transaction type may be only
partially similar to the components
pertaining to another transaction
type.
 We will list the trade enrichment
components of each transaction
type.
Principal Transaction
 Required
 Cash value calculation
 Securities depot details
 Trade confirmation
 Transaction reporting
 Settlement instructions
 Securities accounting
 Cash accounting
Repo Transaction
 Required
 Cash value calculation
 Securities depot details
 Trade confirmation
 Transaction reporting
 Settlement instructions
 Securities accounting
 Cash accounting
Securities Lending and
Borrowing
 Required
 Cash value calculation
 Securities depot details
 Trade confirmation
 Transaction reporting
 Settlement instructions
 Securities accounting
 Cash accounting
Trading Book Transfer
 Required
 Cash value calculation
 Securities accounting
 Cash accounting
 Not Required
 Securities depot details
 Trade confirmation
 Transaction reporting
 Settlement instructions
Depot (Custodian)
Transfer
 Required
 Securities depot details
 Settlement instructions
 Securities accounting
 Not required
 Cash value calculation
 Trade confirmation
 Transaction reporting
 Cash accounting
Unsecured Borrowing and
Lending
 Required
 Cash value calculation
 Trade confirmation
 Settlement instructions
 Cash accounting
 Not required
 Securities depot details
 Transaction reporting
 Securities accounting
Nostro Transfer
 Required
 Cash value calculation
 Settlement instructions
 Cash accounting
 Not required
 Securities depot details
 Trade confirmation
 Transaction reporting
 Securities accounting
Foreign Exchange
 Required
 Cash value calculation
 Trade confirmation
 Settlement instructions
 Cash accounting
 Not required
 Securities depot details
 Transaction reporting
 Securities accounting
Determining Factors in Trade
Enrichment
 Before enrichment of individual
trades can occur, consideration
must be given to the choices that
an STO has for deriving the correct
information to attach to a trade.
 We will consider issues pertaining
to each component in detail.
Calculation of cash values
 In order to calculate all the cash related
components of a trade, it is necessary to
consider the following.
 Operation
 That is
 Buying or selling/Borrowing or lending
 This has implications for cash value calculations
 For instance client purchases of UK equity attract
stamp duty, but sales do not.
 Only sellers of US securities are required to pay an
SEC fee.
Calculation…(Cont…)
 Security group
 Stamp duty is payable on Irish equities but
not on Japanese equities
 Accrued interest is applicable to coupon
paying bonds but not to ZCBs.
 Counterparty Type
 Sales credits are normally calculated on
trades with institutional clients, but not on
trades with other STOs.
 Sales credits may be calculated differently
for different types of institutional clients.
Selection of Custodian
Details
 The selection of the relevant custodian
details for both the trading company and
the counterparty will be affected by the
following issues.
 Trading company
 If an STO processes the business of more than one
trading company
 Different custodians may be used by each of the
companies, even for the same security group.
 The same custodian may be used by both trading
companies, distinguished by different account numbers
for each company at the custodian.
Selection…(Cont…)
 Transaction Type
 Different transaction types will determine the settlement
location of a trade.
 A principal trade will settle at a securities custodian, whereas
a foreign exchange trade is likely to settle over a main bank
account.
 The custodian and the bank may not be the same entity.
 Security Group
 US equities will settle at the NEW York Custodian
 New Zealand government bonds will settle at the Wellington
custodian.
 Counterparty
 Where there is a choice of settlement locations, a
counterparty may choose. Some counterparties may select
the settlement location on a trade-by-trade basis.
Counterparty Trade
Confirmation Requirements
 An STO will normally issue a trade
confirmation to its institutional
clients, as a part of its service.
 But it may not issue confirmations
to other STOs with which it trades.
Determining the method of
Transaction Reporting
 The types of security in which an STO
trades may require that the STO carries
out its transaction reporting via
different methods.
 For instance, a UK based STO may be
required to report UK equities via one
route, and its international bond
transactions via another route.
Method of Transmission of
Settlement Instructions
 The methods used to transmit settlement
instructions will depend on the following.
 Trading Company
 Where an STO processes the business of more
than one trading company each company may
have a preferred but different method of
transmission.
 For instance company A may choose to transmit
via telex while company B may choose to transmit
via SWIFT.
Transmission (Cont…)
 Custodian
 Custodians typically have a preference
for the method of communication
between themselves and the STO.
Failure to Apply Static Data
Defaults
 In an automated environment,
failure to fully enrich a trade may
be intentional or unintentional.
Intentional Failure
 In a situation where the default of a
particular trade component is best applied
manually, the STO may choose to set no
automatic default of static data.
 For instance Italian Government bonds can
settle domestically in Milan or
internationally in Euroclear or Clearstream.
 An STO may choose to settle an individual
trade in or other location depending upon
the circumstances.
 If no general rule can be applied then it is not
possible to automate the default.
Unintentional Failure
 In an automated environment it is not possible
to default static data automatically if such data
is missing for a particular component.
 For instance a specific counterparty is set up
within both the trading system and the
settlement system, but no custodian details are
set up within the settlement system for that
counterparty.
Enrichment of Counterparty
Custodian Details
 An STO needs to calculate its counterparty’s
custodian details in addition to its own
custodian details.
 When a trade is executed by an STO, it is
necessary to determine where it wishes to
settle the trade.
 This is particularly true if it trades in many markets.
 It must also determine how the counterparty
wishes to settle the trade
 This information will be required on the settlement
instruction issued by the STO
Example
 WSIL an STO has bought 5,000,000 News
Corporation shares from PTIF.
 WSIL first needs to assess how it wishes to
settle the trade from its own perspective.
 It needs to determine its appropriate custodian
based on the individual security or security group.
 In this case the equity is Australian.
 So the decision is taken to settle at Custodian A in
Sydney.
Example (Cont…)
 A similar decision needs to be taken by
WSIL regarding where it believes PTIF will
settle the trade according to the
information received from PTIF and held
within WSIL’s static data.
 The custodian to be used by the counterparty
will appear on the settlement instruction that
will be sent by WSIL to its custodian.
Example (Cont…)
 This is essential information.
 Otherwise WSIL’s custodian will not know
with whom the trade is to settle.
 Merely stating PTIF does not provide the
answer.
 The information required to match and
settle the instruction sent by WSIL is
 The account number at the relevant
depository of the Australian custodian being
used by PTIF
 Let us assume it is Custodian B in Melbourne.
Example (Cont…)
 Following trade execution between WSIL and
PTIF the trade would be
 captured within the trading system
 then captured within the settlement system
 followed by trade enrichment within the
settlement system.
 In the process WSIL would have calculated
 The custodian that it wishes to use
 And PTIF’s custodian
 The sequence of steps taken would be as
follows.
Example (Cont…)
 WSIL issues a settlement instruction
to its custodian telling
 Custodian A in Sydney to receive
5,000,000 News Corporation ordinary
shares, against payment of the
relevant cash amount
 From Custodian B Melbourne whose
depository account number is
5532896.
Example (Cont…)
 PTIF issues a settlement instruction to Custodian B
asking it to deliver shares against the relevant cash
amount to Custodian A
 Whose account number at the depository is 5023598.
 Custodian A should update its records with the details
of the instruction received from WSIL
 Custodian B should update its records with the details
of the instructions received from PTIF.
Example (Cont…)
 Each custodian should aim to achieve a
match of their client’s settlement
instructions with the counterparty’s
custodian.
 If the information does not match the
custodians have no authority to change any
aspect of the client’s settlement instruction.
 They must however advise the client about
the status of the instruction.
Example (Cont…)
 If there is a mismatch WSIL would need
to investigate.
 If its static data is accurate in all respects
 And if the trade is properly enriched
 The number of unmatched instructions will be
minimized.
 However settlement instructions may be
unmatched for other reasons
 Such as price or quantity differences
Trade Validation
 Having executed, captured and
enriched a trade it is now complete
and further taskes such as
 Issuing a trade confirmation
 Reporting the trade to the regulatory
authorities
 Issuing settlement instructions can
proceed.
Trade Validation (Cont…)
 However many STOs adopt a final
check of the data contained within
a fully enriched trade to reduce the
possibility of incorrect information
being sent to the outside world.
 This is known as Trade Validation.
Fundamental Risks
 The basic risks associated with trades are that
an STO may make a loss
 This could happen directly
 While buying
 By paying more cash than the market value
 By paying the correct amount but without simultaneous
receipt of securities
 While selling
 By receiving less cash than the market value
 By delivering securities without simultaneous receipt of
cash
 This could happen indirectly
 By losing clients due to provision of slow and
inaccurate service.
Reasons
 These risks can arise as a result of the following
issues
 Trading error: The trader makes a mistake at the
time of execution
 He trades at a price that is significantly different from the
market price
 Or he agrees to settle on an FoP basis
 Trade recording error
 The trade has been captured with one or more components
that differ from those that were in fact executed
 Eg.: 10 MM shares were purchased but is has been recorded as
1 MM.
Reasons (Cont…)
 Trade enrichment error
 The calculation of trade cash values is
incorrect
 For instance the number of days of
accrued interest on a bond is incorrect
 Trade validation is a task that is
designed to detect such situations
on a trade by trade basis.
Basic Trade Validation
 The trade components ought to be viewed
from the following perspectives.
 Trading book
 May be restricted to specific transaction types
(eg. Principal only)
 May be restricted to specific instrument groups
(eg. Japanese securities)
 May be restricted to specific traders
Validation (Cont…)
 Trade Date
 Should be `today’ for a new trade
 Cannot be in the future
 Should be today or in the recent past
for an amended trade
 Should be a business day
 Cannot be after the value date
 Trade Time
 Cannot be in the future
Validation (Cont…)
 Value Date
 Is normally the standard settlement cycle for the
security group eg. T+3 for US securities
 May be shorter or longer than the standard (if the
trader has agreed at the time of execution and
has recorded that date)
 Should be a business day in the location of
settlement
 Cannot be earlier than the trade date
 Cannot be earlier than the primary value date of
a new issue
Validation (Cont…)
 Operation
 This typically cannot be validated
 Settlement personnel have no means of knowing whether the
trader should be buying or selling; borrowing or lending
 Quantity
 Cannot be less than the minimum denomination of a
bond
 Must be in multiples of the minimum denomination of
a bond
 Is normally in multiples of a round lot for equities
 May be an odd lot for equities
Validation (Cont…)
 Security
 Cannot be a matured bond
 Cannot be an expired warrant
 Must be clearly distinguishable from other
securities
 Price
 Must be expressed according to the security
group
 Share price must be an amount per share
 Bond price must be either a percentage relevant to face
value or a yield
Validation (Cont…)
 Counterparty
 Must be clearly distinguishable from others
 Must include location
 Trade cash value
 Must be quantity x price plus or minus other
costs such as stamp duty
 Accrued days must be relevant to last coupon
payment date and value date
 Accrued interest must be relevant to quantity,
accrued days, and coupon rate
Validation (Cont…)
 Trade confirmation
 Should be sent to institutional clients
 Should not be sent to STOs if for
instance an electronic trade matching
system is in place
 Company’s and Counterparty’s
Custodian
 Must be relevant to the security group
Additional Trade Validation
 In order to have the ultimate level of control regarding
the information that is about to be sent to the outside
world, the following types of validation measures are
taken by some STOs in addition to the basic trade
validation steps.
 Any trade falling within or more of the following
categories should be treated as an exception and held
pending validation.
 This means that such trades will not be handled on an STP basis.
Additional Validation
(Cont…)
 Trades due to settle on an FoP basis
 Extreme caution needs to be taken when settling
on an FoP basis
 All such trades should be held for validation
 Trades with a cash value at or above a certain
figure
 To give specific focus to all trades that are deemed
to be large, all trades with a net settlement values
of a given figure or greater, or the currency
equivalent of that figure or greater, should be held
for validation.
Additional Validation
(Cont…)
 Trades in a Specific Transaction Type
 All trades in a specific transaction type may be
required to be held for validation to ensure
correctness before transmission to the outside
world.
 Trades with a specific counterparty
 This is likely to be required for trades with
institutional clients
 May be necessary because the client is new
 Or could be because an existing client has complained
about the accuracy of information or speed of service
provided on past trades.
Additional Validation
(Cont…)
 Trades in a Specific Market or Security
Group
 Where an STO is trading in particular
market for the first time it may
 Wish to recheck that trade cash values are
accurate
 That custodian details are correct for all trades
on securities within a group
 This may prove necessary for a limited
period only until it is proved that new
trades are correct routinely.
