Monday, October 31, 2011

Trade Life Cycle/Securities trade life cycle

Have you wondered what happens when you initiate a trade, in simple terms when you put an order to buy or sell a stock/shares in the stock market through your trading terminal.


To understand trade life cycle we need to understand detailed steps involved in trade life cycle.
Below mentioned are the important steps:
1. Order initiation and delivery. (Front office function)
2. Risk management and order routing.(middle office function)
3. Order matching and conversion into trade.(front office function)
4. Affirmation and confirmation.(back office function)
5. Clearing and Settlement.(back office function)




PICTORIAL VIEW OF TRADE CYCLE




Them main objective of every trade is to get executed at the best price and settled at the least risk and less cost. Some may say trade life cycle is divided into 2 parts pre-trade activities and post trade activities, well, pre-trade activities consists of all those steps that take place before order gets executed, post trade activities are all those steps that involve order matching, order conversion to trade and entire clearing and settlement activity.

Now lets discuss every step of life cycle in detail.


Order initiation and delivery. (Front office function)

Who initiates the orders: Retail client like me and you, institutional clients like any Mutual fund company's.

Clients keep a close watch on the stock market and build a perception on the movement of market. They also try to find investment opportunities so that they can build position in the market. Positions are the result of trade that are executed in the market.Clients place orders with brokers through telephone, fax , online trading and hand held devices. Orders can be placed either market orders or limit orders, market orders means order to buy or sell is placed at the market price of the share/equity/stock that the investor/client wants to buy/sell whereas limit orders means order placed to buy or sell at a price that investor/client wants to buy/sell.

When Broker receives these orders, he/she records these orders carefully so that there is no ambiguity/mistakes in processing. Institutional investor/ fund manager at this stage would not have decided on the allocation of the funds so he/she will just contact sales desk and place the order so that later they can allocate their investments to the mutual funds(irrespective whether it is buy/sell).



Risk management and order routing.(middle office function)


As we know that getting trades settled lies with the broker, if any client makes any trade default, then the same has to be made good by the broker to the clearing corporation by broker.


When orders are accepted and sent to exchange these orders go through various risk management checks institutions and retails clients. Although the risk management checks are more for retail investors , the underlying assumptions is that they are less creditworthy also due to online trading the client has become faceless so the risk has increased more.Its not same for institutional investors because they have a large balance sheet compared to the size of orders they want to place. They also maintain collateral with the members they push their trades through. Their trades are hence subjected to fewer risk management checks than retail clients.


Below are the steps how risk management is done in case of retail transactions: 
  • Client logs into the trading portal provide credential and places orders.
  • The broker validates that the order is coming from a reliable source.
  • Lets say the client places buy order, in this case the broker places query to verify whether the client has sufficient balance(margin money) and passes the order to the exchange, in case the client does not have sufficient margin then order is rejected. If client has the margin money then the order is accepted and margin money is reduced from the available margin so that client is aware of the real time margin available to him for trade, also to make sure that he/she does not place order more than margin money available so later on the broker need not make good on behalf of client to the exchange.
  • Lets say the client places sell order, in this case the broker places query to verify whether the client has sufficient stocks to place the order in case of there are no sufficient stocks then the order stays rejected, if there are sufficient stocks available then the order is accepted and stocks are blocked for sale and remaining stocks are shown as balance available for sell.
  • Once the above risk management check passes then the order is passed to the exchange.
  • On receipt of the order, the exchange immediately sends an order confirmation to the broker's trading system.
  • Depending upon the order terms and the actual prices prevailing in the market, the order could get executed immediately or remain pending in the order book of the exchange.
A margin is an amount that clearing corporations levy on the brokers for maintaining positions on the exchange. The amount of margin levied is proportional to the exposure and risk the broker is carrying. Since positions may belong to a broker’s clients, it is the broker’s responsibility to recover margins from clients. To protect the market from defaulters, clearing corporations levy margins on the date of the trade.



