What is Derivatives?

Derivatives are defined as the type of security in which the price of the security depends/is
derived from the price of the underlying asset. The most common underlying assets include
stocks, bonds, commodities, currencies, interest rates and market indexes. The common
types of derivatives include Options, Futures, Forwards, Warrants and Swaps.
Derivatives allow users to meet the demand for cost-effective protection against risks
associated with movement in the prices of the underlying. In other words, users of
derivatives can hedge against fluctuations in exchange and interest rates, equity and
commodity prices, as well as creditworthiness.
Participants in derivatives markets are often classified as either “hedgers” or “speculators”.
However, hedging and speculating are not the only motivations for trading derivatives.
Some firms use derivatives to obtain better financing terms. Fund managers sometimes use
derivatives to achieve specific asset allocation of their portfolios.
The two major types of markets in which derivatives are traded are namely:
Exchange Traded Derivatives
Over the Counter (OTC) derivatives
Exchange traded derivatives (ETD) are traded through central exchange with publicly visible
prices.
Over the Counter (OTC) derivatives are traded between two parties (bilateral negotiation)
without going through an exchange or any other intermediaries. OTC is the term used to
refer stocks that trade via dealer network and not any centralized exchange. These are also
known as unlisted stocks where the securities are traded by broker-dealers through direct
negotiations.

With different characteristics, the two types of markets complement each other in providing
a trading platform to suit different business needs. On one hand, exchange-traded
derivative markets have better price transparency as compared to OTC markets. Also, the
counterparty risks are smaller in exchange-traded markets with all trades on exchanges
being settled daily with the clearinghouse. On the other hand, the flexibility of OTC market
means that they suit better for trades that do not have high order flow or special
requirements. In this context, OTC market performs the role of an incubator for new
financial products.

Why OTC?
1) The Company may be small and hence not qualifying the exchange listing requirements
2) It is an instrument that is used for hedging, risk transfer, speculation and leverage
3) OTC gives exposure to different markets as an investment avenue
4) In many cases it implies less financial burden and administrative cost for the end users
(e.g. corporate)
Swaps are widely regarded as the first modern example of OTC financial derivatives. All OTC
derivatives are negotiated between a dealer and the end user or between two dealers.
Inter-dealer brokers (IDBs) also play an important role in OTC derivatives by helping dealers
(and sometimes end users) identify willing counterparties and compare different bids and
offers.

Types of OTC Derivatives

OTC Contracts can be broadly classified on the basis of the underlying asset through which
the value is derived:
Interest rate derivatives: The underlying asset is a standard interest rate. Examples of
interest rate OTC derivatives include LIBOR, Swaps, US Treasury bills, Swaptions and FRAs.
Commodity derivatives: The underlying are physical commodities like wheat or gold. E.g.
forwards.
Forex derivatives: The underlying is foreign exchange fluctuations.
Equity derivatives: The underlying are equity securities. E.g. Options and Futures
Fixed Income: The underlying are fixed income securities.
Credit derivatives: It transfers the credit risk from one party to another without transferring
the underlying. These can be funded or unfunded credit derivatives. e.g: Credit default swap
(CDS), Credit linked notes (CLN).
OTC markets have two dimensions to it, namely customer market and interdealer market. In
customer market, bilateral trading happens between the dealers and customers. This is
done through electronic messages which are called dealer-runs providing the prices for
buying and selling the derivatives. On the other hand, in the interdealer market, dealers
quote prices to one other to offset some of the risk in the trade. This is passed on to other
dealers within fractions. This clearly provides a view point on the customer market.

Advantages of OTC

 These derivatives offer companies more flexibility because, unlike the

“standardised” exchange-traded products, they can be tailored to fit specific needs,
such as the effects of a particular exchange rate or commodity price over a given
period.
 Companies say such derivatives play a big part in helping them to provide consumers
with stable prices.

RISKS managed using OTC Derivatives

Interest rate risk: Companies prefer to take loans from banks at a fixed rate of interest in
order to avoid the exposure to rising rates. This can be achieved through interest rate swap
which locks the fixed rate for a term of loan.
Currency Risk: Currency derivatives allow companies to manage risk by locking the
exchange rate, beneficial for importer or exporter companies that face the risk of currency
fluctuations.
Commodity Price Risk: Financing in terms of expansion can only be available if the future
selling price is locked. This price risk protection is provided through customized OTC
derivative. e.g. Crude Oil producer would like to increase production in tandem to increase
in the demand. The financing will be done only if the future selling price of the crude is
locked.

