What are 'Capital Markets'​?

"Capital Markets" refers to activities that gather funds from some entities and make them available to other entities needing funds. The core function
of such a market is to improve the efficiency of transactions so that each individual entity doesn't need to do search and analysis, create legal
agreements, and complete funds transfer.

Breaking down Capital Markets

Capital markets consist of suppliers and users of funds. Suppliers of funds include households and institutions serving them, such as pension funds; life
insurance companies; charitable foundations such as colleges, hospitals, and religious institutions; and nonfinancial companies generating cash
beyond their needs for investment. Users of funds include home and motor vehicle purchasers; nonfinancial companies; and governments financing
infrastructure investment and operating expenses.

Markets include primary markets, where new equity stock and bond issues are sold to investors, and ​secondary markets​, which trade existing
securities.

Capital Markets in Context

Broadly, capital markets can refer to markets for any financial asset. (See also, ​Financial Markets: Capital Versus Money Markets​.​)

In the context of corporate finance, the term refers to venues for obtaining investable capital for nonfinancial companies. Here, "investable
capital" includes the external funds included in a weighted average cost of capital calculation – common and preferred equity, public bonds, and
private debt – that are also used in a return on invested capital calculation.

In a more limited corporate finance context, it refers to only equity funding, excluding debt.

In a financial services industry context, it refers to financial companies involved primarily in private markets, as opposed to public ones. In this sense, it
is referring to investment banks, private equity, and venture capital firms in contrast to broker-dealers and public exchanges. In this case, capital
markets are considered primary offerings of debt and equity (​initial public offering​) supported by investment banks through underwriting. This
contrasts with the time after the initial public offering when the offering is publicly trading on exchanges in a secondary market. In the U.S., the
primary regulator for an exchange is the ​Securities and Exchange Commission (SEC)​. This industry context is often meant when "capital markets" are
contrasted with "financial markets."

In the context of public markets operated by a regulated exchange, "capital markets" can refer to equity markets in contrast to debt/bond/fixed
income, money, derivatives, and commodities markets. Mirroring the corporate finance context, "capital markets" can also mean equity and
debt/bond/fixed income markets. (See also, ​Introduction to Capital Markets History​.)​

In a tax context, capital markets might refer to investments intended to be held for over one year for ​capital gains tax​ treatment. This is often related
to transactions arranged privately through investment banks or private funds (such as private equity or venture capital).

Capital markets are perhaps the most widely followed markets. Both the stock and bond markets are closely followed, and their daily movements are
analyzed as proxies for the general economic condition of the world markets. As a result, the institutions operating in capital markets – ​stock
exchanges​, ​commercial banks​ and all types of corporations, including non-bank institutions such as insurance companies and mortgage banks – are
carefully scrutinized.

The institutions operating in the capital markets access them to raise capital for long-term purposes, such as for a merger or acquisition, to expand a
line of business or enter into a new business, or for other capital projects. Entities that are raising money for these long-term purposes come to one or
more capital markets. In the bond market, companies may issue debt in the form of ​corporate bonds​, while both local and federal governments may
issue debt in the form of ​government bonds​.

Similarly, companies may decide to raise money by issuing equity on the stock market. Government entities are typically not publicly held and,
therefore, do not usually issue equity. Companies and government entities that issue equity or debt are considered the sellers in these markets. (See
also: ​What Are the Differences Between Debt and Equity Markets?​)

The buyers (or the investors) buy the stocks or bonds of the sellers and trade them. If the seller (or ​issuer​) is placing the securities on the market for
the first time, then the market is known as the ​primary market​.

Conversely, if the securities have already been issued and are now being traded among buyers, this is done on the ​secondary market​. Sellers make
money off the sale in the primary market, not in the secondary market, although they do have a stake in the outcome (pricing) of their securities in the
secondary market.

The buyers of securities in the capital market tend to use funds that are targeted for longer-term investment. Capital markets are risky markets and
are not usually used to invest short-term funds. Many investors access the capital markets to save for ​retirement​ or education, as long as the investors
have lengthy time horizons. (For related reading, see ​Types of Financial Markets and Their Roles​.

What is a 'Secondary Market'

The secondary market is where investors buy and sell securities they already own. It is what most people typically think of as the "stock market,"
though stocks are also sold on the primary market when they are first issued. The national exchanges, such as the ​New York Stock Exchange​ (NYSE)
and the ​NASDAQ​, are secondary markets.
Breaking down 'Secondary Market'
Though stocks are one of the most commonly traded securities, there are also other types of secondary markets. For example, ​investment banks​ and
corporate and individual investors buy and sell mutual funds and bonds on secondary markets. Entities such as ​Fannie Mae​ and Freddie Mac also
purchase mortgages on a secondary market.

Transactions that occur on the secondary market are termed secondary simply because they are one step removed from the transaction that originally
created the securities in question. For example, a financial institution writes a mortgage for a consumer, creating the mortgage security. The bank can
then sell it to Fannie Mae on the secondary market in a secondary transaction.

Secondary Market Pricing

Primary ​market prices​ are often set beforehand, while prices in the secondary market are determined by the basic forces of supply and demand. If the
majority of investors believe a stock will increase in value and rush to buy it, the stock's price will typically rise. If a company loses favor with investors
or fails to post sufficient earnings, its stock price declines as demand for that security dwindles.

Primary vs. Secondary Markets

It is important to understand the distinction between the secondary market and the primary market. When a company issues stock or bonds for the
first time and sells those securities directly to investors, that transaction occurs on the primary market. Some of the most common and well-publicized
primary market transactions are ​IPOs​, or initial public offerings. During an IPO, a ​primary market​ transaction occurs between the purchasing investor
and the investment bank underwriting the IPO. Any proceeds from the sale of shares of stock on the primary market go to the company that issued
the stock, after accounting for the bank's administrative fees.
If these initial investors later decide to sell their stake in the company, they can do so on the secondary market. Any transactions on the secondary
market occur between investors, and the proceeds of each sale go to the selling investor, not to the company that issued the stock or to
the ​underwriting​ bank.

Multiple Markets
The number of secondary markets that exists is always increasing as new financial products become available. In the case of assets such as mortgages,
several secondary markets may exist. Bundles of mortgages are often repackaged into securities such as ​GNMA​ pools and resold to investors.

Money Market​s

It is the organized exchange on which participants can lend and borrow large sums of money for a period of one year or less. While it is an
extremely efficient arena for businesses, governments, banks, and other large institutions to transact funds, the money market also provides an
important service to individuals who want to invest smaller amounts while enjoying the best ​liquidity​ and safety found anywhere.

● The money market is the organized exchange where participants lend and borrow large sums of money for one year or less.
● Investors are drawn to short-term money market instruments because of superior safety and liquidity.
● Short-term investment pools include money market mutual funds, local government investment pools, and short-term investment funds of
bank trust departments.
● Money market mutual funds are the most accessible to individuals.
● Treasury bills are regularly issued by the U.S. Treasury to refinance earlier T-bill issues reaching maturity and to help finance federal
government deficits.
● (A Treasury Bill (T-Bill) is a short-term debt obligation backed by the U.S. Treasury Department with a maturity of one year or less.

● Treasury bills are usually sold in denominations of $1,000 while some can reach a maximum denomination of $5 million.
● The longer the maturity dates, the higher the interest rate that the T-Bill will pay to the investor).

The money market is often accessed alongside the capital markets. While investors are willing to take on more risk and have patience to invest in
capital markets, money markets are a good place to "park" funds that are needed in a shorter time period – usually one year or less. The financial
instruments used in capital markets include stocks and bonds, but the instruments used in the money markets include ​deposits​, collateral loans,
acceptances and ​bills of exchange​. Institutions operating in money markets are central banks, commercial banks and acceptance houses, among
others.

Types of Money Market Instruments

A large number of financial instruments have been created for the purposes of short-term lending and borrowing. Many of these money market
instruments are quite specialized, and they are typically traded only by those with intimate knowledge of the money market, such as banks and large
financial institutions. Some examples of these specialized instruments are federal funds, the discount window, negotiable certificates of deposit
(NCDs), Eurodollar time deposits, repurchase agreements, government-sponsored enterprise securities, shares in money market instruments, futures
contracts, futures options, and swaps.
Aside from these specialized instruments on the money market are the investment vehicles with which individual investors will be more familiar, such
as short-term investment pools (STIPs) and money market mutual funds, Treasury bills, short-term municipal securities, ​commercial paper​, and
bankers' acceptances. Here we take a closer look at STIPs, money market mutual funds, and Treasury bills.

The Bottom Line

There are both ​differences and similarities between capital and money markets​. From the issuer or seller's standpoint, both markets provide a
necessary business function: maintaining adequate levels of funding. The goal for which sellers access each market varies depending on their liquidity
needs and time horizon.

Similarly, investors or buyers have unique reasons for going to each market: capital markets offer higher-risk investments, while money markets offer
safer assets; money market returns are often low but steady, while capital markets offer higher returns. The magnitude of capital market returns
often has a direct correlation to the level of risk, but that's not always the case. (See also: ​Financial Concepts: The Risk/Return Tradeoff.​ )

Although markets are deemed ​efficient​ in the long run, short-term inefficiencies allow investors to capitalize on anomalies and reap higher rewards
that may be out of proportion to the level of risk. Those anomalies are exactly what investors in capital markets try to uncover. Although money
markets are considered safe, they have occasionally experienced negative returns. Inadvertent risk, although unusual, highlights the risks inherent in
investing – whether putting money to work for the short-term or long-term in money markets or capital markets.

OTC ​What is an Over-The-Counter Market?

An over-the-counter (OTC) market is a decentralized market in which market participants trade stocks, commodities, currencies or other instruments
directly between two parties and without a central exchange or broker. Over-the-counter markets do not have physical locations; instead, trading is
conducted electronically. This is very different from an ​auction market system​. In an OTC market, dealers act as market-makers by quoting prices at
which they will buy and sell a security, currency, or other financial products. A trade can be executed between two participants in an OTC market
without others being aware of the price at which the transaction was completed.​1​​ In general, OTC markets are typically less transparent than
exchanges and are also subject to fewer regulations. Because of this liquidity in the OTC market may come at a premium.

KEY TAKEAWAYS

● Over-the-counter markets are those in which participants trade directly between two parties, without the use of a central exchange or other
third party.
● OTC markets do not have physical locations or market-makers.
● Some of the products most commonly traded over-the-counter include bonds, derivatives, structured products and currencies.

Understanding Over-The-Counter Markets

OTC​ markets are primarily used to trade bonds, currencies, derivatives and structured products. They can also be used to trade equities, with
examples such as the OTCQX, OTCQB, and OTC Pink marketplaces (previously the OTC Bulletin Board and ​Pink Sheets​) in the U.S. Broker-dealers that
operate in the U.S. OTC markets are regulated by the Financial Industry Regulatory Authority (​FINRA​).​2​​

Limited Liquidity
Sometimes the securities being traded over-the-counter lack buyers and sellers. As a result, the value of a security may vary widely depending on
which market markers trade the stock. Additionally, it makes it potentially dangerous if a buyer acquires a significant position in a stock that trades
over-the-counter should they decide to sell it at some point in the future. The lack of liquidity could make it difficult to sell in the future.​3​​

Risks of Over-The-Counter Markets

While OTC markets function well during normal times, there is an additional risk, called a ​counter-party risk​, that one party in the transaction will
default prior to the completion of the trade and/or will not make the current and future payments required of them by the contract. Lack of
transparency can also cause a vicious cycle to develop during times of financial stress, as was the case during the 2007–08 global credit crisis.​4​​

Mortgage-backed securities and other derivatives such as ​CDOs​ and ​CMOs​, which were traded solely in the OTC markets, could not be priced reliably
as liquidity totally dried up in the absence of buyers. This resulted in an increasing number of dealers withdrawing from their market-making
functions, exacerbating the liquidity problem and causing a worldwide credit crunch. Among the regulatory initiatives undertaken in the aftermath of
the crisis to resolve this issue was the use of clearinghouses for post-trade processing of OTC trades.​5​​

A Real-World Example
A portfolio manager owns about 100,000 shares of a stock that trades on the over-the-counter market. The PM decides it is time to sell the security
and instructs the traders to find the market for the stock. After calling three market makers, the traders come back with bad news. The stock has not
traded for 30 days, and the last sale was $15.75, and the current market is $9 bid and $27 offered, with only 1,500 shares to buy and 7,500 for sale. At
this point, the PM needs to decide if they want to try to sell the stock and find a buyer at lower prices or place a limit order at the stock’s last sale with
the hope of getting lucky.
What is Forex (FX)?

Forex (FX) refers to the marketplace where various ​currencies​ and currency derivatives are traded, as well as to the currencies and currency
derivatives traded there. Forex is a portmanteau of "foreign exchange." The forex market is the largest, most ​liquid​ market in the world by ​trading
volume​, with trillions of dollars ​changing hands every day​. It has no centralized location; rather the ​forex​ market is an electronic network of banks,
brokers, institutions, and individual traders (mostly trading through brokers or banks).

Many entities, from financial institutions to individual investors, have currency needs, and may also speculate on the direction of the movement of a
particular ​pair of currencies​. They post their orders to buy and sell currencies on the network so they can interact with other currency orders from
other parties.

The forex market is open 24 hours a day, five days a week, except for holidays. The forex market is open on many holidays on which stock markets are
closed, though trading volume may be lower.

KEY TAKEAWAYS

● The forex market is a network of institutions, allowing for trading 24 hours a day, five days per week, with the exception of when all markets
are closed because of a holiday.
● Retail traders can open a forex account and then buy and sell currencies. A profit or loss results from the difference in price the currency pair
was bought and sold at.
● Forwards and futures are another way to participate in the forex market. Forwards are customizable with the currencies exchanged after
expiry. Futures are not customizable and are more readily used by speculators, but the positions are often closed before expiry (to avoid
settlement).
● The forex market is the largest financial market in the world.
● Retail traders typically don't want to have to deliver the full amount of currency they are trading. Instead, they want to profit on price
differences in currencies over time. Because of this, brokers rollover positions each day
● Forex Pairs and Quotes
● When trading currencies, they are listed in pairs, such as USD/CAD, EUR/USD, or USD/JPY. These represent the U.S. dollar (USD) versus the
Canadian dollar (CAD), the Euro (EUR) versus the USD and the USD versus the Japanese Yen (JPY).
● There will also be a price associated with each pair, such as 1.2569. If this price was associated with the USD/CAD pair it means that it costs
1.2569 CAD to buy one USD. If the price increases to 1.3336, then it now costs 1.3336 CAD to buy one USD. The USD has increased in value
(CAD decrease) because it now costs more CAD to buy one USD.

How Large Is the Forex?

The forex market is unique for several reasons, mainly because of its size. ​Trading volume​ is generally very large. As an example, trading in foreign
exchange markets averaged $6.6 trillion per day in April 2019, according to the ​Bank for International Settlements​.1​​ ​

The largest foreign exchange markets are located in major global financial centers like London, New York, Singapore, Tokyo, Frankfurt, Hong Kong, and
Sydney.

What Is a Commission?

A commission is a ​service charge​ assessed by a ​broker or investment advisor​ for providing investment advice or handling purchases and sales
of ​securities​ for a client.

There are important differences between commissions and fees, at least in the way these words are used to describe professional advisors in the
financial services industry. A commission-based advisor or ​broker​ makes money by selling investment products such as mutual funds and annuities
and conducting transactions with the client's money. A fee-based advisor charges a flat rate for managing a client's money. This may be either a dollar
amount or a percentage of assets under management (AUM). Sales between family members are often ​gifts of equity​, which are not
commission-based.

A fee-based advisor charges a flat rate for managing a client's money, while a commission-based advisor makes money by selling investment products
and conducting transactions.

KEY TAKEAWAYS

● Full-service brokerages derive much of their profit from charging commissions on client transactions.
● Commission-based advisors make money from buying and selling products on behalf of their clients.
● When considering a brokerage or advisor, look at the full list of commissions for services.
Understanding Commission

Full-service brokerages derive much of their profit from charging commissions on client transactions. ​Commissions​ vary widely from brokerage to
brokerage, and each has its own fee schedule for various services. When determining the ​gains and losses from selling a stock​, it's important to factor
in the cost of commissions in order to be completely accurate.

Commissions can be charged if an order is filled, canceled, or modified, and even if it expires. In most situations, when an investor places a market
order that goes unfilled, no commission is charged. However, if the order is canceled or modified, the investor may find extra charges added to the
commission. Limit orders that go partially filled often will incur a fee, sometimes on a prorated basis.

Commission Costs
Commissions can eat into an investor’s returns. Suppose Susan buys 100 shares of Conglomo Corp. for $10 each. Her broker charges a 2.5%
commission on the deal, so Susan pays $1,000 for the shares, plus $25. Six months later, her shares have appreciated 10% and Susan sells them. Her
broker charges a 2% commission on the sale, or $22. Susan’s investment earned her a $100 profit, but she paid $47 in commissions on the two
transactions. Her net gain is only $53.

For this reason, online discount brokerages and robo-advisors are gaining popularity in the 21st century. These services provide access to stocks, index
funds, exchange-traded funds (ETFs), and more on a user-friendly platform for self-directed investors. Most charge a flat fee for trades, commonly
$4.95. Such services provide a wealth of financial news and information but little or no personalized advice. This can prove troublesome for rookie
investors.

Commissions vs. Fees

Financial advisors often advertise themselves as being ​fee-based​ rather than commission-based. A fee-based advisor charges a flat rate for managing a
client's money, regardless of the type of investment products the client ends up purchasing. This flat rate will be either a dollar amount or a
percentage of assets under management (AUM).

A commission-based advisor derives income from selling investment products, such as mutual funds and annuities, and conducting transactions with
the client's money. Thus, the advisor gets more money by selling products that offer higher commissions, such as annuities or universal life insurance,
and by moving the client's money around more frequently.

A professional advisor has a ​fiduciary​ responsibility to offer the investments that best serve the client's interests. That said, a commission-based
advisor may try to steer clients toward investment products that pay generous commissions.

What is 'Private Equity'

Private equity is capital that is not listed on a public exchange. Private equity is composed of funds and investors that directly invest in ​private
companies​, or that engage in ​buyouts​ of public companies, resulting in the ​delisting​ of public equity. Institutional and retail investors provide the
capital for private equity, and the capital can be utilized ​to fund​ new technology, make ​acquisitions​, expand working capital, and to bolster and solidify
a balance sheet.

What is 'Cost of Capital'

Cost of capital is the required return necessary to make a ​capital budgeting​ project, such as building a new factory, worthwhile. Cost of capital
includes the cost of debt and the cost of equity. ​Another way to describe cost of capital is the cost of funds used for financing a business​. Cost of
capital depends on the mode of financing used — it refers to the ​cost of equity​ if the business is financed solely through equity, or to the ​cost of
debt​ if it is financed solely through debt. Many companies use a combination of debt and equity to finance their businesses and, for such companies,
the overall cost of capital is derived from a weighted average of all capital sources, widely known as the ​weighted average cost of capital​ (WACC).
Since the cost of capital represents a ​hurdle rate​ that a company must overcome before it can generate value, it is extensively used in the capital
budgeting process to determine whether the company should proceed with a project.