Order matching and conversion into trade.(front office function)


Below are the steps:

  • All the orders are collated and sent to the exchange for execution, exchange tries to allot the shares in the best price available to the investors.
  • Broker has the record of all the orders that were received from whom , at what time, against which stock, type of order and quantity. Broker maintains these records against client ID.
  • Brokers are in real time conversation with exchange so that they have details of how many orders are still pending and and how many have been executed in the exchange.
  • Once the order is executed it turns into trade and exchange sends sends notification of the trade to the broker. The broker in turn communicates these trades to the client either immediately or end of day.
  • Official communication from broker is done to the client through contract note, which contains details of the trade executed along with taxes being charged and commission being charged by the broker and other institutions like clearing corporation, custodian etc...

Affirmation and confirmation.(back office function)

Every institution engages the services of an agency called a custodian to assist them in clearing and settlement activities. Institutions specialize in taking positions and holding. To outsource the activity of getting their trades settled and to protect themselves and their shareholder’s interests, they hire a local custodian in the country where they trade. When they trade in multiple countries, they also have a global custodian who ensures that settlements are taking place seamlessly in local markets using local custodians.

As discussed earlier, while giving the orders for the purchase/sale of a particular security, the fund manager may just be in a hurry to build a position. He may be managing multiple funds or portfolios. At the time of giving the orders, the fund managers may not really have a fund in mind in which to allocate the shares. So to make more profit and avoid unfavourable market conditions he/she places the order.

The broker accepts this order for execution. On successful execution, the broker sends the trade confirmations to the institution. The fund manager at the institution during the day makes up his mind about how many shares have to be allocated to which fund and by evening sends these details to broker. Brokers does a cross verification whether all the alocation details match the trade details and  then prepares the contract notes in the names of the funds in which the fund manager has requested allocation.

Along with the broker, the institution also has to send details to custodian for the orders it has given to the broker. The institution provides allocation details to the custodian as well. It also provides the name of the securities, the price range, and the quantity of shares ordered. This prepares the custodian, who is updated about the information expected to be received from the broker. The custodian also knows the commission structure the broker is expected to charge the institution and the other fees and statutory levies.


On receipt of the trade details, the custodian sends an affirmation to the broker indicating that the trades have been received and are being reviewed.Trades are validated to check the following:


  • Whether trade has happened on the desired security.
  • Whether the trade is correct i.e buy or sell.
  • The price at which rate it was executed.
  • Whether the charges are as per the agreement.
For this verification process the custodian normally runs a software such as TLM for recon process.In case the trade details do not match, the custodian rejects the trade, and the trades shift to the broker’s books. It is then the broker’s decision whether to keep the trade (and face the associated price risk) or square it at the prevailing market prices.



Clearing and Settlement.(back office function)


As we know that there are hundreds and thousands of trades being executed everyday and all these trades needs to be cleared and settled. Normally all these trades gets settled in T+2 days, which means the trade will gets allotted to the investor to his/her demat account in 2 days from trade date. 


The clearing corporation has obligation to every investor in form of 

  • Funds (for all buy transactions and also to those transactions that are not squared for the sale positions).
  • Securities(for all the sale transactions done)

Clearing corporation calculates and informs the members of what their obligations are on the funds side (cash) and on the securities side. These obligations are net obligations with respect to the clearing corporation. Lets say broker purchased 1000 shares of reliance for client A  and sold 600 shares of reliance for client B which means the obligation of the clearing corporation to the broker is only for 400 shares. 

Clearing members are expected to open clearing accounts with certain banks specified by the clearing corporation as clearing banks. They are also expected to open clearing accounts with the depository. They are expected to keep a ready balance for their fund obligations in the bank account and similarly maintain stock balances in their clearing demat account.

Once the clearing corporation informs all members of their obligations, it is the responsibility of the clearing members to ensure that they make available their obligations (shares and money) in the clearing corporation’s account. Once these obligations are done the balance of payments takes place and all the investors will have their stocks/financial instruments/shares in their demat account if a buy trade is executed and cash will be credited to their demat accounts if sale trade is executed. On every end of day basis the clearing corporation generates various reports that need to be circulated to exchanges and custodians.