Disadvantages of OTC

 Lack of a clearing house or exchange, results in increased credit or default risk

associated with each OTC contract.
 Precise nature of risk and scope is unknown to regulators which leads to increased
systemic risk.
 Lack of transparency.
 Speculative nature of the transactions causes market integrity issues.

Conclusion
Although OTC Derivatives is a good tool for corporate, it does need more education to
attract investors and be used on frequent basis.
Trade Life Cycle of OTC Derivatives - Trading Events - Pre-trade (
Part – 1 )
Trade Lie Cycle in OTC Derivative Markets

The continued growth in OTC derivatives volumes combined with inflexible and manual processing has led to
confirmation backlogs, regulatory attention and constraints on the front office’s ability to allocate assets or
capital to these instruments.

OTC derivative trade life cycle events.

This life cycle is defined worldwide by the existing operational practices of most institutions, and the processes
are more or less similar. The emphasis is on getting the orders transacted at the best possible price and on
getting trades settled with the least possible risk and at manageable costs. Designated employees in the
member’s office ensure that each trade that takes place through them or in their house account gets settled
properly. Unsettled trades lead to liability, risk, and unnecessary costs.

Trading Events - Pre-trade ( Part – 1 )

Introduction
Every trade has its own life cycle. The entire Life Cycle of a trade can be broken down into pre-trade and post-
trade events. Before going into the details of the trading events, let me explain how a trading deal is being
struck between two entities.

We know that one of the primary usages of derivative contract is to hedge the risk. Let us consider that a
company has got a floating rate liability in LIBOR (London Inter Bank Offered Rate) and it wants to convert its
liability into a fixed rate. The feasible option would be to enter into an Interest Rate Swap. The company would
strike a deal with a bank and enter into a swap where it would pay fixed rate to the bank and receive floating
rate. The company and the bank would enter into a trade and the trade passes through various stages. The
various trade events can be categorized into Front Office, Middle Office and Back Office activities which are
explained below:

Front Office:

The FO forms the stage where the trade gets initiated. Here, the order gets placed and the entity will price the
instrument and give the quote to the counterparty. If the counterparty agrees to the details of the trade and is
willing to enter into the deal, the trade gets executed. The trade is then captured in the trading desk usually
using a deal capture system. The deal capture system validates all the necessary trade economics before
assigning a trade reference number. Subsequent trade events like amendment, cancellation would refer to the
trade with the help of the identifier. An acknowledgment is being sent to the counterparty with the trade
details who confirms it back.

Middle Office:

The important function that MO performs is to do the Limits and Risk Management. The Limits are being
calculated at a business hierarchy level. The usual hierarchy would be at a Portfolio level and subsequently
aggregating to a Trader Level, a Desk Level, an Entity Level, and finally to a Group Level. Validations are being
done on the trade captured, and in case of any discrepancy, an exception is being raised.

The MO plays a vital role in the exception management. The trade gets enriched by static data like the
standard settlement instructions of the counterparty, Custodian details, City holidays, etc.
Such static data details are important for the completion and settlement of the trade. The allocation of the
trade is done in the MO and finally the trade is being pushed to the BO and the trade goes live.

Back Office:

The BO is the back bone of the entire life cycle of the trade. The BO mostly deals with the operational activities
like record keeping, confirmation, settlement and regulatory reporting. In most cases, BO activities are being
outsourced to cheaper sources to cut down on costs for the company.

The Life Cycle of such a trade can be categorized into pre-trade events and post-trade events which are
discussed below: -

Pre-Trade Events

Setting up a Master Agreement:

It is a standardized contract between the counterparties and should be there in place before the two parties
enter into a deal. For derivative contracts, the Master Agreement is drafted according to ISDA protocols
Define Product Characteristics: Every Deal has to be defined by some primary characteristics called the primary
economics of the trade. In case of a Plain Vanilla Interest Rate Swap, the economics of trade would be as
follows: -

Pre-Trade Negotiation:

In this stage the client tries to reach a preliminary agreement with the bank. This stage may include
documentation, indication of the interest rate and defines the criteria for executing a trade which may include
the credit support and the bank policies which the counterparty has to abide by.