Additional Validation
(Cont…)
 Trades Due to Settle at a Specific
Custodian
 If an STO has recently changed
custodians at a financial centre it may
wish to verify all trades destined for
settlement at that custodian
Additional Validation
(Cont…)
 Trade Price Outside of market Price
 As a precautionary measure an STO
may decide to validate all trades to
ensure that prices are reasonable.
 Because price is a major factor in
deriving the Net Settlement Values,
there is a danger of an STO making
overpayment on purchases or
receiving underpayment on sales.
Additional Validation
(Cont…)
 If the current market price is accessible and a tolerance
is set against the current market price (to allow for
typical validity) then only those trades falling outside the
set tolerance should be held for validation.
 When such trades are identified management may need
to be informed. The management should decide as to
how tight the tolerance should be.
 Too tight a tolerance may mean that many trades are being held
for validation thereby preventing STP
 Too loose a tolerance may mean that incorrect prices are being
processed undetected.
Additional Validation
(Cont…)
 Trades in a Specific Trading Book
 The management may wish to
monitor the trading activity of a
particular trading book
 Trades with trade dates in the past
 Any new trade that has a trade date
in the past may be held for validation
to ensure that it is valid.
Additional Validation
(Cont…)
 Trades with value dates in the past
 Any new trade with a value date in the past should be
held for validation for this is an indication that
something is seriously wrong.
 If settlement should have occurred in the past this is
highly likely to result in a cost to the STO.
 All amended trades
 Some STOs may wish to monitor all amended trades
to ensure that trades recorded with incorrect quantity
or price have been amended correctly.
Additional Validation
(Cont…)
 All Cancelled Trades
 The need for outright cancellation should be
minimum and an STO may wish to check the detail
before issuing information such as canceling trade
confirmations and canceling settlement instructions
to the outside world.
 Validation provides the STO with a high degree
of control resulting in reduced inaccuracies.
 But there is a compromise between sufficient
control and STP.
Manual Trade Validation
 Due to the number of trade
components manual validation is
likely to result in
 A limited number of components
being validated so as not to adversely
affect meeting external deadlines
 Occasional human error resulting in
the failure to identify a risk or an error
Manual Validation (Cont…)
 In order to identify problematic trades manual
validation needs to be undertaken by the more
knowledgeable members of the middle or back
office using their `experienced eye’ to scan the
components of a trade and their knowledge to
sense whether or not a trade is acceptable.
 But a significant amount of manpower would be
required to validate all trades to the fullest
extent due to the sheer volume of trades
executed by an STO.
Manual Validation (Cont…)
 In order to meet the combined demands of
 STP
 Servicing clients accurately and speedily
 Issuing settlement instructions by the necessary
deadlines
 Transaction reporting within required deadlines
extensive validation is possible only by using
efficient and intelligent systems.
Automated Trade
Validation
 The processing of trades can be highly
automated while achieving satisfactory
levels of STP and control over trades
requiring additional validation.
 An STO could decide that all trades should
be handled on an STP basis unless identified
to be held for validation.
 Trades held for validation are referred to as
`exceptions’ and are therefore subject to
`exception handling’.
Automated Validation
(Cont…)
 The trigger that causes trades to be treated
as exceptions is the setting of rules within
the settlement system.
 All or some of the rules studied earlier could
be set up within the settlement system.
 After each trade has been enriched the
system would compare the trade details
with the relevant rules.
Automated Validation
(Cont…)
 If the trade passes the validation check
it would be allowed to continue
immediately and can be regarded as
having been processed on an STP basis.
 If the trade fails the validation check it
will be treated as an exception and will
be held for validation.
Automated Validation
(Cont…)
 When a trade is held for validation it is
temporarily suspended and no actions
such as
 Issuance of a trade confirmation
 Or issuance of a settlement instruction
should occur until the trade has been
released from its exception state.
Flow
 We will summarize the flow of trades where
handled on an STP basis and where an
exception is found.
 The trade is captured, enriched and is now
subject to validation.
 The details of the trade are compared with
preset validation rules.
 If all rules are passed the trade will be
forwarded immediately for actioning of
other operational tasks such as
 Trade agreement and
 Transaction reporting
Flow (Cont…)
 If the trade fails the validation check it will be held for
validation and routed for exception handling
 The trade will be forwarded to the appropriate authorizer
depending on the reason for being withheld
 Having been investigated and found to be correct the trade
is authorized.
 The trade within the exception handling system is updated
and released to the settlement system
 The trade is now forwarded for actioning of operational
tasks.
 If the trade is found to require amendment or cancellation
further action may be required by the fornt office staff.
Flow (Cont…)
 Further automation may be employed
where resolution of an exception has
not occurred within an acceptable
timeframe.
 The management of an STO may
decide for instance that unresolved
exceptions that are for example 45
minutes old should be escalated to a
more senior staff member.
Trade Agreement
 Once a trade has passed validation a
number of tasks can commence.
 The action that is regarded as most urgent
is the act of gaining agreement of the
trade details with the counterparty.
 Trade agreement can be achieved through:
 Issuance of outgoing trade confirmation to the
counterparty
 Receipt of incoming trade confirmation from the
counterparty
 Trade matching
 Trade affirmation
Trade Agreement (Cont…)
 In a generic sense trade agreement is
achieved by the STO communicating the
details of each trade to its counterparty
whereupon the counterparty should check
the detail and revert to the STO if:
 It recognizes the trade but the details differ
 Or if does not recognize the trade
Trade Agreement (Cont…)
 The communication needs to contain all the
basic trade details as a minimum plus
 The cash value calculations and optionally
 The settlement details including
 STOs and the counterparty’s custodian details
 Their account numbers
 And whether the trade is to settle on a DvP or FoP
basis
Trade Agreement (Cont…)
 Matching of buyer’s and seller’s details is in
many cases effected through two routes
 Trade Agreement: Agreement of trade detail
between the two parties
 And additionally
 Settlement Instruction Matching: The custodians
of the buyer and the seller attempt to match
settlement instructions prior to delivery of
securities and payment of cash.
Trade Agreement (Cont…)
 These two exercises are similar in that the trade
details are matched prior to the value date.
 But the timing is usually different.
 Trade agreement is necessary immediately after trade
execution to ensure that the correct counterparty has
been recorded by the STO and that the details agree
 This is from a risk mitigation perspective
 Settlement instruction matching is typically effected at
any time between trade execution and the value date.
Reducing the STO’s Risk
 For each executed trade the STO
remains at risk of its trading P&L
being incorrect if the trade and its
detail has not been agreed or
matched by the counterparty within a
reasonable timeframe.
 The P&L remains subject to change until
it is proven that all trades have been
agreed by the counterparties.
Reducing Risk (Cont…)
 Because of the risk the objective is to gain
agreement of the trade detail as soon as
possible after trade execution.
 To reiterate, the situation is as follows:
 The trader has just executed a trade with the
counterparty
 The trade has been recorded within the trading
system
 The trade has been captured within the
settlement system
 The trade has been validated internally
Reducing Risk (Cont…)
 But there is no guarantee that:
 The counterparty with whom the trade
has been captured is the same as the
counterparty with whom the trade was
executed
 The trade details
 Quantity
 Price
 Net settlement value
 Will be agreed to by the counterparty
Risk Reduction (Cont…)
 From an STO’s perspective failing to seek
agreement of trades with its counterparties soon
after trade execution will inevitably
 Result in the identification or errors during the settlement
instruction matching process
 Which in a T+3 cycle is unlikely to bring errors to light
until the day following the trade date at the earliest.
 The longer a trade remains unmatched after
execution the greater is the risk of price movement
and subsequent loss.
Risk Reduction (Cont…)
 Time is an important factor.
 Assume that trader believes he sold 15 MM shares
at a price of HKD 22.59 on trade date 15 June for
value date 18th June.
 On 17 June it becomes apparent through the
settlement instruction matching process that the
counterparty believes it bought at HKD 22.55 and
investigation proves that the other party is correct.
 The trade will have to be amended to the correct price
 This will have a negative impact on the P&L
Risk Reduction (Cont…)
 Take a worse example
 On 17 June the counterparty does not
recognize the trade at all.
 If this results in the trade being cancelled
outright
 The STO will have a positive position of 15MM
shares
 If the price were to have fallen in the interim
the trader would have failed to realize a
profitable opportunity.
Trade Agreement Methods
 The method of agreement of trade details
between the parties to a trade varies
according to
 Local regulations
 Market practice
 Type of counterparty
 Generally agreement of trades executed
with other STOs is likely to be handled
differently from trades with institutional
clients .
Method-I
 Issuance of outgoing trade confirmations
 It is highly likely that an STO will be required to
issue a trade confirmation to its institutional
clients particularly where a trade affirmation
facility is not being used
 It is likely that an STO will want to issue a
confirmation to other STOs particularly where a
trade matching facility is not being used.
Method-II
 Receipt of incoming confirmations
from counterparties
 The STO may receive confirmations
from other STOs
 It is unlikely to receive confirmations
from institutional clients
 As such clients are the recipients of
service from the STO.
Method-III
Trade Matching
 Trade matching is a term used for the mandatory
electronic matching of trade details between STOs
and other members of stock exchanges/markets
such as agents for investors (excluding institutional
clients).
 Both parties are required to input the trade details
to a central matching facility.
 The matching results are provided to both parties.
 Where trades have been executed electronically the trade
detail is usually considered to have been already
compared and matched.
Method-IV
Trade Affirmation
 This relates to the optional electronic
matching of trade details between STOs and
institutional clients.
 The trade details are input by the STO to a
trade affirmation facility and the institutional
client agrees or disagrees.
 Both parties must elect to subscribe to such
a service.
Outgoing Trade
Confirmations
 Trade confirmations to Institutional Clients
 Where an STO has executed a trade with an institutional
client (for instance over the telephone) the client is likely to
require the receipt of a confirmation within a mutually
agreed time frame such as 1-2 hours.
 This timeframe is likely to shrink as settlement cycles shrink.
 The confirmation represents formal confirmation of trade
details which must be received by the client within an
agreed time frame and which must be completely accurate.
Outgoing Confirmations
(Cont…)
 Under some circumstances it may not be
possible for an STO to issue a confirmation
within the required timeframe.
 Institutional clients like fund managers
usually place an order to buy or sell a specific
quantity of a specific security within a limited
price.
 Once the trade is executed the STO’s salesperson
will report the details of the execution to the fund
manager informally, usually via telephone.
Outgoing Confirmations
(Cont…)
 Following trade execution the fund
manager will allocate the total trade to
one or many of its underlying funds.
 In practice the fund manager will
usually not convey to the STO the
names of the underlying funds until
some time after trade execution.
Outgoing Confirmations
(Cont…)
 For example an STO has sold USD
50MM World Bank 6.50% bonds
maturing 1st February 2018 to QRS
Fund Managers at a price of
98.625%.
 QRS will require the total quantity
of bonds to be allocated to its
underlying funds as shown below.
Allocation
Fund Name Quantity Price
QRS Healthcare 12,000,000.00 98.625
Growth Fund
QRS Global 10,000,000.00 98.625
Bond Growth
Fund
QRS European 25,000,000.00 98.625
Income Fund
QRS Pacific 3,000,000.00 98.625
Income Fund
TOTAL 50,000,000.00
Outgoing Confirmations
(Cont…)
 The fund manager usually requires the
receipt of trade confirmations for each
of the underlying funds.
 For ultimately it is the underlying funds that
have purchased or sold the securities and
not the parent.
 The STO needs to decide whether to
record the trade with the parent.
 It knows that this will have to be replaced
by one or many trades with the underlying
funds at some point later in the day.
Outgoing Confirmations
(Cont…)
 If the trade is recorded in the name of
the parent immediately after execution,
the STO would have reflected the
factual situation.
 If not the settlement system will not
reconcile with the trading system – the
trading positions will differ.
Outgoing Confirmations
(Cont…)
 Some STOs treat these situations as follows.
 The original trade is captured in the trading
system and fed to the settlement system.
 Eg. Sold USD 50 MM of bonds to QRS Fund Managers at
a price of 98.625%
 The original trade is captured within the
settlement system but is treated as a trade with
the parent, awaiting allocation to the underlying
funds.
 The trade is simply held in the knowledge that
allocations will be advised by the fund manager at the
earliest.
 No trade confirmation is usually issued to the parent.
Outgoing Confirmations
(Cont…)
 The fund manager advises the STO of the
allocations.
 The original trade is replaced by one or more
trades.

