Trade Life Cycle Events - by Plaban Roy Bhowmik * Page - 1 Introduction Every trade has its own life cycle. The entire Life Cycle of a trade can be broken down into pre-trade and post-trade events. Before going into the details of the trading events, let me explain how a trading deal is being struck between two entities.
We know that one of the primary usages of derivative contract is to hedge the risk. Let us consider that a company has got a floating rate liability in LIBOR (London Inter Bank Offered Rate) and it wants to convert its liability into a fixed rate. The feasible option would be to enter into an Interest Rate Swap. The company would strike a deal with a bank and enter into a swap where it would pay fixed rate to the bank and receive floating rate. The company and the bank would enter into a trade and the trade passes through various stages. The various trade events can be categorized into Front Office, Middle Office and Back Office activities which are explained below: Front Office: The FO forms the stage where the trade gets initiated. Here, the order gets placed and the entity will price the instrument and give the quote to the counterparty. If the counterparty agrees to the details of the trade and is willing to enter into the deal, the trade g ets executed. The trade is then captured in the trading desk usually using a deal capture system. The deal capture system validates all the necessary trade economics before assigning a trade reference number. Subsequent trade events like amendment, cancellation would refer to the trade with the help of the identifier. An acknowledgement is being sent to the counterparty with the trade details who confirms it back. Middle Office: The important function that MO performs is to do the Limits and Risk Management. The Limits are being calculated at a business hierarchy level. The usual hierarchy would be at a Portfolio level and subsequently aggregating to a Trader Level, a Desk Level, an Entity Level, and finally to a Group Level. Validations are being done on the trade captured, and in case of any discrepancy, an exception is being raised.
Page - 2 The MO plays a vital role in the exception management. The trade gets enriched by static data like the standard settlement instructions of the counterparty, Custodian details, City holidays, etc. Such static data details are important for the completion and settlement of the trade. The allocation of the trade is done in the MO and finally the trade is being pushed to the BO and the trade goes live. Back Office: The BO is the back bone of the entire life cycle of the trade. The BO mostly deals with the operational activities like record keeping, confirmation, settlement and regulatory reporting. In most cases, BO activities are being outsourced to cheaper sources to cut down on costs for the company. The Life Cycle of such a trade can be categorized into pre-trade events and post-trade events which are discussed below: Pre-Trade Events Setting up a Master Agreement: It is a standardized contract between the counterparties and should be there in place before the two parties enter into a deal. For derivative contracts, the Master Agreement is drafted according to ISDA protocols. Define Product Characteristics: Every Every Deal has to be defined defined by some primary primary characteri characteristic stics s called called the primary economics of the trade. In case of a Plain Vanilla Interest Rate Swap, the economics of trade would be as follows:
Notional Maturity FixedRate FloatingRate Trading Book
Trade Life Cycle Events - by Plaban Roy Bhowmik * Previous Page - 3 Pre-Trade Negotiation: In this stage the client tries to reach a preliminary agreement with the bank. This stage may include documentation, indication of the interest rate and defines the criteria for executing a trade which may include the credit support and the bank policies which the counterparty has to abide by.
Request for Quote: The client will ask for a quote to the bank, say the fixed rate against LIBOR. Provide Quote: The bank will provide the quote which may be through their traditional channels like phone, fax and email, or through standardized channel as provided by Swaps wire. Request Trade Pricing Inputs: The Client will ask inputs which will help to price the product. It may relate to volatility of the underlying in some cases. The trade is priced after matching every detail of the trade. For an IRS, both the parties will agree to the rates when the Net Present Value of the swap is zero. Trade Execution & Immediate Post-Trade Events Execution of Trade: When both the parties agree to the details of the trade and are willing to enter into the deal, the trade gets executed. Confirmation: The bank would draft an inception document capturing all the trade details and send it to the counterparty to get it confirmed. The counterparty will check the details of the trade and sign it back confirming the trade on its behalf. The communication of confirmation can be through SWIFT, Telex, Fax, or through other similar medium of financial information exchange.
