I have used the following flow diagram (included at the end of this post) to explain to many people how someone trading a listed future contract on a screen actually has money moved into our out of the clearing account. This is a basic view of a normal trade.
Each Futures Commission Merchant (FCM), Exchange, and Clearinghouse processes transactions slightly differently.
Note: I am not going to go into the role of the middle office. Execution only, processing, algo trading, or brokerage commissioning are likely discussions for future articles.
Please refer to the numbers in the diagram as they match the numbers in each section title.
1: Trader Enters Order
The buy side trader enters an order into an electronic trading system. Common popular independent electronic trading systems include
CQG, Fidessa, and
Bloomberg. (For a more complete list check out
MarketsWiki’s ISV Category.) Many FCMs also have their own mobile and web-based trading systems.
A basic order includes the following information:
Side - The buy or sell indication
Quantity - The number of contracts
Contract information - Which product and maturity on which exchange
Order Type - Instruction to the broker how to handle the order (Common order types are Market, Limit, and Stop)
Price - The price where the order should be bought or sold
Time In Force - How long the order stays open (Common times in force include Day or Good Till Cancelled)
Account Number - the account number identification for the FCM’s tracking system Note: This may or may not be the same account number used in the clearing system.
Once the trader submits the order it is passed to the OMS technology controlled by the FCM. The OMS technology may be hosted at an independent software vendor (ISV), however, it is under contract to an exchange member firm and the connection to the exchange
is provided by the member firm.
2: Order Management System (OMS) - Receive Order
Once the order is received by the FCM’s trading system, it is recorded in the OMS database and also recorded to a transaction log file (#3). The OMS is responsible for maintaining the state of the order. At this time, the order state is “Pending New,” the
order has been received by the broker but not yet sent to an exchange.The order is then passed on to the Pre Trade Risk Check (#4).
3: Client Communication Transaction Log File
All client communication around the world is required to be kept for at least five years. All transactions in the communication log should be timestamped so that activity can be reconstructed by internal or external examiners. The order that is received
from the trader is the first in a chain of transactions that will all relate to this order.
The transaction log should include every order status change with the corresponding transaction timestamp. These state changes include:
Order Transmission to Exchange
Order Acknowledgement by Exchange
Order Acceptance by Exchange
Order Partial Fill
Order Fully Filled
Order Too Late To Cancel
Order Cancel Rejection
4: Pre Trade Risk Check
Before the trade is submitted to the exchange the FCM needs to check to see if the order meets approved sizing controls. Some trading systems use a financial number for this check. However, it has been my experience, that many use a contract count size limit.
This check is usually at a trader or account number level.
Some of the common checks include:
Fat Finger - This check ensures that an unusually large sized order is not allowed into the exchange. An unusually large order could affect a price change. This check is on an individual each order. Many trading systems have different limits for each contract.
(Note: Some FCMs use Fat Finger Limits to prevent someone who isn’t familiar or approved to trade a market from entering any orders.)
Position Limits - This check ensures that the trader does not accumulate a large position in any one contract. This is typically a count of contracts. Position limits may be in total or as values for long or short positions. Since many trading systems do
not have a direct link with the clearing system, the position limits are usually for each day. Position limits typically check to see if the new order quantity plus the filled number of contracts will exceed the position limit.
Open Order Quantity Limits - Some trading systems limit the number of contracts that can be in the traders open order book. This is similar to the Position Limits, but takes into account the total number of contracts ordered. This way a lot of small orders
cannot be entered to get around Fat Finger and Position Limits.
Price Reasonableness Check - This control checks to make sure that the order being entered into the market is reasonable for the market. This prevents junk or erroneous orders from manipulating the orderly market process.
If the order passes these checks it is then sent on to the Exchange through the Exchange Gateway (#5). Orders that fail the order are rejected by the OMS (#6).
5: Exchange Gateway - Send Order
Many trading systems have an exchange specific gateway. This technology is responsible for translating the order from the Trading System’s order representation to the exchange required communication protocol.
Any transactions processed through the gateway are required to be recorded and maintained for five years. This is stored in an exchange specific log file (#7).
6: Failed Pre-Trade Risk Check
If, for any reason, the original client order fails to pass the pre trade checks, (#4) then the order is rejected back to the client.
7: Exchange Specific Transaction Log
The exchange specific transaction log contains all communication between the FCM technology and the exchange. This includes, but isn’t limited to, the following transactions:
Exchanges typically have a format where these files must comply. All transactions should be timestamped to the millisecond level or better and have some sort of sequencing so that transactions can be reconstructed at a later time by an internal or external
8: Exchange Pre Trade Risk Controls
Exchanges operating with a best practice approach as outlined by the
Futures Industry Association
(FIA) have their own pre-trade risk controls. These controls exist to prevent inappropriate orders from entering the electronic market, and are often implemented at a firm wide level. The controls may also work at account, or account grouping (sometimes
called sub-firm), or at an individual connection.
