UNIT – 2

TRADE LIFE CYCLE (TLC) – EXCHANGE TRADED AND OVER THE

COUNTER

TRADE LIFE CYCLE:

The trade life cycle is the sequence of events that occur from the initiation of a trade to its
settlement.

STEPS IN TRADE LIFE CYCLE:

Stage 1: Pre-Trade

Pre-trade preparation for an institution includes the development of systems, processes, and
protocols to ensure that:

• All trading facilitated through the institution complies with relevant laws and
regulatory requirements
• Data related to all trading and the trade lifecycle is captured and preserved
• Appropriate legal agreements, such as ISDA documentation for OTC derivatives
trades, are used when trades are made.
• Counterparty credit risk is understood to ensure suitability of counterparties.
• Appropriate collateral is collected and managed.
• Risks associated with positions are understood and managed.
• Appropriate controls are put into practice throughout the trade lifecycle.

Stage 2: Trade Execution

Once a client is in an institution’s system, the institution is willing to facilitate trading on

behalf of that client.

The client’s motivation for trading may be:

• A cash need
• The need to hedge a position
• The need to diversify its portfolio
 • The desire to monetize a view, such as the view that a specific stock will increase in
value

Whatever the motivation, the client must communicate with the institution to place orders
when it wishes to engage in trades. The nature of a client’s orders can vary. For example:

• Some orders require that trading take place at a specific price while other orders do
not.
• Some orders require that trading take place immediately while others condition
trading on a specified price level being met.
• Some orders may require that trading take place within a certain amount of time while
others do not.

The institution then works to execute the trade and inform the client of its execution. Trades
may be executed not only on exchanges but using a wide range of systems and trading
venues. Note that, in addition to executing trades on behalf of clients, some institutions may
also execute trades on their own account.

Stage 3: Trade Clearing

When a trade is executed, the agreed transaction does not complete immediately. We can
distinguish between three dates associated with a trade:

Trade Date

This is the date that the counterparties agree to trade. While the counterparties agree to trade
on this date, the exchange of cash for securities, or the exchange of currencies in the case of
an FX trade, does not actually take place on this date. Instead, the exchange takes place at a
specified future date depending on the underlying product and market.

Value Date

The value date is the date that the counterparties to a trade are contractually obligated to
exchange cash for securities, or one currency for another in the case of an FX trade. Note that
while the counterparties are contractually obligated to engage in the exchange on the value
date, they may fail to do so in practice.

Settlement Date
This is the date that the counterparties actually exchange cash for securities. It may differ
from the intended settlement date (value date). If a trade does not settle on the date that it was
contractually scheduled to take place, then a settlement fail has occurred.

Once a trade is executed, an extensive clearing and settlement process is implemented to

finalize the trade. Trade clearing refers to the process through which the counterparties to the
trade and their agents determine and verify the exact details of the transaction and prepare for
settlement. Trade settlement refers to the completion of the agreed-upon transaction.

The process through which trade clearing is implemented includes the following steps:

Trade Capture

Trade capture refers to an institution’s initial recording of executed trades. Only basic
information is initially captured, such as the underlying asset or currencies, price,
amount/quantity, and trade date and time.

Trade Enrichment

Trade enrichment refers to the process of applying additional information to a trade to

facilitate processing of the subsequent stages of the trade lifecycle. The type of data included
in the trade enrichment stage includes the value date, securities identifiers, legal details, and
detailed counterparty information.

Trade Validation

Trade validation is a final check on the information that an institution has gathered in relation
to a trade. The validation process provides the institution with an opportunity to identify
problems before communication with other entities begins in relation to the trade.

Trade Confirmation/Affirmation

Trade confirmation is the process through which trade details are verified and agreed between
direct participants to a trade, for example, between two institutions that are both trading on
behalf of their clients.

Trade affirmation is the process through which trade details are verified and agreed between
the direct and indirect participants to a trade, for example, between an institution that has
traded on behalf of a client and the client itself (the institution is the direct participant while
the client is the indirect participant).

Trade Reporting

Trade reporting refers to the reporting of transactions using an approved reporting

mechanism.

Settlement Instructions

The final step that takes place before settlement is the preparation of settlement instructions.

Stage 4: Trade Settlement

Trade settlement refers to the completion of the agreed-upon transaction. Settlement is a

crucial stage as it represents actual exchange of value. Settlement therefore requires careful
management, protocols, and safeguards.

Broadly, there are two types of settlement method:

Delivery-versus-Payment (DVP)

DVP refers to settlement whereby securities are only delivered if payment is made and
payment is only made if securities are delivered. For example, if a trade involves the
purchase of shares of a stock, then both the cash and shares are exchanged simultaneously.

Free-of-Payment (FOP)

FOP refers to settlement whereby the delivery of the securities and payment of funds take
place separately. This form of settlement is risky for the counterparty that delivers first as the
other counterparty may not deliver.