I have covered all the steps of the trade life cycle to the best of my knowledge, any comments are welcome.


Sunday, August 7, 2011

ECONOMY SLOWDOWN: WHAT ARE THE CHANCES?


Somebody has finally asked the question, how are you going to pay up for the US bonds that we hold, Its china that made the comment , as we know that china holds nearly 900 billion dollars in the U.S bonds, to put it in simple words china is a loan shark or a land lord . Now the Chinese have selling these bonds and there is no buyers for these bonds so if there are no buyers then US will have to pay China not only 900 billion dollars but also interest on that 900 billion dollars. Why did this happen? 
Ø  China does not trust any more the U.S treasury new policy of quantitative easing.
Ø  Dollar has started to lose its value the moment it received AA+ credit rating from the S&P or standard and poor. China will take an action to withdraw its holding from U.S bonds to avoid losing its value.
Ø  U.S has not successfully managed to create more jobs.

There is a saying if a bank lends you a couple of thousand dollars then the bank owns you and if the bank lends you a million dollars then you own the bank. 

The situation is something similar. China has reported asked to cut down its expenditure on defense, artillery and instead concentrate on creating jobs. What if china sells all these bonds, then there is sudden outflow of cash from the U.S economy and then there is no one to purchase those U.S bonds.

The Standard and poor have downgraded the ratings of European countries; this has reduced the demand from Europe from the US as Europe happens to be largest importer of goods from US. Thus decreasing the exports of the US and finally dollar value being depreciated.  As a matter of fact Indian exports to the European nations will also decrease as their credit ratings are down and industries like textiles and exports of precious metals will also decrease.  If the dollar value falls down drastically then even IT outsourcing will get a HIT as the value of contracts will fall due to decrease in dollar value and moving forward the US will find it expensive to outsource. All this while the US market was stable and there was no growth but enough money was pumped in to promote jobs.  The housing bubble has created an impact on the mindsets of the public in the US as people have been reluctant towards spending, this is one of the major reasons that business do not see any reason for expand, expenditure on Research and development is almost equal to Null.

The Euro debt crisis is spreading like a virus, all the way from small European countries, now the testing times have come to ITALY, the 3rd largest economy in Europe. If this economy fails how will we bail out ITALY? This is one of the major worries.

In case of INDIA, the FDI (foreign direct investment) has fallen sharply, food inflation takes no sign of reducing below 2%, and our WPI (wholesale price index) does not show signs of abating from 9.4%, RBI have become almost helpless , current account deficit has increased to 2.7% and finally the retail investors will start investing more in commodities like gold, silver etc rather than stocks.

MY VIEWS


How will US repay the debt of china, it has lost majority of its export market of goods from europe. Will it wage one more war and destroy another economy? Or will china ask US to outsource majority of the jobs to china rather than INDIA and other nations? Will it simply print currency and repay the loan? If it repays the loan, then who will buy the bonds from US? Even if it repays the loan the value of dollar depreciates and all the contracts signed with US on the on-going currency exchange rate will become valueless, if so there will be a major hit on not only IT industry in India but other dependent industries also like real estate, infrastructure, textiles, transport, electronic industry , automobiles etc.... all the loan will become NPA (Non performing assets) and banks will get a big hit.... 


As said by Sir M Vishveshwaraiah : Agriculture is the backbone of India and unfortunately we have been neglecting it for years to come, its time we realise and industrialise it. 


Wednesday, August 3, 2011

Informative -- National Pension Scheme (NPS) or New Pension System


We have been hearing about National pension scheme or New pension system, this article will address as to what is NPS.

Lets understand pension first, a pension is an arrangement to provide people with an income when they are no longer earning a regular income from employment. In some countries they are also called as retirement plans or superannuation.

How does it work?