This may happen both in the trading as well as the
settlement system or only in the settlement
system.
 From the settlement system formal trade
confirmations can now be generated and
transmitted to the fund manager at the
underlying fund level.
Outgoing Confirmations
(Cont…)
 In order to gain agreement of trade details, the
STO normally issues a trade confirmation to
other STOs with which it has traded.
 There could be exceptions if an electronic trade
matching system is being used.
 Confirmations to institutional clients are
regarded as a part of the service.
 But confirmations to other STOs are used to
confirm that the trade details are correct as
soon as possible after trade execution.
Outgoing Confirmations
(Cont…)
 The issuing STO hopes that the
recipient STO will check the detail
upon receipt, and respond without
delay if its is found to be incorrect.
Content of a Confirmation
 From – the name of the issuing STO
 To – the name of the counterparty
 Attention – the relevant
person/department at the counterparty
 Subject – a heading that states the
purpose of the message, namely `Trade
Confirmation’.
 Our trade reference – the STO’s
settlement system trade reference
Content (Cont…)
 Trading capacity – the capacity in which the
STO has traded (principal or agent)
 Transaction type – principal, repo, FOREX etc.
 Operation – Buying/selling; Lending/borrowing
 Trade date – date of trade execution
 Trade time – time of trade execution
 Value date – contractual settlement date
 Quantity – quantity of shares, or quantity of
bonds with currency
Content (Cont…)
 Security – the exact, unmistakable
description of the security
 Security reference – ISIN, CUSIP etc.
 Price – quoted according to type of
security (share or bond)
 Principal – quantity x price
 Accrued days – relevant number of days
of accrued interest
 Accrued interest – cash value of accrued
interest
Content (Cont…)
 NSV – the cash value to be paid/received
 Our depot – the STO’s settlement location
of securities
 Our Nostro – The STO’s settlement
location of cash
 Your depot – the counterparty’s
settlement location of securities
 Your NOSTRO – the counterparty’s
settlement location of cash
Content (Cont…)
 Settlement basis – DVP or FOP
 Exchange/market – exchange or market
where a trade has been executed
 Rules – a statement that the trade is
subject to rules of the exchange/market
 Signoff by the STO – full name and
location of the STO
 Transmission time – a clear statement
of the date and time of transmission
No. of Copies
 Some counterparties – typically
institutional clients – may require the
receipt of one or more copies of a
confirmation for each trade.
 If multiple copies are required
 The counterparty may require all copies to
be sent to the same destination
 Or to different destinations via different
transmission methods
No of Copies (Cont…)
 The different destinations may
include
 The counterparty’s head office
 Its bank
 Its accountant
 To enable automation of this
service this information needs to be
held within the STOs static data
Incoming Confirmations
 Some of the counterparties with whom an
STO trades may issue confirmations.
 Usually this is the case if the counterparty is
another STO.
 Institutional clients typically expect only to
receive confirmations.
 After receiving an incoming confirmation
an STO needs to check whether to expend
resources checking the details contained
in the confirmation with its own records.
Incoming Confirmations
(Cont…)
 To gain trade agreement and to
avoid risk, it is better to check the
confirmation on receipt.
 This will highlight whether the STO
and the counterparty agree or
disagree.
Risks of failing to check
 Decisions are sometimes taken not
to check incoming confirmations.
 For trades where agreement will not
be achieved by another means this
could result in monetary loss for the
STO.
Example
 A telex confirmation has been received
by an STO from a counterparty on the
afternoon of the trade date.
 The trade is due to settle T+3
 The STO decides not to check the incoming
confirmation.
 However a discrepancy comes to light a
day prior to the value date.
 Investigation reveals that the counterparty’s
price or quantity was incorrect.
 The counterparty has to consequently amend its
detail.
Example (Cont…)
 It look as if the STO has incurred no
cost.
 It was the counterparty that recorded the
trade details erroneously.
 But if the counterparty subsequently
realizes that a trade confirmation was
sent and that the receiving STO failed to
highlight the discrepancy
 It may seek some form of compensation.
Trade Matching with STOs
 Trade matching is a generic term used to
describe an electronic method of
comparing the trade detail of both seller
and buyer.
 The process typically includes:
 The transmission of trade details by both
parties to central trade matching facility by a
specified deadline
 The application by the matching facility of the
current status – matched or unmatched.
TRAX
 ISMA based in Zurich is a self regulatory
organization and trade association
responsible for regulating and enforcing
rules governing the orderly functioning of
the international securities market.
 During the 1980’s ISMA was primarily
focused on the Eurobond market.
TRAX (Cont…)
 In the Eurobond market, prior to 1989,
when an STO traded with another
STO, agreement was attempted but
not necessarily achieved by the
issuance of confirmations, normally in
the form of telexes.
 The situation was inefficient and full of
risk.
TRAX (Cont…)
 In 1989, ISMA introduced TRAX.
 It is a real-time trade matching
mechanism covering all
internationally traded debt and equity
securities.
 All ISMA members are required to send a
message to TRAX so as to be received by
TRAX within 30 minutes of trade
execution.
TRAX (Cont…)
 If a message is not received by TRAX
within a 30 minute deadline, a fine is
imposed on the STO.
 The fine is on a sliding scale.
 The later the message is received, the
larger is the fine.
 ISMA also imposes fines for other non-
compliance reasons such as
 Failure to provide all necessary trade details
 Failure to act on a no-matching advice
within a reasonable timeframe.
TRAX (Cont…)
 A TRAX message conveys the
details of the trade to a central
matching facility that compares
both seller’s and buyer’s trade
details.
 After comparison a real-time report
is generated that details the
current status of each trade.
TRAX (Cont…)
 However a TRAX message is not a
settlement instruction.
 There is a need to issue a settlement
instruction to the relevant custodian
independently of the TRAX message.
The TRAX System
 An STO executes a trade with a counterparty
both of whom must be ISMA members – or
non-member users of the system.
 Both parties send their trade details to TRAX
 TRAX searches for a match and then applies
the status
 The trade status is then made available to
both the parties.
The TRAX System (Cont…)
 The receipt of a status other than
`matched’ requires immediate
investigation by the STO, resulting in one
of the following actions.
 The STO leaves its trade details intact and the
counterparty amends it details
 The STO amends its trade details
 The STO cancels the trade
 The counterparty cancels or denies the trade
The TRAX System (Cont…)
 TRAX will apply the following trade statuses
for messages sent by the STO
 Matched – the STO’s and the counterparty’s
details have been compared and found to
agree
 Unmatched – The STO has input its trade
details, but the counterparty has not input
matching trade details.
 Denied Advisory – The counterparty does
not recognize the trade and has stated that
is denies knowledge of the trade
The TRAX System (Cont…)
 The following trade statuses will be
applied to messages not sent by the
STO.
 Advisory – Trade detail has been input
by the counterparty. The receiving STO
must either input trade details or else
state `denied’.
 Denied – If the STO does not recognize
the advisory trade, it can state `denied’.
Other Trade Matching
Services
 In the US the National Securities
Clearing Corporation (NSCC) has a
trade comparison service.
Automation
 In modern settlement systems the following
aspects of trade matching messages can
usually be automated
 The decision to issue the message pre or post
trade validation
 The decision whether to issue a message or not
according to the type of security - Eurobond
versus US T-bond
 The decision whether to issue a message or not
depending upon the counterparty – ISMA
members as opposed to non-ISMA members.
Automation (Cont…)
 The following can also be automated
 The transmission of the message to the
trade matching facility
 The receipt of the message status from the
facility
 The updating of the relevant trade record
(internally with the STO’s books and records)
with the trade matching status
 The highlighting of trades with a status other
than `matched’.
Trade Affirmation with
Institutional Investors
 Institutional investors are able to
have trades confirmed to them by
STOs and brokers electronically,
via Omgeo’s Oasys Global system.
 The advantage is that an
institution based in Tokyo can have
its trades confirmed electronically
by an STO based in Toronto.
Trade Affirmation (Cont…)
 Unlike trade matching for STOs
which is typically regulated by an
exchange or local regulator, the
decision to subscribe to the Oasys
Global system has to be taken by
each institutional investor.
Trade Affirmation (Cont…)
 Strictly speaking there is a
difference between Trade Matching
and Trade Affirmation.
 In trade matching, both parties input
details at the same time to a central
facility.
 In trade affirmation, the STO inputs its
trade details to which the institutional
investor affirms or responds.
Trade Affirmation (Cont…)
 Institutions that choose to
subscribe to Oasys Global usually
encourage STOs to use the system
in order to ensure that as many
trades as possible are affirmed via
this route and to realize the full
vale of the subscription.
Illustration
 Step-1: An STO executes a trade
with a fund manager.
 At this point he knows only the name
of the fund manager and not the
names of the underlying funds.
 Step-2: The basic trade detail for
the counterparty is input to Oasys
Global which forwards the detail to
the fund manager.
Illustration (Cont…)
 Step-3: The fund manager will check the
trade details with his own records and if
found correct the trade in Oasys Global
will be affirmed as correct and the
details of allocation to the underlying
funds will be input.
 Step-4: The STO will replace the original
trade by trades with the underlying
funds.
Illustration (Cont…)
 Step-5: The individual trades are input
to Oasys Global including the net
settlement value for each trade.
 Step-6: The fund manager checks the
trade detail for each of the funds, and if
found correct each trade in Oasys
Global is affirmed as `agreed’.
Trade Affirmation (Cont…)
 The receipt of a trade status other than
agreed requires that the STO
investigate without delay.
 The salesperson within the STO will have to
be informed.
 If the record of the trade detail is found to
be incorrect the STO’s books and records
will require amendment.

