User:WikiDorset/Securities trade allocations

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Stock trade allocations (United States) is the business process used by investment managers and broker-dealers to apportion large buy or sell order executions (trades) among multiple client accounts. Large investment advisers often manage assets for hundreds or thousands of clients, and hedge fund managers often manage separate hedge funds. The portfolio manager responsible for deciding which stocks to buy or sell makes such decisions on behalf of many clients or funds simultaneously, rather than individually. Consequently, for large investment firms the decision to buy or sell results in very large orders, in the hundreds of thousands or millions of shares. Once the order has been fully executed, portions are assigned to specific clients at the average price obtained for the full order, thus ensuring that all clients benefit from the same price, and that none is favored over others with better prices.

Beneficial Owners

Many large investors, such as pension and endowment funds, choose to outsource investment decision to investment managers rather than make the investment decisions themselves. For example, a city pension fund might have $1 billion. Its strategy might be to allocate a fifth ($200 million) to each of five investment managers. After a period of time, it would replace the poorest performing investment manager with a new one, in order to keep each competing to achieve the highest returns.

Beneficial owners choose their custodian banks, and authorize their custodians for accept delivery instructions from the investment managers they have chosen. In our example, the fund authorizes the five investment managers it has chosen to instruct its custodian. The five investment managers execute orders on behalf of the funds, using any number of broker-dealers of their choosing, and then direct those executing broker-dealers to settle each trade done for the fund with the custodian. Thus at any point in time, the fund knows how much cash and securities it has in its single account at its custodian bank.

Investment Managers

Investment mangers compete to obtain as many fund clients as possible. In so doing, they accept the obligation to settle trades done for a client fund at the custodian of the fund's choosing. Both funds and custodians may be in the US or abroad. It is the investment manager's responsibility to keep track of each client's custody bank, custody account number and related information. For investment managers with hundreds or thousands of fund clients, keeping track of these relationships can be a significant challenge. Lastly, investment managers deal with tens or even hundreds of broker-dealers. All need to be supplied with up to date information about the funds and their custodian accounts in order for trades to settle on time.

Order Processing

To illustrate, let's imagine that investment manager A gives an order to buy 50,000 shares of company DEF at a limit price of $45 to broker B. Later in the day broker B reports back that the order has been filled at an average price of $44.95. Investment manager A must now give the broker B the names of the 35 clients on whose behalf the stocks were purchased, along with details about each one's custodian bank, account number at the bank and so on. This is the allocation process.

Now let's imagine that the order at investment manager A was for 1 million shares rather than the 50,000 above. The trader at the investment firm would be reluctant to give that size of an order to a single broke-dealer. Instead, she would be chop it into multiple orders, such as ten of 100,000 shares each for 10 broker-dealers. To allocate that single order, investment manager A must send 35 instructions to 10 broker-dealers. Any miscommunication will lead to a portion of the trade not being settled on time.

Standing Settlement Instructions

A standing settlement instruction is the information regarding a fund's custody arrangements: the name of the custodian bank, the account number at the custodian, a tax ID, names and addresses of parties to which copies of confirmations must be sent and other details required for settlement purposes. The information is "standing" because it is valid until such time as the fund chooses to move its assets to another custodian. At that point, all standing settlement instructions with all the fund's investment managers and their broker-dealers must be updated.

Investment advisers can transmit settlement data each time a trade is done, or they can inform their broker-dealers on a standing basis. Typically they will assign an identification code, so that only the identification data need be sent for each trade, rather than the entire settlement data. This can be done either via fax or via an industry database called Alert, which is part of the Omgeo suite of post-trade services offered by DTCC.^[1]

Each time an investment adviser takes on a new client, it must distribute standing settlement instructions for the new client to all of its broker-dealers. In addition, from time to time the beneficial owner changes custodian bank. Again, the investment adviser must communicate the new data, along with an effective date, to all its broker-dealers.

Blocks

Once a broker-dealer has completed the execution an order for an investment adviser, the broker informs the of the average price obtained. This is know as the "block" level. In the example above, a buy of 50,000 shares of DEF was completed at an average price of $44.95. This block then becomes the basis for the allocations.

Large orders may be completely filled on the day of the order, if in a security which has a large daily trading volume. Other orders may take several days to fill. The broker reports the block when filled, or at the end of each market day when executions are spread over multiple days. Allocations take place daily, regardless as to whether the entire order has been filled, based on each day's block and the average price of the block.

Investment advisers using order management systems often require their broker-dealers to report each individual execution electronically at it occurs. Our example of a 50,000 share block might have required upwards of 500 individual trade executions to complete the order. Once filled, and the block reported by the broker, the investment adviser confirms agreement with the average price calculated by the broker. This then becomes the basis for the allocation calculations.

Trade Allocations

Once the number of shares and average price of the block has been agreed, the investment manager can send the broker-dealer its breakdown of clients. This can be done by telephone (for small numbers of clients), by spreadsheet or by various electronic products (see below). The broker then proceeds to verify that it has allocation data for the entire block and has open accounts on its books for fund. If nothing is missing, the broker then issues 10-b-10 trade confirmations, either in paper or electronically. If the investment adviser has allocated to new clients for which the broker has yet to receive settlement instructions (and therefore has yet to open a client account), the broker may book that part of the block to a suspense account, awaiting further instructions.

Trade Matching

DTC introduced the Institutional Delivery (ID) system in the 1970's to improve settlement processing. Now known as Tradesuite, the system centralizes data processing among the parties to investment manager trades, and is used by parties globally for all US securities. Allocation data is submitted by brokers frequently during the trading day. The system sends the confirmations electronically to the investment advisers, custodians and any other party designated to receive them for a particular client (beneficial owner). The investment adviser then compares the confirmations against its trading records. If in agreement, it "affirms" the confirmation. This become the instruction for the custodian to settle the trade. Some custodians offer an affirmation service whereby they receive settlement instructions from the investment adviser, and then affirm the trades in the ID system.

Settlement Instructions

To complete a transaction, the parties to a trade must send instructions to the next party in the settlement chain. Custodians do not participate in the trading, and therefore must be instructed by the investment manager. Then the custodian completes the transaction by submitting settlement instructions which will ultimately be matched at the securities depository with those of the broker-dealer. Keep in mind that most custodians and broker-dealers are not members of their national securities depository. Rather they have accounts with custodians and broker-dealers which are members of the depository.

The process begins once the executed order has been allocated. The investment manager, having agreed with the broker-dealer the clients to which the trade has been assigned, sends settlement instructions to the custodians, using the financial details agreed with the broker-dealer.

Service Providers

Omgeo - a suite of post-trade related products from DTCC
SS&C - a provider of order management software
Bloomberg - a provider of order management software

These three firms have been approved by the US Securities and Exchange Commission as providers of post-trade matching services.^[2]

Financial Information eXchange - a software protocol for electronic communications between investors and brokers, with message standards for communicating blocks and allocations on a bilateral basis.
SWIFT - the global network for financial institutions

References

^ Weiss, David M. (2006). After the Trade is Made. New York: Penguin. p. 215. ISBN 1-59184-127-5.
^ "US Post-Trade Matching". FinOps Report. Retrieved 27 March 2017.

External links

Category:Financial markets Category:Securities clearing and depository institutions

[1] Weiss, David M. (2006). After the Trade is Made. New York: Penguin. p. 215. ISBN 1-59184-127-5.

[2] "US Post-Trade Matching". FinOps Report. Retrieved 27 March 2017.

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