What is 'Underwriting'
Underwriting is the process by which ​investment bankers​ raise investment capital from investors on behalf of corporations and governments that are
issuing either ​equity​ or ​debt securities​. The word "underwriter" originated from the practice of having each risk-taker write his name under the total
amount of risk he was willing to accept at a specified premium. This centuries-old practice continues, in a way, as ​new issues​ are usually brought to
market by an underwriting ​syndicate​, in which each firm takes the responsibility, as well as the risk, of selling its specific ​allotment​.

What is a 'Bill of Exchange'

A bill of exchange is a written order used primarily in international trade that binds one party to pay a fixed sum of money to another party on
demand or at a predetermined date.

Money markets provide a variety of functions for either individual, corporate or government entities. Liquidity is often the main purpose for accessing
money markets. When ​short-term debt​ is issued, it's often for the purpose of covering operating expenses or ​working capital​ for a company or
government and not for capital improvements or large-scale projects. Companies may want to invest funds overnight and look to the money market
to accomplish this, or they may need to cover payroll and look to the money market to help.

The money market plays a key role assuring companies and governments maintain the ​appropriate level of liquidity​ on a daily basis, without falling
short and needing a more expensive loan or without holding excess funds and missing the opportunity of gaining interest on funds. (See also: ​Money
Market Instruments​.)

Investors, on the other hand, use money markets to invest funds in a safe manner. Unlike capital markets, money markets are considered low
risk; ​risk-averse​ investors are willing to access them with the anticipation that liquidity is readily available. Those individuals living on a ​fixed
income​ often use money markets because of the safety associated with these types of investments.

Trade Life Cycle/Securities trade life cycle – 1​st​ Explanation

Have you wondered what happens when you initiate a trade, in simple terms when you put an order to buy or sell a stock/shares in the stock market
through your trading terminal.

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)

The 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\

1.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).

2.​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.
Let’s 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.

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

Below are the steps:

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 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...

4.Affirmation and confirmation.(back office function)

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.

5.Clearing and Settlement.(back office function)

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.

Trade Life Cycle/Securities trade life cycle – 2​nd​ Explanation

What is a trade?

Trade is a process of buying and selling any financial instrument.

Just like any other product even a trade has its life cycle involving several steps, as those with a ​career in investment banking​ know.

What are the Steps involved in a Trade Life Cycle?

Overview of the Process

1. Sale​ –

This is a process of client acquisition in which HNIs or Institutional clients are introduced to various investment products or vehicles.
These vehicles or products are available with an Investment Manager or Bank by whom the client’s investments are managed.
The investments are collectively called a Mutual or a Hedge fund.
2. Trade Initiation and Execution​ –

This is the process of placing an order in the market.

Trade Initiation and Execution can be done both in Order and Quote-driven markets.
This depends on the choice of a marketplace and on the external platform.
Once the order is placed and it gets matched, the trade is said to be executed.

3. Trade Capture​ –

Trades are then booked internally in an FO system for it to flow down to the operating systems.
It is booked in a Risk Management System (RMS)

4. Trade Validation and Enrichment​ –

Reference data team set up the static and dynamic details which help middle office teams to validate the trade, before releasing instructions into the
market.

Repository for data management

5. Trade Confirmation –

This is an extremely critical step for the trade settlement.

Trade details and SSIs are agreed with the counterparty at least a day prior to settlement date.
Confirmation via depositories like Euro clear/DTCC
6. Trade Settlement –

This is the process of simultaneous exchange of cash versus securities for a security trade ​or c​ ash versus cash for a Derivative trade.

7. Reconciliation –

Reconciliation involves matching ledgers against statements to ensure correct accounting of all trade booked.

Reconciliation is an ​accounting​ process that uses two sets of records to ensure figures are correct and in agreement. It confirms whether
the ​money​ leaving an account matches the amount that's been spent, ensuring the two are balanced at the end of the recording period. The purpose
of reconciliation is to provide consistency and accuracy in ​financial accounts​.

Reconciliation is particularly useful for explaining the difference between competing financial records or ​account balances​. Some differences may be
acceptable due to the timing of ​payments​ and ​deposits​; unexplained or mysterious discrepancies may be signs of theft or ​cooking the books​.

A SIMPLE EXPLANATION OF HOW SHARES MOVE AROUND THE SECURITIES SETTLEMENT SYSTEM

I explained ​here​ how money moves around the banking system and how the Bitcoin system causes us to revisit our assumptions about what a

payment system must look like. In this post, I turn my attention to ​securities settlement​: if I sell some shares to you, how do they actually move from

my account to yours? What is actually “moving”? What do I mean by “account”? Who is involved? What are the moving parts?

I have argued for some time that the Bitcoin system is best regarded as a ​global, decentralized asset register​ and that some of the assets it could

register, track and transfer could be securities (stocks and bonds). In this post, I go back to basics to explain what actually happens behind the scenes

today and use that to think through the implications should schemes such as ​ColoredCoins.org​ or ​MasterCoin​ gain traction. I’ve discussed these

systems in a couple of articles ​here (coloured coins)​ and ​here (MasterCoin)​.

As in the previous article, my focus is on imparting understanding by telling a story and building up a narrative. This means some of the precise details

may be simplified. So please don’t build a securities settlement system for your client using this article as your guide!

First, let’s establish some common ground.

Here are the simplifying assumptions I’m going to make:

● I’m going to invent a fictional company called MegaCorp

 ● I’m going to assume we start back in the days when certificates were in ​paper form.​ I’ll move to electronic systems later in the article but I

think it helps first to think about paper – it helps us keep track of what’s really going on

● I’m going to rewrite history to suit the story. If you’re a historian of finance, this article is ​not for you!​

● Finally, I’m going to assume that MegaCorp already exists, has issued shares and that they are in the hands of a large number of individuals,

banks and other firms. I’m going to assume you’re one of these owners. How these shares were issued would be a fascinating story itself but

there isn’t space here to talk about corporate finance, IPOs and all the rest. Google it: “primary market” activity is a really interesting area of

investment banking.

So let’s get started. You own some MegaCorp shares and you want to sell them.

Selling shares if everything was paper-based​ So… you own some shares in MegaCorp and you have a piece of paper that proves it: a share certificate.

You’d like to sell those shares. Now you have a problem. How do you find somebody who is willing to buy them from you? I guess you could put an

advert in the paper or maybe walk around town wearing a sandwich board proclaiming your desire to sell. But it’s not ideal.

Figure 1 The fundamental problem: how does a seller find a buyer or a buyer find a seller?

The obvious answer is that it would all be so much easier if there were a place – a ​venue​ where people commonly in the business of buying and selling

shares could get together and find each other. Happily, there are and we call such places ​stock exchanges.​ In the early days, they were simply ​coffee

houses​ or under a ​Buttonwood tree​ in trading centres such as London. Over time, they became formalized. But the idea is the same: concentrate

buyers and sellers in one place to maximize the chance of ​matching​ them with each other.

This adds a new box to our diagram: the stock exchange.

Figure 2 A stock exchange brings buyers and sellers together to help them execute trades

There are still some problems, however. What if you’re just an occasional buyer or seller? Do you really want to have to trek to London or New York

every time you want to buy or sell? And as an out-of-towner, do you really think you’d get a good deal from the locals who spend all their time there?

You’d be completely out of your depth. So you’d probably value the services of an intermediary – somebody who could go to the exchange on your

behalf and get you the best deal they could. We call these people stockbrokers (or just brokers). An example for retail investors may be Charles

Schwab. An example for, say, pension funds might be Deutsche Bank or Morgan Stanley.
Figure 3 Brokers act on behalf of buyers and sellers

You’ll notice that “stock exchange” has become “stock exchange(s)”: this reflects the reality that there could be ​multiple​ venues you could visit to

trade a particular share. This creates opportunities for ​arbitrage​ (the price may be different at each venue) but we’ll ignore this from now on.

Now this works fine if there is lots of trade in MegaCorp shares: when my broker tries to sell, there will probably be somebody else who wants to buy.

But what happens if there are no buyers just then? Does that mean the share is worthless? Clearly not. So there’s an opportunity to somebody to

make a living taking a bit of risk by buying and selling shares ​on their own account​. Whereas a broker is acting in an ​agency​ capacity, this new person

would make money from their wits: buying low and selling high with their own money. We call these people ​market-makers ​– since they literally

create a market in the shares in which they specialize. We call firms like Goldman Sachs and Morgan Stanley ​broker-dealers​ because some of their

subsidiaries engage in both broking and market-making in various markets.

Figure 4 Market-makers buy and sell shares on their own account, creating liquidity

Guess what: we ​still ​have problems! Remember: I’ve asked my broker to sell my shares for me but imagine they succeed. Then what? We now have

the tricky problem of ​settlement​. Remember: we’re still in the days of paper-based certificates. So my broker has just sold my MegaCorp shares.

Well… the buyer is going to want the certificate pretty soon. And I would quite like the cash.

Now… I could just trust my broker. I could leave the paper certificate in their hands and ask them to take receipt of the cash when the buyer’s broker

hands over their cash. But that means placing a lot of trust in that individual. And remember: I chose the broker because they could navigate the

rough and tumble of the stock exchange, not because I trusted their book-keeping skills!

Worse, what happens if MegaCorp issues a dividend while the share certificate is in the hands of the broker? Do they really have the ability or

inclination to collect the divident, allocate it to my account and report to me about this in a timely manner? Perhaps, but probably not.
But we still have the need for somebody to keep the certificate safe and to be on hand to give it to the purchaser if a sale takes place. It’s just that the

skills needed by this person are completely different to those needed by the broker. The broker needs to be able to negotiate the best price for me.

But the person who looks after my certificate needs to be good with accounts, book-keeping, reporting and security. After all, I’m trusting them with

the safekeeping of my share certificate: it’s in their ​custody​. So we call these people ​custodians.​ Examples include State Street and Northern Trust, as

well as divisions of Citi and HSBC, etc.

Figure 5 Custodians are responsible for the safekeeping of shares

So now, when my broker finds a willing buyer at the exchange, they can tell my custodian to expect to receive cash from the buyer’s custodian and to

send the certificate to the buyer’s custodian when this happens.

And while the share certificate is sitting at the custodian, they can deal with all the tedious things that can happen to a share during its life: dividends,

stock-splits, voting, … It’s as if the shares need regular attention, like an old car that needs constant servicing: so we call this business the business

of ​securities servicing​. The picture above shows a line from the buyer/seller to their custodians, because the custodian is working on their behalf.

However, retail investors will probably not be aware of this relationship as their brokerage will manage the relationship on their behalf.

So… what have we achieved? I can lodge my share certificate with a ​custodian,​ instruct my ​broker​ to sell the shares on my behalf by finding a willing

buyer at a ​stock exchange​ and wait for the cash to arrive. We’re done!

Erm… not so fast. There are still several problems. The first becomes obvious when you think about how the picture I’ve described would work in

practice. You have loads of brokers shouting at each other, making trades all the time. It would be completely chaotic yet, somehow, we need to get

to a point where the buying and selling brokers agree completely on the details of the trade they just did and have communicated

matching ​settlement instructions​ perfectly to the two custodians so they can settle the trade. That’s not going to be easy.

In reality, there’s quite some work that must be done ​post-trade​ to get it to the point where it can be settled (matching, maybe netting, agreement of

settlement details, agreeing on time and place of settlement, etc, etc). We call this process ​clearing​. (I wrote previously about a real-life example

of ​spontaneous clearing at the world’s first-ever open-outcry Bitcoin exchange​.)

And there’s a second, more subtle, problem: how does my broker know that the person they’re selling to is good for the cash? And how does the

buyer know that my broker can lay their hands on the shares? In the model I’ve just described, they don’t. Now, perhaps that’s not a problem: after
all, smart custodians are only going to exchange shares and cash at the same time. But it’s still problematic: sure… if the buyer turns out not to have

the cash, I still have my shares… but I wanted to sell them! And the price may drop before I can find a replacement buyer.

A ​clearing house​ is intended to solve both these problems. Here’s how: after a trade is ​matched​ (both sides agree on the details), the information is

sent to the clearing house by the exchange. And here’s the trick: as well as orchestrating the clearing process and getting everything ready for

settlement, the clearing house does something clever: it steps into the middle of the trade. In effect, it tears up the trade and creates two new ones

in its place: it becomes my buyer and it becomes the seller to the buyer. In this way, I have no exposure to the buyer: if they turn out to be a fraud,

it’s now the clearing house’s problem. And the ultimate seller has no exposure to me: if I turn out to be a fraud, the buyer still gets their shares (the

clearing house will go into the market and buy them from somebody else if it really has to). We call this “stepping in” process ​novation​ and say that

the clearing house is acting as a ​central counterparty​ if it performs this service. As an example, the London Stock Exchange uses LCH.Clearnet Ltd as its

clearing house.

Of course, this amazing service comes at a price: they charge a fee and, more importantly, impose strict rules on who can be a ​clearing member​ of the

exchange and how they should be run. In this way, the clearing house acts as a policeman, ensuring only people and firms with a good track record

and deep resources are allowed to participate. (I’ll leave to one side whether this privileging of one group over another is a net good or bad!)

So we can update our picture again:

Figure 6 A clearing house manages the post-trade process of getting to a point where settlement can take place and often also acts as a central

counterparty

We’re almost there… but there are still some loose ends. To see why, consider this from MegaCorp’s perspective. We’ve been talking about buying

and selling their shares and this all happens without any involvement from them at all. That’s fine in most circumstances but it does cause problems

from time to time. Specifically, what happens when the company issues a dividend or wants its shareholders to vote on something? How does it know

who its shareholders are? Imagine it knew I was a shareholder. What happens after I’ve sold the shares using the system above to somebody else?

How does the company get to hear about the new owner?
Enter ​yet another​ player: the registrar (UK) or share transfer agent (US). These companies work on behalf of the company and are responsible for

maintaining a register of shareholders and keeping it up to date. If the company pays a dividend, these companies are responsible for distributing it.

They rely on one of the participants in the process to tell them about share transfer. An example of a registrar in the UK would be Equiniti.

Figure 7 A registrar (or stock transfer agent) keeps track of who owns a company’s shares on behalf of the company

Now, I assumed up front that we were using paper certificates. And it’s amazing how far you can go in the description without needing to bring IT into

the narrative at all. But, clearly, paper certificates are a complete pain. They can get lost, you have to move them around, you have to reissue them if

the company does a stock split, etc. It would clearly be easier if they were electronic.

For any given custodian, it’s not a problem: they can just set up an IT book-keeping system to keep track of the share certificates under their

safekeeping. And this can work well: imagine if the seller of a share uses the ​same​ custodian as the buyer: if the custodian is electronic, no paper

needs to move at all! The custodian can just update its electronic records to reflect the new owner. But it doesn’t work if the buyer and seller use

different custodians: you’d still need to move paper between them in this case.

So this raises an interesting possibility: what if we had a “custodian to the custodians”? If the custodians could deposit their paper certificates with a

trusted third party, then they could transfer shares between each other simply by asking this “custodian to the custodians” to update its electronic

records and we’d never need to move paper again!

And that’s what we have. We call these organisations ​central securities depositories​. In the early days, they were just that: a depository where the

share certificates were placed in exchange for an equivalent entry on the electronic register. The shares were, in effect, ​immobilized a​ t the CSD. Over

time, people gained trust in the system and agreed that there really wasn’t any need for paper certificates at all… so we moved from immobilization

to ​dematerialization.​ The UK’s CSD is Euroclear (CREST).

This completes our picture (and notice how it is the CSD who informs the registrar when shares change hands… left as an exercise to a reader is

thinking through what happens if shares change hands within the same custodian and what it means for the granularity of the data held by registrars):
Figure 8 A CSD acts as the “custodian to the custodians”

This picture also introduces regulators, governments and taxation authorities, for completeness. However, I don’t discuss them here. I also don’t

discuss what happens if you’re trading shares cross-border.

So now we have the full story: if I want to sell some MegaCorp shares, here’s what happens:

● My shares start off in the account of my broker, who uses a custodian for safekeeping

● The broker executes a sale at an exchange

● The clearing house establishes everybody’s respective liabilities, steps in as central counterparty and orchestrates the settlement process

● The buyer’s and seller’s custodians exchange shares for cash (“Delivery versus Payment”), utilizing the CSD if shares need to move between

custodians as a result. Assuming so, the company’s registrar is informed.

● Somebody probably has to pay some tax J

You’ll notice many parallels with the global payments system: lots of intermediaries and lots of specialists – all of them there for a reason but imposing

costs nonetheless.

Now, I said I would use this narrative to discuss what it could mean for Bitcoin “colored coins”. I think there are two key concepts that can help us

think through workable models: ​risk​ and ​the meaning of settlement.​

Risk

Consider the picture above: what risks are you exposed to as an investor? Ideally, if you buy shares in MegaCorp, the only risks you want to be

exposed to are those associated with MegaCorp itself, realized through changes in share price or dividend payments. So, the ideal state is when you

just face this ​market risk.​ And that’s broadly what the system above delivers: by depositing your shares in a custodian bank, which should keep them

in a ​segregated a​ ccount at the CSD, you’re protected even if the custodian goes bust: your shares are not considered part of the custodian bank’s

assets. So the only risk you’re exposed to beyond the market risk (which you want) is ​operational risk​ that the custodian makes a mistake. (I’ll ignore

cash here but note that it’s typically not protected in the same way)
Now, when we look at “colored coin” share representation schemes, we see there is the notion of a colored coin “issuer”: somebody who ​asserts​ that

a given set of coins represents a particular number of shares in a particular company. So now we have a big question: who is this somebody? This

matters because if the “somebody” reneges on their promise or goes bust, you’ve lost your shares.

Now, if a colored coin scheme were “grafted on” to today’s system, it could work quite well if done right. Imagine a firm wanted to offer colored coins

representing 100 MegaCorp shares. They could open a custody account, fund it with 100 MegaCorp shares as “backing” and we’d be done: such firms

could perhaps compete on the completeness of their transparency. However, owners of colored MegaCorp coins would have counterparty exposure

to this firm, which means the risk profile would be different (worse?) than if they simply owned coins in a regular custody account. Interestingly, you

can’t overcome the problem entirely by having a custodian bank be the issuer because it’s not obvious to me that a coloured MegaCorp coin issued by

a custodian bank is the same as a segregated share for the purposes of bankruptcy protection: you’d presumably also need a legal opinion – and I am

not a lawyer!

Bottom line: there is work to do for those developing these schemes.

However, there is one intriguing possibility with this approach: think through what happens if MegaCorp themselves were to issue colored coins

representing their shares. Any analysis of counterparty risk becomes moot: if MegaCorp went bust, you’d lose your money ​regardless​ of how your

shares were held! Perhaps this is the future? (Note also that I’m not discussing here precisely ​why​ anybody would want to issue – or buy – coloured

coins! I’ll leave that to others)

Do you actually want ​settlement​?