In case of government employees or public servants a part of their salary is contributed towards pension scheme provided from their organizations.  This individual contribution is administered by Employees Provident fund organization of India (EPFO). EPFO is a statutory body of government of India under Ministry of Labour and Employment which administers a compulsory contribution of Provident fund, pension and also an insurance scheme for Indian work force.

Superannuation or retirement pension is payable upon fulfillment of the below conditions:
1)      Completes 10 years of service
2)      Attaining age of 58 years.
Contribution made by the employee every month is invested in government securities ,fixed income securities and other debt instruments.

What is the National Pension Scheme (NPS)?
The NPS is a new voluntary contributory scheme introduced by Government of India through Pension fund Regulatory and development Authority (PFRDA) to promote savings for retirement or income on retirement. This is a purely a voluntary contribution scheme available to all the citizens of India other than those who are already covered under the pension scheme.  Under the NPS individuals who open retirement account will be provided by PRAN (permanent retirement account number) through PFRDA.

To an INDIAN citizen the following two types of accounts will be available:
1)      Tier 1 account: Citizen shall contribute savings for retirement into his non-withdrawal account.
2)      Tier 2 account: Citizen shall contribute savings for retirement. In this case he/she is allowed to withdraw whenever they wish.
Minimum contribution is Rs 500 per month or Rs 6000 annually. Minimum number of contributions is 4. One can invest in both Tier 1 account and Tier 2 account.

Every individual has a choice of investment type he/she wants to subscribe.

Active choice:  In this option the individual is allowed to invest in any of the mentioned below choice of investment option.
Ø  Asset Class E:  Invest in Equity markets up to a maximum of 50%.
Ø  Asset Class C: Investment in fixed income securities other than government securities like bonds.
Ø  Asset Class G: Investment in government securities.
An individual is allowed to invest the entire fund in C or G asset classes, or up to a maximum of 50% in Asset Class E and remaining in other 2 classes. 

Lifecycle choice:  In this option the investment will be made considering 3 major factors, Age, risk taking ability and planned retirement age. Refer the below mentioned table as to how the investor contribution will be invested.


Investment of the individual wealth or contribution
Age of individual
Asset class E
Asset class C
Asset class G
between 25 to 30 years
50%
30%
20%
Between 30 to 35 years
50%
29%
21%
36 years
48%
29%
23%
37 years
46%
28%
26%
38 years
44%
27%
29%
39 years
42%
26%
32%
40 years
40%
25%
35%
41 years
38%
24%
38%
42 years
36%
23%
41%
43 years
34%
22%
44%
44 years
32%
21%
47%
45 years
30%
20%
50%
46 years
28%
19%
53%
47 years
26%
18%
56%
48 years
24%
17%
59%
49 years
22%
16%
62%
50 years
20%
15%
65%

All this is managed by pension fund managers, ICICI pension fund management, IDFC pension fund management, KOTAK Mahindra, Reliance Capital, SBI pension funds, UTI retirement solutions and annuity service provider.
Once the investment is done NAV or Net Asset value of the contribution will be released at regular intervals, so that investor will be able to take an informed decision. On this basis an individual can switch from current portfolio. Currently only one switch is allowed in a year (NAV will be discussed in detail in my following blog).
The government through PFRDA charges .009% fee for managing your wealth. The charges are as follows:
Opening account charges Rs 50, Annual PRA (permanent retirement account) maintaining charges Rs 350, Initial subscriber registration charges for selecting either of the investment type mentioned above Rs 60, Custodian charges are at .075% pa deducted through NAV and finally the investment management fee of .009% pa deducted from NAV.

Tax advantage

This forms part of Sec80C of income tax act , where an individual is eligible for tax exempted upto Rs 1 lakh. 
Although upon withdrawal of the pension amount the interest component is taxable.


Think point: Does this sound like a Mutual Fund, Watch out for more on this space I will blog on Mutual funds in my next Post.