Request for Quote:

The client will ask for a quote to the bank, say the fixed rate against LIBOR.

Provide Quote:

The bank will provide the quote which may be through their traditional channels like phone, fax and email, or
through standardized channel as provided by Swaps wire.
Request Trade Pricing Inputs:

The Client will ask inputs which will help to price the product. It may relate to volatility of the underlying in
some cases. The trade is priced after matching every detail of the trade. For an IRS, both the parties will agree
to the rates when the Net Present Value of the swap is zero.

Setting up master agreement/master confirmation.

Know Your Client (KYC)

Define product characteristics.

Pretrade negotiation - Present term sheets to clients/ preliminary agreement.

Request/provide documentation / governing law.

Indication of interest.

Provide indicative price/rate/value.

Request/define criteria for executing trade (conditionality,credit support, bank policies.

RFQ - Product Details - Request Quote.

Provide Quote - Price/Rate/Value - Request Quote Response.

Chek Credit - Client Product Details.

The Structure and Trade Life Cycle of OTC Derivatives

The Structure of OTC Derivatives

INTRODUCTION

Derivatives are financial contracts whose value is linked to the price of an underlying commodity, asset, rate,
index or the occurrence or magnitude of an event. The term derivative comes from how the price of these
contracts is derived from the price of some underlying commodity, security or index or the magnitude of some
event. The term derivative is used to refer to the set financial instruments that include futures, forwards,
options and swaps. The combination of a derivative with a security or loan is called a hybrid instrument or
alternatively a structured security and structured financing. Derivatives are traded in two kinds of markets:
exchanges and OTC markets. Exchanges have traditionally been defined by “pit” trading through open outcry,
but exchanges have recently adopted electronic trading platforms that automatically match the bids and offers
from market participants to execute trades in a multilateral environment. The trading of derivatives
(traditionally futures and options) on exchanges is conducted through brokers and not dealers.

TRADITIONAL DEALER MARKET – “BILATERAL NEGOTIATION”

The OTC markets have traditionally been organized around one or more dealers who “make a market” by
maintaining bid and offer quotes to market participants. The quotes and the negotiation of execution prices
are generally conducted over the telephone, although the process may be enhanced through the use of
electronic bulletin boards by the dealers for posting their quotes. The trading process of negotiating by phone,
whether end-user-to-dealer or dealer-to-dealer, is known as bilateral trading because only the two market
participants directly observe the quotes or execution. This bilateral trading arrangement, from a regulatory
point of view, is not considered a trading facility because it is not multilateral. However, it should be pointed
out the bilateral negation process under this market arrangement is often highly automated. Dealers have
direct phone lines between themselves and other dealers and their major customers, and this enables
instantaneous communication so that a market participant can call up a dealer ask for quotes and then hang
up and call another so as to survey several dealers in just a few seconds. A quick series of such calls can give an
investor a view of the market that is not entirely different from a view obtained by observing a multilateral
negotiating process.

“ELECTRONICALLY BROKERED MARKETS”

OTC markets have also adapted new electronic and networking technologies to their trading needs. One use of
the technology is the formation of an electronically brokered OTC market through the use of an electronic
brokering platform (sometimes referred to as a electronic brokering system). These electronic brokering
platforms are essentially the same as the electronic trading platforms used by exchanges, and they create a
multilateral trading environment. If this electronic brokering platform automatically matches bids and offers so
as to execute a trade, the Commodity Exchange Act defines this trading as a trading facility because it is open
to multilateral participation (i.e. the quoting of bid and offer prices and the execution of trades) by many
parties. If it functions merely as an electronic bulletin board for the posting of bids and offers, then it is
excluded from the definition.

“PROPRIETARY ELECTRONIC DEALER OR TRADING PLATFORM”

Yet another type of trading arrangement found in OTC derivatives markets is a composite of the traditional
dealer and the electronic brokering platform in which an OTC derivatives dealer sets up their own proprietary
electronic trading platform. Note the use of the term electronic trading, not brokering, platform because it is a
dealing platform and does not function as a neutral broker. In this arrangement, the bids and offers are posted
exclusively by the dealer; other market participants observe these quotes, and possibly also execution prices,
in what is best described as a one-way multilateral environment. It is one-way, because no one but the
dealer’s quotes are observable and those of the other market participants might at best be inferred from
changes in the execution price. In this electronic trading, or dealing, platform, the dealer is the counterpart to
every trade so that the dealer holds the credit risk in the market.

