What is the trade life cycle?
January 25, 2021 2021-01-25 20:31What is the trade life cycle?
When you buy something from your local food shop, the process is simple and easy. You exchange money with that shop for the goods you want to buy.
When you’re trading financial instruments, the process or trade life cycle is a little more complex. Due to the nature and complexity of trade processing, it goes through several stages to ensure that both the buyer and seller are getting what’s agreed.
What is a trade life cycle?
A trade life cycle is just as it sounds. It is the entire process a trade must go through from start to finish.
With the emergence of online trading, a trade needs to go through several stakeholders and processes before it’s live.
The trade life cycle can be broken into two key parts:
- Trade activity
- Operational activity
These can be broken down further but all steps lead to the receipt of the original order. From order to the settlement of the trade.
Trade activity
The trade activity covers the entire process of capturing a trade from the client via the front office before it goes into the operational activity for processing in the back office.
There are two main parts to the trade activity:
- Trade execution
- Trade capture (front office)
We’ll take a look at both in more detail below.
Trade execution
This is the process where a client places an order into the market. Trade execution can be done in two markets:
- Order-driven markets – In this market, orders from sellers and buyers are matched electronically.
- Quote-driven markets – In this market, market makers offer quoted prices where they are willing to buy and sell an instrument. They do this in the hope of attracting either a buyer or a seller to be their counterparty in the trade.
The vast majority of retail traders tend to stick with quote-drive markets and use local retail brokers to help execute their trades.
Therefore before the trade process begins you will need to go through a process to get there. That includes:
- Choosing a broker and account
- Choosing a financial market
- Placing the order
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Choosing a broker and a trading account
Choosing a broker does require some homework. As mentioned in our previous lesson ‘What are the bid and offer prices’, choosing a broker with good spreads is important because it affects your bottom line. There are lots of other things that you should take into account when choosing a broker, here are a few of the important points to look out for:
- The size of their spreads
- Whether they are regulated
- Markets you can trade
- Additional educational material
- Customer service
- Trade execution and speed
Once you’ve chosen a broker, you’ll find that some have different accounts available to you. Normally this is dependant on how much you can deposit or have in your account. If you think about it, that isn’t the ideal scenario because why should those who can deposit more get a better offering than those who don’t? Do be careful when you see brokers doing this, it doesn’t mean that they’re in the wrong but just snake sure you’re aware.
Choosing your financial market
Once you’re set up with a broker and trading account, you then need to decide which market you want to trade. This will come down to your strategy and figuring out which one suits you best.
Different markets do have their pros and cons, for more insight check out our lesson ‘What are the financial markets’.
Placing an order
Once you have a broker, a trading account and know which market you want to trade, the next step is executing the trade. How you execute the trade will depend on the broker and the platform you use.
The normal scenario is you will have a buy and sell button, which will open an order ticket. You select the criteria required and then hit the correct button and your order then goes to trade capture.
Trade capture
Trade capture refers to the trading system that you’re using capturing the information of your order and then sending it from the front office to the back office to be processed.
This is done via the platform interface and technology nowadays however before the internet this would be written down on a ‘dealing slip’ and manually taken to the back office.
Once the order is executed, it goes through to the back office and the operational activity begins.
Operational activity
Operational activity is everything after the actual trade has been executed. It gets booked internally in so that it can flow down to the operating systems. The first place it’s is then booked is the risk management system.
It then goes through the following process; trade validation and enrichment, trade agreement or confirmation, trade settlement, and trade reconciliation.
Trade validation
The trade validation stage is where the relevant team ensures that the details of the order are correct and validate it with the pricing available (matching the market price to the order price and entry price).
Once they’re happy they will release instructions to the market. This is where they go to find a counterparty for the order, someone to take the other side of the trade. If you’re selling, then they’re looking for a buyer and vice versa if you’re buying.
Trade agreement
This step is critical. This is where a counterparty is found and the trade is agreed. As mentioned above, if you’re selling, this is where you match with a buyer.
The trade details are agreed by both parties, the buyer and the seller. This includes the price and the amount.
Once the trade is agreed, this is then reported back to both the buyer and the seller and the trade is recorded.
Trade settlement
As the title suggests, this is where the trade is settled. This is where the exchange of goods for money or goods for goods takes place.
In traditional financial markets, it is the exchange of cash for the instrument in question. This could be something like a commodity like oil or a derivative.
After this step, the buyer will be in possession of the instrument they have just purchased.
Profit and Loss
This is also where both parties will understand whether they have profited or lost from the transaction. Including any fees etc, they’ll be able to see the price they bought at and sold at and therefore understand their profit and loss.
Trade reconciliation
The trade reconciliation phase is where the accounts are confirmed. This involves matching the ledgers against statements. Statements from both counterparties and the market to ensure correct accounting of the trade has been agreed.
A trade break or a failure can occur when prices are mismatched or amounts aren’t the same. As you can imagine, if there is an extra ‘0’ at the end of one parties trade and not on the others, then there will be insufficient funds for one side of the trade.
It’s therefore imperative that this process is conducted thoroughly to ensure a smooth transaction for both parties.
Trade life cycle summary
You should now be better placed to understand the lifecycle of a trade, from the start right through to when it gets settled.
One of the key aspects you should take away from this lesson is that it is a thorough process to ensure both transparency to the parties involved and also that it’s secure. Making sure that both parties agree with the amount and price of the trade. Divergences here without a proper process will lead to misallocations of funds and issues between parties.
In our next lesson, we tackle the important topic of margin and leverage. This is hugely important for beginner traders to understand because it can be the difference between blowing up an account or not.
It’s not uncommon for beginners to do that simply because they don’t understand how leverage works.