The revised input will have to be re-input to Oasys
Global.
Trade Affirmation (Cont…)
 The use of a system like Oasys
Global requires that the history of
each individual trade be recorded
in case of the need to investigate
past events.
 Other trade affirmation services in
the U.S. include Omgeo’s
TradeMatch system.
Automation
 The following aspects of trade
affirmation messages can normally
be automated.
 The decision whether to issue the
message pre or post trade validation
 The decision whether to issue a
message or not.
 For example a message need be sent only
if the counterparty is an Oasys Global
subscriber.
Automation (Cont…)
 Furthermore, the following can also be
automated.
 The transmission of the message via Oasys
Global.
 The receipt of message statuses from Oasys
Global.
 The updating of the relevant internal trade
record.
 The highlighting of trades with a status other
than matched.
Transaction Reporting
 Following the execution of a trade
the exchange/member is required
to report to the appropriate
regulator the details of each
transaction, within a pre-specified
timeframe after execution.
 This is referred to as Supervision or
Surveillance.
Transaction Reporting
(Cont…)
 There are different methods for
reporting.
 The chosen method depends on the
local regulator.
 One way is for the computerized
exchange to forward the trade
details to the regulator on behalf of
the stock exchange member.
Transaction Reporting
(Cont…)
 Or a part of the message sent by a
member may be used for reporting
purposes.
 For example if TRAX were to be used the
relevant information would be forwarded by
ISMA to the regulator.
 Or else a settlement instruction sent to a
depository may be forwarded to the
regulator

