Post-Trade Operations in the Indian Capital Market — Part 1
Every business day in India, investors execute hundreds of millions of securities transactions — exchanging money for shares of stock, bonds, mutual funds, and other financial instruments. The equity transactions are executed on NSE (National Stock Exchange) and BSE (Bombay Stock Exchange).
NSE Stats: 22.7 Mn trades, 2.75 Bn in volume and ₹669 Bn in value were traded on NSE (end of day in equity) on 14th July 2023.
Behind the scenes, the post-trade settlement is an interesting process that enables the safe transfer of ownership of securities from the buyer to the seller in return for payment. We will limit the scope of this discussion to equity trades using cash. The focus of this article is on Clearing and Settlement processes, and managing counterparty risk.
To better understand post-trade, let’s first understand the capital markets and the lifecycle of a trade.
Capital Markets
Capital markets recognize and drive investment to the best ideas and enterprises. Coupled with the free flow of capital, innovation is an integral component for supporting job creation, economic development and prosperity.
Clients benefiting from robust and efficient capital markets include investors, both individual and institutional, governments and corporations. Capital, raised through equity and debt, can be used to grow businesses, finance investments in new plants, equipment and technology and fund infrastructure. This grows the economy and creates jobs and wealth.
Capital markets are split into primary and secondary markets. In addition to promoting capital formation in primary markets, investors utilize secondary markets (trading) to generate returns and manage risk.
Market Participants
The Lifecycle of a Trade
- The lifecycle of a trade begins with execution, the buying and selling of securities.
- It then moves into the clearing phase. Clearing houses have members (or participants) consisting of clearing brokers, typically a broker-dealer firm, that act as liaisons between investors and clearing houses to ensure trades are completed and recorded. Once entering the clearing phase of the trade lifecycle, counterparty risk is introduced. Values of the security (or the underlying asset with derivatives) can fluctuate between trade and settlement dates.
- The trade is then closed out at settlement when the ownership of securities is transferred.
If you noticed that after buying or selling a stock, bond, or mutual fund, you have to wait for 1 day for that stock to reflect in your Demat account or the fund to come into your account? Well, the period to do so is called T + 1 settlement.
Post-Trade
A trade in the stock market takes place in an instant. However for the trade to settle smoothly and efficiently, many processes and handshakes between Exchange, Banks, Depository Participants, Clearing Members and Trading Members (Brokers) occur in the background between T and T + 1 day.
Post-trading refers to all the processes that take place once a trade has taken place and includes all the activities that enable the safe transfer of ownership of securities from the buyer to the seller in return for payment. These activities include clearing, settlement, custody and asset servicing, and reporting.
Counterparty Risk
One of the major concern in any financial transaction is whether the person or organisation on the other side of the deal — the buyer if you’re selling or the seller if you’re buying — will live up to the terms of the bargain. This potential default, known as counterparty risk, is serious enough when the agreement is between individuals.
But it can be even more problematic if the agreement depends on a financial institution, such as a brokerage firm, which may be the counterparty to millions of trades that occur in various marketplaces each day. If the brokerage firm fails to pay for the securities its clients bought or to deliver the securities its clients sold, the entire system could falter.
Managing Counterparty Risk
The counterparty risk is managed in 4 ways.
- Presence of Clearing house or central counterparty clearing house (CCP)
- Shortening the settlement cycle (T + 2 → T + 1, intraday early pay-in)
- Matching and Netting
- Risk Management — Margin
Central counterparty
A CCP bridges the gap between counterparties, becoming the buyer to every seller and the seller to every buyer. The CCP guarantees the trades and becomes responsible for managing cash flows until T+1 settlement, thereby taking on the counterparty risk of a trade.
In India, CCPs include the Clearing Corporation of India (CCIL), Indian Clearing Corporation Ltd (ICCL), NSE Clearing Ltd (NSCCL) and others.
Matching and Netting
Matching and netting are key elements in clearing and settling securities transactions.
Let’s say brokerage firms A and B have received trade instructions from multiple clients to buy and sell HDFC stock. The following are the trade details:
Trade 1: Client A wants to buy 100 shares of HDFC @ ₹1650 per share. Trade 2: Client B wants to sell 50 shares of HDFC @ ₹1600 per share. Trade 3: Client C wants to buy 75 shares of HDFC @ ₹1750 per share. Trade 4: Client D wants to sell 200 shares of HDFC @ ₹1700 per share.
Matching: The matching process involves comparing the trade details to identify offsetting trades. In this example, we can see that Trade 1 (buy) and Trade 2 (sell) involve the same stock and quantity, but at different prices and are placed via Firm A. Similarly, Trade 3 (buy) and Trade 4 (sell) have the same stock and quantity, but at different prices.
Netting: Once the matching process is complete, the next step is netting. Netting involves offsetting the matching trades and calculating the net settlement or obligation amounts. In this example, we can net the matching trades as follows:
Net Trade 1: Firm A is the net buyer of 50 shares of HDFC stock (offsetting Trade 1 and 2). For simplicity, the average buy price is excluded from this example.
Net Trade 2: Firm B is the net seller of 125 shares of HDFC stock (offsetting Trade 3 and 4).
The netting process eliminates the need to settle each individual trade separately. Instead, the netted trades represent the consolidated positions for settlement.
Settlement: After netting, the brokerage firms will settle the net trades with the clients. In this example, Client A will receive a confirmation of purchasing 100 shares of HDFC stock at Rs 1650 per share. The settlement process will involve the transfer of funds from client A to the brokerage firm and the transfer of the corresponding shares from the brokerage firm to client A.
Significance of Matching and Netting
At the end of each trading day, netting consolidates the amounts due from and owed to a brokerage firm across all the securities it has traded to a single net debit or credit position, also called obligations. The netting settles more than 90% of daily trades.
Netting significantly reduces industry counterparty risk and helps brokerage firms optimize capital by freeing up billions of rupees that they can use for other investment purposes. That increased liquidity is a significant advantage of the centralized clearance and settlement system that’s a feature of capital markets.
The principle behind matching and netting is that less money means less risk.
Conclusion
Post-trading activities play a crucial role within Indian capital markets. These services are referred to as the ‘plumbing’ of the securities markets, and they are essential for the proper functioning of financial markets as a whole.
Further, efficient post-trading processes are essential for attracting foreign investors and promoting liquidity in Indian capital markets, contributing to economic growth and development.
In Part 2 of this series, we will delve deeper into risk management strategies employed in the Indian capital market, highlighting the importance of proactive risk mitigation for market stability and investor confidence.
