How Stock Market Works?

4.6

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Think of your favorite movie? What pops into your head? A scene, a song, or maybe an entire monologue? Whatever it may be, the first thing that you’ll think of is something on the front end - something that you can see or hear. But if you stop awhile and think about it, there’s a lot of behind-the-scenes effort that goes into making a blockbuster movie. Right from creating the script to shooting for all those power-packed action scenes, there’s a lot that goes on behind the curtain.

And just like your movie, which is the end product, the front end of the markets is also seamless and smooth. Buying and selling happens with just a few clicks on your mobile trading app or on your web-based trading terminal. But what really goes on behind the scenes? To put it simply, there’s a lot that’s going on at the backend of the stock markets, right from the time you place your order to the time it’s executed and settled.

Getting into the details of the backend of the stock markets can be fascinating. You’ll get to discover how multiple participants work in tandem to ensure that your trade is executed smoothly. The parties involved do this not just for your one trade, but for the millions of transactions that occur on the exchange each day. Beautiful, isn’t it?

To begin this interesting journey backstage, let’s first look at an example of a trading timeline.

Say you place your order on the exchange today. This day is then known as the ‘trade date’ for the order concerned and it’s represented as ‘T day.’ The subsequent days will be known as T+1 day, T+2 day and so on.

The timeline when you buy a stock

  • Let’s assume you buy 1 share of ABC Limited at Rs. 1,000 today, that is, T day.
  • So, when you do this, an amount of Rs. 1,000 is deducted from your trading account on T day.
  • Additionally, the broker you’re trading through will also issue a contract note to you by the end of T day. This document contains the details of all the trades you’ve made that day.
  • On T+1 day, the internal processing for the trade you carried out on T day happens.
  • Then, on T+2 day, the share of ABC Limited that you purchased on T day is credited into your demat account.

The timeline when you sell a stock

  • Conversely, let’s assume you sell 1 share of ABC Limited at Rs. 1,000 today, that is, T day.
  • The share, which you would have held in your demat account prior to this trade, is blocked to minimise the chances of default.
  • Before T+2 day, the share is moved out of your account and given to the exchange.
  • On T+2 day, you receive the sale proceeds of Rs. 1,000 in your trading account.

The phases involved in the transfer of shares

As you can see from the example above, there are three phases in the process of transfer of shares: execution, clearance and settlement.

Execution:

In this phase, a trader like you places a buy or a sell order and the stockbroker fulfills the requirements of that order. This takes place on the T day. 

Clearance:

Clearance occurs on the T+1 day. Here, third parties known as clearing houses identify the amount of money that needs to go to the seller and the number of shares that need to be transferred to the buyer.

Settlement:

During the settlement phase, which takes place on the T+2 day, shares are credited to the buyer’s demat account and the money is paid into the seller’s trading account.

 

Types of settlement in the stock market

Settlement is the process of transferring the money owed to the seller and the securities owed to the buyer. There are two main types of settlement in the stock market, namely spot settlement and future settlement. Let’s take a closer look at these two kinds of settlements.

Spot settlement:

Spot settlement occurs immediately, and it follows the principle of rolling settlement. According to the principle of rolling settlement, each trade is settled two days after the day on which it occurred. So, if we label the trading day as ‘T,’ then, in the case of spot settlement, the transaction is settled in T+2 days.

For example, if a trade occurred on a Monday, it would be settled on the following Wednesday. Saturdays, Sundays, banking and exchange holidays are not counted as a part of the T+2 window.

Forward settlement:

In the case of forward settlement, the parties involved agree to settle the trade at a later date, such as the T+5 day or the T+7 day. This date is generally agreed upon earlier, so it is called ‘forward’ settlement.

The participants involved in the clearance and settlement process 

Now that you’re aware of the entire process during clearance and settlement, which happens at the backend of trading, let’s move on and get to know the participants involved. 

Clearing corporations

A clearing corporation is the entity behind the entire process of clearance and settlement of trades. In India, the National Securities Clearing Corporation Limited (NSCCL) and the Indian Clearing Corporation Limited (ICCL) are primarily responsible for this process.

Clearing members (custodians)  

Clearing members are entities that identify the amount of funds and the number of shares to be transferred to the respective traders. 

Clearing Banks 

The process of settlement of funds happens only via clearing banks. The custodians are mandatorily required to have a ‘clearing account’ with any one of the 13 authorised ‘clearing banks.’

Depositories      

Since we’ve already covered depositories in the chapter ‘The key players in the stock market,’ let’s move on to understanding the role they play in the clearing and settlement process. A specialised account known as the ‘clearing pool account’ is maintained by the clearing members with the depositories. On the settlement day, the clearing members transfer the concerned securities to the ‘clearing pool account.’ 

Wrapping up

So, all in all, there are many participants who work together to make the backend of the trading process a smooth and hassle-free system. What’s more compelling is the fact that the intricate process of clearing and settlement of millions of trades happens day in and day out in perfect synchronisation, without any hitches whatsoever. This seamless process ensures that the stock market functions efficiently.     

A quick recap

  • The day on which you place your buy or sell order is called T day. The subsequent days are labeled as T+1 day, T+2 day and so on.
  • There are three phases involved in the transfer of shares: execution, clearance and settlement.
  • The execution phase takes place on the T day. In this phase, you place a buy or a sell order and the stockbroker fulfills the requirements of that order. 
  • The clearance phase takes place on the T+1 day. Here, third parties known as clearing houses identify the amount of money that needs to go to the seller and the number of shares that need to be transferred to the buyer.
  • During the settlement phase, which takes place on the T+2 day, shares are credited to the buyer’s demat account and the money is paid into the seller’s trading account.
  • There are many participants involved in the backend of the clearance and settlement process, such as clearing corporations, clearing members, clearing banks and depositories.
  • A clearing corporation is the entity behind the entire process of clearance and settlement of trades. India’s major clearing corporations are the National Securities Clearing Corporation Limited (NSCCL) and the Indian Clearing Corporation Limited (ICCL).
  • Clearing members or custodians are entities that identify the amount of funds and the number of shares to be transferred to the respective traders. 
  • The process of settlement of funds happens only via clearing banks. Custodians are mandatorily required to have a ‘clearing account’ with any one of the 13 authorised ‘clearing banks.’
  • A specialised account known as the ‘clearing pool account’ is maintained by the clearing members with the depositories. On the settlement day, the clearing members transfer the concerned securities to the ‘clearing pool account.’ 
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