Eg. CREST in the U.K.
Transaction Components
 The usual trade information requiring submission
to the regulator is:
 Capacity – Principal or Agent
 Trade date
 Trade time
 Vale date
 Operation – Buy or sell
 Quantity
 Security
 Price
 Counterparty
Transaction Reporting
(Cont…)
 Upon receipt, the regulator will
analyze the details and attempt to
identify unusual patterns of trading
which may have been caused by
 Market manipulation
 Insider trading
 Errors on the part of the STO
Transaction Reporting
(Cont…)
 One objective of surveillance is to
identify trading activity that falls
outside the norm.
 Another objective is to identify
breaches of trading rules.
 Yet another objective is the
identification of insider trading.
Transaction Reporting
 In some markets automation is used to
search for abnormal trading patterns.
 On the NYSE a computer system named
StockWatch is used to identify abnormal
trading activity.
 At the Australian Stock Exchange a system
called SOMA is set up with limits
representing normal market activity

This enables any reported transactions that fall
outside the limits to be identified automatically.
After Detection
 When a regulator detects dubious
activity he will begin an investigation
 Typically all transactions executed by
the member in the specific security will
be examined.
 The member’s books and records will be
examined.
 Key personnel may be interviewed.
After Detection (Cont…)
 The issuing company may be contacted to
establish whether any company notices are
due for publication.
 If so, it is possible that insider trading may have
occurred.
 If suspicious trading practices are
uncovered disciplinary action can be taken
– this is termed as enforcement.
After Detection (Cont…)
 Punishment can be severe – including
prison sentences for insider trading.
 Members may be expelled; their license
to trade may be suspended.
 Investors who have suffered financial
losses may be eligible for compensation.
Settlement Instructions
 Settlement instruction is a generic term
used to describe the mechanism by which
trade settlement is initiated between the
seller and the buyer.
 The instructions are normally generated
and transmitted from the STO’s settlement
system to the appropriate custodian from
the list of the STO’s custodians depending
on the security that has been traded.
Settlement Instructions
(Cont…)
 Upon receipt of the instruction the
custodian will attempt to match the
detail with the custodian of the
counterparty and apply a status –
Matched or Unmatched.
 On the value date he will then attempt
to exchange securities and cash with
the counterparty’s custodian.
Risks associated with
settlement instructions
 In a manual system the generation of
settlement instructions should be restricted
to a select group.
 In an automated environment trade capture
within the STO’s trading system should be
restricted to authorized traders.
 If trade validation is through settlement
instructions should be allowed to flow
through in order to achieve STP unless
certain conditions are applicable.
Risks (Cont…)
 As far as possible the STO should
avoid settling on an FoP basis.
 That is, the trades as far as
possible, should settle on a DvP
basis.
 FoP settlement may be with or
without risk to the STO.
FoP with Risk
 The STO delivers securities prior to
the receipt of cash from the
counterparty.
 Or the STO pays the NSV prior to
the receipt of securities from the
counterparty.
FoP without Risk
 The STO delivers the securities
only after confirmation of receipt
of cash from the counterparty.
 Or the STO pays the NSV only after
confirmation of receipt of
securities from the counterparty.
Risks (Cont…)
 No back office should take unilateral decisions
that puts the company at risk.
 These decisions are best left to those with the
appropriate level of authority.
 When the back office is advised by a trader or
a salesperson to take risk, the operations
areas of some STOs insist on written
authorization from the head of trading.
Risks (Cont…)
 STOs must minimize the possibility of the
transmission channel between itself and
the custodians being accessed by those
who may seek to attempt fraud.
 An STO is likely to select a particular
custodian if it feels that the custodian’s
settlement instruction transmission system
is sufficiently secure – where high levels of
encryption are used to prevent outsiders
from deciphering the coded message.
Risks (Cont…)
 An instruction that has been issued
but not received by the custodian is
no different from an instruction that
has not been transmitted.
 There is a risk of financial loss in such
cases because settlement typically
cannot occur until settlement
instructions are matched with the
counterparty’s custodian.
Risks (Cont…)
 To minimize risk STOs typically require the
relevant custodian to acknowledge receipt
of the instruction.
 In an automated system instructions issued
can be compared against
acknowledgements received.
 If an acknowledgement is missing, it will be
highlighted as an exception.
Risks (Cont…)
 STOs trade and settle on a global basis
 They will consequently have custodians in
many different time zones.
 Each custodian will impose a deadline,
which will be relevant to the value date of
the trade.
 Thus the STO must remain aware of the
appropriate deadlines pertaining to each
custodian.
Settlement Instruction
Types
 Settlement of trades occurs in one
of two ways
 DvP
 Or FoP
DvP
 DvP is the simultaneous and irreversible
exchange of securities and cash
 Where DvP is the mode of settlement
 It is normal to issue a single instruction to the
relevant custodian requesting
 Delivery of securities versus payment
 Or receipt of securities versus payment
FoP
 FoP refers to the non-simultaneous
exchange of securities and cash.
 For FoP settlement it is normal for
two settlement instructions to be
generated.
FoP – When the STO is
Buying
 A settlement instruction needs to be
issued to the STO’s custodian to receive
the securities against nil cash value
 A separate instruction needs to be
issued to the STO’s bank (Nostro) to
make payment.
 The second instruction would depend on
whether settlement is to occur with or
without risk.
FoP – Without Risk
 The instruction will be submitted to
the bank only after receiving
confirmation of receipt of
securities by the custodian.
 This is known as `Upon Receipt’
FoP – With Risk
 In this case the instruction will
need to be transmitted in time for
cash to be paid to the counterparty
on the value date, irrespective of
the receipt of securities.
FoP – When the STO is
Selling without Risk
 In this case a settlement
instruction needs to be issued to
the custodian to deliver the
securities against nil cash value.
 If the STO is not to be at risk, this
instruction will be transmitted only
after having received confirmation
of receipt of cash by the Nostro.
FoP- When the STO is
Selling with Risk
 In this case the custodian has to be
instructed in time for the securities
to be delivered to the counterparty
on the value date, irrespective of
the receipt of cash.
Pre-Advice
 Irrespective of whether the STO is
selling with or without risk, a c ash
pre-advice may need to be issued
to the bank advising it to expect to
receive payment.
Content of Settlement
Instructions
 A settlement instruction tells the custodian
to carry out precise commands such as:
 To whom securities have to be delivered
 From whom payment is to be received
 Or
 From whom securities have to be received
 To whom payment has to be made
Content…(Cont…)
 The quantity of securities to be
received or delivered
 The net settlement value to be paid
or received
 The earliest date that the instructions
are to be carried out.
Typical Instruction
 From: name of the issuing STO
 To: name of the STO’s custodian
 Depot Account Number
 Nostro Account Number
 Trade Reference: the STO’s settlement
system trade reference number
 Deliver/Receive
Typical Instruction
(Cont…)
 Settlement Basis: DvP or FoP
 Value Date
 Quantity
 Security Reference: ISIN; CUSIP etc.
 Settlement Currency
 Net Settlement Value
 Counterparty Depot
 Counterparty Nostro
 Transmission Time: A clear statement of the date and
time of transmission
Other Components
 Trade components such as:
 Trade date
 Price