However, there’s another way of looking at this: you don’t have to own a share to enjoy the benefits of ownership. ​Contracts for Difference​ (or, more

generally, ​Equity Swaps​) allow you to enjoy the losses or gains from owning a stock without actually owning it. They are, instead, ​contracts,​ with a

counterparty, in which the counterparty pays (or receives) cash that matches the gain or loss in the share price (and payment of dividends). Now, the

counterparty often hedges their risk by buying the shares – but that becomes their problem, not yours. So this gives you all the benefits of owning the

stock without having to go through the pain of actually taking delivery. It also has tax advantages in some jurisdictions.

The downside is that you take on ​counterparty risk​ to the party issuing the CFD: if they go bust while you’re in the money, you’re out of luck. But

we’ve already established that there could well be quite considerable counterparty risk with colored coins in any case. So perhaps this is the right

model. I don’t yet have a view on which will prevail but hopefully laying out how today’s system is constructed will help others think this through

more clearly.

I’ll end with one final observation: the issuance is the easy part.. but somebody still has to do the servicing. But notice how this is much easier if you

use a technology such as the Block Chain: there’s no need for the arbitrary distinctions between custodian, CSD and registrar: the issuer can see

immediately which addresses own their coins and to whom they should send messages or dividends. Similarly, the peer-to-peer nature of Bitcoin

means the hierarchy of custodians and CSDs could possibly be collapsed.

I know many people think blockchain technology could be hugely disruptive for the world’s banks but I look at it another way: I believe there are huge

opportunities for those financial firms that really take the time to study this space.

[Final comment: a reminder to readers that this is my personal blog and the opinions are mine alone… I don’t speak on behalf of my employer]

[Update – 2014-01-07 – One question I failed to address above is precisely ​why​ anybody would want to settle share trades using a coloured coin

scheme! I think there are two possible answers:

1) if settlement can be effected over the blockchain, the cost potentially reduces to the fee of the Bitcoin transaction in simple cases.

2) if opens up the potential for custodians, CSDs and registrars/stock transfer agents to innovate their business models in a new way: do they still need

to be separate entities, for example? Further, would ‘regular’ companies see value in becoming their own issuers, etc?

However, I’m not convinced this approach does anything to reduce risk – the challenge would be how to build a system with risk as good as what we

have today.

A pictorial representation of the steps.

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 six: 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 seven: 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 eight: 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 nine: 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 ten: 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

Guide to equity vs fixed income

A guide to equity vs fixed income. Both ​equity​ and ​fixed income​ products are financial instruments that can help investors achieve their financial goals.
Equity investments generally consist of ​stocks​ or stock mutual funds, while fixed income securities generally consist of corporate or government
bonds.

Equity vs fixed income products have their respective risk-and-return profiles; investors will often choose an optimal mix of both asset classes in order
to achieve the desired risk-and-return combination for their portfolios.

Equity
Equity investments allow investors to hold partial ownership of issuing companies. As one of the principal asset classes, equity plays a vital role in
financial analysis and portfolio management.

Equity investments come in various forms, such as stocks and stock mutual funds. Generally, stocks can be categorized into ​common
stocks​ and ​preferred stocks​. Common stocks, the securities that are traded most often, grant the owners the rights to claim the issuing company’s
assets, receive dividends, and vote at shareholders’ meetings. Preferred stocks, in comparison, offer the same claim on assets and rights to dividends,
but do not grant the right to vote.

Risks of equity
For investors, equity investments offer relatively higher returns than fixed income instruments. However, the higher returns are accompanied by
higher risks, which are made up of systematic risks and unsystematic risks.

Systematic risks​ are also known as market risks, and refers to the market volatility in various economic conditions.

Unsystematic risks​, also called idiosyncratic risks, refer to the risks that depend on the operations of individual companies. Systematic risks cannot be
avoided through diversification (i.e. mixing a variety of stocks with distinctive characteristics), while unsystematic risks, on a portfolio level, can be
minimized through diversification.

Important variables in analyzing equity instruments

We generally use two variables, ​expected return (E)​ and ​standard deviation (σ)​, to describe the risk-and-return characteristics of an equity
instrument. In constructing a portfolio, we consider these two variables of each asset class to determine their respective weights.

Learn more in our finance tutorials online​.

Fixed Income
A fixed-income security is a security that promises fixed amounts of cash flows at fixed dates. We frequently refer to fixed-income securities as bonds.

We will discuss two types of bonds: zero-coupon bonds and coupon bonds. A zero-coupon bond (or zero) promises a single cash flow, equal to the
face value (or par value), when the bond reaches maturity. Zero coupon bonds are sold at a discount to their face value. The return on a zero coupon
bond is the difference between the purchase price and the bond’s face value.

A coupon bond, similarly, will also pay out its listed face value upon maturity. Additionally, it also promises a periodic cash flow, or coupon, to be
received by the bondholder during their holding period. The coupon rate is the ratio of the coupon to the face value. Coupon payments are typically
semi-annual for US bonds and annual for European bonds.

To learn more, ​launch our free fixed income course now​!

Risks of fixed income securities
Fixed income securities typically have lower risks, which means they provide lower returns. They generally involve ​default risk​, i.e., the risk that the
issuer will not meet the cash flow obligations. The only fixed-income securities that involve virtually no default risk are government treasury securities.
Treasury securities include treasury bills (that mature in a year), notes (that mature in between 1 and 10 years), and long-term bonds (that mature in
more than 10 years).

Types of Equity Accounts

The 7 main equity accounts are:

#1 Common Stock
Common stock​ represents the owners’ or shareholder’s investment in the business as a capital contribution. This account represents the shares that
entitle the owners to vote and their residual claim on the company’s assets. The value of common stock is equal to the par value of the shares times
the number of shares outstanding. For example, 1 million shares with $1 of par value would result in $1 million of common share capital on the
balance sheet.

#2 Preferred Stock
Preferred stock​ is quite similar to common stock. The preferred stock is a type of share that often has no voting rights, but is guaranteed a cumulative
dividend. If the dividend is not paid in one year, then it will accumulate until paid off.

Example: A preferred share of a company is entitled to $5 cumulative dividends in a year. The company has declared a dividend this year but has not
paid dividends for the past two years. The shareholder will receive $15 ($5/year x 3 years) in dividends this year.

#3 Contributed Surplus
Contributed Surplus​ represents any amount paid over the par value paid by investors for stocks purchases that have a par value. This account also
holds different types of gains and losses resulting in the sale of shares, or other complex financial instruments.

Example: The company issues 100,000 $1 par value shares for $10 per share. $100,000 (100,000 shares x $1/share) goes to common stock, and the
excess $900,000 (100,000 shares x ($10-$1)) goes to Contributed Surplus.

#4 Additional Paid-In Capital

Additional Paid-In Capital​ is another term for contributed surplus, the same as is described above.

#5 Retained Earnings
Retained Earnings​ is the portion of net income that is not paid out as dividends to shareholders but retained for reinvesting or to pay-off future
obligations.

#6 Other Comprehensive Income

Other comprehensive income is excluded from net income on the income statement and consists of income that has not been realized yet. For
example, unrealized gains or losses on securities that have not yet been sold would be reflected in other comprehensive income. Once the securities
are sold the gain/loss will then move into net income on the income statement.

#7 Treasury Stock (contra-equity account)

Treasury stock​ is a contra-equity account and represents the amount of common stock that the company has purchased back from the investors. This
is reflected in the books as a deduction from total equity.
What are the most important fixed income terms?

Welcome to CFI’s guide to the most important fixed income terms. For a complete understanding of bonds and fixed income securities, check out
our ​free Fixed Income Fundamentals course​.

Annuity:

An annuity is a series of payments in equal time periods, guaranteed for a fixed number of years.

Annuity factor:

Present value of $1 paid for each of “t” periods.

Constant perpetuity:

A constant stream of identical cash flows without end.

Correlation:

A statistical measure of how two securities move in relation to each other.

Coupon rate:

The amount of interest received by a bond investor expressed on a nominal annual basis.

Current yield:

The coupon from a bond divided by the market price of the bond, expressed as a percentage.

Discount factor:

The percentage rate required to calculate the present value of a future cash flow.

Expected value:

The anticipated value for a given investment. Calculate EV by multiplying each possible outcome by its likelihood of occurring, and then calculate the
sum of all those values.

Growing perpetuity:

A constant stream of cash flows without end that is expected to rise indefinitely.

Moving average:

Mean of time series data (observations equally spaced in time) from several consecutive periods. Called ‘moving’ because it is continually recomputed
as new data becomes available.

Par value:

The principal amount returned to a bond investor, by the issuer, upon maturity.

Time value of money:

The concept that money available now is worth more than the same amount of money available in the future, due to the fact that money available
now can be invested and thereby increased in the future

Yield to maturity:
The annual return earned by a bond investor if purchasing a bond today and holding it until maturity.

Junk bonds, also known as high-yield bonds, are bonds that are rated below investment grade by the big three rating agencies (see image below).
Junk bonds carry a ​higher risk of default​ than other bonds, but they pay higher returns to make them attractive to investors. The main issuers of junk
bonds are capital-intensive companies with high ​debt ratios​ and early-stage startups that are yet to establish a strong credit rating.

When you buy a junk bond, you are typically lending to the issuer in exchange for periodic interest payments. Once the bond matures, the issuer is
required to repay the principal amount in full to the investors. But due to the poor financial state of the issuers, the interest payments may not be
disbursed as scheduled. Thus, such bonds offer high yields to compensate for the additional risk.

Arbitrage​ the simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take
advantage of differing prices for the same asset.

A hedge​ is a ​risk management​ technique used to reduce any substantial losses or gains suffered by an individual or an organization.

In ​finance​, ​margin​ is ​collateral​ that the holder of a ​financial instrument​ has to deposit with a ​counterparty​ (most often their ​broker​ or an ​exchange​) to
cover some or all of the ​credit risk​ the holder poses for the counterparty.

DERIVATIVES
The ​derivatives market​ is the ​financial market​ for ​derivatives​, ​financial instruments​ like futures contracts or options, which are derived from other
forms of ​assets​.
The market can be divided into two, that for ​exchange-traded derivatives​ and that for ​over-the-counter derivatives​. The legal nature of these products
is very different, as well as the way they are traded, though many market participants are active in both.

Participants in a Derivative Market​[​edit​]

Participants in a derivative market can be segregated into four sets based on their trading motives.​[1]

● Hedgers
● Speculators
● Margin Traders
● Arbitrageurs

WHAT ARE DERIVATIVES?

Derivatives are financial contracts that derive their value from an underlying asset. These could be stocks, indices, commodities, currencies, exchange
rates, or the rate of interest. These financial instruments help you make profits by betting on the future value of the underlying asset. So, their value is
derived from that of the underlying asset. This is why they are called ​‘Derivatives’

The ​International Swaps and Derivatives Association​ (​ISDA​ ​/ˈɪzdə/​) is a trade organization of participants in the market for ​over-the-counter
derivatives​. It is headquartered in ​New York City​, and has created a standardized contract (the ​ISDA Master Agreement​) to enter
into ​derivatives​ transactions. In addition to legal and policy activities, ISDA manages ​FpML​ (Financial products Markup Language),
an ​XML​ message ​standard​ for the ​OTC Derivatives​ industry. ISDA has more than 820 members in 57 countries; its membership consists of derivatives
dealers, service providers and end users

What is an ISDA used for?

The ​ISDA master agreement​ is published by the ​International Swaps and Derivatives Association​. The ​master agreement​ is a document agreed
between two parties that sets out standard terms that apply to all the transactions entered into between those parties.
ISDA was initially created in 1985​[2]​ as the International Swap Dealers Association and subsequently changed its name switching “Swap Dealers” to
“Swaps and Derivatives”. This change was made to focus more attention on their efforts to improve the more broad derivatives markets and away
from strictly ​interest rate swap​ contracts.
In 2009 a New York Times article mentioned that in 2005 the ISDA allowed rule changes to CDO payouts (Pay as You Go) that would benefit those who
bet against (shorted) mortgage-backed securities, like ​Goldman Sachs​, ​Deutsche Bank​, and others.​[3]
ISDA has offices in New York, London, Hong Kong, Tokyo, Washington D.C., Brussels and Singapore. It has more than 800 member firms from six
continents. The current Chief Executive Officer is Scott O'Malia, who joined ISDA in 2009.
What is a 'Derivative'
A derivative is a financial ​security​ with a value that is reliant upon or derived from an underlying asset or group of assets. The derivative itself is a
contract between two or more parties based upon the asset or assets. Its price is determined by fluctuations in the ​underlying asset​. The most
common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.

Derivatives can either be traded ​over-the-counter (OTC)​ or on an ​exchange​. OTC derivatives constitute the greater proportion of derivatives in
existence and are unregulated, whereas derivatives traded on exchanges are standardized. OTC derivatives generally have greater risk for
the ​counterparty​ than do standardized derivatives.

Common Forms of 'Derivative'

Futures contracts​ are one of the most common types of derivatives. A futures contract (or simply futures, colloquially) is an agreement between
two parties for the sale of an asset at an agreed upon price.​ One would generally use a futures contract to hedge against risk during a particular
period of time. For example, suppose that on August 1, 2016, Diana owned 10,000 shares of Walmart (WMT) stock, which were then valued at $73.78
per share. Fearing that the value of her shares would decline, Diana decides to arrange a futures contract to protect the value of her stock. Jerry, a
speculator predicting a rise in the value of Walmart stock, agrees to a futures contract with Diana, dictating that in one year’s time Jerry will buy
Diana’s 10,000 Walmart shares at their agreed-upon value of $73.78.

The futures contract can be considered a sort of bet between the two parties. If the value of Diana’s stock declines, her investment is protected
because Jerry has agreed to buy them at their August 2016 value, and if the value of the stock increases, Jerry earns greater value on the deal, as he is
paying August 2016 prices for stock in August 2017. A year later, August 1 rolls around and Walmart is valued at $80.50 per share. Jerry has benefited
from the futures contract, purchasing shares at $6.72 less per share than if he would have simply waited until August 2017 to buy stock. While this
might not seem like much, this difference of $6.72 per share translates to a discount of $67,200 when considering the 10,000 shares that Jerry buys.
Diana, on the other hand, has speculated poorly and lost a sizable sum.

Forward contracts​ are an ​important kind of derivative​ similar to futures contracts​, the key difference being that unlike futures, forward contracts (or
“forwards”) are not traded on exchange, ​rather only over-the-counter.

Swaps​ are another common type of derivative. A swap is most often a contract between two parties agreeing to trade loan terms​. One might use
an ​interest rate swap​ to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa. If someone with a variable interest rate
loan were trying to secure additional financing, a lender might deny him or her a loan because of the uncertain future bearing of the variable interest
rates upon the individual’s ability to repay debts, perhaps fearing that the individual will default. For this reason, he or she might seek to switch their
variable interest rate loan with someone else, who has a loan with a fixed interest​ ​rate that is otherwise similar. Although the loans will remain in the
original holders’ names, the contract mandates that each party will make payments toward the other’s loan at a mutually agreed upon rate. Yet this
can be risky, because if one party defaults or goes bankrupt, the other will be forced back into their original loan. Swaps can be made using interest
rates, currencies or commodities.

Options​ are another common form of derivative. An option is similar to a futures contract in that it is an agreement between two parties granting
one the opportunity to buy or sell a security from or to the other party at a predetermined future date. The key difference between options and
futures is that with an option, the buyer is not obligated to make the transaction if he or she decides not to, hence the name “option.”​ The
exchange itself is, ultimately, optional. Like with futures, options may be used to hedge the seller’s stock against a price drop and to provide the buyer
with an opportunity for financial gain through speculation. An option can be ​short​ or ​long​, as well as a ​call​ or ​put​.

[Options are one of the most common forms of derivatives for retail traders since they can be easily traded on most large equities. If you're new to
options trading, Investopedia's ​Options for Beginners Course​ provides everything you need to get started with over five hours of on-demand video,
exercises and interactive content. You'll learn how calls serve as a down payment, how puts can be used for insurance, why option values fluctuate,
how to calculate breakeven points and much more.]

● Call options​ allow the holder to buy the asset at a stated price within a specific timeframe.
● Put options​ allow the holder to sell the asset at a stated price within a specific timeframe.

American options​ can be exercised any time before the expiration date of the option, while ​European options​ can only be exercised on the expiration
date or the exercise date. Exercising means utilizing the right to buy or sell the underlying security.

What Is an Options Contract?

An options contract is an agreement between two parties to facilitate a potential transaction on the ​underlying security​ at a preset price, referred to
as the ​strike price​, prior to the expiration date.

The two types of contracts are put and call options, both of which can be purchased to speculate on the direction of stocks or stock indices, or sold to
generate income. For stock options, a single contract covers 100 shares of the underlying stock.

The Basics of an Options Contract

In general, call options can be purchased as a leveraged bet on the appreciation of a stock or index, while put options are purchased to profit from
price declines. The buyer of a call option has the right but not the obligation to buy the number of shares covered in the contract at the strike price.

Put buyers have the right but not the obligation to sell shares at the strike price in the contract. Option sellers, on the other hand, are obligated to
transact their side of the trade if a buyer decides to execute a call option to buy the underlying security or execute a put option to sell.

Options are generally used for hedging purposes but can be used for speculation. That is, options generally cost a fraction of what the underlying
shares would. Using options is a form of leverage, allowing an investor to make a bet on a stock without having to purchase or sell the shares outright.

Call Option Contracts

The terms of an option contract specify the underlying security, the price at which that security can be transacted (strike price) and the expiration date
of the contract. A standard contract covers 100 shares, but the share amount may be adjusted for stock splits, special dividends or mergers.

In a call option transaction, a position is opened when a contract or contracts are purchased from the seller, also referred to as a writer. In the
transaction, the seller is paid a premium to assume the obligation of selling shares at the strike price. If the seller holds the shares to be sold, the
position is referred to as a covered call.

Put Options
Buyers of put options are speculating on price declines of the underlying stock or index and own the right to sell shares at the strike price of the
contract. If the share price drops below the strike price prior to expiration, the buyer can either assign shares to the seller for purchase at the strike
price or sell the contract if shares are not held in the portfolio.

KEY TAKEAWAYS

● An options contract is an agreement between two parties to facilitate a potential transaction involving an asset at a preset price and date.
● Call options can be purchased as a leveraged bet on the appreciation of an asset, while put options are purchased to profit from price
declines.
● Buying an option offers the right, but not the obligation to purchase or sell the underlying asset.
● For stock options, a single contract covers 100 shares of the underlying stock.

Options Spreads
Options spreads are strategies that use various combinations of buying and selling different options for a desired risk-return profile. Spreads are
constructed using ​vanilla options​, and can take advantage of various scenarios such as high- or low-volatility environments, up- or down-moves, or
anything in-between.

Spread strategies, can be characterized by their payoff or visualizations of their profit-loss profile, such as ​bull call spreads​ or​ iron condors​. See our
piece on ​10 common options spread strategies​ to learn more about things like covered calls, straddles, and calendar spreads.