Tuesday, August 2, 2011

Basics on tax and its computation ( INDIA )



Most of my friends, colleagues complain about such a huge amount of tax being deducted from their salary component. I write this blog to give them a basic understanding of how the tax is computed and what they can do to reduce the amount of tax being deducted from their income or TDS (tax deducted at source).

What is TAX?
Tax is a compulsory contribution of a part of income to the government by either individual or a business entity or a product or by any activity. If a tax is directly levied on person or business entity then it is direct tax. If tax is levied on price of goods and services then it is called as indirect tax.
Purpose of tax is to finance government expenditure and public goods and services.
Before we understand how tax is calculated below mentioned information is important.


For General tax payers

Income tax slab ( Rs )
Tax
Income between 0 to 180000
No Tax
Income between 180001 to 500000
10%
Income between 500001 to 800000
20%
Income above 800000
30%

For Women employees

Income tax slab ( Rs )
Tax
Income between 0 to 190000
No Tax
Income between 190001 to 500000
10%
Income between 500001 to 800000
20%
Income above 800000
30%



Let’s consider an example of an employee named Mr. Zed who is earning an annual income of 600000. In simple words his salary is 600000 per annum. Now let’s compute and understand how much tax he needs to pay for the year 2011-2012. Let’s assume that he has not invested (LIC policy or tax exempted Mutual fund), nor has any housing loan or education loan. This is a plain vanilla example.


SI no
Gross salary
600000

Less professional tax deducted (200 * 12 = 2400)
2400

gross taxable salary
597600

Deductions as part of any investment done
(Sec 80 C , Sec 80 CCC , Sec 80 CCD , Sec 80G or Sec 80 E)
0

Total Taxable income
597600




Computation of tax

a)
As per the slab there is no tax on Rs180000
0
b)
As per next slab there is 10% tax on income
between 180000 to 500000
( 500000 - 180000 = 320000)
320000
c)
taxable income after deducting 180000
(597000 - 180000 = 417600)
417600
d)
Tax deducted on b or c whichever is lesser
( 320000 * 10%)
32000
e)
As per next slab there is 20% tax on income
between 500000 to 800000
( 800000 - 500000 = 300000)
300000
f)
taxable income remaining
(417600 - 320000 = 97600)
97600
g)
Tax deducted on e or f whichever is lesser
(97600 * 20%)
19520




Total tax payable for the year (19520 + 32000 = 51520)
51520

Tax payable monthly (51520 / 12 = 4293)
4293







Let’s consider an example of an employee named Mr. Red who is earning an annual income of 600000. In simple words his salary is 600000 per annum. Now let’s compute and understand how much tax he needs to pay for the year 2011-2012. Let’s assume that he has invested in PF 12000 has a LIC policy with premium 25000 has invested in Tax benefit mutual fund of 25000 and in government bonds for 25000 and in fixed deposit for 5 years for 13000. Lets compute and find out how much tax he pays as per the tax slabs.


SI no
Gross salary
600000

Less professional tax deducted (200 * 12 = 2400)
2400

gross taxable salary
597600

Deductions as part of any investment done
(Sec 80 C , Sec 80 CCC , Sec 80 CCD , Sec 80G or Sec 80 E)( 12000 + 25000+25000+25000+13000)
100000

Total Taxable income
497600




Computation of tax

a)
As per the slab there is no tax on Rs180000
0
b)
As per next slab there is 10% tax on income
between 180000 to 500000
( 500000 - 180000 = 320000)
320000
c)
taxable income after deducting 180000
(497000 - 180000 = 317600)
317600
d)
Tax deducted on b or c whichever is lesser
( 317600 * 10%)
31760




Total tax payable for the year
31760

Tax payable monthly (31760 / 12 = 2647)
2647





From the example mentioned we infere that by doing a right investment in to various tax savings instruments , be it pension fund , public provident fund , Insurance policies, fixed deposit for a period of 5 years , investment in government bonds and tax saving mutual funds we will reduce our tax burden. So Invest intelligently and wisely. Before investing try to always find a reason not to invest into particular scheme.

CHEERS

Comments Welcome