Understanding Trading Cycle in 3 Steps: Trading, Clearing & Settling

The trading cycle doesn’t consist of buying and selling stocks of a company. These are just two steps of the trading cycle which is a whole process. Yes, you read it right. If you want to know all about it, then you are on the right platform. In this article, we are going to explain the trade life cycle and the intermediaries involved in it. We have a lot to learn and understand. So, let’s begin right away. 

Trading cycle

The trading cycle is a process that ensures a smooth transaction between the trader and the firm. Once this process used to happen physically on stock exchanges. However, the trading cycle has also revolutionized in this modern digital age. Nowadays, trade transactions happen digitally and the overall process has become simple but efficient. The trading cycle consists of the following phases.

1. Trading

The trading cycle begins with buying and selling of securities and exchanges play a vital role in making trading a seamless experience. The electronic order matching system matches buy orders with sell orders so that trading transactions get executed with ease. The system records both buy and sell orders and then matches a buy order with a sell order at a particular price to execute trades. 

Anonymity is a key aspect of how exchanges manage this electronic order-matching system. Where exchanges promise a speedy and seamless order process, it also ensures anonymity. Now, it is important to note here that you don’t interact directly with the exchange. Instead, you interact with your broker and then your broker interacts with the exchange on your behalf. 

2. Clearing

A trade has to go through the clearing phase after its completion. This phase revolves around identifying which stocks or securities and the quantity of them are owed to the buyer and how much payment is owed to the seller. In other words, clearing makes sure that the buyer has acquired the stocks and the seller has received the payment. 

It is also important to note that clearing houses or corporations are independent entities. They have a system in place to clear trades executed in the first phase. The settlement phase starts after the completion of the clearing phase.

3. Settlement 

The settlement phase is to fulfill the respective obligations to both parties involved in a trade transaction. In other words, this phase involves making sure that the buyer receives the number of stocks he has paid and the seller receives the amount he sold stocks for. The transaction is said to be settled when the buyer receives the security and the seller receives the payment for the stocks sold.

Intermediaries involved in the trading cycle

As we have mentioned earlier, the trading cycle is a long process and it isn’t possible to complete that process without intermediaries. Intermediaries are a crucial aspect of the trading life cycle and play different roles depending on their position. The following are the intermediaries involved. 

1. Trading members

Trading members refer to the professionals of the stock exchange that make it possible for traders and investors to execute transactions. Yes, you guessed it right. We mean brokers or sub-brokers you deal with to buy or sell stocks. It is important to note that not everyone can become a broker. The reason is that stock exchanges have certain conditions such as capital requirements, net worth, etc. for appointing brokers. In addition, these are not the requirements just once. Stock exchanges continuously monitor their position as brokers. Furthermore, there are certain rules and regulations that brokers must abide by. Trading members can be trading members or clearing houses or both. The next intermediaries in the cycle of trade are clearing houses.

2. Clearing houses

Clearing houses are independent entities that facilitate transactions by directly interacting with buyers and sellers. Buyers entrust funds to them while sellers entrust their securities. Clearing houses may be subsidiaries of a stock exchange or an independent institution. They exist to minimize settlement risk by employing a specific risk management mechanism that typically involves margin deposits. Next in the process are depositories and depository participants. 

3. Depositories and depository participants

Depositories and depository participants play a key role in the trading cycle by holding and facilitating the exchange of securities. Brokers deposit securities to centralized depositories for book entry and record keeping. Depositories also hold securities in dematerialized form. In other words, securities are held electronically and issuers of the securities also consent to that. Thus, securities are held electronically as entries against investors’ names. 

Depository participants are appointed by depositories to facilitate the process. They act as intermediaries between the investors and depositories. Another aspect here is DEMAT accounts which are Dematerialized accounts. Every investor holds a Dematerialized account with a depository participant. All the settlements of transactions are done through these accounts and depository participants notify depositories about the change of ownership after a transaction’s settlement. 

4. Custodians

Finally, custodians play a role in the trading cycle by holding funds and securities on behalf of large institutional investors like mutual funds, insurance companies, banks, etc. They settle secondary market trades and may also act as clearing members for these big institutions. 

The wrap-up

A trading cycle is a long process that starts with buying and selling of securities and ends with the settlement of the transaction. There are several intermediaries that perform their roles to make the process smooth. This cycle and the intermediaries are vital to make trading for both buyers and sellers seamless and without any issues.