ITM Options​ (In the money options)

a) A call option is said to be in ITM if the strike price is less than the current spot price of the security.
I.e. Spot- Strike > 0
b) A put option is said to be ITM if the strike price is more than the current spot price of the security.
I.e. Spot- Strike < 0

ATM Options​ (At the money options)

a) A call option is said to be in ATM if the strike price is equal to the current spot price of the security.
I.e. Spot- Strike = 0
b) A put option is said to be ATM if the strike price is equal to the current spot price of the security.
I.e. Spot- Strike = 0

OTM options​ (Out of the money options)

a) A call option is said to be in OTM if the strike price is more than the current spot price of the security.
I.e. Spot- Strike < 0
b) A put option is said to be OTM if the strike price is less to the current spot price of the security.
I.e. Spot- Strike > 0

American vs. European Options: An Overview

American and European options have similar characteristics but the differences are important. For instance, owners of American-style options may
exercise at any time before the option expires.​1​​ On the other hand, major broad-based indices, including the S&P 500, have very actively traded
European-style options, while owners of European-style options may exercise only at expiration.
KEY TAKEAWAYS

● All optionable stocks and exchange-traded funds have American-style options while only a few broad-based indices have American-style
options.
● European index options stop trading one day earlier, at the close of business on the Thursday preceding the third Friday of the expiration
month.
● The settlement price​ ​is the official closing price for the expiration period, establishing which options are in the money and subject to
auto-exercise.

American Options
All optionable stocks and exchange-traded funds (ETFs) have American-style options while only a few broad-based indices have American-style
options. American index options cease trading at the close of business on the third Friday of the expiration month, with a few exceptions.​1​​ For
example, some options are quarterlies, which trade until the ​last trading day​ of the calendar quarter, while weeklies cease trading on Wednesday or
Friday of the specified week.

The settlement price​ ​is the official closing price for the expiration period, establishing which options are ​in the money​ and subject to auto-exercise.
Any option that's in the money by one cent or more on the expiration date is automatically exercised unless the option owner specifically requests
his/her broker not to exercise. The settlement price for the ​underlying asset​ (stock, ETF, or index) with American-style options is the
regular closing price or the last trade before the market closes on the third Friday. After-hours trades do not count when determining the settlement
price.

European Options
European index options stop trading one day earlier, at the close of business on the Thursday preceding the third Friday of the expiration month.

It is not as easy to identify the settlement price for European-style options. In fact, the settlement price is not published until hours after the market
opens. The European settlement price is calculated as follows:

● On the third Friday of the month, the ​opening price​ for each stock in the index is determined. Individual stocks open at different times, with
some of these opening prices available at 9:30 a.m. ET while others are determined a few minutes later.
● The underlying index price is calculated as if all stocks were trading at their respective opening prices at the same time. This is not a
real-world price because you cannot look at the published index and assume the settlement price is close in value.

Cash Settlement
It's advantageous to all parties when options are settled in cash:

● No shares exchange hands.

● You don't have to worry about rebuilding a complex stock portfolio because you don't lose active positions if assigned an exercise notice on
calls you wrote, as in covered call writing or a collar strategy.
● The option owner receives the cash value and the option seller pays the cash value of the option. That cash value is equal to the
option's ​intrinsic value​. If the option is out of the money, it expires worthless and has zero cash value.

These cash-settled options are almost always European-style and assignment only occurs at expiration, thus the option's cash value is determined by
the settlement price.

Settlement Price
The settlement price is often a surprise with European-style options because, when the market opens for trading on the morning of the third Friday, a
significant ​price change​ may occur from the previous night's close. This doesn't happen all the time but it happens often enough to turn the
apparently low-risk strategy of holding the position overnight into a gamble.

Here's the scenario faced by European option traders Thursday afternoon on the day before expiration:

● If the option is almost worthless, holding on and hoping for a miracle is not a bad idea. Owners of low-priced options, worth a few nickels or
less, have earned hundreds or thousands of dollars when the market shifted higher or lower on Friday morning. However, these options
expire worthless most of the time.
● If you own an option that has a significant value, you have a decision to make. The settlement price could make the option worthless or
double its value. Do you want to roll the dice? It's a risk-based decision that individual investors need to make for themselves.

When short the option, you face a different challenge:

 ● When short an out-of-the-money option, covering is a wise move. With American-style options, you see the stock approaching the strike and
can spend a nickel or two to cover. But with European options, there are no warnings. Any out-of-the-money option can move 10 or 20 points
into the money, costing $1,000 to $2,000 per contract when forced to pay the settlement price. It's just not worth the risk.

What Is an Assign?
An assign in the short options and futures contract markets is the matching of counterparties by clearinghouses and brokerages. The process is
random. Once the assign is made, the underlying securities or commodities are delivered to the holders of maturing or exercised contracts.

KEY TAKEAWAYS

● An assign in the options market is a random matching of buyer and seller for maturing or exercised options contracts.
● The assigned party is required to deliver the assets underlying the options to the contract holder at the date established by the contract.
● More generally, an assign is a transfer of rights or property from one party to another.
● Broadly speaking, to assign is to transfer rights or property from one person or business to another. An assignment can be any transfer of any
sort of rights. In the financial markets, the term assign generally relates to the party who is required to deliver on an options contract. In the
wider business world, it may also refer to the transfer of a trademark, banknotes, and other property rights. Mortgage assignments involve
transferring mortgage deeds, while lease assigns transfer lease contracts.
● Understanding the Assign
● Not all contracts in options will be exercised or tendered. The ones that are exercised or tendered must be settled with the delivery of the
underlying security. These are randomly assigned to brokerages that, in turn, randomly select which of their clients will be assigned.
● During an assignment of options or futures contracts, the clearinghouse assigns an option writer who will be the required buyer or seller of
the underlying contract upon its exercise.
● The Assign Process
● Brokerages and clearinghouses are needed to connect buyers and sellers of options contracts.
● The seller and writer of a call option will sell a set number of shares at a set price if the option is exercised. If the option is called, the
brokerage assigns a client with a short position, again at random, to deliver the stock to another client with a long position in the same
contract. The brokerage will randomly select the counterparty who must deliver the asset when the contract requires it to be delivered.
● Assign and Options
● An assign generally refers to an option contract. Options offer the right but not the obligation to buy an underlying asset at a specific price. In
the U.S. markets, options can be exercised anytime, while options in the European markets are exercised only on the option expiration date.
If an option is exercised, the assignment will be made immediately.
● When an option is exercised, the option writer, who is the call seller in this case, must fulfill the obligations of the contract. In the example
above, the call writer would be obligated to sell a specific number of underlying securities for a specific price.
● Options buyers speculate on the future movements of stocks or other assets. Option buyers believe that the underlying asset will move one
way, while option sellers, who are called writers, are betting on a move in the opposite direction

What Does Exercise Mean?

Exercise means to put into effect the right to buy or sell the underlying financial instrument specified in an ​options contract​. In options trading, the
holder of an option has the right, but not the obligation, to buy or sell the option's ​underlying security​ at a specified price on or before a specified date
in the future.

If the owner of an option decides to buy or sell the underlying instrument—instead of allowing the contract to expire, worthless or closing out the
position—they will be "exercising the option," or making use of the right, or privilege that is available in the contract.

The decision to ​exercise an option​ isn't always a clear-cut one. There are several factors that need to be considered before making the decision;
however, more often than not, it's safer to hold or sell the option instead.

Exercising Put and Call Options

An options holder may exercise his or her right to buy or sell the contract's underlying shares at a specified price—also called the ​strike price​.

● Exercising a ​put option​ allows you to ​sell ​the underlying security at a stated price within a specific timeframe.
● Exercising a ​call option​ allows you to ​buy ​the underlying security at a stated price within a specific timeframe.

To exercise an option, you simply advise your broker that you wish to exercise the option in your contract. Your broker will initiate an ​exercise notice​,
which informs the seller, or ​writer​ of the contract that you are exercising the option. The notice is forwarded to the option seller via the ​Options
Clearing Corporation​. The seller is obligated to fulfill the terms of an options contract if the holder exercises the contract.
KEY TAKEAWAYS

● In options trading, "to exercise" means to put into effect the right to buy or sell the underlying security that is specified in the options
contract.
● If the holder of a ​put ​option ​exercises t​ he contract, then he will ​sell ​the underlying security at a stated price within a specific timeframe.
● If the holder of a ​call ​option ​exercises ​the contract, then she will ​buy ​the underlying security at a stated price within a specific timeframe.
● Before exercising an option, it is important to consider what type of option you have and whether you can exercise it.

Unexercised Options
The majority of options contracts are not exercised but, instead, are allowed to expire, worthless, or are closed by opposing positions. For example,
the holder of an option can close out a ​long​ call or put prior to expiration by selling it, assuming the contract has market value. If an option expires
unexercised, the holder no longer has any of the rights granted in the contract. In addition, the holder loses the premium he or she paid for the
option, along with any commissions and fees related to its purchase.

Things to Consider When Exercising an Option

● What kind of option do you have?​ This is very important, as contracts have different guidelines. American-style contracts allow you to
exercise them before their expiration date. European options may be exercised only after the contract has expired.
● Can you exercise your options?​ In some cases, such as ​employee stock ownership plans (ESOPs)​, your shares may be ​vested​, meaning that
you will need to wait a set amount of time before you exercise the option.
● Will the cost outweigh the benefits?​ Exercising a contract costs you commission money, so make sure that the ​exercise price​ will make you
money; otherwise, you'll end up paying more in fees and you will lose out on any potential profit.
● Are there taxes involved?​ You will want to consider any tax implications associated with the type of contract you are exercising because, for
example, an employee cashing out an ESOP will have to pay additional tax.

What Is Maturity?
Maturity is the date on which the life of a transaction or ​financial instrument​ ends, after which it must either be renewed, or it will cease to exist. The
term is commonly used for deposits, foreign exchange spot, and forward transactions, interest rate and commodity swaps, options, loans and ​fixed
income​ instruments such as bonds. They are sometimes altered by bonus rates as part of ​promotions​.

KEY TAKEAWAYS

● Maturity is the agreed-upon date in which the investment ends, often triggering the repayment of a loan or bond, the payment of a
commodity or cash payment, or some other payment or settlement term.
● It's a term that is most commonly used in relation to bonds but is also used for deposits, currencies, interest rate and commodity swaps,
options, loans, and other transactions.
● The maturity date for loans and other debt can change repeatedly throughout the lifetime of a loan, should a borrower renew the loan,
default, incur higher interest fees, or pay off the total debt early.

Understanding Maturity
Some financial instruments, such as deposits and loans, require repayment of principal and interest at maturity; others, such as ​foreign
exchange​ transactions, provide for the delivery of a commodity. Still others, such as ​interest rate swaps​, consist of a series of cash flows with the final
one occurring at maturity.

Maturity of a Deposit
The maturity of a ​deposit​ is the date on which the principal is returned to the investor. Interest is sometimes paid periodically during the lifetime of
the deposit, or at maturity. Many interbank deposits are overnight, including most euro deposits, and a maturity of more than 12 months is rare.

Bond
At the maturity of a fixed-income investment such as a bond, the borrower is required to repay the full amount of the outstanding principal plus any
applicable interest to the lender. Nonpayment at maturity may constitute default, which would negatively affect the issuer's ​credit rating​. The
maturity of an investment is a primary consideration for the investor since it has to match his ​investment horizon​. For example, a person who is saving
money for the down payment on a home that he intends to purchase within a year would be ill-advised to invest in a five-year term deposit and
should instead consider a money-market fund or a one-year term deposit.

Derivatives
The term maturity can also be used concerning ​derivative​ instruments such as options and ​warrants​, but it's important to distinguish maturity from
the expiration date. For an option, the expiration date is the last date on which an American-style option can be exercised, and the only date that a
European-style option can be exercised; the maturity date is the date on which the underlying transaction settles if the option is exercised. The
maturity or expiration date of a stock warrant is the last date that it can be exercised to purchase the underlying stock at the strike price.

The maturity on an interest rate swap is the settlement date of the final set of cash flows.
Foreign Exchange
The maturity date of a spot foreign exchange transaction is two business days, with the exception of U.S. dollar vs. Canadian dollar transactions, which
settle on the next business day. On that date, company A pays currency A to company B and receives currency B in return.

The maturity date on a foreign exchange forward or swap is the date on which the final exchange of currencies takes place; it can be anything longer
than spot

What Is an Expiration Date? (Derivatives)

An expiration date in derivatives is the last day that derivative contracts, such as ​options​ or ​futures​, are valid. On or before this day, investors will have
already decided what to do with their expiring position.

Before an option expires, its owners can choose to ​exercise​ the option, close the position to realize their profit or loss, or let the contract expire
worthless.

KEY TAKEAWAYS

● Expiration date for derivatives is the final date on which the derivative is valid. After that time, the contract has expired.
● Depending on the type of derivative, the expiration date can result in different outcomes.
● Options owners can choose to exercise the option (and realize profits or losses) or let it expire worthless.
● Futures contract owners can choose to roll over the contract to a future date or close their position and take delivery of the asset or
commodity.

Basics of Expiration Dates

Expiration dates, and what they represent, vary based on the derivative being traded. The expiration date for listed stock options in the United States
is normally the third Friday of the contract month or the month that the contract expires. On months that the Friday falls on a holiday, the expiration
date is on the Thursday immediately before the third Friday. Once an options or futures contract passes its expiration date, the contract is invalid. The
last day to trade equity options is the Friday prior to expiry.​1​​ Therefore, traders must decide what to do with their options by this last trading day.

Some options have an automatic exercise provision. These options are automatically exercised if they are ​in the money​ (ITM) at the time of expiry. If a
trader doesn't want the option to be exercised, they must close out or roll the position by the last trading day.

Index options also expire on the third Friday of the month, and this is also the last trading day for ​American style index options​. For ​European style
index options​, the last trading is typically the day before expiration.​1​​

Expiration and Option Value

In general, the longer a stock has to expiration, the more time it has to reach its strike price and thus the more ​time value​ it has.

There are two types of options, calls and puts. Calls give the holder the right, but not the obligation, to buy a stock if it reaches a certain strike price by
the expiration date. Puts give the holder the right, but not the obligation, to sell a stock if it reaches a certain strike price by the expiration date.

This is why the expiration date is so important to options traders. The concept of time is at the heart of what gives options their value. After the put or
call expires, time value does not exist. In other words, once the derivative expires the investor does not retain any rights that go along with owning the
call or put.

The expiration time of an options contract is the date and time when it is rendered null and void. It is more specific than the expiration date and
should not be confused with the last time to trade that option.

Expiration and Futures Value

Futures are different than options in that even an out of the money futures contract (losing position) holds value after expiry. For example, an oil
contract represents barrels of oil. If a trader holds that contract until expiry, it is because they either want to buy (they bought the contract) or sell
(they sold the contract) the oil that the contract represents. Therefore, the futures contract does not expire worthless, and the parties involved are
liable to each other to fulfill their end of the contract. Those that don't want to be liable to fulfill the contract must roll or close their positions on or
before the last trading day.

Futures traders holding the expiring contract must close it on or before expiration, often called the "final trading day," to realize their profit or loss.
Alternatively, they can hold the contract and ask their broker to buy/sell the underlying asset that the contract represents. Retail traders don't
typically do this, but businesses do. For example, an oil producer using futures contracts to sell oil can choose to sell their tanker. Futures traders can
also "​roll​" their position. This is a closing of their current trade, and an immediate reinstitution of the trade in a contract that is further out from
expiry.
A ​credit derivative​ is a loan sold to a speculator at a discount to its true value. Though the original lender is selling the loan at a reduced price, and will
therefore see a lower return, in selling the loan the lender will regain most of the capital from the loan and can then use that money to issue a new
and (ideally) more profitable loan. If, for example, a lender issued a loan and subsequently had the opportunity to engage in another loan with more
profitable terms, the lender might choose to sell the original loan to a speculator in order to finance the more profitable loan. In this way, credit
derivatives exchange modest returns for lower risk and greater liquidity.

Another kind of derivative is a ​mortgage-backed security​, which is a broad category defined by the fact that the assets underlying the derivative
are ​mortgages​.

Limitations of Derivatives
As mentioned above, derivative is a broad category of security, so using derivatives in making financial decisions varies by the type of derivative in
question. Generally speaking, the key to making a sound investment is to fully understand the risks associated with the derivative, such as the
counterparty, underlying​ ​asset, price and ​expiration​. The use of a derivative only makes sense if the investor is fully aware of the risks and
understands the impact of the investment within a portfolio strategy.

What is 'Over-The-Counter - OTC'

Over-the-counter (OTC) is a security traded in some context other than on a formal exchange such as the ​New York Stock Exchange​ (NYSE), ​Toronto
Stock Exchange​ or the ​NYSE MKT​, formerly known as the American Stock Exchange (AMEX). The phrase "over-the-counter" can be used to refer to
stocks that trade via a ​dealer​ network as opposed to on a centralized exchange. It also refers to ​debt securities​ and other ​financial instruments​, such
as ​derivatives​, which are traded through a dealer network.

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BREAKING DOWN 'Over-The-Counter - OTC'

For many investors, there is little practical difference between OTC and major exchanges. Improvements in electronic quotation and trading have
facilitated higher liquidity and better information. However, there are key differences between the transaction mediums. On an exchange, every party
is exposed to offers by every other counterparty, which may not be the case in dealer networks. There is less transparency and less stringent
regulation on these exchange," so unsophisticated investors take on additional risk and could be subject to adverse conditions.

[OTC stocks can also be very volatile. Learn how to use proper risk management techniques when you trade by taking our ​Day Trading course​ on
the ​Investopedia Academy​]

Popular OTC Networks

The OTC Markets Group operates some of the most well-known networks, such as the ​OTCQX​ Best Market, the ​OTCQB​ Venture Market and the Pink
Open Market. These markets include unlisted stocks that are known to trade on the ​Over the Counter Bulletin Board​ (OTCBB) or on the ​pink sheets​.
Although ​Nasdaq​ operates as a dealer network, Nasdaq stocks are generally not classified as OTC because the Nasdaq is considered a stock exchange.
Conversely, OTCBB stocks are often either penny stocks or are offered by companies with bad credit records.

The OTCQX Best Market includes securities of companies that have the largest market caps and greater liquidity than the other markets. The OTCBB
trades stocks that are small and developing, and that report to regulators. Pink sheets stocks come in a wide variety.

Securities on OTC Networks

Stocks are usually traded OTC because the company is small and cannot meet exchange listing requirements. Also known as unlisted stock, these
securities are traded by broker-dealers who negotiate directly with one another over computer networks and by phone. The dealers act as market
makers, and the OTC Bulletin Board is an inter-dealer quotation system that provides trading information.

Some well-known large companies are listed on the OTC markets. For instance, the OTCQX trades Allianz, BASF, Roche and Danone.