Stage 5: Ongoing Position & Risk Management

Throughout the trade lifecycle, there is a requirement for ongoing position and risk
management. This refers to the management of the numerous positions that an institution
holds in its portfolio, otherwise known as its trading book.

Some examples of position and risk management activities include:

 • Managing corporate actions
• Managing counterparty credit risk
• Trade reconciliation
• Measuring profit and loss (P&L)
• Measuring risk and sensitivity
• Preparing internal and external reports

Conclusion:

In conclusion, the lifecycle of a trade refers to the sequence of events that occurs and
processes that are implemented when a trade takes place.

EXCHANGE TRADED AND OVER THE COUNTER EXCHANGE:

OTC (Over-the-Counter) and Exchange refer to two different methods of buying and selling
securities. OTC refers to a transaction conducted directly between two parties, without the
supervision of an exchange. Exchange-traded refers to a transaction executed on a centralized
exchange, with the exchange acting as a middleman.

DISTINGUISH BETWEEN OTC AND EXCHANGE:

FEATURES OVER THE COUNTER (OTC) EXCHANGE

Definition A market where securities are traded A centralized platform where buyers
directly between two parties, and sellers can trade securities, such
without the use of an exchange. as stocks and derivatives, according
to pre-established rules and
regulations.
Market Typically financial institutions, Retail and institutional investors,
Participants hedge funds, and large investors. market makers,and authorized
participants.
Trading Continuous, 24/7 Limited to specific exchange hours
Hours
Price Based on direct negotiations Based on supply and demand, as
Discovery between buyer and seller. determined by the bid and ask prices
of multiple market participants.
Transparency
Liquidity
Regulation
Speed
Costs Typically higher, due to the absence Lower, due to the presence of price
Of price competition. competition and the ability to take
advantage of volume discounts
Accessibility Limited to large financial Generally more accessible, with
institutions and high net-worth many online brokerages offering
individuals. retail investors the ability to trade on
major exchanges.

BEST PRACTICES IN THE GLOBAL MARKET:

ISDA (INTERNATIONAL SWAPS AND DERIVATIVES

ASSOCIATION):

What is the International Swaps and Derivatives Association (ISDA)?

The International Swaps and Derivatives Association (ISDA) is a trade collective made up of
more than 800 participants from almost 60 countries around the world. In 1992, the
association developed a standardized contract called the ISDA Master Agreement for
derivatives transactions. The group works to establish and oversee policies and legal statutes
surrounding the trading of derivatives.

Derivatives:

The ISDA is concerned with derivatives, so in order to gain a better understanding of exactly
what the ISDA focuses on, it’s critical to understand derivatives. Derivatives are contracts
that get their value from an underlying index, interest rate, or asset. Derivatives are used for:

• Opening up exposure to price fluctuations, so speculation is easier

• Insurance or hedging against price movements
• Providing lines of access to assets and markets that are more difficult to trade

There are a variety of derivatives available for use. They include:

 DERIVATIVES

Swaps Futures Forward Options

OPTIONS:

• Options are financial derivative contracts that give the buyer the right, but not the
obligation, to buy or sell an underlying asset at a specific price (referred to as the
strike price) during a specific period of time.
• American options can be exercised at any time before the expiry of its option period.
On the other hand, European options can only be exercised on its expiration date.

FUTURES:

• Futures contracts are standardized contracts that allow the holder of the contract to
buy or sell the respective underlying asset at an agreed price on a specific date. The
parties involved in a futures contract not only possess the right but also are under the
obligation to carry out the contract as agreed.
• Futures contracts are traded on the exchange market and as such, they tend to be
highly liquid, intermediated and regulated by the exchange.
• Because of the highly standardized nature of futures contracts, it is easy for buyers
and sellers to unwind or close out their exposure before the expiration of the contract.

FORWARD:

• Forwards contracts are similar to futures contracts in the sense that the holder of the
contract possesses not only the right but is also under the obligation to carry out the
contract as agreed. However, forwards contracts are over-the-counter products, which
mean they are not regulated and are not bound by specific trading rules and
regulations.
• Since such contracts are unstandardized, they are customizable to suit the
requirements of both parties involved. Given the bespoke nature of forward contracts,
they tend to be generally held until the expiry and delivered into, rather than be
unwound.
 F0=S0×erT
F0 = Forward
S0 = Spot price of underlying asset
R = risk free rate of return
T = Time to maturity

Problem:

Calculate the Forward Price from the following equation.

Current price of an asset = 500000

Risk-free rate of return = 7.5%

Time to expiration = 75 days

Solution:

Given data:

S0 = 500000, r = 7.5% = 0.075%, T = 75 days = 75/365 = 0.21

F0 = 500000*e

SWAPS:

• Swaps are derivative contracts that involve two holders, or parties to the contract, to
exchange financial obligations. Interest rate swaps are the most common swaps
contracts entered into by investors. Swaps are not traded on the exchange market.
They are traded over the counter, because of the need for swaps contracts to be
customizable to suit the needs and requirements of both parties involved.
• As the market’s needs have developed, more types of swaps have appeared, such as
credit default swaps, inflation swaps and total return swaps.

