Lifecycle of a Trade | Course Module

Key Takeaways

Hi, and welcome to the CFI course, The Life Cycle of a Trade. I'm Ryan Spindelow, VP of Content here at CFI. It's hard to know exact numbers on how many trades are executed every day in the financial markets. However, it is estimated that tens of millions of trades take place daily across various financial markets, including stocks, bonds, currencies, commodities, and derivatives. Because of the sheer size and scale of this level of trading activity, it's little surprise so many roles within the financial services industry relies, to some degree, on knowledge about the trade life cycle. In this course, you'll gain a comprehensive understanding of the entire trade life cycle, enabling you to make better-informed decisions regarding the trade life cycle, navigate real-world complexities that arise during the trade life cycle, and, if required, to be able to resolve issues related to the trade life cycle effectively. Now, we'll do this by introducing all the roles that both buy-side and sell-side market participants play within the trade life cycle. We'll discuss the motivations behind trade initiation, as well as the mechanisms for trade matching and execution. Crucially, we'll explore the key process of confirmation, clearing, and settlement for capital market trades, and how this differs for the trade process for derivative market transactions. This means that, by the end of this course, learners will be able to identify the participants involved in capital and derivative market trades, as well as describing their roles. List reasons why trades are initiated and determine the price they will be executed at on both order-driven and quote-driven markets. Explain the role sell-side institutions play in executing capital markets and derivative market trades. Describe the process that occurs once a trade is matched to when it's cleared and settled. Compare the similarities and differences between the capital market and derivative market trade life cycle. Whether you're seeking to deepen your financial knowledge or enhance your career prospects, mastering the trade life cycle is essential in today's complex financial landscape. We have a lot of exciting content to cover, so let's get started. So, what exactly is a capital market? A capital market is a market where companies and governments raise capital. The two sources of capital are equity capital or shares and debt capital or bonds. Within the capital markets, there are two distinct markets, a primary market and a secondary market. Primary markets are where large issuers like companies and governments go to raise capital. In exchange for this capital, these corporations and governments issue equity securities or shares and debt securities or bonds to mostly institutional investors. Secondary markets are where institutional investors like asset managers, insurance companies, hedge funds, and sovereign wealth funds buy and sell existing securities. Capital markets are critical as they help to drive economic activity. They do this in several ways. Capital markets facilitate investment by allowing investors, both institutional and individual, with the opportunity to invest savings into productive ventures, stimulating economic growth. By pricing securities based on their risk and return profiles, capital markets ensure that capital is efficiently allocated to its most productive uses. Companies can raise funds for expansion or innovation by issuing stocks or bonds to investors in the capital markets. And finally, capital markets provide liquidity, allowing investors to buy and sell securities easily, promoting market efficiency. There are quite a few participants in the capital markets. Often, they are grouped into either the buy side or the sell side. Buy side investors fulfill their function by buying securities in both the primary new issue market as well as the secondary market in order to fulfill their investment mandates. Examples include investment managers and hedge funds. On the other hand, the core function of sell side firms is to sell their services to companies and governments looking to issue securities in the primary market as well as support buying and selling to provide liquidity of those securities in the secondary markets. An investment bank is a great example of a sell side firm. And within an investment bank, there are lots of different divisions offering their services to all types of clients. Buy side investors aim to maximize returns for their investors, earning themselves fees along the way. The buy side can be categorized as traditional and non-traditional investors. Traditional firms follow conventional investment strategies and include fund managers, insurers, and pension funds. Fund managers, by the way, may also be called investment managers, mutual fund managers, and even asset managers. Non-traditional firms often employ more alternative and specialized investment strategies to generate returns for their investors. Examples include hedge funds, distressed debt funds, and venture capital. In this course, institutional investors or buy side encompasses all these different types of investors. The most well-known type of sell side entity is probably the investment bank, typically divided into two main divisions, the investment banking division or IBD and capital markets, although these titles may vary among banks. IBD segregates into industry and product groups. Industry groups, such as financial institutions and real estate, offer financial advisory services to clients in these industries. Product groups, like mergers and acquisitions or M&A, provide specialized services regardless of industry. Origination within the product group facilitates capital raising for clients in the primary markets, aiding in issuing bonds and debt markets