American depository receipts​, which represent shares in an equity that is traded on a foreign exchange, are often traded OTC, because the underlying
company does not wish to meet the stringent exchange requirements. Instruments such as bonds do not trade on a formal exchange and are also
considered OTC securities.

Most debt instruments are traded by investment banks making markets for specific issues. An investor must call the bank that makes the market in
that bond and asks for quotes to buy or sell a bond.

Financial Regulators: Who They Are and What They Do

Federal and state governments have a myriad of agencies in place that regulate and oversee ​financial markets​ and companies. These agencies each
have a specific range of duties and responsibilities that enable them to act independently of each other while they work to accomplish similar
objectives. Although opinions vary on the efficiency, effectiveness and even the need for some of these agencies, they were each designed with
specific goals and will most likely be around for some time. With that in mind, the following article is a complete review of each regulatory body.

Federal Reserve Board

The ​Federal Reserve Board​ (FRB) is one of the most recognized of all the regulatory bodies. As such, the "Fed" often gets blamed for economic
downfalls or heralded for stimulating the economy. It is responsible for influencing money, ​liquidity​ and overall credit conditions. Its main tool for
implementing ​monetary policy​ is its ​open market operations​, which control the purchase and sale of ​U.S. Treasury​ securities and federal ​agency
securities​. Purchases and sales can change the quantity of reserves or influence the ​federal funds rate​ - the interest rate at which depository
institutions lend balances to other depository institutions overnight. The Board also supervises and regulates the banking system to provide overall
stability to the financial system. The ​Federal Open Market Committee (FOMC)​ determines the actions of the Fed. (To learn more, see our tutorial on
the ​Federal Reserve.​ )

Federal Deposit Insurance Corporation

The ​Federal Deposit Insurance Corporation​ (FDIC) was created by the ​Glass-Steagall Act of 1933​ to provide insurance on deposits to guarantee the
safety of checking and savings deposits at banks. Its mandate is to protect up to $250,000 per depositor. The ​catalyst​ for creating the FDIC was the run
on banks during the ​Great Depression​ of the 1920s. (For background reading, see ​The History Of The FDIC​.)

Office of the Comptroller of the Currency

One of the oldest federal agencies, the ​Office of the Comptroller of the Currency (OCC)​ was established in 1863 by the National Currency Act. Its main
purpose is to supervise, regulate and provide charters to banks operating in the U.S. to ensure the soundness of the overall banking system. This
supervision enables banks to compete and provide efficient banking and ​financial services​.

Office of Thrift Supervision

The ​Office of Thrift Supervision​ (OTS) was established in 1989 by the Department of Treasury through the Financial Institutions Reform, Recovery and
Enforcement Act of 1989. It is funded solely by the institutions it regulates. The OTS is similar to the OCC except that it regulates federal savings
associations, also known as thrifts or savings and loans.

Commodity Futures Trading Commission

The ​Commodity Futures Trading Commission​ (CFTC) was created in 1974 as an independent authority to regulate
commodity ​futures​ and ​options​ markets and to provide for competitive and efficient market trading. It also seeks to protect participants from market
manipulation, investigates abusive trading practices and fraud, and maintains fluid processes for clearing. The CFTC has evolved since 1974 and in
2000, the Commodity Futures Modernization Act of 2000 was passed. This changed the landscape of the agency by creating a joint process with
the ​Securities and Exchange Commission (SEC)​ to regulate single-stock futures. (Read ​Futures Fundamentals​ for a basic explanation of how the futures
market works.)

Financial Industry Regulatory Authority

The ​Financial Industry Regulatory Authority​ (FINRA) was created in 2007 from its predecessor, the ​National Association of Securities Dealers (NASD)​.
FINRA is considered a self-regulatory organization (SRO) and was originally created as an outcome of the ​Securities Exchange Act of 1934​. FINRA
oversees all firms that are in the securities business with the public. It is also responsible for training financial services professionals, licensing and
testing agents, and overseeing the mediation and arbitration processes for disputes between customers and brokers. (For more insight, see ​Who's
Looking Out For Investors?)​

State Bank Regulators

State bank regulators operate similarly to the OCC, but at the state level for state-chartered banks. Their oversight works in conjunction with the
Federal Reserve and the FDIC.

State Insurance Regulators

State regulators monitor, review and oversee how the insurance industry conducts business in their states. Their duties include protecting consumers,
conducting criminal investigations and enforcing legal actions. They also provide licensing and authority certificates, which require applicants to
submit details of their operations. (For a directory of specific state agencies visit ​www.insuranceusa.com​.)

State Securities Regulators

These agencies augment FINRA and the SEC for matters associated with regulation in the state's securities business. They provide registrations
for ​investment advisors​ who are not required to register with the SEC and enforce legal actions with those advisors.

Securities and Exchange Commission

The SEC acts independently of the U.S. government and was established by the Securities Exchange Act of 1934. One of the most comprehensive and
powerful agencies, the SEC enforces the federal securities laws and regulates the majority of the securities industry. Its regulatory coverage includes
the U.S. ​stock exchanges​, options markets and options exchanges as well as all other electronic exchanges and other electronic securities markets. It
also regulates investment advisors who are not covered by the state regulatory agencies. (To learn more, read ​The Treasury And The Federal
Reserve,​ ​Policing The Securities Market: An Overview Of The SEC​ and ​Are Your Bank Deposits Insured?)​
Conclusion
All of these government agencies seek to regulate and protect those who participate in the respective industries they govern. Their areas of coverage
often overlap; but while their policies may vary, federal agencies usually supersede state agencies. However, this does not mean that state agencies
wield less power, as their responsibilities and authorities are far-reaching.

Understanding the regulation of the banking, securities and insurance industry can be confusing. While most people will never deal directly with these
agencies, they will affect their lives at some time. This is especially true of the Federal Reserve, which has a strong hand in influencing liquidity,
interest rates and ​credit markets​.

What is 'Anti Money Laundering - AML'

Anti money laundering (AML) refers to a set of procedures, laws and regulations designed to stop the practice of generating income through illegal
actions. Though anti-money-laundering laws cover a relatively limited number of transactions and criminal behaviors, their implications are
far-reaching. For example, AML regulations require institutions issuing credit or allowing customers to open accounts to complete due-diligence
procedures to ensure they are not aiding in ​money-laundering​ activities. The onus to perform these procedures is on the institutions, not on the
criminals or the government.

BREAKING DOWN 'Anti Money Laundering - AML'

Anti-money-laundering laws and regulations target activities that include market manipulation, trade of illegal goods, corruption of public funds
and ​tax evasion​, as well as the activities that aim to conceal these deeds.

Money that's obtained illegally through actions such as drug trafficking needs to be cleaned. To do so, the money launder runs it through a series of
steps to make it appear like it was earned legally. Once there's a record to show how the money was earned, the criminals hope it will not arouse
suspicion.

One of the most common ways to launder money is to run it through a legitimate cash-based business owned by the criminal organization. Money
launderers may also sneak cash into foreign countries for deposit, deposit it in smaller increments or buy other cash instruments. Launderers often
want to invest, and brokers will occasionally break rules to earn larger commissions.

It's up to financial institutions that issue credit or allow customers to open accounts to investigate customers to ensure they are not taking part in a
money-laundering scheme. They must verify where large sums of money originated, monitor suspicious activities and report cash transactions
exceeding $10,000. In addition to complying with AML laws, financial institutions are expected to make sure clients are aware of these laws and guide
people with them without prior active government orders.

AML rules and regulations rose to global recognition when the ​Financial Action Task Force (FATF)​ was formed in 1989, setting international standards
for fighting money laundering. The aim of enforcement groups like the FATF is to maintain and promote the ethical and economic advantages of a
legally credible and stable financial market.

Since money is a limited resource, money accumulated illegally and with no regulation prevents capital from flowing into socioeconomically
productive industries. The imbalance in ​money flow​ also inevitably leads to further printing of money, harming the ​purchasing power​ of a country's
currency. If not controlled, this inflation can cripple and erode an economy.

How Anti-Money-Laundering Action Helps Reduce Overall Crime

Money-laundering investigations center on parsing financial records for inconsistencies or suspicious activity, and these financial records often tie
perpetrators to criminal activity. In today's regulatory environment, extensive records are kept on just about every significant financial transaction.
Therefore, when trying to uncover the identity of a criminal, few methods are more effective than locating records of financial transactions in which
he or she was involved.
Terrorists, organized criminals and drug smugglers rely extensively on money laundering to maintain cash flow for their illegal activities. Taking away a
criminal's ability to launder money hampers the criminal operation by shutting off cash flow. Therefore, fighting money laundering is a highly effective
way to reduce overall crime.

In cases of robbery, ​embezzlement​ or larceny, the funds or property uncovered during money-laundering investigations frequently are able to be
returned to the victims of the crime. For example, when money that was laundered to cover up embezzlement is discovered, it can usually be traced
back to the source of the embezzlement. While this does not nullify the original crime, it can put the money in question back in the proper hands and
part it from the perpetrator.

Anti-Money-Laundering Enforcement Groups

The ​Financial Action Task Force​ sets the international standard for combating money laundering. Formed in 1989 by leaders of countries and
organizations around the world, the FATF is an international body of governments that sets standards for stopping money laundering and promotes
the implementation of these standards. Because laundering money is one way in which terrorists finance their activities, money laundering and
terrorism go hand in hand. The FATF is, therefore, also dedicated to the setting and implementation of standards for fighting terrorist financing and
other threats to the international financial system.

The FATF developed a series of recommendations that were adopted in February 2012 to give its 35 member countries and two regional organizations
a comprehensive set of measures to implement in the fight against money laundering, terrorist financing and financing of the proliferation of weapons
of mass destruction. The FATF promotes the implementation of these measures, but the leaders of each member country carry out the measures on a
national level. Each country must adapt the measures to make them appropriate for its own circumstances. To assist members in implementing the
recommended anti-money-laundering measures, the FATF provides them with guidance and best practices.

In 2000, the FATF began using a name-and-shame system that publicly announced countries that failed to produce and enforce comprehensive AML
laws and had minimal to zero participation in the international crusade against illegal moneymaking activities.

Another international group that participates in combating money laundering is the ​International Monetary Fund (IMF)​. With 189 member countries,
the IMF has been expanding its anti-money-laundering efforts since 2000.

The events of September 11, 2001 led to an intensification of the IMF's work in this area and spurred the broadening of its goals to include fighting the
financing of terrorism. Shortly thereafter, the IMF began assessing the compliance of its member countries with the international standard for
combating terrorist financing.

The IMF pays special attention to the effects of money laundering and terrorist financing on the economies of its member countries. The IMF points
out that people who launder money and finance terrorism target countries with weak legal and institutional structures and use the weaknesses to
their advantage in order to move funds. Ways in which the IMF helps its members stop money laundering and terrorist financing include serving as an
international forum for the exchange of information and helping countries develop common solutions to these problems and effective policies to
guard against them.

In addition, the IMF contributes to the evaluation of each country's compliance with anti-money-laundering measures and to the identification of
areas where improvements are needed. The IMF focuses its work on assessing the strengths and weaknesses of each member's financial sector in
complying with the FATF recommendations, providing members with the technical assistance needed to strengthen their legal and financial
institutions, and offering advice to members in the process of developing policies directed toward compliance with FATF measures.

What is a 'Compliance Department'

The compliance department within a brokerage firm, bank or ​financial institution​ is designed to ensure compliance with all applicable laws, rules and
regulations. Depending on the business of the financial institution, these duties may range from monitoring trading activity, preventing conflicts of
interest and ensuring compliance with regulations at brokerage firms to preventing ​money laundering​ and potential ​tax evasion​ at large banks.

BREAKING DOWN 'Compliance Department'

As a firm's internal police force, the compliance department is unlikely to be the most popular unit in a firm. However, a competent compliance
department is of the utmost importance in maintaining a firm's integrity and reputation.

Compliance demands for most financial firms increased regulatory oversight significantly in the wake of the 2008 ​credit crisis​. This has led to increased
demand for experienced compliance staff.

Although compliance costs have spiraled higher in recent years, the costs of non-compliance - even if inadvertent - can be far greater for a financial
institution. Non-compliance may lead to stiff monetary fines, legal and regulatory sanctions, and loss of reputation.

Compliance Department Members

The compliance department generally has a wide range of roles and responsibilities within a firm. Compliance, in one way or another, must also be
upheld by almost every employee within the firm. Each office has a manager who is responsible for supervising the office. Larger offices may have a
compliance officer, whose sole job is to help maintain the branch’s compliance with both industry and firm regulations. Both the manager and
compliance officer are required to have a special license that enables them to act in a supervisory capacity. For example, in the brokerage industry,
this is the general securities sales supervisory license. These are also known as the Series 9 and 10 licenses.

Employees of the firm are required to maintain compliance in day-to-day activity, especially those that have regular client contact. In order to help
satisfy this, financial institutions have developed annual continuing education courses that cover the various compliance-based topics. Individuals who
are licensed must also uphold the continuing education requirements for their licenses as well.

Compliance Department Duties

The job of the compliance department is to be proactive within the company and prevent possible non-compliant actions before consequences occur.
Compliance has special software that may monitor all incoming and outgoing communications employees have with the public. Emails may be flagged
if certain key words or complaints are evident. Written correspondence is usually checked to make sure the proper disclosures are present and the
content is suitable. All written correspondence, mailed or faxed, is also photocopied and retained by the compliance department for future reference.

Compliance also has the duty to review transactions or activity in order to ensure there are no errors or evidence of wrongdoing. The banking
industry, for example, has implemented several safe guards to automatically flag suspicious activity which could be caused by fraud or money
laundering. These potential issues are forwarded to the compliance department for immediate review.

What is a 'Corporate Action'

A corporate action is any activity that brings material change to an organization and impacts its stakeholders, including shareholders, both common
and preferred, as well as bondholders. These events are generally approved by the company's ​board of directors​; shareholders may be permitted to
vote on some events as well. Some corporate actions require shareholders to submit a response.

BREAKING DOWN 'Corporate Action'

When a ​publicly traded company​ issues a corporate action, it is initiating a process that directly affects the securities issued by that company.
Corporate actions can range from pressing financial matters, such as bankruptcy or liquidation, to a firm changing its name or trading symbol, in which
case the firm must often update its ​CUSIP​ number, which is the identification number given to securities. Dividends, stock splits, mergers, acquisitions
and spinoffs are all common examples of corporate actions.

What is a 'Spinoff'
A spinoff is the creation of an independent company through the sale or distribution of new shares of an existing business or division of a parent
company. A spinoff is a type of ​divestiture​. The spun-off companies are expected to be worth more as independent entities than as parts of a larger
business.

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What is a 'Stock Split'

A stock split is a corporate action in which a company divides its existing shares into multiple shares to boost the liquidity of the shares. Although the
number of shares outstanding increases by a specific multiple, the total dollar value of the shares remains the same compared to pre-split amounts,
because the split does not add any real value. The most common split ratios are 2-for-1 or 3-for-1, which means that the stockholder will have two or
three shares, respectively, for every share held earlier.

A stock split is also known as a forward stock split. In the UK, a stock split is referred to as a scrip issue, bonus issue, capitalization issue, or free issue.

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Corporate actions can be either mandatory or voluntary. Mandatory corporate actions are automatically applied to the investments involved while
voluntary corporate actions require an investor's response to be applied. Stock splits, acquisitions and company name changes are examples of
mandatory corporate actions; ​tender offers​, optional dividends and ​rights issues​ are examples of voluntary corporate actions.

Corporate actions that must be approved by shareholders will typically be listed on a firm's ​proxy statement​, which is filed in advance of a public
company's annual meeting. Corporate actions can also be revealed in ​8-K filings​ for material events.

Common Corporate Actions

A ​cash dividend​ is a common corporate action that alters a company's stock price. A cash dividend is subject to approval by a company's board of
directors, and it is a distribution of a company's earnings to a specified class of its shareholders. For example, assume company ABC's board of
directors approves a $2 cash dividend. On the ​ex-dividend date​, company ABC's stock price would reflect the corporate action and would be $2 less
than its previous closing price.

A ​stock split​ is another common corporate action that alters a company's existing shares. In a stock split, the number of outstanding shares is
increased by a specified multiple, while the share price is decreased by the same factor as the multiple. For example, in June 2015, Netflix Inc.
announced its decision to undergo a seven-for-one stock split. Therefore, Netflix's share price decreased by a factor of seven, while its shares
outstanding increased by a factor of seven. On July 15, 2015, Netflix closed at $702.60 per share and had an adjusted closing price of $100.37.
Although Netflix's stock price changed substantially, the split did not affect its market capitalization.

Mergers and acquisitions (​M&A​) are a third type of corporate action that bring about material changes to companies. In a merger, two or more
companies synergize to form a new company. The existing shareholders of merging companies maintain a shared interest in the new company.
Contrary to a merger, an acquisition involves a transaction in which one company, the acquirer, takes over another company, the target company. In
an acquisition, the target company ceases to exist, but the acquirer assumes the target company's business, and the acquirer's stock continues to be
traded.

What Are Corporate Actions?

The Stock Split
A stock split, sometimes called a bonus share, divides the value of each of the ​outstanding shares​ of a company. A two-for-one stock split is most
common. An investor who holds one share will automatically own two shares, each worth exactly half the price of the original share.

So, the company has just cut its own stock price in half. Inevitably, the market will adjust the price upwards the day the split is implemented.

The effects: Current shareholders are rewarded, and potential buyers are more interested.
Notably, there are twice as many common stock shares out there than there were before the split. Nevertheless, a stock split is a non-event, because
it does not affect a company's ​equity​ or its ​market capitalization​. Only the number of shares outstanding changes.

Stock splits are gratifying to shareholders, both immediately and in the longer term. Even after that initial pop, they often drive the price of the stock
higher. Cautious investors may worry that repeated stock splits will result in too many shares being created.

The Reverse Split

A ​reverse split​ would be implemented by a company that wants to force up the price of its shares.

For example, a shareholder who owns 10 shares of stock valued at $1 each will have only one share after a reverse split of 10 for one, but that one
share will be valued at $10.

A reverse split can be a sign that the company's stock has sunk so low that its executives want to shore up the price, or at least make it appear that the
stock is stronger. The company may even need to avoid getting categorized as a ​penny stock​.

In other cases, a company may be using a reverse split to drive out small investors.

Dividends

Dividends​ are the ​cash flows​ of stocks. They are discretionary, meaning that companies are not obligated to pay out dividends to investors. When
paid, they are non-tax deductible, and often paid out quarterly. ​Preferred stock​ owners are entitled to dividends before common stock owners,
although holders of both stocks can only receive dividends after all creditors of the company have been satisfied.

Learn more in CFI’s finance tutorials online​.

A company can issue ​dividends​ in either cash or stock. Typically, they are paid out at specific periods, usually quarterly or annually. Essentially, these
are a share of the company profits that are being paid to owners of the stock.

Dividend payments affect the equity of a company. The distributable equity (​retained earnings​ and/or ​paid-in capital​) is reduced.

A ​cash dividend​ is straightforward. Each shareholder is paid a certain amount of money for each share. If an investor owns 100 shares and the cash
dividend is $0.50 per share, the owner will be paid $50.