Page - 4 Allocation of Trade: Some trades have to be allocated to various sub entities. This is called allocation of trade and is done for flexibility of Profit & Loss Booking. Creation of Standard Identifier: Every trade will be stored with the help of a unique Trade ID which is used to identify the trade. Post-Trade Changes Amendment: The trade can be amended by the consent of both the parties. The amendment can be done in terms of the economics of the trade. If a trade is being booked incorrectly, then the amendments can be done to the booked trade with the agreed changes and it can be re-booked. Counterparty Changes:
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Assignment / Novation: Novation can be explained by an example. Suppose A and B has entered into a trade, and then C wants to enter and take A's position, or A wants to exit and let C take its position, then whoever is at an advantageous position will receive some novation fee. The most important thing is there should be consent from B for C to come in, through a Consent Letter, and B is called the remaining party. The assignment of the new counterparty can be done by the bank or the new counterparty can be assigned by the counterparty himself.
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Give Ups: In a Give up Trade, the client will execute a transaction at a price supplied by an executing broker but then faces the prime broker as the counterparty. The prime broker mirrors the transaction with the executing broker as the counterparty and effectively intermediates between the two.
Trade Life Cycle Events - by Plaban Roy Bhowmik * Previous Page - 5 Partial Termination: A trade is partially terminated when there is a change in the notional of the trade and it is not pre-fixed according to the agreement. Full Termination: This indicates the full termination of the deal before the maturity of the trade. This may or may not entail a termination fee.
Normal Termination: A trade is normally terminated when it gets matured. Servicing Events Rate Fixing: The Floating Rate has to be fixed every period for the cash flow settlement of the floating rate leg. The fixing rule can be defined and it may differ on a trade to trade basis. The Floating Rate may be fixed in advance or at the end of the period according to the fixing rule set for the trade. Payment: 3.
Cash Flow Settlement: Every settlement term, there will be cash flow that the entity will pay and receive. The cash flow will happen according to the standard settlement instructions. In case of the Interest Rate Swap, it will be the Pay Flow and Receive Flow.
4.
Fee: A trade may have scheduled and non-scheduled fee event. A payment of brokerage or option premium might be booked as a fee for the records.
Revaluation: The trade can be revalued at intermediate stage according to the market interest rates at that point of time. That is, the future cash flows are discounted to find out the present value and then the NPV is calculated to find out the position of the entity on that particular trade. This is done for accounting purpose.
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Conclusion The entire Trade Life Cycle is a labyrinth of complex functions where the trade passes through a stream of different events. There is a lot of manual intervention in all these events and this increases the time bucket for processing and settlement of the various functions. The answer to this is STP (Straight through Processing), where the transactions can be conducted electronically without the need of re-keying or manual intervention. The market today is definitely moving towards such a solution. Concluded
Trade Life Cycle Tutorial By Bradley James Bryant, eHow Contributor updated: September 11, 2009 I want to do this!
Most investors have no idea about the life cycle of a trade. This is because they rarely have occasion to work with the middle or back office. The middle and back office are support functions for the front, or sales, office. The back office works on trade settlement and the middle office is concerned with confirmations. All three contribute to the actual buying or selling of stock along the trade life cycle.
Back Office The back office exists for three reasons: clearance, settlements and accounting. These three function interact directly with external agencies like the custodian (actual holder of the security), the clearing firm (third party) and a commercial bank. The back office maintains external relationships and control functions and is where the trade ends. 1.
Middle Office 2. The middle office, as the name implies, is a hybrid function between the front and back office. The middle office handles validations (of stock orders), bookings (orders) and confirmations. Technically, these are all back office operations, however, they often require the help of front office staff to resolve.
Front Office The front office is responsible for trade capture and execution. This is where the trade originates and the client relationship is maintained. The front office makes/takes orders and executions. Traders and sales staff are considered front office staff. 3.
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