The Trade Life Cycle Explained

Ever wondered how on Earth all the different components and stages of a trade fit
together? There’s a well-oiled infrastructure machine that carries through the trade life
cycle for literally trillions of trades – every day! Here’s an explanation of the key stages of
the trade life cycle…

We start with our investors. An investor (either an individual who invests for themselves,
known as a ‘retail investor’, or an institution, an organisation investing on behalf of their
clients such as a fund) scopes out some tasty potential investment opportunities. Once
they’ve made a decision to make a move and buy a particular security, such as shares in a
company, the process kicks off…

Stage one: the order

The investor informs the broker firm and their custodian (a financial institution – usually a
bank – which looks after their assets for safekeeping) of the security they would like to buy,
and at what price – either the market price or lower. This is called a buy order.

(A couple more jargon nuggets for you here: A market order is an order to buy or sell at the
market prices. A limit order is an order to buy or sell at a client’s specified price, or higher.)

Stage two: front office action

The investor’s order is received by the front office sales traders at the brokerage firm. From
this point, the order is fed down to the risk management experts in the middle office of the
organisation. The sales traders then ‘execute’ the order…

Stage three: risk management

The risk management team will conduct a number of checks and calculations to see whether
the levels of risk involved with the client’s order mean it’s still safe to accept and proceed to
the next stages. Amongst other things they will check the client placing the order has
sufficient stocks to pay for the security and the limits.

Stage four: off to the exchange

When an order is accepted and validated by the risk management team, the broker firm
sends it to the Stock Exchange…

Now, let’s pause for a breather and consider what’s going on the sell-side of things, i.e. the
guys with the security to sell. They will also put in a sell order to their broker, stating the
security they have to make available on the market and the market price (how much they
want to sell it for).

The sell order goes through all of the necessary risk management procedures in the middle
office on this side as well. All being well, it then shoots off to the exchange too…

Stage five: match making

Now it’s time for match making at the exchange. It’s a bit like the awkward Singles’ Night of
trading. The exchange has to find the match between a security’s buy order and sell order.
Once the beautiful moment of a perfect match happens…

Stage six: trade made

A trade is born! Then, quick as a flash, we’re into post trade territory. The exchange sends
information on the trade back to the brokers for confirmation, and also details of the trade
to the investor’s custodian. The brokers’ front office sales team can then inform their clients
of the trade.

Stage seven: confirmation

In order to proceed further, confirmation is necessary. The broker on each side of the trade
has checked that their client agrees with details and conditions: details such as which
security is being traded, how much it’s being traded for and the settlement date.
The exchange will also send these details to the custodian who will relay this information to
the broker for confirmation.

Once the trade has been confirmed by the brokers and as long as each party agrees with the
details and conditions, the back office team gets to work, and the clearing house comes into
play…

Stage eight: clearing begins

The clearing house will make all of the necessary calculations for the buy side and the sell
side of the trade in order to determine what’s needed from each of them and by when. It’s
their job to make sure all of the obligations are fulfilled. They inform each party of what’s
needed.

Trades are referred to generally as T+1, T+2 and T+3. ‘T’ refers to the transaction date (the
date on which the trade was made). +1, +2 or +3 refers to the settlement date. If a trade is
marked T+2 for example, securities and cash will be exchanged two days after the trade is
made. On the settlement date the sell side must have transferred their security and the buy
side must have transferred the money for their purchase.

The majority of settlements are now T+2. The UK and Irish capital markets will move to a
T+2 settlement period from October 2014.

Stage nine: settlement

Finally, the glorious settlement date arrives: the transfer of money and the security. Back
office staff are responsible for ensuring that these payments are made on time and
documented and reported in the correct manner.

The transfer isn’t done directly between the trading parties: the clearing house will have
accounts for each side of the trade and will facilitate the transfer. The buy side will transfer
cash for the security via the clearing house, and likewise the sell side will hand over their
security. Then everyone’s happy!