and equities in equity markets. Capital markets includes sales, trading, and research. With sales and trading or S&T divided into desks for specific asset classes. Research provides comprehensive market analysis. This course focuses on the services offered by the capital markets division in the life cycle of a trade. We ended the previous lesson by introducing sell-side investment banks, and you might recall that the capital markets roles we introduced comprised of sales, trading, and research. This is referred to as the front office. Because a lot of the trade life cycle happens within a sell-side firm, it's useful to know how they are generally structured. The front office is responsible for dealing directly with institutional clients. Research teams generate trade ideas for clients, sales people work really hard to understand the needs of their clients, and traders will execute trades on behalf of these clients. The middle office work directly with the front office to support their work with their clients. They will book trades on internal systems, confirm trades with counterparties, and provide key metrics for the front office, as well as the risk, performance, and compliance teams. These metrics include daily profit and loss numbers, position sizes, and market exposures. Back office roles provide essential functions to the entire business. Roles and jobs classified as back office are often classified under the term operations. In order for the entire trade process to operate efficiently with minimum disruption or errors, all three areas, the front, middle, and back office, need highly skilled finance professionals who can collaborate across teams. Capital markets are places where debt and equity securities are bought and sold. Now, at CFA, we have a lot of courses that explore both equity securities and debt securities. So, the purpose of this lesson is just to provide a quick comparison of the investment characteristics of both types of capital market products. Equities are issued by companies as a means of raising capital for various purposes such as expansion, research and development, or debt repayment. Equities are considered riskier than bonds. Equity prices can be volatile and investors are exposed to market volatility and company-specific risks. However, equities have historically offered the potential for higher returns over the longer term. Equities represent ownership in a company and investors typically earn returns through capital appreciation or an increase in stock price and dividends, which are a share of company profits. Equity investments have an indefinite term. Investors can hold stocks for as long as they choose and there is no fixed maturity date. Bonds are typically issued by companies and governments to raise capital for specific purposes. Governments issue bonds to fund public expenditures such as infrastructure projects or social programs. Corporations issue bonds as a means of borrowing money for expansion, acquisitions, or refinancing existing debt. Bonds are considered relatively safer investments than equities and this is because while returns are generally lower, they're typically more predictable and certain than they are for equity securities. Bonds have a fixed term known as maturity, which can range from a few months to several decades. At maturity, bondholders receive the face value of the bond. So far, we've introduced buy-side investors and sell-side investment banks, but there are many participants involved in the trade life cycle. You might find it useful for the rest of this course if I provide you with an overview of all the participants of the trade life cycle. Some participants will explore in depth. Some we might mention in passing where appropriate. But let's see if we can build a 30,000-ft picture for you to get some important early perspective. Borrowers and issuers are entities like corporates and governments that require capital, so issue debt and equity securities to raise funds. The investment banking division of an investment bank will help them with this process. Asset owners are buy-side investors that we've already introduced in this course, as well as individual investors like you and me. Asset owners invest in debt and equity securities as part of their investment strategies. The capital markets division of an investment bank helps to facilitate the buying and selling of debt and equity securities in the secondary capital markets. They provide trading and execution services to institutional investors and offer financial advice on investment decisions. Custodians are financial institutions responsible for safeguarding and administering securities on behalf of asset owners. They hold securities in custody, settle trades, and provide reporting and record keeping services. They play a vital role in the trade life cycle. Central security depositories or CSDs are essential components of the trade life cycle. They facilitate the transfer of ownership of debt and equity securities and ensure the timely and accurate settlement of trades between buyers and sellers. Data vendors are companies that collect and analyze and disseminate financial market data to market participants. They provide real-time market information, news, and analytics to traders, investors, and financial institutions. Trading service providers are firms that offer trading platforms, technology, and infrastructure for executing trades in the capital markets. They provide access to trading venues, order routing, and execution services for market participants. Finally, regulators are government agencies responsible for overseeing and regulating financial markets and participants. They establish rules and regulations to ensure fair and orderly markets, to protect investors, and to maintain market integrity. Continue learning. Join CFI today.