Risk Management and Order Routing
Regardless of how an order gets generated or delivered, it passes through a risk management matrix. This matrix is a series of risk management checks that an order undergoes before it is forwarded to the exchange. The onus of getting the trades settled resides with the broker. Any client default will have to be made good to the clearing corporation by the broker. Credit defaults are thus undesirable from the point of view of the broker who puts money and credibility on the line on behalf of the customer. Hence, these credit and risk management checks are deemed necessary.
Institutions are normally considered less risky than retail customers. That is because they have a large balance sheet compared to the size of orders they want to place. They also maintain a lot of collateral with the members they push their trades through. Their trades are hence subjected to fewer risk management checks than retail clients.
The mechanisms followed when orders are accepted and sent to exchanges for matching are the same for both institutions and retail clients. However, for retail customers the orders are subjected to tighter risk management checks and scrutiny. The underlying assumption in all such risk management checks is that retail clients are less credit worthy and hence more susceptible to defaulting than institutions. A recent extension of retail trading has been trading through the Internet. This exposes brokers to even more risk because the clients become faceless. In the good old days of “call and trade” (receiving orders by phone), most brokers executed transactions of clients they knew. With the advancement in trading channels, the process of account opening became more institutionalized, and the numbers came at the expense of client scrutiny. Most brokers who operate on behalf of retail clients these days operate on the full-covered concept. This means that while accepting orders from retail clients, they cover their risks as much as possible by demanding an equal value of cash or near cash securities.
The steps below show how a retail transaction is conducted and the benefit provided by risk management. The method utilized is more or less the same in call and trade as in Internet trading. The order delivery mechanism changes, but the basic risk management principle implemented remains the same. Here are the steps:
- The client calls the broker to give the orders for a transaction (in Internet trading the client logs on to the Internet trading site, provides credentials, and enters orders).
- The broker validates that the order is coming from a correct and reliable source.
- In case the client gives a buy order, the broker’s system makes a query to ascertain whether the client has enough balance in a bank account or in the account the client maintains with the broker. In case the client does not have enough balance, the order is rejected even before forwarding to the exchange. If the client has the balance, the order is accepted, but the value of the order is deducted from the client’s balance to ensure that he does not send a series of orders for which he cannot make an upfront payment. Many brokers still do not have direct interfaces to a banking system. In such cases, they ask the client to maintain a deposit and collateral in the form of cash and other securities; they keep the ledger balances of a client’s cash and collateral account in their back-office system and query this system while placing the order to ensure that the client has enough money in his account. The figure below illustrates this process.
- In case a client gives a sell order, the broker checks the client’s custody/demats account to ensure that he has a sufficient balance of securities to honor the sale transaction. Short selling is prohibited in most countries, and brokers need to ensure that the client is not short of securities at the time of settlement, especially in markets that do not have an adequate stock-lending mechanism in place. Most markets have an auction mechanism in place for bailing out people with short positions, but such bailouts could be very expensive. Once the sale transaction is executed, the broker keeps a record and updates the custody balance’s system if it is in-house or keeps reducing the figures from the figures returned by the depository to reflect the client’s true stock account position. In many countries, brokers have a direct interface with the depository system that lets them query the amount of shares of a particular company in which the client has balances. Wherever a direct interface is absent, the broker maintains the figures in parallel; the broker then does a periodic refresh of this data by uploading the figures provided by the depository and maintains a proper intraday position by debiting figures in his system when the clients give sale orders that are executed on the exchange. The figure below illustrates this step.
- Once the risk management check passes, the client’s order is forwarded 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.
You can appreciate the role technology plays when you consider that the entire process of receiving the order, doing risk management checks, forwarding the order to the exchange, and getting back the confirmation is expected to take a few hundredths of a second. Any performance not conforming to this standard is considered unacceptable and could be a serious reason for clients to look for other brokers who can transact faster and get them more aggressive prices.
One of the ways of implementing risk management is through margining. 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. Margins make the client stand by trades in case the market goes against the client by the time the trades get settled.
To protect the market from defaulters, clearing corporations levy margins on the date of the trade. Margins are computed and applied to a client’s position in many ways, but the underlying philosophy of levying margins is to tie the customer to a position and preserve the integrity of the market even if a large drop in stock prices occurs.
Order Matching and Conversion into Trade
All orders are aggregated and sent to an exchange for execution. Stock exchanges follow defined rules for matching all the orders they receive. While protecting the interests of each client, the exchange tries to execute orders at the best possible rates. The broker’s trading system communicates with the exchange’s trading system on a real-time basis to know the fate of orders it has submitted.
A broker keeps a record of which orders were entered during the day, by whom, and on behalf of which client. A broker also maintains details of how many orders were transacted and how many are still pending to be executed. Using this system, a broker can modify the order and order terms, cancel the order, and also split the order if required depending upon the behavior of the market and instructions from the clients. Once the order is executed, it gets converted to a trade. The exchange passes the trade numbers to the broker’s system. The broker in turn communicates these trade details to the client either during the day or by the end of the day through a contract note or through an account activity statement. The contract note is a legal document that binds the broker and the client. Contract note delivery is a legal requirement in many countries. Apart from the execution details, the contract note contains brokerage fees and other fees that brokers levy for themselves or collect on behalf of other agencies such as the Clearing Corporation, exchange, or state.
On my next post, I’ll discuss about the last two steps. Have a nice day.