At the end of each trade day the clearing house will provide reports on settled trades to
exchanges and custodians.
To understand trade life cycle we need to understand detailed steps involved in trade life
cycle.
Below mentioned are the important steps:
1. Order initiation and delivery. (Front office function)
2. Risk management and order routing.(middle office function)
3. Order matching and conversion into trade.(front office function)
4. Affirmation and confirmation.(back office function)
5. Clearing and Settlement.(back office function)

PICTORIAL VIEW OF TRADE CYCLE

Them main objective of every trade is to get executed at the best price and settled at the
least risk and less cost. Some may say trade life cycle is divided into 2 parts pre-trade
activities and post trade activities, well, pre-trade activities consists of all those steps that
take place before order gets executed, post trade activities are all those steps that involve
order matching, order conversion to trade and entire clearing and settlement activity.

Now lets discuss every step of life cycle in detail.

Order initiation and delivery. (Front office function)

Who initiates the orders: Retail client like me and you, institutional clients like any Mutual
fund company’s.
Clients keep a close watch on the stock market and build a perception on the movement of
market. They also try to find investment opportunities so that they can build position in the
market. Positions are the result of trade that are executed in the market.Clients place orders
with brokers through telephone, fax , online trading and hand held devices. Orders can be
placed either market orders or limit orders, market orders means order to buy or sell is
placed at the market price of the share/equity/stock that the investor/client wants to
buy/sell whereas limit orders means order placed to buy or sell at a price that
investor/client wants to buy/sell.

When Broker receives these orders, he/she records these orders carefully so that there is no
ambiguity/mistakes in processing. Institutional investor/ fund manager at this stage would
not have decided on the allocation of the funds so he/she will just contact sales desk and
place the order so that later they can allocate their investments to the mutual
funds(irrespective whether it is buy/sell).

Risk management and order routing.(middle office function)

As we know that getting trades settled lies with the broker, if any client makes any trade
default, then the same has to be made good by the broker to the clearing corporation by
broker.

When orders are accepted and sent to exchange these orders go through various risk
management checks institutions and retails clients. Although the risk management checks
are more for retail investors , the underlying assumptions is that they are less creditworthy
also due to online trading the client has become faceless so the risk has increased more.Its
not same for institutional investors because they have a large balance sheet compared to
the size of orders they want to place. They also maintain collateral with the members they
push their trades through. Their trades are hence subjected to fewer risk management
checks than retail clients.

Below are the steps how risk management is done in case of retail transactions:

 Client logs into the trading portal provide credential and places orders.
 The broker validates that the order is coming from a reliable source.
 Lets say the client places buy order, in this case the broker places query to verify
whether the client has sufficient balance(margin money) and passes the order to the
exchange, in case the client does not have sufficient margin then order is rejected. If
client has the margin money then the order is accepted and margin money is reduced
from the available margin so that client is aware of the real time margin available to him
for trade, also to make sure that he/she does not place order more than margin money
available so later on the broker need not make good on behalf of client to the exchange.
 Lets say the client places sell order, in this case the broker places query to verify
whether the client has sufficient stocks to place the order in case of there are no
 sufficient stocks then the order stays rejected, if there are sufficient stocks available
then the order is accepted and stocks are blocked for sale and remaining stocks are
shown as balance available for sell.
 Once the above risk management check passes then the order is passed to the
exchange.
 On receipt of the order, the exchange immediately sends an order confirmation to the
broker’s trading system.
 Depending upon the order terms and the actual prices prevailing in the market, the
order could get executed immediately or remain pending in the order book of the
exchange.
A margin is an amount that clearing corporations levy on the brokers for maintaining
positions on the exchange. The amount of margin levied is proportional to the exposure and
risk the broker is carrying. Since positions may belong to a broker’s clients, it is the broker’s
responsibility to recover margins from clients. To protect the market from defaulters,
clearing corporations levy margins on the date of the trade.