 Accrued days

Are also usually included in a settlement

instruction.
In the event of the instruction being
unmatched this allows the custodian to
communicate with the counterparty’s
custodian to identify the discrepancy.
Methods of Transmission
 Modern methods of transmitting
settlement instructions include the
following characteristics.
 The automatic generation of settlement
instructions by settlement systems
 The automatic transmission of instructions –
individually or in batches
 Electronic exchange of test keys
 Settlement instructions in standardized
formats
Methods…(Cont…)
 Secure transmission environment due
to high levels of message encryption
 High speed of transmission
 Predictable cost of transmission
 Enables STP
Methods…(Cont…)
 A widely used electronic
settlement instruction mechanism
is SWIFT.
 In order to utilize the SWIFT
network both the STO transmitting
the settlement instruction and the
destination custodian must
subscribe to SWIFT.
Methods…(Cont…)
 For transmission of settlement instructions
to International Central Securities
Depositories such as Euroclear and
Clearstream there is a choice of:
 SWIFT
 EUCLID for Euroclear
 CEDCOM for Clearstream
 Tested Telex
 Mail
Format
 Cedcom, Euclid, and SWIFT
transmission systems all have
standardized messages
incorporating mandatory fields
that are required to be used
according to the action required of
the custodian by the STO.
Format (Cont…)
 SWIFT has numerous categories of
settlement instructions and
messages for different purposes
 Some relate to securities
 Others relate only to cash movements
Format (Cont…)
 Series 2: cash related
 MT200: transfer between two
accounts of the same account holder
 MT202: payment of cash to a financial
institution
 MT210: receipt of cash from a
financial institution
Format (Cont…)
 Series 5: Securities Related
 MT540: sent to a custodian to receive
FoP
 MT541: sent to a custodian to receive
versus payment
 MT542: sent to a custodian to deliver
FoP
 MT543: sent to a custodian to deliver
versus payment
Format (Cont…)
 EUCLID
 It uses a numbering convention that
distinguishes between settlement
with another Euroclear participant as
opposed to settlement with a
Clearstream participant.
Format (Cont…)
 Euclid settlement instructions
 E01: Receive free or versus payment
from a Euroclear participant
 E02: Deliver free or versus payment
to a Euroclear participant
 E03C: Receive free or versus payment
from a Clearstream participant
 E07C: Deliver free or versus payment
to a Clearstream participant
Format (Cont…)
 CEDCOM
 Clearstream’s proprietary system
CEDCOM has a settlement instruction
numbering method that does not
distinguish the system the
counterparty is using.
Format (Cont…)
 Example of CEDCOM instructions
 41: Receive versus payment from a
Clearstream oe Euroclear participant
 41F: Receive free of payment from a
Clearstream or Euroclear participant
 51: Deliver versus payment to a
Clearstream or Euroclear participant
 51F: Deliver free of payment to a
Clearstream or Euroclear participant
Format (Cont…)
 CREST
 Is the system over which UK and Irish
settlements are effected
 Codes used by CREST
 ADVN: Delivery Input
 ASDN: Stock deposit input
 ASWN: Stock withdrawal input
Deadlines
 All custodians will quote a deadline
by which settlement instructions
must be received by them relevant
to the value date.
 The method of transmission is also
likely to affect the deadline imposed
by the custodian.
Deadlines (Cont…)
 Assume that the settlement processing
occurs in Bangkok during daylight hours of
the value date.
 A custodian in Bangkok may impose a
deadline of say 8 a.m. Bangkok time on the
value date
 Provided the instruction in transmitted in an
electronic form.
 This normally allows for matching of instructions
with the counterparty’s custodian.
Deadlines (Cont…)
 If a NYC based dealer buys shares
in a Thai equity for settlement on a
T+3 basis
 He must issue the instructions by
close of business on T+2 (EST) in
order to meet the deadline imposed
by the Bangkok custodian

This is to take into account the time
difference between the two cities.
Deadlines (Cont…)
 Euroclear and Clearstream begin to operate
their overnight settlement processing during
the evening of the day prior to the value
date.
 The deadline for the receipt of settlement
instructions imposed by Euroclear is 19:45
Central European Time on the day prior to
the value date.
Deadlines (Cont…)
 Deadlines exist so that the dealers are
aware of the time by which instructions
must be received in order for the trade
to settle on the value date.
 If instructions are received after the
deadline, the custodian may still
accept the instruction
 However it cannot be processed on the
value date.
Deadlines (Cont…)
 From the standpoint of the ICSDs
deadlines for transmission via
SWIFT or via the proprietary
systems are identical because the
format is standardized and the
information can be automatically
captured into the custodian’s
system.
Deadlines (Cont…)
 However transmission via telex is
not in a standardized format and
requires the custodian to rekey the
information.
 Thus a considerably earlier deadline
is imposed for instructions
transmitted by telex.
Deadlines (Cont…)
 Dealers effecting cross border
trading and settlement must be
conscious of the deadlines of each
custodian.
 They would need to take extra care if
using a mixture of electronic and non-
electronic methods of transmission.
Deadlines (Cont…)
 It is recommended that settlement
instructions be generated and
transmitted as soon as possible
after trade validation on the trade
date.
 This gives maximum time to resolve
any discrepancies prior to the value
date.
Deadlines (Cont…)
 Another reason not to delay
instructions is the possibility that a
software or communication fault
can occur before the deadline,
thereby preventing automatic
transmission.
Validation
 As for trade validation, some
dealers wish to review and
authorize certain types of
settlement instructions prior to
transmission to the custodian.
 This requires the setting up of
validation rules within the settlement
system.
Validation (Cont…)
 At the point of transmission the
system would compare the trade
detail with the relevant rules:
 If the instruction passes the check it is
allowed to continue immediately, and
can be regarded as having been
processed on an STP basis.
 If it fails, it will be held as an exception,
pending authorization by the relevant
staff.
Manually Generated
Instructions
 Even in an automated environment, it
may be necessary to generate
settlement instructions manually in
certain cases.
 For instance assume that a trader has
executed a trade but has failed to
record it within the trading system.
 Obviously there will be no record within
the settlement system either.
Manually (Cont…)
 On the value date the dealer finds that the
counterparty has input a settlement instruction
which is unmatched.
 If investigation reveals that the trade was in
fact executed, the trader would need to record
it within the trading system, and feed it to the
settlement system.
 This would obviously need to the generation and
transmission of a settlement instruction.
Manually…(Cont…)
 But at times there may be insufficient
time to follow such a process.
 In such cases the only option is to input
the instruction manually directly into
the transmission mechanism destined
for the custodian, so as not to incur the
settlement failure costs.
Manually…(Cont…)
 In such a case if the trade has not
been recorded within the
settlement system, the trade
reference number will be unknown.
 So a dummy trade reference
number will have to be applied to
the manual settlement instruction.
Manually …(Cont…)
 In such a situation when the trade is
captured within the settlement system,
the automatically generated settlement
instruction would need to be suppressed
to avoid duplication.
 When a custodian receives the manually
sent instruction, it will be subject to all
the normal settlement instruction
events.
Manually…(Cont…)
 But there will be no connection
between the instruction and the
trade within the settlement
system.
 Thus the trade record within the
settlement system will not be
updated automatically.
Safe Custody
 Following the execution of a trade
dealers typically expect to settle
externally with counterparties.
 This means issuing settlement
instructions to custodians.
 They will undertake the exchange of
securities and cash with the
counterparty’s custodian.
Safe Custody (Cont…)
 But what if the counterparty does
not have a custodian relationship
for external settlement to occur.
 In such cases the dealer may offer
to hold the client’s securities, and
possibly cash in safe custody.
Safe Custody (Cont…)
 This means that when the dealer sells
securities to the client, it retains control but
not ownership of the securities.
 He will therefore issue a settlement instruction
to remove the securities from its own account
(in which its securities are held) to a
segregated account at the custodian, in which
the securities owned by its safe custody
clients are kept.
 The reverse flow must occur when the dealer
buys securities from a safe custody client.
Safe Custody (Cont…)
 Both the main account and the safe
custody account are under the
direct control of the dealer.
 By law in many countries a dealer’s
own securities and those held on
behalf of others must be segregated
and held in different accounts at the
custodian.