ISDA HIERARCHY:

The framework consists of a master agreement, a schedule, confirmations, definition

booklets, and credit support documentation. The master agreement is a document agreed
to between two parties that sets out standard terms that apply to all the transactions
entered into between those parties.
 Confirmations

Negotiated part of collateral

document

Pre-printed form of
collateral document

Schedule of ISDA
master agreement
Pre-printed
form of ISDA
master
agreement

ISDA DOCUMENTATION:

The ISDA hierarchy out Confirmations

1.Master Agreement:

➢ Negotiated part of collateral document

➢ Pre-printed form of collateral document Master Agreement allows the
counterparties to negotiate standard terms between them at the

outset of their relationship

2. Schedule:

THEN they enter into a Confirmation for each transaction incorporating the standard

terms which means that only the specific financial terms of the transaction must be set

Schedule to ISDA Master

Agreement

Pre-printed

form of ISDA

Master

Agreement
UMBRELLA DOCUMENT - framework for the derivative

Sets out the standard (non-economic) T&Cs including representations, undertakings,

events of default, termination events, change of law and netting

Pre-printed, not amended; all modifications are done in Schedule (transferability point)

Cl 1- 4: interpretation, obligations, representations, agreements

ClS-7:events of default, termination and early termination

Cl8-14: admin stuf

Allows parties to tailor the agreement by modifying Master and adding extra

provisions to agree their own economic terms

Details about derivative

Within the Master Agreement there are various options you can select and in

the Schedule you choose from the options

Economic terms = e.g. I am buying gold on a swap

Part 1-termination events

Takes precedence over master agreement

Part 2- agreement to deliver documents

Part 3 -miscellaneous matters/administration -governing law/notices/netting

Part 4: parties amend and delete MA provisions and incorporate additional provisions

Fewer amendments in the schedule = more transferability

3. Confirmation:

The information is often referred to as "dates and rates"

Locks down the exact price at the last minute

Sets out the key details fora particular trade, covering how payments are to be

calculated and when they are due from each party

Final short document

Confirmation may incorporate, amend or disapply any of the provisions of the standard

ISDA definitions applicable to the transaction

If there is inconsistency, the terms of Confirmation prevail

Collateral can be held under ISDA Credit Support Documents: Credit Support Annex or

Credit Support Deed

Collateral falls under the Financial Collateral Arrangements (no 2)

Regulations 2003 (SI 2003/3226)

The Annex is classified as a Title Transfer Collateral Arrangement

The Deed is classified as a Security Financial Collateral Agreement

Therefore, there is no need to register collateral at Companies House

(s859A CA 2006)

Registering is time consuming and registering collateral negatively impacts credit

rating so would not want them registered

Credit Support Annex

An optional document. Bank needs it to support its risks as the borrower owes

more money to the bank as a result of entering into more derivative

transactions = intended to address the issue of credit exposure of one

counterparty to the other under an ISDA Master Agreement.

Parties agree that if certain events occur, one party will have to transfer title

to the collateral they are giving to the other party based on its exposure to
the other party.

The English law annex (Note: a New York Credit Support Annex

difers as it creates a security interest)

:allows a transfer of title to the collateral. In the event of default, the

collateral holder can net of the amount of collateral against what is owed

under the ISDA transactions

Transferee can use the collateral in any way it wishes and only

has an obligation to redeliver equivalent collateral

This allows the transferee to use the collateral for its own

purpose and only has an obligation to redeliver equivalent

collateral (a fungible asset)

This is rehypothecation- = whereby you have

transferred legal title to an asset as collateral to the

other side which allows them to do whatever they

want with it as long as they return a fungible asset to

you at the end of the derivative.p

E.g. if the collateral was cash, transferee could use the

cash as collateral for one of its own derivatives

E.g. if collateral was oil and thought price of oil was

falling, could sell oil to get the cash and buy back the

oil in the future when it is cheaper and return this oil

at the end of the derivative

Credit support annex is recognised in more jurisdictions around the

world than credit support deed

The Annex forms part of, supplements and is subject to the ISDA Master

Agreement and will be part of its Schedule (see intro para in annex)

This is why when you do the close out calculation (how much

money is owed to each party) any collateral given under the

5.

annex cOunts as money you have given to them

E.g. you give £500 collateral, that amount is taken of your bill

Linking the annex to the Master is also important because it

ensures a liquidator cannot set it partially aside as an

unprofitable transaction

Credit Support Deed

it

No title transfer

Creates security over the collateral by charge (efectively an equitable interest)

Similar to a fixed charge rather than a mortgage

Enforced in the event of default

Does not allow for rehypothecation

If collateral was something valuable like property, may prefer this to CSA as less risk of

transferee doing something with the property

Standalone document - does NOT form part of the Master and Schedule

Therefore, does not count towards close out amount