A ​stock dividend​ also comes from distributable equity but in the form of stock instead of cash. If the stock dividend is 10%, for example, the
shareholder will receive one additional share for every 10 owned.

If the company has a million shares outstanding, the stock dividend would increase its outstanding shares to a total of 1.1 million. Notably, the
increase in shares dilutes the ​earnings per share​, so the stock price would decrease.

The distribution of a cash dividend signals to an investor that the company has substantial retained earnings from which shareholders can directly
benefit. By using its retained capital or paid-in ​capital account​, a company is indicating that it expects to have little trouble replacing those funds in the
future.

However, when a ​growth stock​ starts to issue dividends, many investors conclude that a company that was rapidly growing is settling down for a
stable but unspectacular rate of growth.

Rights Issues
A company implementing a rights issue is offering additional or new shares only to current shareholders. The existing shareholders are given the right
to purchase or receive these shares before they are offered to the public.

A rights issue regularly takes place in the form of a stock split, and in any case can indicate that existing shareholders are being offered a chance to
take advantage of a promising new development.

Mergers and Acquisitions

A ​merger​ occurs when two or more companies combine into one with all parties involved agreeing to the terms. Usually, one company surrenders its
stock to the other.

When a company undertakes a merger, shareholders may welcome it as an expansion. On the other hand, they could conclude that the industry is
shrinking, forcing the company to gobble up the competition to keep growing.
In an ​acquisition​, a company buys a majority stake of a ​target company's​ shares. The shares are not swapped or merged. Acquisitions can be friendly
or ​hostile​.

A reverse merger is also possible. In this scenario, a ​private company​ acquires a public company, usually one that is not thriving. The private company
has just transformed itself into a publicly-traded company without going through the tedious process of an ​initial public offering​. It may change its
name and issue new shares.

The Spin-Off
A ​spin-off​ occurs when an existing public company sells a part of its assets or distributes new shares in order to create a new independent company.

Often the new shares will be offered through a rights issue to existing shareholders before they are offered to new investors. A spin-off could indicate
a company ready to take on a new challenge or one that is refocusing the activities of the main business.

What is the 'CUSIP Number'?

The CUSIP number is a unique identification number assigned to all stocks and registered bonds in the United States and Canada, and it is used to
create a concrete distinction between securities that are traded on public markets. The ​Committee on Uniform Securities Identification Procedures
(CUSIP) oversees the entire CUSIP system. ​Foreign securities​ have a similar number called the CINS number.

BREAKING DOWN 'CUSIP Number'

While assigned stock symbols are also unique, a CUSIP number is designed for use by most computerized trading record-keeping systems.

The CUSIP System

The CUSIP system is owned by the ​American Bankers Association​ in conjunction with ​Standard & Poors​. The system is in place to facilitate the
settlement process and the clearance of associated securities. The CUSIP is composed of nine characters and can be composed of letters and numbers.
It is assigned to all stocks and registered bonds that are sold or traded within the United States and Canada. A CUSIP number is similar to a serial
number. The first six characters are known as the base, or CUSIP-6, and identify the bond issuer. The seventh and eighth digits identify the bond
maturity and the ninth digit is a “check digit” that is automatically generated.

These numbers are used to help facilitate trades and settlements by providing a constant identifier to help distinguish the securities within a trade.
Each trade and the corresponding CUSIP number is recorded to facilitate the tracking of actions and activities.

Locating a CUSIP Number

CUSIP numbers are publicly available and can be accessed through the ​Municipal Securities Rulemaking Board​ (MSRB) via the Electronic Municipal
Market Access (EMMA) system. Additionally, the information is often listed on official statements relating to security such as confirmations of
purchase or periodic ​financial statements​, or the information can be accessed through various securities dealers.

ISIN Numbers
Expanding beyond the CUSIP system is the ​International Securities Identification Number​ (ISIN) system. ISINs are used internationally with most
United States and Canadian securities labeled with an additional two character prefix and one final check character attached at the end of the
originally issued CUSIP.

Additionally, information regarding the currency of the specified security is also required to facilitate proper processing and recording. This has helped
establish an international system for the clearance of securities. While it is not yet used worldwide, the ISIN system has gained traction across foreign
markets as a way to simplify trading processes, particularly for international investing.

What is the 'Securities And Exchange Commission - SEC'

The U.S. Securities and Exchange Commission (SEC) is an independent federal government agency responsible for protecting investors, maintaining
fair and orderly functioning of ​securities​ markets and facilitating capital formation. It was created by Congress in 1934 as the first federal regulator of
securities markets. The SEC promotes full public disclosure, protects investors against fraudulent and manipulative practices in the market, and
monitors corporate takeover actions in the United States.

Generally, ​issues​ of securities offered in interstate commerce, through the mail or on the Internet, must be registered with the SEC before they can be
sold to investors. Financial services firms, such as broker-dealers, advisory firms and asset managers, as well as their professional representatives,
must also register with the SEC to conduct business.

Mutual Funds
What is a 'Mutual Fund'
A mutual fund is an ​investment vehicle​ made up of a pool of moneys collected from many investors for the purpose of ​investing​ in ​securities​ such
as ​stocks​, ​bonds​, ​money market​ instruments and other ​assets​. Mutual funds are operated by professional ​money managers​, who allocate the fund's
investments and attempt to produce ​capital gains​ and/or​ income​ for the fund's ​investors​. A mutual fund's ​portfolio​ is structured and maintained to
match the ​investment objectives​ stated in its ​prospectus​.

How Mutual Fund Companies Work

Mutual funds are virtual companies that buy pools of stocks and/or bonds as recommended by an ​investment advisor​ and ​fund manager​. The fund
manager is hired by a ​board of directors​ and is legally obligated to work in the best interest of mutual fund shareholders. Most fund managers are also
owners of the fund, though some are not.

There are very few other employees in a mutual fund company. The investment advisor or fund manager may employ some ​analysts​ to help pick
investments or perform market research. A fund ​accountant​ is kept on staff to calculate the fund's net asset value (NAV), or the daily value of the
mutual fund that determines if share prices go up or down. Mutual funds need to have a ​compliance officer​ or two, and probably an attorney, to keep
up with government regulations.

Most mutual funds are part of a much larger ​investment company​ apparatus; the biggest have hundreds of separate mutual funds. Some of
these ​fund companies​ are names familiar to the general public, such as ​Fidelity Investments​, the ​Vanguard​ Group, ​T. Rowe Price​ and Oppenheimer
Funds.

A mutual fund is an investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such
as stocks, bonds, ​money market​ instruments and similar assets. Mutual funds are operated by money managers who invest the fund's capital and
attempt to produce capital gains and income for the fund's investors.

Mutual funds give small or individual investors access to professionally managed portfolios of ​equities​, bonds and other securities.
Each ​shareholder,​ therefore, participates proportionally in the ​gains​ or losses of the fund. Mutual funds invest in a wide amount of securities, and
performance is usually tracked as the change in the total ​market cap​ of the fund, derived by aggregating performance of the underlying investments.

Mutual fund units, or ​shares​, can typically be purchased or redeemed as needed at the fund's current ​net asset value (NAV)​ per share, which is
sometimes expressed as ​NAVPS​. A fund's NAV is derived by dividing the total value of the securities in the portfolio by the total amount of shares
outstanding.

From a structural perspective, mutual funds can typically be broken down into two types.

Open-Ended Funds​
These funds dominate the ​mutual fund​ marketplace, in terms of volume and assets under management. With open-ended funds, purchases and sales
of fund shares take place directly between investors and the fund company. There's no limit to the number of shares the fund can issue; as more
investors buy into the fund, more shares are issued. Federal regulations require a daily valuation process, called ​marking to market​, which
subsequently adjusts the fund's per-share price to reflect changes in portfolio (asset) value. The value of the individual's shares is not affected by the
number of shares outstanding.

Closed-End Funds​ (CEF)

These funds issue only a specific number of shares through an initial public offering and do not issue new shares as investor demand grows. Prices are
not determined by the ​net asset value​ (NAV) of the fund, but are driven by investor demand. Purchases of shares are often made at a premium or
discount to NAV.

Net Asset Value​ is a mutual fund's assets less its liabilities, divided by the number of shares outstanding.

How do you calculate net asset value?

It is a simple calculation - just take the current market value of the fund's net assets (securities held by the fund minus any liabilities) and divide by the
number of shares outstanding. Thus, if a fund has total net assets of $50 million and there are one million shares of the fund, then the NAV is $50 per
share.

Bond Funds​
Bond funds invest primarily in bonds and other debt instruments. The exact type of debt the fund invests in will depend on its focus, but investments
may include government, ​corporate​, municipal and convertible bonds, along with other debt securities like mortgage-backed securities. A bond fund's
purpose is to provide investors with a source of income that is generally less volatile than income derived from investments in the stock market.
SEE: ​Evaluating Bond Funds: Keeping It Simple​ and ​Bond Funds Boost Income, Reduce Risk

Balanced Funds
Balanced funds combine a stock component, a bond component and, sometimes, a money market component in a single portfolio. These funds
generally stick to a relatively fixed mix of stocks and bonds that reflects either a moderate (higher equity component) or conservative (higher
fixed-income component) orientation. A balanced fund's purpose is to provide a mixture of safety, income and modest capital appreciation.

SEE: ​In Praise Of Portfolio Simplicity

Equity Funds
Equity funds invest primarily in stocks. They are principally categorized according to the size of the companies in which they invest (large cap, small
cap, mid cap), the investment style of the holdings in the portfolio (growth, value, core) and geography (domestic, international).

Global/International Funds
International funds come in two varieties. The first is global funds, which invest in both foreign and domestic markets. The second is international
funds, which invest only in foreign markets. These can be broad market, regional or single-country funds. For investors who live in developed nations,
global and international funds generally offer both the opportunity for higher returns and the possibility of greater volatility.

Specialty Funds
Specialty stock funds invest in target business sectors such as healthcare, commodities and real estate. Because their focus is more concentrated than
other equity funds, they tend to offer both the opportunity for higher returns and the possibility of greater volatility.

Exchange-Traded Funds

An exchange-traded fund (ETF) is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an
exchange. ETFs experience price changes throughout the day as they are bought and sold. Because it trades like a stock, an ETF does not have its net
asset value (NAV) calculated every day like a mutual fund does. By owning an ETF, you get diversification as well as the ability to sell ​short​, buy
on ​margin​ and purchase as little as one share. Another advantage is that the ​expense ratios​ for most ETFs are lower than those of the average mutual
fund. When buying and selling ETFs, you have to pay the same commission to your broker that you'd pay on any regular order.

Index​
From an ​investment strategy​ standpoint, traditional ​exchange-traded funds​ (ETFs) are designed to track indexes. ETFs are available in hundreds of
varieties, tracking nearly every index you can imagine; they offer all of the benefits associated with index mutual funds, including low ​turnover​, low
cost and broad diversification, plus their ​expense ratios​ are significantly lower.

Commodity
Commodities​ are a separate asset class from stocks and bonds, so investing in ​commodity ETFs​ can provide extra diversification in a portfolio. Because
they are ​hard assets​, these ETFs can also provide protection against unexpected inflation.

Commodity ETFs​ can be divided in three types:

ETFs that track an individual commodity like gold, oil or soybeans,

ETFs that track a basket of different commodities and
ETFs that ​invest​ in a group of companies that produce a commodity.

Commodity ETFs either hold the actual commodity or purchase ​futures contracts​. ETFs that use futures contracts have uninvested cash that is used to
purchase interest-bearing government bonds. The interest on the bonds is used to cover the expenses of the ETF and to pay dividends to the holders.

Currency​
Currency ETFs​ are designed to track the movement of a currency in the exchange market. The underlying investments in a currency ​ETF​ will be either
foreign cash deposits or futures contracts. ETFs based on futures will invest the excess cash in high-quality bonds, typically U.S. ​Treasury bonds​. The
management fee is deducted from the interest earned on the bonds.
Several choices of currency ETFs are available in the marketplace. An investor can purchase ETFs that track individual currencies such as the Swiss
franc, the euro, the Japanese yen or a basket of currencies; however, currency ETFs should not be considered a long-term ​investment​. Investors who
are looking to diversify their U.S. dollar assets are generally better off investing in foreign stock or ​bond ETFs​; however, currency ETFs can help
investors to ​hedge​ their exposure to foreign currencies.

Leveraged
An exchange-traded fund (ETF) that uses financial derivatives and debt to amplify the returns of an underlying index. Leveraged ​ETFs​ are available for
most indexes, such as the Nasdaq-100 and the Dow Jones Industrial Average. These funds aim to keep a constant amount of leverage during the
investment time frame, such as a 2:1 or 3:1 ratio.

A leveraged ​ETF​ does not amplify the annual returns of an index, it follows the daily changes, instead. For example, let's examine a leveraged fund
with a 2:1 ratio. This means that each dollar of investor capital used is matched with an additional dollar of invested debt. If one day the underlying
index returns 1%, the fund will theoretically return 2%. The 2% return is theoretical, as management fees and transaction costs diminish the full
effects of leverage.

The 2:1 ratio works in the opposite direction as well. If the index drops 1%, your loss would then be 2%.

Inverse​
With the advent of inverse ETFs, investors can easily bet against the market. Inverse ETFs are designed to move in the opposite direction of their
benchmarks. For example, if the S&P 500 rises by 1%, the inverse S&P 500 ETF should drop by 1% and vice versa. There are also leveraged inverse
ETFs, which are designed to provide double the opposite performance of the underlying index, so, if the S&P 500 drops by 1%, a leveraged inverse S&P
500 ETF should increase by 2%.

An inverse ETF can either use short positions of the underlying stocks or futures. ETFs that use futures contracts can have the excess cash invested in
bonds, which covers the expenses of the ETF and can pay dividends to the owners.

There are a number of reasons to use inverse ETFs. For example, while speculators can easily make a bearish bet on the market, for investors who
have positions that they do not want to sell because of unrealized capital gains or illiquidity, this is not so easy. In this case, they can buy an inverse
ETF as a hedge.

In fact, many investors prefer to use inverse ETFs instead of selling short the index. Inverse ETFs can be purchased in tax-deferred accounts, but
shorting stocks is not allowed because in theory, it exposes the investor to unlimited losses. However, the most an investor in an inverse ETF can lose
is the entire value of the inverse ETF.

What is a 'Crypto currency'

A crypto currency is a digital or virtual currency that uses cryptography for security. A crypto currency is difficult to counterfeit because of this security
feature. A defining feature of a cryptocurrency, and arguably its most endearing allure, is its organic nature; it is not issued by any central authority,
rendering it theoretically immune to government interference or manipulation.

BREAKING DOWN 'Cryptocurrency'

The anonymous nature of cryptocurrency transactions makes them well-suited for a host of nefarious activities, such as ​money laundering​ and ​tax
evasion​.

The first cryptocurrency to capture the public imagination was ​Bitcoin​, which was launched in 2009 by an individual or group known under the
pseudonym Satoshi Nakamoto. As of September 2015, there were over 14.6 million bitcoins in circulation with a total market value of $3.4 billion.
Bitcoin's success has spawned a number of competing cryptocurrencies, such as ​Litecoin​, Namecoin and PPCoin, Etherum, Ripple, Dash

Cryptocurrency Benefits and Drawbacks

Cryptocurrencies make it easier to transfer funds between two parties in a transaction; these ​transfers​ are facilitated through the use of public and
private keys for security purposes. These fund transfers are done with minimal processing fees, allowing users to avoid the steep fees charged by most
banks and ​financial institutions​ for ​wire transfers​.

Central to the genius of Bitcoin is the ​block chain it uses to store an online ledger of all the transactions that have ever been conducted using
bitcoins, providing a data structure for this ledger that is exposed to a limited threat from hackers and can be copied across all computers running
Bitcoin software​. Many experts see this block chain as having important uses in technologies, such as online voting and crowdfunding, and major
financial institutions such as JP Morgan Chase see potential in cryptocurrencies to lower transaction costs by making payment processing more
efficient.
However, because cryptocurrencies are virtual and do not have a central repository, a digital cryptocurrency balance can be wiped out by a computer
crash if a backup copy of the ​holdings​ does not exist. Since prices are based on supply and demand, the rate at which a cryptocurrency can be
exchanged for another currency can fluctuate widely.

Cryptocurrencies are not immune to the threat of hacking. In Bitcoin's short history, the company has been subject to over 40 thefts, including a few
that exceeded $1 million in value. Still, many observers look at cryptocurrencies as hope that a currency can exist that preserves value, facilitates
exchange, is more transportable than hard metals, and is outside the influence of central banks and governments.

What is 'Bitcoin'
Bitcoin is a ​digital currency​ created in 2009. It follows the ideas set out in a ​white paper​ by the mysterious Satoshi Nakamoto, whose true identity has
yet to be verified. Bitcoin offers the promise of lower transaction fees than traditional online payment mechanisms and is operated by a decentralized
authority, unlike government-issued currencies.

There are no physical bitcoins, only balances kept on a public ledger in the cloud, that – along with all Bitcoin transactions – is verified by a massive
amount of computing power. Bitcoins are not issued or backed by any banks or governments, nor are individual bitcoins valuable as a commodity.
Despite its not being ​legal tender​, Bitcoin charts high on popularity, and has triggered the launch of other virtual currencies collectively referred to
as ​Altcoins​.

[ While Bitcoins are the key player in the cryptocurrency marketplace, as you'll read below, the whole ecosystem is much greater than this one coin. For
a detailed explanation of the world of cryptocurrency taught with graphic depictions and simplified example, check out I​ nvestopedia Academy's
Cryptocurrency for Beginners course​. ]

BREAKING DOWN 'Bitcoin'

Bitcoin is a type of ​cryptocurrency​: Balances are kept using public and private "keys," which are long strings of numbers and letters linked through the
mathematical ​encryption​ algorithm that was used to create them. The public key (comparable to a bank account number) serves as the address which
is published to the world and to which others may send bitcoins. The private key (comparable to an ATM PIN) is meant to be a guarded secret, and
only used to authorize Bitcoin transmissions.

Style notes: According to the official Bitcoin Foundation, the word "Bitcoin" is capitalized in the context of referring to the entity or concept, whereas
"bitcoin" is written in the lower case when referring to a quantity of the currency (e.g. "I traded 20 bitcoin") or the units themselves. The plural form
can be either "bitcoin" or "bitcoins."

How Bitcoin Works

Bitcoin is one of the first digital currencies to use ​peer-to-peer​ technology to facilitate instant payments. The independent individuals and companies
who own the governing computing power and participate in the Bitcoin network, also known as "​miners​," are motivated by rewards (the release of
new bitcoin) and transaction fees paid in bitcoin. These miners can be thought of as the decentralized authority enforcing the credibility of the Bitcoin
network. New bitcoin is being released to the miners at a fixed, but periodically declining rate, such that the total supply of bitcoins approaches 21
million. One bitcoin is divisible to eight decimal places (100 millionth of one bitcoin), and this smallest unit is referred to as a Satoshi. If necessary, and
if the participating miners accept the change, Bitcoin could eventually be made divisible to even more decimal places.