The exchanges typically have pre trade controls that include:
Fat Finger - Ensures that no order exceeds a predefined and approve quantity.
Price Reasonableness Checks - Ensures that no order is outside an acceptable range from the last traded or current bid/offer prices.
Intraday Position Limits - Ensures that no single position allows that for the potential failure of the market participant.
Market Sweep Protections - Ensures that no single order “sweeps” or matches with too large of a percentage of open orders in the market.
Self Match/Cross Protections - Ensures that no order matches with another order from the same client.
Other pre trade risk controls exist. For more information on these controls read the
FIA’s Market Access Risk Recommendations.
9: Failed Exchange Pre Trade Risk Controls
If, for any reason, the FCM’s order fails to pass the Exchange’s pre trade checks, (#8) then the order is rejected back to the FCM who is responsible for maintaining the correct order state and for communicating the order rejection to the client.
10: Pass Pre-Trade Risk Controls
Orders that pass the Exchange’s pre-trade risk controls are then sent to the Exchange’s matching engine to be processed.
11: Order Management System - Rejection Received
Rejections don’t just happen. There are procedures around them. First, the order must be properly marked as rejected with a corresponding reason for the rejection in the OMS component of the trading system. Rejections that are created as a result of failed
FCM pre trade controls (#4, #6) need to be sent to the client.
12: Exchange Specific Rejections
Rejections that are received from the exchange pre-trade controls (#8, #9) must be recorded as rejected in the Exchange Specific Transaction Log.
13: Communicating rejected orders to the client.
The rejected orders need to be communicated to the client. Any communication with the client needs to be stored in the Client Communication Transaction Log (#14). If the client is currently logged on, then the rejection should notify the client immediately.
If the client is not logged on, then the rejection should be made immediately available as soon as the client is connected.
14: Client Communication Log for Rejections
Rejections must be communicated with the client. All client communication around the world is required to be kept for at least five years. All transactions in the communication log should be timestamped so that activity can be reconstructed by internal or
15: Exchange Matching Engine
The exchange matching engine is the electronic marketplace where buyers Bid for a price, and sellers Ask for a price. The exchange will take Bid and Ask orders and match them appropriately. Orders that are not immediately matched are held in the matching
engine as part of the book of open orders. They wait until a new order arrives that will match the same price.
Orders may match against more than one order. For example:
Time 1: Account SS-1 submits Order #1 to sell 10 Jelly Bean contracts at 75.
Time 2: Account SS-2 submits Order #2 to sell 10 Jelly Bean contracts at 80.
Time 3: Account BB-3 submits Order #3 to buy 15 Jelly Bean contracts at 80.
This buy order is immediately matched with the 10 contracts from Order #1 resulting in a partial fill of 10 at price 75.
This order is also immediately matched with 5 of the contracts from Order #2 resulting in a partial fill of 5 contracts at price 80. This partial fill will result in Order #3 being fully filled and Order #2 remaining partially filled with 5 contracts still
in the open order book.
Each exchange matching engine performs somewhat differently. The logic for how the orders are matched is determined by the exchange. The most common logic is “Price-Time” priority. This means that the best price is used to match the order and that orders
that have been in the open order book have priority. This can easily be thought of as “First-In, First Out” at each price level.
16: Exchange Matching Engine: Fill Reporting
Every fill involves at least one buyer and one seller. The Exchange reports both fills to the FCM trading system that originated the order. These reports may go to the same FCM or they may go to different FCMs. This keeps the order state in the trading systems
correct and notifies the trader of the execution.
However, this is only a report to the trader. No money has moved into or out of a clearing account. No position change has been recorded. To record the actual move of a position, or to debit/credit an account, the exchange need to report the trade to the
17: Exchange Gateway - Receive Fill
Once the exchange reports the fill to the FCM’s trading system, that fill needs to be recorded and reported. The Exchange Gateway (#5) that sent the order will be notified of the fill. This fill needs to be recorded to the Exchange Specific Log file (#18),
and sent to the Order Management portion of the trading system for proper order state handling.
18: Recording the Fill to the Exchange Specific Log File
The exchange specific transaction log contains all communication between the FCM technology and the exchange as explained in #7. The exchanges typically have a format where these files must comply. All transactions should be timestamped to the millisecond
level or better and have some sort of sequencing so that transactions can be reconstructed at a later time by an internal or external auditor. Fills typically include the following information:
Transaction Timestamp: This is the time that the order was filled at the exchange.