But there is no need to hold the accounts
at separate custodians.
Safe Custody (Cont…)
 In terms of settlement instructions
this can mean the need to
generate and transmit either a
single instruction or two
settlement instructions.
 Consider the case of a sale by a
dealer to a safe custody client.
Safe Custody (Cont…)
 Whether one or two instructions
are required depends on the way
the custodian wishes to operate
movements between the two
accounts owned by the dealer.
The case of two
instructions
 One for the removal of securities
from the dealer’s main account
and delivery to the safe custody
account
 One for the receipt of securities
into the safe custody account from
the main account.
The case of a single
instruction
 For the removal of the securities
from the main account and
delivery to the safe custody
account
 This is known as `Own Account
Transfer’.
Instructions under Power
of Attorney
 Where trades have been executed either
on a computerized stock exchange
 Or via an electronic communications
network (ECN)
 The entity over which the trade has been
executed issues the settlement instruction on
behalf of the dealer.
 For this to occur, the dealer must give a power
of attorney to the entity.
Power of Attorney (Cont…)
 In such cases the dealer would
need to suppress the generation of
settlement instructions by its
settlement system, to avoid
duplication.
Power of Attorney (Cont…)
 When instructions are directly issued
to the custodian by another entity,
the dealer benefits
 This is because instructions are issued
very shortly after trade execution
 And the expense of issuing an
instruction is avoided.
 Besides the risk of issuing an incorrect
instruction is avoided.
Link Between a Trade and
its Settlement Instruction
 Dealers typically wish to maintain a
history of settlement instruction events
for each individual trade such as:
 Transmission to the custodian
 Receipt by the custodian
 Achieving a status of unmatched
 Achieving a status of matched
 Settlement failure
 Settlement completion
Link…(Cont…)
 To update the trades within the
settlement system automatically
with the information received from
the custodian, there is a need for a
link
 Between the settlement instruction
reference and the trade residing
within the settlement system.
Link…(Cont…)
 When the dealer has issued the
settlement instruction, the
settlement system trade reference
number is normally sent as a part
of the content of each settlement
instruction.
Link…(Cont…)
 But if another entity such as an ECN has
issued a settlement instruction under a
power of attorney
 The settlement instruction reference
number may not be the same as the
settlement system trade reference number.
 However there is still a need to update a
trade with the current status of the
settlement instruction.
Link…(Cont…)
 Maintaining a link between the trade
and its settlement instruction enables
the dealer to have a complete picture
of trades that require no action, such
as those with:
 Successful instruction receipt by the
custodian
 Matched instructions
 Instructions that have settled
Link…(Cont…)
 As well as trades requiring
investigation and action such as
those with:
 Unmatched instructions
 Instructions that have failed to settle
on the value date
The Role of the Custodian
 We have used the term custodian
as a generic term to describe those
organizations that effect
settlement on behalf of dealers.
 In reality, a number of organization
types fall within this group.
Custodians (Cont…)
 Custodians provide services not
only to dealers, but also to
 Individual investors
 Institutional investors
 And brokers
 These entities will be described
generically as the custodian’s
account holders.
Custodians (Cont…)
 Why is a custodian required?
 A custodian is appointed by an
account holder to take care of his
assets

Normally securities and cash
 And to carry out his instructions to
 Deliver or receive securities
 And to pay or receive cash
Holding Securities and
Cash in Safe Custody
 Following previous purchases of
securities by the account holder, once
settlement has occurred, the custodian
will hold the securities in safe custody.
 He will provide some or all of the
following services relating to the
holding of securities in safe custody.
Safe Custody…(Cont…)
 Keep the securities safe from the threat of theft
or loss
 Provide daily statements of securities and cash
holdings
 Provide current market valuations of securities
holdings
 Provide securities lending or borrowing facilities
 Collect income or additional securities relating to
the account holder’s entitlement.
 Advise of optional corporate actions.
Safe Custody…(Cont…)
 Following purchases of securities and upon
settlement the custodian will debit the cash
account of the account holder.
 The custodian may or may not allow the
account holder to hold cash balances on an
overnight basis.
 In case he does, then he will provide one or
more of the following services.
Safe Custody…(Cont…)
 Keep the cash safe
 Pay interest on cash balances
 Provide daily statements of cash
balances
Movement of Securities
and Cash
 When the account holder sells securities held by
the custodian or buys securities that will be held
by the custodian, he will issue a settlement
instruction to effect the appropriate movement
of securities and cash.
 He may also issue settlement instructions
relating to other transactions like
 Repos
 Depot transfers
Movement…(Cont…)
 When it comes to the movement of
securities and cash, the custodian will
provide some or all of the following services.
 Acknowledge receipt of the settlement instruction
 Apply the current pre-settlement status
 Unmatched
 Matched
 Failed to settle
 Transmit the current status of each instruction to
the account holder
Movement…(Cont…)
 Effect the delivery or receipt of
securities and the receipt or payment
of cash
 Upon settlement of each instruction
 Apply the status of `settled’