Bitcoin mining​ is the process through which bitcoins are released to come into circulation. Basically, it involves solving a computationally difficult
puzzle to discover a new ​block​, which is added to the ​blockchain​, and receiving a reward in the form of few bitcoins. The block reward was 50 new
bitcoins in 2009; it decreases every four years. As more and more bitcoins are created, the difficulty of the mining process – that is, the amount of
computing power involved – increases. The mining difficulty began at 1.0 with Bitcoin's debut back in 2009; at the end of the year, it was only 1.18. As
of April 2017, the mining difficulty is over 4.24 ​billion.​ Once, an ordinary desktop computer sufficed for the mining process; now, to combat the
difficulty level, miners must use faster hardware like Application-Specific Integrated Circuits (ASIC), more advanced processing units like Graphic
Processing Units (GPUs), etc.

What's a Bitcoin Worth?

In 2017 alone, the price of Bitcoin rose from a little under $1,000 at the beginning of the year to close to $19,000, ending the year more than 1,400%
higher.

(For more news and the real-time price of Bitcoin, check out the ​Investopedia Bitcoin Center​)

Bitcoin's price is also quite dependent on the size of its mining network, since the larger the network is, the more difficult – and thus more costly – it is
to produce new bitcoins. As a result, the price of bitcoin has to increase as its cost of production also rises. The Bitcoin mining network's aggregate
power has more than tripled over the past twelve months.

How Bitcoin Began

Aug. 18, 2008: ​The domain name bitcoin.org is ​registered​. Today, at least, this domain is "WhoisGuard Protected," meaning the identity of the person
who registered it is not public information.

Oct. 31, 2008:​ Someone using the name Satoshi Nakamoto makes an announcement on The Cryptography Mailing list at metzdowd.com: "I've been
working on a new electronic cash system that's fully peer-to-peer, with no trusted third party. The paper is available
at ​http://www.bitcoin.org/bitcoin.pdf​." This link leads to the now-famous white paper published on bitcoin.org entitled "Bitcoin: A Peer-to-Peer
Electronic Cash System." This paper would become the Magna Carta for how Bitcoin operates today.
Jan. 3, 2009:​ ​ The first Bitcoin block is mined, Block 0. This is also known as the "genesis block" and contains the text: "The Times 03/Jan/2009
Chancellor on brink of second bailout for banks," perhaps as proof that the block was mined on or after that date, and perhaps also as relevant
political commentary.

Jan. 8, 2009: ​The first version of the Bitcoin software is announced on The Cryptography Mailing list.

Jan. 9, 2009:​ ​ Block 1 is mined, and Bitcoin mining commences in earnest.

Who Invented Bitcoin?

No one knows. Not conclusively, at any rate. Satoshi Nakamoto is the name associated with the person or group of people who released the
original Bitcoin white paper in 2008 and worked on the original Bitcoin software that was released in 2009. The Bitcoin protocol requires users to
enter a birthday upon signup, and we know that an individual named Satoshi Nakamoto registered and put down April 5 as a birth date. And that's
about it.

Before Satoshi
Though it is tempting to believe the media's spin that Satoshi Nakamoto is a lone, quixotic genius who created Bitcoin out of thin air, such innovations
do not happen in a vacuum. All major scientific discoveries, no matter how original-seeming, were built on previously existing research. There are
precursors to Bitcoin: Adam Back’s Hashcash, invented in 1997, and subsequently Wei Dai’s b-money, Nick Szabo’s bit-gold and Hal Finney’s Reusable
Proof of Work. The Bitcoin white paper itself cites Hashcash and b-money, as well as various other works spanning several research fields.

Investing in Bitcoins
There are many Bitcoin supporters who believe that digital currency is the future. Those who endorse it are of the view that it facilitates a much
faster, no-fee payment system for transactions across the globe. Although it is not itself any backed by any government or central bank, bitcoin can be
exchanged for traditional currencies; in fact, its exchange rate against the dollar attracts potential investors and traders interested in currency plays.
Indeed, one of the primary reasons for the growth of digital currencies like Bitcoin is that they can act as an alternative to national fiat money and
traditional ​commodities​ like gold.

In March 2014, the ​IRS​ stated that all virtual currencies, including bitcoins, would be taxed as ​property​ rather than currency. Gains or losses from
bitcoins held as ​capital​ will be realized as ​capital gains​ or losses, while bitcoins held as ​inventory​ will incur ordinary gains or losses.

Like any other asset, the principle of buy low and sell high applies to bitcoins.The most popular way of amassing the currency is through buying on a
Bitcoin exchange, but there are many other ways to earn and own bitcoins. Here are a few options which Bitcoin enthusiasts can explore.

Ways to Earn Bitcoins

Receiving As Payment

Bitcoins can be accepted as a means of payment for products sold or services provided. If you have a brick and mortar store, just display a sign saying
“Bitcoin Accepted Here” and many of your customers may well take you up on it; the transactions can be handled with the requisite hardware
terminal or wallet address through QR codes and touch screen apps. An online business can easily accept bitcoins by just adding this payment option
to the others it offers, like credit cards, PayPal, etc. Online payments will require a Bitcoin merchant tool (an external processor like Coinbase or
BitPay).

Working For Them

Those who are self-employed can get paid for a job in bitcoins. There are several websites/job boards which are dedicated to the digital currency:

WorkForBitcoin​ brings together work seekers and prospective employers through its website
Coinality​ features jobs – freelance, part-time and full-time – that offer payment in bitcoins, as well as ​Dogecoin​ and ​Litecoin
Jobs4Bitcoins​, part of reddit.com
BitGigs

Interest Payments

Another interesting way (literally) to earn bitcoins is by lending them out, and being repaid in the currency. Lending can take three forms – direct
lending to someone you know; through a website which facilitates peer-to-peer transactions, pairing borrowers and lenders; or depositing bitcoins in
a virtual bank that offers a certain interest rate for Bitcoin accounts. Some such sites are ​Bitbond​, ​BitLendingClub ​and ​BTCjam​. Obviously, you should
do due diligence on any third-party site.

Gambling

It’s possible to play at casinos that cater to Bitcoin aficionados, with options like online lotteries, jackpots, spread betting and other games. Of course,
the pros and cons and risks that apply to any sort of gambling and betting endeavors are in force here too.

Risks of Investing in Bitcoins

Though Bitcoin was not designed as a normal equity investment (no shares have been issued), some speculative investors were drawn to the digital
money after it appreciated rapidly in May 2011 and again in November 2013. Thus, many people purchase bitcoin for its investment value rather than
as a ​medium of exchange​. But their lack of guaranteed value and digital nature means the purchase and use of bitcoins carries several inherent risks.
Many investor alerts have been issued by the ​Securities and Exchange Commission​ (​SEC​), the ​Financial Industry Regulatory Authority​ (​FINRA​),
the ​Consumer Financial Protection Bureau​ (​CFPB​), and other agencies.

The concept of a virtual currency is still novel and, compared to traditional investments, Bitcoin doesn't have much of a longterm track record or
history of credibility to back it. With their increasing use, bitcoins are becoming less experimental every day, of course; still, after eight years, they (like
all digital currencies) remain in a development phase, still evolving. "It is pretty much the highest-risk, highest-return investment that you can possibly
make,” says​ ​Barry Silbert, CEO of Digital Currency Group, which builds and invests in Bitcoin and blockchain companies.

Not for the risk-adverse, in other words. If you are considering investing in bitcoin, understand these unique investment risks:

Regulatory Risk:​ Bitcoins are a rival to government currency and may be used for black market transactions, money laundering, illegal activities or tax
evasion. As a result, governments may seek to regulate, restrict or ban the use and sale of bitcoins, and some already have. Others are coming up with
various rules. For example, in 2015, the New York State Department of Financial Services ​finalized regulations​ that would require companies dealing
with the buy, sell, transfer or storage of bitcoins to record the identity of customers, have a compliance officer and maintain capital reserves. The
transactions worth $10,000 or more will have to be recorded and reported.

Although more agencies will follow suit, issuing rules and guidelines, the lack of uniform regulations about bitcoins (and other virtual currency) raises
questions over their longevity, liquidity and universality.

Security Risk:​ ​Bitcoin exchanges are entirely digital and, as with any virtual system, are at risk from hackers, malware and operational glitches. If a
thief gains access to a Bitcoin owner's computer hard drive and steals his private encryption key, he could transfer the stolen Bitcoins to another
account. (Users can prevent this only if bitcoins are stored on a computer which is not connected to the internet, or else by choosing to use a ​paper
wallet​ – printing out the Bitcoin private keys and addresses, and not keeping them on a computer at all.) Hackers can also target Bitcoin exchanges,
gaining access to thousands of accounts and ​digital wallets​ where bitcoins are stored. One especially notorious hacking incident took place in 2014,
when Mt. Gox, a Bitcoin exchange in Japan, was forced to close down after millions of dollars worth of bitcoins were stolen.

This is particularly problematic once you remember that all Bitcoin transactions are permanent and irreversible. It's like dealing with cash: Any
transaction carried out with bitcoins can only be reversed if the person who has received them refunds them. There is no third party or a payment
processor, as in the case of a debit or credit card – hence, no source of protection or appeal if there is a problem.

Insurance Risk:​ Some investments are insured through the ​Securities Investor Protection Corporation.​ Normal bank accounts are insured through the
​Federal Deposit Insurance Corporation​ (FDIC) up to a certain amount depending on the jurisdiction. Bitcoin exchanges and Bitcoin accounts are not
insured by any type of federal or government program.

Fraud Risk:​ While Bitcoin uses private key encryption to verify owners and register transactions, fraudsters and scammers may attempt to sell false
bitcoins. For instance, in July 2013, the SEC brought legal action against an operator of a Bitcoin-related Ponzi scheme.

Market Risk:​ Like with any investment, Bitcoin values can fluctuate. Indeed, the value of the currency has seen wild swings in price over its short
existence. Subject to high volume buying and selling on exchanges, it has a high sensitivity to “news." According to the CFPB, the price of bitcoins fell
by 61% in a single day in 2013, while the one-day price drop in 2014 has been as big as 80%.

If fewer people begin to accept Bitcoin as a currency, these digital units may lose value and could become worthless. There is already plenty of
competition, and though Bitcoin has a huge lead over the other 100-odd digital currencies that have sprung up, thanks to its brand recognition
and ​venture capital​ money, a technological break-through in the form of a better virtual coin is always a threat.

Tax Risk:​ As bitcoin is ineligible to be included in any ​tax-advantaged​ retirement accounts, there are no good, legal options to shield investments from
taxation.

Pre-matching
A transfer of securities, both in DTC and in FED, is initiated by a single delivery instruction. As a consequence, there is no matching of delivery and
receipt instructions on the U.S. market in DTC or FED.

However, for transactions settled in DTC against payment, DTC provides an affirmation process which is equivalent to a matching facility. Provided
that both sets of instructions match, the custodian will electronically affirm the broker's confirmation on the ID system. Affirmed ID confirmations will
result in an automated settlement in DTC's books, with no need for the delivering party (that is, the broker or the custodian as the case may be) to
input additional separate delivery instructions.

In addition, DTC has launched a “Settlement Matching” initiative whereby certain deliveries are subject to approval by the receiving party before
settlement.

Settlement cycles

The settlement cycle in the US is ​T+2​ for equities, corporate bonds, ​municipal bonds, unit investment trusst (UIT) ​and T+0 or T+1 for Money Market
Instruments and Government Securities.
Settlement flow
Both against and free of payment settlement are supported by DTC and Fedwire Securities Services.

DTC settlement
For DVP settlement, securities and cash provisionally settle simultaneously during the day. The delivery and receipt of securities and cash are effective
upon booking on the DTC account. Securities and funds are available for additional settlement, but cash is only available for withdrawal until net end
of day cash settlement through the Fedwire system.

FedWire Securities settlement

Transactions are effected via book entry simultaneously throughout settlement date.

Cash settlement

● For settlement in DTC and NSCC, the cash settlement is performed at the end of the processing day, on a net basis.
● For settlement in Fedwire Securities, the cash settlement is performed transaction by transaction during the day.

In both cases, central bank money is used to settle the cash transaction.

Settlement finality
Delivery of securities or cash may be reversed by the buyer/recipient. There is no limitation on the reversal time frame. However, most securities
reversals (referred to as the "Don't Know" - DK procedure) take place on settlement day.

Under the DTC “Settlement Matching” initiative, certain deliveries are now subject to approval by the receiving party before settlement, using the DTC
RAD function. Once approved and settled in DTC, the transaction can no longer be “DK'ed” by the receiving party.

Deliveries that are subject to RAD approval are as follows:

● All against-payment deliveries with a countervalue above USD 0.01;

● Free of payment deliveries on DTC-eligible Money Market Instruments (MMIs).

Note:​ Although these transactions can no longer be DK'ed, DTC still allows receiving counterparties to request a return of a previously settled position
after the initial settlement, but, contrary to DK, such return request is subject to the prior approval of the original delivering counterparty.

Registration
Book-entry securities held in DTC are registered in the nominee name of DTC, Cede & Co., and held in the account of the broker or custodian that is
the DTC member.

Physical registered securities must be forwarded to the corporation's transfer agent to change the evidence of ownership on the legal records of the
issuing corporation.

The issuing corporation generally appoints a transfer agent, a bank or trust company to perform the registration. Some large corporations perform
this function themselves. Transfer agents must complete a transfer according to rules set forth by the SEC. For most securities, the re-registration
should be processed within three business days after receipt.

Nominee registrations are used by banks, brokers, mutual funds and other financial institutions to minimise re-registration of securities and speed the
delivery and settlement process.

Stamp duty
Stamp duty is not applicable in the U.S. market.

Penalties

Buy-ins
Rules and procedures for buy-ins vary according to the type of market, security and settlement system in which the failing trade is processed. We
therefore recommend to refer to each institution’s rules and regulations.

TMPG Fails Charge Trading Practice

The Treasury Market Practices Group (TMPG) and the Securities Industry and Financial Markets Association (SIFMA) have published a Trading Practice
to provide a standard procedure that market participants may elect to use to assess and pay "fails charges" for certain delivery failures in the market
for U.S. Treasury securities.

The purpose is to preserve and enhance the efficiency and operational integrity of the marketplace for Treasuries by reducing the incidence of
delivery failures.
Securities lending and repo market
Securities financing/lending is a common practice in the U.S. market. The terms of the loan is governed by a "Securities Lending Agreement". Under
U.S. law, the borrower must provide the lender with collateral in the form of cash, government securities or a letter of credit. As payment for the loan,
the parties negotiate a fee, quoted as an annualized percentage of the value of the loaned securities.

Repurchase agreements are also widely used in the U.S.A. Foreign investors can participate in the local repo market without restrictions.

Both ​forward​ and ​futures contracts​ allow investors to buy or sell an ​asset​ at a specific time and price. But they have subtle differences.

Futures contracts are traded on exchanges, making them standardized contracts. Forward contracts are private agreements between two parties to
buy and sell an asset at a specified price in the future. There’s always the chance one party in a forward contract may ​default​. Futures contracts
have ​clearing houses​ that guarantee the transactions.

Forward contracts are settled on one date at the end of the contract. Futures contracts are ​marked-to-market​ daily, which means their value is
determined day-by-day until the contract ends. Futures contracts can settle over a range of dates.

Speculators​ who bet on the direction an asset’s price will move, often use futures. Futures are usually closed out prior to ​maturity​, and delivery rarely
occurs. ​Hedgers​ mainly use forwards to eliminate the volatility of an asset’s price. Asset delivery and cash settlement usually take place.

What is an 'American Depositary Receipt - ADR'

An American depositary receipt (ADR) is a ​negotiable​ certificate issued by a U.S. bank representing a specified number of shares (or one share) in a
foreign stock traded on a U.S. exchange.

ADRs are denominated in U.S. dollars, with the ​underlying security​ held by a U.S. financial institution overseas. Holders of ADRs realize any dividends
and capital gains in U.S. dollars, but dividend payments in euros are converted to U.S. dollars, net of conversion expenses and foreign taxes. ADRs are
listed on either the NYSE, AMEX or Nasdaq, but they are also sold ​over-the-counter​ (OTC).

What is a 'Buy-In'
A buy-in is when an investor is forced to repurchase shares, because the ​seller​ did not deliver securities in a timely fashion — or did not deliver them
at all.

Those who fail to deliver the securities are generally notified with a buy-in notice. A buyer will send notice to exchange officials. Following this,
officials will usually notify the seller of their delivery failure. The ​exchange​ (e.g. NASDAQ or NYSE) supports the investor in buying his or her stocks a
second time. The original seller in most cases must make up any price difference.

The Depository Trust & Clearing Corporation​ (​DTCC​)​ is an American ​post-trade​ ​financial services​ company providing ​clearing​ and ​settlement​ services
to the ​financial markets​. It performs the exchange of ​securities​ on behalf of buyers and sellers and functions as a ​central securities depository​ by
providing central custody of securities.

DTCC was established in 1999 as a holding company to combine ​The Depository Trust Company (DTC)​ and National Securities Clearing Corporation
(NSCC). User-owned and directed, it automates, centralizes, standardizes, and streamlines processes in the ​capital markets​.[2]​
​ Through its subsidiaries,
DTCC provides clearance, settlement, and information services for equities, corporate and municipal ​bonds​, ​unit investment trusts​, government
and ​mortgage-backed​ securities, ​money market​ instruments, and ​over-the-counter​ ​derivatives​. It also manages transactions between ​mutual
funds​ and ​insurance​ carriers and their respective investors.

Independent amount

Initial Margin a.k.a performance bond, or performance collateral is collateral posted by a market participant to protect the counterparty to the trade
from loss over and above the protection afforded by Variation Margin (q.v.), should the original counterparty become insolvent during the life of the
contract or otherwise be unable or unwilling to perform under the terms of the contract and should the Variation Margin be insufficient to cover the
exposure.

Independent Amount is the same concept as initial margin except that the term independent amount only applies to unlearned OTC swaps that are
collateralized and initial margin applies to derivatives of all types that are cleared

The amount of collateral required over and above the mark to market of a portfolio. It is designed to cater for changes in the market value of a
portfolio between margin calls.
Rebate

A rebate option is an offer for a cash return on the purchase of a product.

REBATE AGREEMENTS:

A special discount paid retroactively to a customer once he reaches sales volume in a given period of time.

The primary difference between a Rebate and a Discount is that a Rebate is given after payment and a Discount is deducted before the payment.

What Is a Trailer Fee?

A trailer fee is a fee that a mutual fund manager pays to a salesperson who sells the fund to investors. The trailer fee is paid to the salesperson for
providing the investor with ongoing ​investment advice​ and services. This fee will be paid annually to the advisor for as long as the investor owns the
fund. The trailer fee is also known as a "trailer commission" throughout the financial industry

● A trailer fee is a payment made to a broker by a mutual fund manager for selling the fund to an investor and continually providing the
investor with investment advice and services.
● Trailer fees fall under the category of management fees and are withheld by the mutual fund manager at the time of the purchase, exchange,
or redemption of mutual fund shares.
● Trailer fees will be detailed in a mutual fund’s prospectus.
● Trailer fees can be controversial due to the potential for a conflict of interest on the part of the advisor.
● Trailer fees typically fall within a range of 0.25% to 1% of the mutual fund’s expenses.