Receipt Timestamp: This is the time that the fill was received by the FCM.
Fill Quantity: The number of contracts or shares filled.
Fill Price: The price at which the trade was made.
Account: The account from the order.
Order Number: The order number being filled.
Financial Instrument: the contract that was traded.
Additional order information is typically included in this report. Some exchanges also include order status information in the fill report. All information received from the exchange should be included in the exchange specific log.
19: Order Management System - Record Fill
The OMS component of the trading system is responsible for tracking state. The OMS knows the current state of all orders. In the case of a fill the OMS needs to calculate, or verify, that the order is either partially filled or fully filled. The number of
contracts that are left unfilled is the new open order quantity. The OMS also typically calculates the average fill price.
20: Notifying the trader of the Fill
The OMS is responsible for communicating the fill to the originating trader. The communication should happen as soon as possible. If the trader is online, then the fill should be reported immediately. If not, then the trader should be notified of the fill
as soon as he or she is reconnected. Of course, all communication with the client needs to be recorded (See #21).
21: Fill Reporting to the Client Communication Transaction Log
All client communication around the world is required to be kept for at least five years. All transactions in the communication log should be timestamped so that activity can be reconstructed by internal or external examiners. The fill should contain information
including the exchange transaction time, price, quantity, and current order status.
22: The Clearinghouse Records the Trade
The Clearinghouse provides centralized clearing. It operates as a proxy buyer for every seller and as a proxy seller for every buyer. As a proxy, it is able to guarantee every trade. That way, if one side of the trade fails to provide a settled trade, the
Clearinghouse will ensure that the other side is not disadvantaged. Centralized clearing provides transparency and security for all market participants.
Once the trade is recorded in the Clearinghouse system, it is then reported directly to the FCM’s back office system. The back office is responsible for recording all trades, managing the positions for each account, and managing the money (profit, loss,
funds on deposit, margin) for the trading firm or the trader.
23: FCM Clearing System Records Trade
The Clearing System at the FCM can be thought of as the central account management system for each clearing account. If the FCM agrees with the trade, then it reports acceptance of the trade to the Clearinghouse for settlement (#24). If it doesn’t agree
with the trade, it will report the rejection of the trade to the Clearinghouse and go through a “trade break” process. Trade breaks aren’t covered in this report.
The FCM is guaranteeing the trade. All trades processed through the FCMs trading systems or brokers are guaranteed. If the trading account is unable to settle the trade for whatever reason the FCM will take the trade into its own accounts.
24: Clearinghouse Settles Trade
Once a trade is accepted by the FCM and accepted the Clearinghouse will complete the trade settlement process. As stated earlier, the Clearinghouse is a proxy buyer to every seller and a seller to every buyer. The Clearinghouse uses the acceptance of the
trade to verify that both sides have accepted the trade. If one side doesn’t, the Clearinghouse will work with the FCM to fix the trade break.
25: Clearing System Debit/Credit Accounts
When the clearing system receives a fill, it must correctly change the position and appropriately debit or credit the account for any change in funds as a result of the trade. When a trade is reported to the clearing system, it does not contain the account’s
position in the financial instrument. It only contains the new fill quantity. The clearing system is the authority on the correctly current position.
26: Clearing System - Calculate Margin
Most accounts in listed derivative trade on margin. This means that the account holder pays for only a portion of the asset in cash and the FCM, serving as a broker, guarantees the remainder. This allows the account holder to leverage the funds on deposit
for more investing. Each position that an account holds is subject to margin as determined by each exchange for its products. Failure to have enough funds on deposit to cover the margin amount results in a margin call from the FCM to the account holder. If
the account holder is unable to cover the margin then the FCM may liquidate some or all of the positions to ensure compliance with the margin requirements.
27: Post Trade Risk Checks
The margin calculations from #26 are the most basic form of post trade risk checks. FCMs typically utilize other post trade position analysis to ensure that the account does not fail resulting in the FCM having to cover the account holder’s positions.
Some common post trade risk checks used by FCMs include:
Position Limits: Ensuring that no single account has too much of a given product. This limit is typically based on the FCM’s risk department's review of the account, it’s finances and it’s trading style.
Position Volatility: The value of the position is subject to changes in the market. Some positions are more volatile than others. Therefore, the FCM is likely to run any number of analytical processes to determine likely and worse case scenarios based on
the account’s positions.
If the FCM’s Risk Department determines that an account is at risk, they will work with the account to ensure that the positions are changed to meet the FCM.
The FCM produces a daily statement for each account. This statement includes all the positions and the transactions throughout the day. This is the official books and records for the account holder.
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