Order matching and conversion into trade.(front office function)

Below are the steps:

Now it’s time for match making at the exchange. The exchange has to find the match between a
security’s buy order and sell order.
 All the orders are collated and sent to the exchange for execution, exchange tries to
allot the shares in the best price available to the investors.
 Broker has the record of all the orders that were received from whom , at what time,
against which stock, type of order and quantity. Broker maintains these records against
client ID.
 Brokers are in real time conversation with exchange so that they have details of how
many orders are still pending and and how many have been executed in the exchange.
 Once the order is executed it turns into trade and exchange sends sends notification of
the trade to the broker. The broker in turn communicates these trades to the client
either immediately or end of day.
 Official communication from broker is done to the client through contract note, which
contains details of the trade executed along with taxes being charged and commission
being charged by the broker and other institutions like clearing corporation, custodian
etc…

Affirmation and confirmation.(back office function)

In order to proceed further, confirmation is necessary. The broker on each side of the trade
has checked that their client agrees with details and conditions: details such as which
security is being traded, how much it’s being traded for and the settlement date.

The exchange will also send these details to the custodian who will relay this information to
the broker for confirmation.
Once the trade has been confirmed by the brokers and as long as each party agrees with the
details and conditions, the back office team gets to work, and the clearing house comes into
play…

Every institution engages the services of an agency called a custodian to assist them in
clearing and settlement activities. Institutions specialize in taking positions and holding. To
outsource the activity of getting their trades settled and to protect themselves and their
shareholder’s interests, they hire a local custodian in the country where they trade. When
they trade in multiple countries, they also have a global custodian who ensures that
settlements are taking place seamlessly in local markets using local custodians.

As discussed earlier, while giving the orders for the purchase/sale of a particular security,
the fund manager may just be in a hurry to build a position. He may be managing multiple
funds or portfolios. At the time of giving the orders, the fund managers may not really have
a fund in mind in which to allocate the shares. So to make more profit and avoid
unfavourable market conditions he/she places the order.
The broker accepts this order for execution. On successful execution, the broker sends the
trade confirmations to the institution. The fund manager at the institution during the day
makes up his mind about how many shares have to be allocated to which fund and by
evening sends these details to broker. Brokers does a cross verification whether all the
alocation details match the trade details and then prepares the contract notes in the names
of the funds in which the fund manager has requested allocation.

Along with the broker, the institution also has to send details to custodian for the orders it
has given to the broker. The institution provides allocation details to the custodian as well. It
also provides the name of the securities, the price range, and the quantity of shares
ordered. This prepares the custodian, who is updated about the information expected to be
received from the broker. The custodian also knows the commission structure the broker is
expected to charge the institution and the other fees and statutory levies.

On receipt of the trade details, the custodian sends an affirmation to the broker indicating
that the trades have been received and are being reviewed.Trades are validated to check
the following:

 Whether trade has happened on the desired security.

 Whether the trade is correct i.e buy or sell.
 The price at which rate it was executed.
 Whether the charges are as per the agreement.

For this verification process the custodian normally runs a software such as TLM for recon
process.In case the trade details do not match, the custodian rejects the trade, and the
trades shift to the broker’s books. It is then the broker’s decision whether to keep the trade
(and face the associated price risk) or square it at the prevailing market prices.
Clearing and Settlement.(back office function)

The clearing house will make all of the necessary calculations for the buy side and the sell
side of the trade in order to determine what’s needed from each of them and by when. It’s
their job to make sure all of the obligations are fulfilled. They inform each party of what’s
needed.

Trades are referred to generally as T+1, T+2 and T+3. ‘T’ refers to the transaction date (the
date on which the trade was made). +1, +2 or +3 refers to the settlement date. If a trade is
marked T+2 for example, securities and cash will be exchanged two days after the trade is
made. On the settlement date the sell side must have transferred their security and the buy
side must have transferred the money for their purchase.

The majority of settlements are now T+2

Finally, the glorious settlement date arrives: the transfer of money and the security. Back
office staff are responsible for ensuring that these payments are made on time and
documented and reported in the correct manner.

The transfer isn’t done directly between the trading parties: the clearing house will have
accounts for each side of the trade and will facilitate the transfer. The buy side will transfer
cash for the security via the clearing house, and likewise the sell side will hand over their
security. Then everyone’s happy!

At the end of each trade day the clearing house will provide reports on settled trades to
exchanges and custodians.

As we know that there are hundreds and thousands of trades being executed everyday and
all these trades needs to be cleared and settled. Normally all these trades gets settled in T+2
days, which means the trade will gets allotted to the investor to his/her demat account in 2
days from trade date.