Update the account holder’s securities
holding

Update the account holder’s cash balance
Movement…(Cont…)
 In addition an account holder may wish
to have cash paid away from its account
at the custodian to another bank
 Or else have cash received by the
custodian from an external source
 In such cases he will issue an instruction
to pay away or a `pre-advice’ to receive
cash.
Types of Custodians
 Various terms are used to describe
those involved in the provision of
trade settlement and custodial
services on behalf of those who
execute trades.
Types of Custodians
(Cont…)
 These include:
 Custodian
 Global custodian
 Local custodian
 Sub-custodian
 Central Securities Depository (CSD)
 National Central Securities Depository (NCSD)
 International Central Securities Depository (ICSD)
 Settlement Agent
Custodian
 An organization that holds
securities and usually cash on its
client’s behalf
 May effect settlement of trades on
its client’s behalf
Global Custodian
 Performs the role of a custodian
 But has a network of local or sub-
custodians that hold securities and
cash and effect settlement on
behalf of it.
Local Custodian
 A custodian that operates within a
specific financial centre
Sub-custodian
 A custodian within a global
custodian’s network of custodians
CSD
 An organization that holds
securities
 Normally in book entry form
 Usually the ultimate place of
settlement effected through book-
entry transfer
NCSD
 A CSD that handles domestic
securities of the country in which it
is located
ICSD
 A CSD that handles domestic and
international securities
 Only two organizations are
recognized as ICSDs
 Clearstream in Luxembourg
 Euroclear in Brussels
Settlement Agent
 An organization that effects the
exchange of securities and cash on
behalf of its clients
 Resultant securities and cash
balances may or may not be held
Example
 A trade initiated by an institutional investor
resulted in the following actions.
 Institution placed an order with a broker
 Broker forwarded the order to a dealer
 Dealer executed the order and recorded the details of
the sale to the broker
 Dealer sent an advice of execution to the broker
 Broker recorded a purchase from the dealer and a
sale to the institution
 Broker sent an advice to the institution
 Institution recorded a purchase from the broker
Example (Cont…)
 Following the trade a settlement
instruction must be issued to effect
settlement ultimately at the CSD.
 Each instruction will request the
recipient to either
 Deliver securities and receive cash
from a specific account at the CSD
 Or receive securities and pay cash to
a specific account at the CSD
Example (Cont…)
 The steps are as follows:
 The institution issues a settlement
instruction to its global custodian
 The global custodian will issue a
settlement instruction to its custodian
in the relevant financial centre.
 Let us call it sub-custodian X
 X will issue a settlement instruction to
its own account at the CSD.
Example (Cont…)
 For its sale to the institution the broker will
issue an instruction to its custodian
 Let us call it local custodian Y
 Local custodian Y will issue an instruction to its
own account at the CSD
 For its purchase from the dealer the broker
issues a settlement instruction to custodian Y
 Local custodian Y will issue a settlement
instruction to its own account at the CSD
 For its sale to the broker the dealer issues a
settlement instruction to the CSD
Example (Cont…)
 On the value date
 The CSD removes the security from
the dealer’s account and adds them
to custodian Y’s account
 It will simultaneously debit cash from
custodian Y’s account and credit the
dealer’s account.
 This concludes settlement for the sale
by the dealer to the broker.
Example (Cont…)
 On the value date:
 The CSD removes securities from the
agent’s account and adds them to
custodian X’s account
 It will simultaneously debit cash from
custodian X’s account and credit the
agent’s account.
 This accounts for the sale by the
agent to the institutional investor.
Example (Cont…)
 Net result of these transactions
 Securities are held within custodian X’s
account at the CSD
 Who is holding on behalf of the global custodian
 Who is holding on behalf of the institutional
investor
 There are no securities held in custodian Y’s
account at the CSD on behalf of the agent
 There are no securities at the dealer’s
account at the CSD
Example (Cont…)
 The cash has been debited to custodian
X’s account at the CSD
 On behalf of the global custodian
 The global custodian will debit the cash cost to
its account with the institution
 There will be no cash held in custodian Y’s
account at the CSD
 The sale proceeds would have been
credited to the dealer’s account at the
CSD
Perspective
 Who is a client and who is a custodian?
 It depends on the specific entity’s view
 The institution regards the global custodian as its
custodian
 The global custodian regards its client as the institution
and its custodian as sub-custodian X
 Custodian X regards its client as the global custodian
and its custodian as the CSD
Perspective (Cont…)
 The broker regards its custodian as
custodian Y
 Custodian Y regards its client as the broker
and its custodian as the CSD
 The dealer regards its custodian as the CSD
 The CSD regards its account holders as

Custodian X

Custodian Y

And the Dealer
Perspective (Cont…)
 An institutional investor, broker or dealer
may choose to set up arrangements for
 Settlement of trades
 And holding of securities and cash
 With
 A local custodian in each financial centre
 CSDs in each financial centre
 A global custodian
 Or any combination of the three
Global Custodians
 A global custodian is appointed to
facilitate trade settlement and the
holding of securities and cash
 By use of its worldwide network of
sub-custodians

Each of which is usually a member of its
local CSD
Global Custodians (Cont…)
 The client issues settlement
instructions to a single destination
– the global custodian
 It will then direct its instructions to
the appropriate sub-custodian

Who will effect settlement on its behalf.
Global Custodians (Cont…)
 The exchange of securities and
cash occurs at the CSD
 Where accounts of the sub-custodians
representing buyer and seller will be
debited or credited with securities
and cash.
 Illustration
Global Custodian

Sub-custodian V Sub-custodian W Sub-custodian X

Australian CSD Spanish CSD Mexican CSD

NCSDs
 An NCSD is typically set up and
operated on behalf of the
members of the national stock
exchange of a country
 It is the core repository of
securities issued, traded and
settled in that country.
NCSDs (Cont…)
 Dealers and custodians located in
the same country as the NCSD are
likely to be direct members of the
NCSD.
 Non-resident dealers may not be
allowed to have direct membership
 They may be required to use a local
custodian
NCSDs (Cont…)
 NCSDs typically provide DvP and
FoP capability for their members
 They keep securities in safe-
keeping for their members
 But some NCSDs do not allow cash
to be held overnight
ICSDs
 An ICSD holds both international and
domestic securities
 Dealers, brokers, institutions and custodians
from round the globe can become members.
 Securities are held on behalf of the ICSD by
depository banks in numerous financial
centres
 Correspondent banks manage the external
movement of currencies.
ICSDs (Cont…)
 They provide DvP and FoP trade
settlement capability on a multi-
currency basis
 Securities are held in safe custody
 Cash balances are held overnight
 Only two ICSDs exist
 Clearstream in Luxembourg
 Euroclear in Brussels
ICSDs (Cont…)
 Settlement at the ICSDs falls into three
categories
 Internal
 Between two participants of the same ICSD
 Bridge

Between a participant of Euroclear and a
participant of Clearstream
 External

Between participants of an ICSD and an NCSD
 This is known as Cross Border Settlement
Custodian Selection
 Dealers have a choice
 They may set up relationships with CSDs or local
custodians in all markets in which they are active
 They may choose to have direct relationships with
CSDs or local custodians only in the markets in
which they are most active
 For less active markets they may use a global custodian
 They may use global custodians for all markets
Custodian Selection
(Cont…)
 One major consideration is cost
 In certain cases it may be cheaper to
set up relationships with CSDs or local
custodians
 On the other hand a global custodian
may offer a premium service.
Custodian Selection
(Cont…)
 The following criteria are typically used
to select a custodian
 Its credit rating

It signifies its status and financial stability
 Past performance

STP rates

Ability to process equities
 Ability to process debt securities

Proficiency of cash management
 Interest rates on cash balances
 Overdraft facilities

Methods of processing corporate actions
Custodian Selection
(Cont…)
 Cost of operating the service
 Cost of securities holdings
 Cost per settlement instruction
 Ability to process multiple currencies

This is provided within the ICSDs

This is likely to be provided by the global
custodian
 It is less likely to be provided by a local
custodian or an NCSD
Settlement Instruction
Statuses
 An STO needs to know the various
statuses applied by the custodian
 The frequency of updating the
instruction with statuses
 Method of communication of the
status
 Electronic or
 Non-electronic
Statuses (Cont…)
 The minimum statuses that a dealer would
expect to receive are
 Unmatched
 Including the reason
 Matched
 Settlement failure
 Including the reason
 Settlement completion
 Including information regarding the quantity of
securities delivered/received and cash paid/received
Services Related to
Securities and Cash
Holdings
 The following criteria relate to the
custodian’s holdings of securities and
cash on behalf of the dealer.
 Securities lending and borrowing
 Cash borrowing arrangements
 Rates of interest on cash balances
 Statements of securities holdings
 Statements of cash balances
 Corporate actions
Securities Lending and
Borrowing
 Some custodians provide a service
whereby an account holder’s securities
can be lent to a borrower
 This service is likely to be offered when a
custodian has access to a large pool of its
account holders’ securities.
 Some account holders are willing to lend
securities for additional income.
Lending and Borrowing
(Cont…)
 When a dealer has sold securities that it
cannot deliver it may be willing to borrow
securities.
 This will enable settlement to go through
 But there will be an associated cost
 The custodian typically acts as an agent
between lenders and borrowers
 The fee collected from the borrower is passed
on to the lender after deduction of the
custodian’s fee
Cash Borrowing
Arrangements
 Typically dealers need to borrow to pay
for the purchases of their securities.
 Some borrow in anticipation of
settlement occurring on the value date
 They have the cash paid into their account
at the custodian
 Others borrow after settlement has
occurred at the custodian
Cash…(Cont…)
 Generally a custodian will not allow
a dealer to incur a cash overdraft
unless the dealer has sufficient
cash or collateral against which
money can be borrowed.
 The collateral acts as a safeguard
for the custodian.
Cash…(Cont…)
 The dealer will have a credit line or
O/D limit
 But the limit is usually usable only to
the extent that the dealer has
collateral
Interest on Cash Balances
 Following settlement of trades a dealer
typically expects to be overdrawn at the
custodian – unless it has already
borrowed from another source.
 Occasionally a dealer may have a credit
balance – if the value of sales is greater
than the value of purchases.
 In either case the dealer needs to know
the rate of interest to be charged by or
received from the custodian.