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STP in Institutional Trading
— Step 0: the Setup
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Large investors, including fund managers,
often hire Investment Managers to make appropriate investments. These
investors separately hire custodians
to hold the resulting assets. This arrangement follows the accounting
principle of separating assets from the control of those assets.
While this separation provides reliable
protection, it introduces a level of indirection that makes trading and settling
these assets more complex. For the investor's assets to be traded,
the investor must provide the investment manager with details of all the accounts
that investor has set up with a custodian. This allows the investment manager to
instruct the custodian to release outgoing funds or securities and accept incoming funds
and securities as trading occurs. To do those trades, the Investment Manager places
orders on behalf of the investor with various brokers, who actually execute the trade.
To settle the trade, the Investment manager must provide the custodian with the details
of the executing broker, and must provide the executing broker with the details of the
investor's account at the custodian. This allows the broker and custodian to present
a combination of trade and counterparty details to CDS. If both parties confirm thier
respective trade and account details, the trade is marked for settlement.
This would be complex enough for a single trade, but the
complexity is made worse by two trading practices. First, for trading efficiency, Investment
managers will often combine orders for the same security held in multiple client portfolios
into a single block order. At the end of the day, the investment manager must tell the broker
what filled quantity applies per custodian and account representing the portion of the block originally
ordered. Second, Investment Managers may separate their blocks to be traded among multiple brokers.
That means that the Investment Manager must then provide each broker with the details of their
portion of the trade and the quantities that thus apply per custodian and account representing
that portion of the original block.
To alleviate the complexity of this process, brokers and investment
managers usually exchange custodian and account information in advance, covering all the custodian/account
combinations the investment manager is likely to make use of for trading activity. These combinations
are referred to using coded names that protect the privacy of the investor represented by the investment
manager. The broker will store the coded names and the custodian/account details in their back office systems.
This information is referred to as Delivery Instructions. As changes occur
with the investment managers' clients, these Delivery Instructions will need updating. Investment Managers
need to track which brokers need which updates and provide them in a timely manner. Because this update process
is mostly manual, errors tend to creep in. Further,
Investment Managers tend not to update Delivery Instructions for brokers they're not dealing with, which often
results in stale instructions. These don't pose a problem until the Investment Manager starts dealing
with the broker again, at which point it is common for the stale instructions to route trades to the wrong
custodian or account, creating the need for corrections and manual intervention.
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