The clearing corporation has obligation to every investor in form of

 Funds (for all buy transactions and also to those transactions that are not squared for
the sale positions).
 Securities(for all the sale transactions done)

Clearing corporation calculates and informs the members of what their obligations are on
the funds side (cash) and on the securities side. These obligations are net obligations with
respect to the clearing corporation. Lets say broker purchased 1000 shares of reliance for
client A and sold 600 shares of reliance for client B which means the obligation of the
clearing corporation to the broker is only for 400 shares.
Clearing members are expected to open clearing accounts with certain banks specified by
the clearing corporation as clearing banks. They are also expected to open clearing accounts
with the depository. They are expected to keep a ready balance for their fund obligations in
the bank account and similarly maintain stock balances in their clearing demat account.

Once the clearing corporation informs all members of their obligations, it is the
responsibility of the clearing members to ensure that they make available their obligations
(shares and money) in the clearing corporation’s account. Once these obligations are done
the balance of payments takes place and all the investors will have their stocks/financial
instruments/shares in their demat account if a buy trade is executed and cash will be
credited to their demat accounts if sale trade is executed. On every end of day basis the
clearing corporation generates various reports that need to be circulated to exchanges and
custodians.

1. Introduction to Asset Class

An asset class is a collection of securities, manifesting comparable traits and goes through
similar market fluctuations. Similar legalities almost always bind securities in one asset class.
Experts put different investment tools in various asset classes to help investors diversify
their portfolio quickly. Risk factors, taxation, return rates, liquidity, tenures and market
volatility differ according to asset classes.
Hence, investors often rely on asset category diversification to earn maximum returns with
minimal costs.

2. Types of Asset Classes

There can be numerous criteria to classify asset classes. You may classify them based on
purpose, i.e. whether it is a consumption asset like oil and natural gas or whether it is an
investment asset like stocks and bonds.
You may also categorise them based on location or the markets like domestic securities,
foreign or international investments, or emerging markets and developed markets.
However, for now, let us dive into the popular asset classes and explore their distinct
characteristics and unique selling propositions.

a. Fixed Income
As the most popular among Indians, the fixed income asset class is one of the most trusted
and oldest forms of investments. Fixed deposits and public provident funds (PPF) are two
examples of this.
However, is this an investment in any case? You are just letting the bank borrow from you
under conditions of capital protection, returns in the form of pre-agreed returns and
liquidity.
With zero risks attached to fixed income asset classes, you will not lose the money you
invest. Moreover, you earn steady returns as promised at the time of investing.
You may get 7%-8% returns on fixed income schemes, but they are not inflation-beating
returns. Subject to STCG or LTCG as per the tenure, fixed income schemes only offer security
and not wealth-growth.

b. Equity
An equity asset class is a fascinating one and has been gaining popularity in recent years.
Investing in equity means to buy into a business – when you buy shares of a firm, you have a
percentage of ownership. The only hitch is that it comes with a certain amount of risk.
Any business takes time to grow, and it is subject to market fluctuations, which can impact
the share price. Among equity investments, Equity Linked Savings Scheme (ELSS) is the only
tax-saving (under section 80-C) and wealth-building scheme with the shortest lock-in term
of three years.
However, equity investments (including ELSS) work well when you invest for the long run as
they have historically delivered 16%-18% returns and rising above inflation. Choose an AMC
with a proven record, if you are planning to invest in equities.

c. Real Estate
The real estate asset class, as the name implies, focuses on plots, apartments, commercial
buildings, industrial areas, villas etc. The millennium has witnessed a growing interest in real
estate investments, exacerbated by the launch of Pradhan Mantri Awas Yojanai.e. house for
all scheme. This is not just in urban areas, but in semi-urban and rural regions too.
However, the property market can be somewhat unpredictable, and there are numerous
factors like city planning, socio-political scenes, and project movement that decide the
returns. This is one asset class that is not always structured or monitored.

d. Commodities
Commodities can be anything ranging from goods, properties or products that can be traded
for different purposes. Gold, silver, bronze, food crops, petroleum, etc. are some examples
of commodities under the asset class, and the market undercurrents vary for each.
The price can rise or fall as per the demand. Merchandises are not meant for long-term
investments unless it is gold or silver. Just buy when the prices are down and sell when the
prices go up.

