Trading Cycle: Trading, Clearing & Settlement

The basic meaning of trading is buying and selling stocks in the share market. But buying and selling are just two steps of the trading cycle. Trading is the whole process in itself. Many novice traders and investors in the stock market may get confused between trading and the trading cycle. Therefore we have come up with a special and explanatory blog on the trading cycle.

What is Trading Cycle?

The trading cycle is the process through which stocks or trades in the stock market are exchanged. It ensures a smooth transaction between the investor and the firm. Earlier, processes involved in the trading cycle used to happen physically at the stock exchange but as technology evolved, the procedure has changed over time, and now most of the transactions happen digitally, making it efficient and simple.

Trade Life Cycle

The trade life cycle involves following phases sequentially:

• Trading

• Clearing

• Settlement

How does the trading cycle work?

Following actions takes place in each phase of the trading cycle.

Trading

Trading involves the actual buying and selling of securities. Exchanges use electronic order matching systems where they essentially match buy and sell orders from different people so that the trade may be executed. So for example, if on the left side there are various buy orders on security and on the right side there are various sell orders. So the matching system tries to see if there is a match between a buy and sell order at a particular price and if so, fill both orders by doing so.

The exchange facilitates efficient, speedy and anonymous execution. All investors depend on brokerages to execute their trading orders. Brokers essentially collect orders from various investors and pass them on to exchange, so that when you start trading broker is the intermediary you will be directly interacting with and the broker will interact with the exchange on your behalf. The next phase in the life of a secondary market transaction is clearing.

Clearing

Once two orders match and trade is executed the trade has to go through something known as the clearing process. The clearing is the process of identifying which securities and in what quantity are owned to a specific buyer and what payment is owed to the seller so for.

For example, if for a trade, investor A is the buyer who buys 100 shares of a company X at ₹10 each from a seller B. The clearing house would do the math and conclude that buyer A has owed 100 shares of company X and seller B has sold it for ₹ 1000.

Now if the buyer or the seller has performed multiple transactions then the clearing house will identify all securities owed to them and the net payment owed to or owed by them. Clearing houses or clearing corporations are independent entities that manage this entire process. Once the clearing process is complete the next process known as the settlement process takes place.

Settlement

After the clearing process, it becomes clear what security in what amount is owed to an investor and what funds are owed by them. The next step now is to fulfill these obligations which are done by following the settlement process. Settlement is essentially the process of fulfilling the respective obligations to buyers and sellers of security. By this process, the buyer receives the security owed to him and the seller receives the payment owed to him. Once the buyer of the security receives the security and the seller of the security receives the payment we say that the transaction has been settled.

Intermediaries involved in the trading cycle

Different intermediaries play different roles depending on where they are involved in the trade life cycle. Let’s look at them one by one:

Trading members

Investors can trade only through members of a stock exchange. Trading members are also called as stockbrokers and their affiliates are called sub-brokers. Trading members are admitted to the exchange only if they fulfill certain minimum requirements for capital qualification, net worth, and other criteria. Exchange members can either be trading members or clearing members or both. Exchanges monitor these members for their positions, capital, and compliance. Their obligation towards clients is also clearly laid out to them. These trading members are the intermediary that a typical investor deals with directly. The next important intermediary is the clearinghouses.

Clearing Houses

Clearing houses facilitate the clearing process we described earlier. Now clearing houses are set up as independent entities to act as counter-parties for all trades executed on the exchange. Hence all buyers pay funds to the clearing house and all sellers deliver the securities to them. Clearing members are the members of Clearing House who facilitate these transactions by directly interacting with buyers and sellers. The Clearing House may be wholly-owned subsidiaries of stock exchanges or they may be a completely independent financial institution.

The purpose of Clearing House is to reduce the settlement risk by using certain risk management mechanisms. Clearing houses often implement a netting mechanism and a system of requiring margin deposits to mitigate settlement risk. Other important intermediaries are the depositories and depository participants.

Depositories and depository participants

The depository is essentially an institution that holds and facilitates the exchange of securities. Centralized depositories enable brokers to deposit securities so that book entry and record-keeping services can be performed in order. For a security grade in the secondary markets, the security should be held in electronic or de-materialized form. The issuer who issues the securities admits them to the depositories where they're held as electronic entries against investor names. To facilitate this process of keeping this list updated, depositors appoint depository participants who act as intermediaries between the depository and the investor.

Every investor holds a DEMAT account with a depository participant. The settlement of securities is done through this DEMAT account with the depository participant. The depository participant, in turn, notifies the depositories about the change of ownership. The payments for respective trades are settled through pre-identified clearing banks. Another important intermediary we like to mention is custodians.

Custodians

Custodians are institutional intermediaries authorized to hold funds and securities on behalf of large institutional investors like banks, insurance companies, mutual funds, and foreign institutional investors. Custodians essentially settle secondary market trades and may also act as clearing members and clearing banks for the institution to manage the settlement of both securities and funds.

Time Period of Trading Cycle (T+2 Settlement)

The Indian Stock Exchange uses a T+2 rolling settlement cycle. The day on which trade is done is denoted by T. This indicates that the entire trade life cycle, from beginning to settlement, took two days. However, SEBI has temporarily permitted several businesses to use the T+1 Settlement cycle in a recent update. Every working day after the trade date is denoted by the letters T+1, T+2, and so on (weekends and stock exchange holidays not included).

Conclusion

A trading cycle is a process that starts by buying/selling trades and ends with the settlement of those trades. The trade life cycle involve intermediary firms to smooth out the transaction and process. The Process is quite simple and helps both parties do a trade without any issues. This might be faster in upcoming years.