e. Cash and Cash Equivalents

These are also known as money market instruments. It is not confined to currency, but also
idle money in a savings account or any other liquid schemes.
Nothing gives more transactional freedom than cash. Many people are reluctant to invest
money in savings account because they don’t have faith in any investment schemes or to
use it without any restrictions at any time.
However, it cannot beat inflation, and the returns too are negligible (not more than 4%).
People often store away cash to evade tax as they are untraceable.

f. Derivatives
A derivative refers to financial security whose value depends on the underlying asset or
group of assets. Standalone, the derivative has no value of its own, and its price is based on
the fluctuations in the cost of the underlying asset.
It is a kind of contract between two or more parties who have a right/obligation to perform
according to the conditions of the contract. Commonly used underlying assets are equity
shares, bonds, debt, foreign exchange, commodities, market indices and interest rates.

g. Alternative Investments
An alternative investment relates to a unique asset and is not one of the traditional asset
classes like equity, debt, and cash. These are mostly held by institutional investors or high
net worth individuals owing to their complex structure and limited regulations.
These attempt to generate exceptionally huge returns but are highly illiquid and risky at the
same time. Some of the alternative investments found in the capital markets are hedge
funds, bitcoins, artworks and structured products.

3. Diversification and Asset Classes

A basic understanding of the various asset classes, which are available for investment helps
to build a lucrative and well-balanced portfolio. A diversified portfolio comprises of different
asset classes that reduce the overall risk, and the portfolio’s performance is not affected by
the inferior performance of any single asset class.
Diversification helps to reduce the non-systematic or firm-related risk of your investment
portfolio by allocating your finances across different asset classes.
It happens when the asset classes in the portfolio are uncorrelated or negatively correlated.
Correlation between two asset classes shows the direction in which both of them at any
point in time.
A negative correlation means that when the price of one asset class falls, the price of other
asset class rises. Such kind of behaviour is observed between equity and fixed income;
especially during a market slump.
The main idea behind diversification is to keep the portfolio returns in line with your
expectations and minimise overall losses. It educates you about not putting all your
investments in one asset class instead distribute them among multiple asset classes.
The percentage of funds which should go into each asset class deals with the problem
of asset allocation. It means how you are going to distribute a fixed sum among all the asset
classes in your portfolio, keeping your target rate of return and risk appetite in mind.
Risk appetite is about the quantum of fall in the portfolio value that you will be able to
digest at a given point in time. Based on it, you decide the asset allocation of your portfolio.
Regulatory Reporting
After the Great Recession hit the U.S., the government instituted a number of new
regulations and reporting procedures to prevent it occurring again in the future.
Many fault the banking industry with the Great Recession, as they inflated the value
of many items, such as houses, in the U.S. economy. When the values were leveled
due to economic factors, it was revealed that there were many errors in the way that
banks provided loans.

Different types of regulatory reports

Licensing and supervision

Banks usually require a banking license from a national bank regulator before they
are permitted to carry on a banking business, whether within the jurisdiction or as an
offshore bank. The regulator supervises licensed banks for compliance with the
requirements and responds to breaches of the requirements by obtaining
undertakings, giving directions, imposing penalties or (ultimately) revoking the
bank's license.

Minimum requirements

A national bank regulator imposes requirements on banks in order to promote the

objectives of the regulator. Often, these requirements are closely tied to the level of
risk exposure for a certain sector of the bank. The most important minimum
requirement in banking regulation is maintaining minimum capital ratios. To some
extent, U.S. banks have some leeway in determining who will supervise and regulate
them.

Market discipline

The regulator requires banks to publicly disclose financial and other information, and
depositors and other creditors are able to use this information to assess the level of
risk and to make investment decisions. As a result of this, the bank is subject to
market discipline and the regulator can also use market pricing information as an
indicator of the bank's financial health.

Financial reporting and disclosure requirements

Among the most important regulations that are placed on banking institutions is the
requirement for disclosure of the bank's finances. Particularly for banks that trade on
the public market, in the US for example the Securities and Exchange Commission
(SEC) requires management to prepare annual financial statements according to a
financial reporting standard, have them audited, and to register or publish them.
Often, these banks are even required to prepare more frequent financial disclosures,
such as Quarterly Disclosure Statements. The Sarbanes–Oxley Act of 2002 outlines
in detail the exact structure of the reports that the SEC requires.