BONDS

The Basics Of Bonds

Bonds represent the debts of issuers, such as companies or governments. These debts are sliced up and sold to investors in smaller units. For example,
a $1 million debt issue may be allocated to one-thousand $1,000 bonds. In general, bonds are considered to be more conservative investments than
stocks, and are more senior to stocks if an issuer declares bankruptcy. Bonds also typically pay regular interest payments to investors, and return the
full principal loaned when the bond matures. As a result, bond prices vary inversely with interest rates, falling when rates go up and vice-versa.

The ​bond markets​ are a very liquid and active, but can take second seat to stocks for many retail or part-time investors. The bond markets are often
reserved for professional investors, pension and ​hedge funds​, and financial advisors, but that doesn't mean that part-time investors should steer clear
of ​bonds​. In fact, bonds play an increasingly important part in your portfolio as you age and, because of that, learning about them now makes good
financial sense. In fact having a diversified portfolio of stocks and bonds is advisable for investors of all ages and risk tolerance.

KEY TAKEAWAYS

● Bonds are debt securities issued by corporations, governments, or other organizations and sold to investors.
● Backing for bonds is typically the payment ability of the issuer to generate revenue, although physical assets may also be used as collateral.
● Because corporate bonds are typically seen as riskier than government bonds, they usually have higher interest rates.
● Bonds have different features than stocks and their prices tend to be less correlated, making bonds a good diversifier for investment
portfolios.
● Bonds also tend to pay regular and stable interest, making them well-suited for those on a fixed-income.

What Is a Bond?
When you purchase a ​stock​, you're buying a microscopic stake in the company. It's yours and you get to share in the growth and also in the loss. On
the other hand, a bond is a type of loan. When a company needs funds for any number of reasons, they may issue a bond to finance that loan. Much
like a home mortgage, they ask for a certain amount of money for a fixed period of time. When that time is up, the company repays the bond in full.
During that time the company pays the investor a set amount of interest, called the ​coupon​, on set dates (often quarterly).

There are many types of bonds, including government, corporate, municipal and mortgage bonds. Government bonds are generally the safest, while
some corporate bonds are considered the most risky of the commonly known bond types.

For investors, the biggest risks are ​credit risk​ and ​interest rate risk​. Since bonds are debts, if the issuer fails to pay back their debt, the bond
can ​default​. As a result, the riskier the issuer, the higher the interest rate will be demanded on the bond (and the greater the cost to the borrower).
Also, since bonds vary in price opposite interest rates, if rates rise bond values fall.

Pricing Bonds
Bonds are generally priced at a ​face value​ (also called par) of $1,000 per bond, but once the bond hits the open market, the asking price can be priced
lower than the face value, called a discount, or higher than the face value, called premium.​2​​ If a bond is priced at a premium, the investor will receive a
lower coupon yield, because they paid more for the bond. If it's priced at a discount, the investor will receive a higher coupon yield, because they paid
less than the face value.

Bond prices tend to be less ​volatile​ than stocks and they often responds more to interest rate changes than other market conditions. This is why
investors looking for safety and income often prefer bonds over stocks as they get closer to retirement. A bond's ​duration​ is its price sensitivity to
changes in interest rates—as interest rates rise bond prices fall, and vice-versa. Duration can be calculated on a single bond or for an entire portfolio
of bonds.

Issuers of Bonds
There are four primary categories of bond issuers in the markets. However, you may also see ​foreign bonds​ issued by corporations and governments
on some platforms.

● Corporate bonds​ are issued by companies. Companies issue bonds—rather than seek bank loans for debt financing in many cases—because
bond markets offer more favorable terms and lower interest rates.
● Municipal bonds​ are issued by states and municipalities. Some municipal bonds offer tax-free coupon income for investors.
● Government (sovereign) bonds​ such as those issued by the U.S. Treasury. Bonds (T-bonds) issued by the Treasury with a year or less to
maturity are called “Bills”; bonds issued with 1 to 10 years to maturity are called “notes”; and bonds issued with more than 10 years to
maturity are called “bonds”. The entire category of bonds issued by a government treasury is often collectively referred to as "​treasuries​."
Government bonds issued by national governments may be referred to as sovereign debt. Governments may also offer inflation-protected
bonds (e.g. ​TIPS​) as well as small denomination ​savings bonds​ for ordinary investors,
● Agency bonds​ are those issued by government-affiliated organizations such as Fannie Mae or Freddie Mac.

What Is an Equity Market?

An equity market is a market in which shares of companies are issued and traded, either through exchanges or over-the-counter markets. Also known
as the ​stock market​, it is one of the most vital areas of a market economy. It gives companies access to ​capital​ to grow their business, and investors a
piece of ownership in a company with the potential to realize gains in their investment based on the company's future performance.

KEY TAKEAWAYS

● Equity markets are meeting points for issuers and buyers of stocks in a market economy.
● Equity markets are a method for companies to raise capital and investors to own a piece of a company.
● Stocks can be issued in public markets or private markets. Depending on the type of issue, the venue for trading changes.
● Most equity markets are stock exchanges that can be found around the world, such as the New York Stock Exchange and the Tokyo Stock
Exchange.

Understanding an Equity Market

Equity markets are the meeting point for buyers and sellers of stocks. The ​securities​ traded in the equity market can either be public stocks, which are
those listed on the stock exchange, or privately traded stocks. Often, private stocks are traded through dealers, which is the definition of
an ​over-the-counter market​.

When companies are born they are private companies, and after a certain time, they go through an ​initial public offering​ (IPO), which is a process that
turns them into public companies traded on a stock exchange. Private stocks operate slightly differently as they are only offered to employees and
certain investors.

Some of the largest equity markets, or stock markets, in the world are the New York Stock Exchange, Nasdaq, ​Tokyo Stock Exchange​, ​Shanghai Stock
Exchange​, and ​Euronext Europe​.

Companies list their stocks on an exchange as a way to obtain capital to grow their business. An equity market is a form of ​equity financing​, in which a
company gives up a certain percentage of ownership in exchange for capital. That capital is then used for a variety of business needs. Equity financing
is the opposite of ​debt financing​, which utilizes loans and other forms of borrowing to obtain capital

Trading in an Equity Market

In the equity market, investors bid for stocks by offering a certain price, and sellers ask for a specific price. When these two prices match, a sale
occurs. Often, there are many investors bidding on the same stock. When this occurs, the first investor to place the bid is the first to get the stock.
When a buyer will pay any price for the stock, they are buying at ​market value​; similarly, when a seller will take any price for the stock, they are selling
at market value.

When a company offers its stock on the market, it means the company is ​publicly traded​, and each stock represents a piece of ownership. This appeals
to investors, and when a company does well, its investors are rewarded as the value of their stocks rise.
The risk comes when a company is not doing well, and its stock value may fall. Stocks can be bought and sold easily and quickly, and the activity
surrounding a certain stock impacts its value. For example, when there is a high demand to invest in the company, the price of the stock tends to rise,
and when many investors want to sell their stocks, the value goes down.

Stock Exchanges
Stock exchanges​ can be either physical places or virtual gathering spots. ​Nasdaq​ is an example of a virtual trading post, in which stocks are traded
electronically through a network of computers. Electronic trading posts are becoming more common and a preferred method of trading over physical
exchanges.

The ​New York Stock Exchange​ (NYSE) on Wall Street is a famous example of a physical stock exchange; however, there is also the option to trade in
online exchanges from that location, so it is technically a ​hybrid market​.

Most large companies have stocks that are listed on multiple stock exchanges throughout the world. However, companies with stocks in the equity
market range from large-scale to small, and traders range from big companies to individual investors.

Most buyers and sellers tend to prefer trading at larger exchanges, where there are more options and opportunities than at smaller exchanges.
However, in recent years, there has been an uptick in the number of exchanges through third-party markets, which bypass the commission of a stock
exchange, but pose a greater risk of ​adverse selection​ and don't guarantee the payment or delivery of the stock.

What Is Fixed Income?

Fixed income broadly refers to those types of investment security that pay investors fixed interest or dividend payments until its ​maturity​ date. At
maturity, investors are repaid the principal amount they had invested. Government and corporate bonds are the most common types of fixed-income
products. Unlike equities that may pay no cash flows to investors, or variable-income securities, where can payments change based on some
underlying measure—such as short-term interest rates—the payments of a fixed-income security are known in advance.

In addition to purchasing fixed income securities directly, there are several fixed-income ​exchange-traded funds (ETFs)​ and mutual funds available.

KEY TAKEAWAYS

● Fixed income is a class of assets and securities that pay out a set level of cash flows to investors, typically in the form of fixed interest or
dividends.
● At maturity for many fixed income securities, investors are repaid the principal amount they had invested in addition to the interest they
have received.
● Government and corporate bonds are the most common types of fixed-income products.
● In the event of a company's bankruptcy, fixed-income investors are often paid before common stockholders.
Understanding Fixed Income
Companies and governments issue debt securities to raise money to fund day-to-day operations and finance large projects. For investors,
fixed-income instruments pay a set interest rate return in exchange for investors lending their money. At the maturity date, investors are repaid the
original amount they had invested—known as the principal.

For example, a company might issue a 5% bond with a $1,000 ​face or par value​ that matures in five years. The investor buys the bond for $1,000 and
will not be paid back until the end of the five-years. Over the course of the five years, the company pays interest payments—called coupon
payments—based on a rate of 5% per year. As a result, the investor is paid $50 per year for five years. At the end of the five-years, the investor is
repaid the $1,000 invested initially on the maturity date. Investors may also find fixed-income investments that pay coupon payments monthly,
quarterly, or semiannually.

Fixed-income securities are recommended for conservative investors seeking a diversified portfolio. The percentage of the portfolio dedicated to fixed
income depends on the investor's investment style. There is also an opportunity to diversify the portfolio with a mix of fixed-income products and
stocks creating a portfolio that might have 50% in fixed income products and 50% in stocks.

Treasury bonds and bills, municipal bonds, corporate bonds, and certificates of deposit (CDs) are all examples of fixed-income products. Bonds trade
over-the-counter (OTC) on the ​bond market​ and secondary market.

Special Considerations
Fixed income investing is a conservative strategy where returns are generated from low-risk securities that pay predictable interest. Since the risk is
lower, the interest coupon payments are also, usually, lower as well. Building a fixed income portfolio may include investing in bonds, ​bond mutual
funds​, and certificates of deposit (CDs). One such strategy using fixed income products is called the ​laddering​ strategy.

A laddering strategy offers steady interest income through the investment in a series of short-term bonds. As bonds mature, the portfolio manager
reinvests the returned principal into new short-term bonds extending the ladder. This method allows the investor to have access to ready capital and
avoid losing out on rising market interest rates.
For example, a $60,000 investment could be divided into one-year, two-year, and three-year bonds. The investor divides the $60,000 principle into
three equal portions, investing $20,000 into each of the three bonds. When the one-year bond matures, the $20,000 principal will be rolled into a
bond maturing one year after the original three-year holding. When the second bond matures those funds roll into a bond that extends the ladder for
another year. In this way, the investor has a steady return of interest income and can take advantage of any higher interest rates.

Types of Fixed Income Products

As stated earlier, the most common example of a fixed-income security is a government or corporate bond. The most common government securities
are those issued by the U.S. government and are generally referred to as Treasury securities. However, many fixed income securities are offered from
non U.S. governments and corporations as well.

Here are the most common types of fixed income products:

● Treasury bills (​T-bills​)​ are short-term fixed-income securities that mature within one year that do not pay coupon returns. Investors buy the
bill at a price less than its face value and investors earn that difference at the maturity.​2​​
● Treasury notes (​T-notes​)​ come in maturities between two and 10 years, pay a fixed interest rate, and are sold in multiples of $100. At the end
of the maturity, investors are repaid the principal but earn semiannual interest payments until maturity.​3​​
● The Treasury bond (​T-bonds​)​ are similar to the T-note except that it matures in 20 or 30 years. Treasury bonds can be purchased in multiples
of $100.​4​​
● Treasury Inflation-Protected Securities (​TIPS​)​ protects investors from inflation. The principal amount of a TIPS bond adjusts with inflation
and deflation.​5​​
● A ​municipal bond​ is similar to a Treasury since it is government-issued, except it is issued and backed by a state, municipality, or county,
instead of the federal government, and is used to raise capital to finance local expenditures. Muni bonds can have tax-free benefits to
investors as well.​6​​
● Corporate bonds​ come in various types, and the price and interest rate offered largely depends on the company’s financial stability and its
creditworthiness. Bonds with higher credit ratings typically pay lower coupon rates.
● Junk bonds​—also called high-yield bonds—are corporate issues that pay a greater coupon due to the higher risk of default. Default is when a
company fails to pay back the principal and interest on a bond or debt security.
● A ​certificate of deposit (​CD​)​ is a fixed income vehicle offered by financial institutions with maturities of less than five years. The rate is higher
than a typical saving account, and CDs carry FDIC or National Credit Union Administration (NCUA) protection.​7​​ 8​​ ​
● Fixed-income mutual funds (​bond funds​)​—such as those offered by Vanguard—invest in various bonds and debt instruments. These funds
allow the investor to have an income stream with the professional management of the portfolio. However, they will pay a fee for the
convenience.
● Asset-allocation or ​fixed income ETFs​ works much like a mutual fund. These funds target specific credit ratings, durations, or other factors.
ETFs also carry a professional management expense.

Advantages of Fixed Income

Fixed income investments offer investors a steady stream of income over the life of the bond or debt instrument while simultaneously offering the
issuer much-needed access to capital or money. Steady income lets investors plan for spending, a reason these are popular products in retirement
portfolios.

The interest payments from fixed-income products can also help investors stabilize the risk-return in their investment portfolio—known as the ​market
risk​. For investors holding stocks, prices can fluctuate resulting in large gains or losses. The steady and stable interest payments from fixed-income
products can partly offset losses from the decline in stock prices. As a result, these safe investments help to diversify the risk of an investment
portfolio.

Also, fixed-income investments in the form of Treasury bonds (T-bonds) have the backing of the U.S. government.​9​​ Fixed income CDs have Federal
Deposit Insurance Corporation (FDIC) protection up to $250,000 per individual.​7​​ Corporate bonds, while not insured are backed by the financial
viability of the underlying company. Should a company declare bankruptcy or liquidation, bondholders have a higher claim on company assets than do
common shareholders.​1​​

Although there are many benefits to fixed income products, as with all investments, there are several risks investors should be aware of before
purchasing them.

Risks Associated with Fixed Income

Credit and Default Risk
As mentioned earlier, Treasurys and CDs have protection through the government and FDIC.​9​​ 7​​ ​ Corporate debt, while less secure still ranks higher for
repayment than do shareholders. When choosing an investment take care to look at the credit ​rating of the bond​ and the underlying company. Bonds
with ratings below BBB are of low quality and consider junk bonds.​10​​

The credit risk linked to a corporation can have varying effects on the valuations of the fixed-income instrument leading up to its maturity. If a
company is struggling, the prices of its bonds on the secondary market might decline in value. If an investor tries to sell a bond of a struggling
company, the bond might sell for less than the face or par value. Also, the bond may become difficult for investors to sell in the open market at a fair
price or at all because there's no demand for it.
The prices of bonds can increase and decrease over the life of the bond. If the investor holds the bond until its maturity, the price movements are
immaterial since the investor will be paid the face value of the bond upon maturity. However, if the bondholder sells the bond before its maturity
through a broker or financial institution, the investor will receive the current market price at the time of the sale. The selling price could result in a
gain or loss on the investment depending on the underlying corporation, the coupon interest rate, and the current market interest rate.

Interest Rate Risk

Fixed-income investors might face ​interest rate risk​. This risk happens in an environment where market interest rates are rising, and the rate paid by
the bond falls behind. In this case, the bond would lose value in the secondary bond market. Also, the investor's capital is tied up in the investment,
and they cannot put it to work earning higher income without taking an initial loss. For example, if an investor purchased a 2-year bond paying 2.5%
per year and interest rates for 2-year bonds jumped to 5%, the investor is locked in at 2.5%. For better or worse, investors holding fixed-income
products receive their fixed rate regardless of where interest rates move in the market.

Inflationary Risks
Inflationary risk is also a danger to fixed income investors. The pace at which prices rise in the economy is called inflation. If prices rise or inflation
increases, it eats into the gains of fixed income securities. For example, if fixed-rate debt security pays a 2% return and inflation rises by 1.5%, the
investor loses out, earning only a 0.5% return in real terms.

A dividend​ is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a proportion of
the profit as a ​dividend​ to shareholders. Any amount not distributed is taken to be re-invested in the business (called retained earnings).

What Is a Prime Brokerage?

A prime brokerage is a bundled group of services that investment banks and other financial institutions offer to hedge funds and other large
investment clients that need to be able to borrow securities or cash in order to engage in ​netting​ to achieve ​absolute returns​. The services provided
under prime brokering include ​securities lending​, leveraged trade ​executions​, and cash management, among other things. Prime brokerage services
are provided by most of the largest financial services firms, including Goldman Sachs, UBS, and Morgan Stanley and the inception of units offering
such services traces back to the 1980s.

KEY TAKEAWAYS

● Prime brokerage refers to a bundle of services that investment banks and other major financial institutions offer to hedge funds and similar
clients.
● Services included within a prime brokerage bundle may include cash management, securities lending and more.
● The services of a prime brokerage aid hedge funds in accessing research, finding new investors, borrowing securities or cash and more.

Understanding Prime Brokerage

Prime brokerage services revolve around facilitating the multifaceted and active trading operations of large financial institutions, such as ​hedge funds​.
Central to their role, prime brokers allow hedge funds to borrow securities and increase their leverage, while also acting as an intermediary between
hedge funds and counterparties such as pension funds and commercial banks.

Prime brokerages, at times referred to as prime brokers, are generally larger financial institutions that have dealings with other large institutions and
hedge funds. As of 2018, for example, Morgan Stanley says its prime brokerage unit serves as a partner to more than 800 hedge funds and
institutional clients. Though prime brokerages offer a large variety of services, a client is not required to take part in all of them and can have services
performed by other institutions as they see fit.

Prime Brokerage Services

A prime brokerage offers a set of services to qualifying clients. The assigned broker, or brokers, may provide settlement agent services along with
financing for leverage. Custody of assets may be offered, as well as daily preparations of account statements. Prime brokers offer a level of resources
many institutions may not be able to have in house. In essence, a prime brokerage service gives large institutions a mechanism allowing them to
outsource many of their investment activities and shift focus onto investment goals and strategy.

Concierge-style services may also be offered. These can include risk management, capital introduction, securities financing, and cash financing. Some
go as far as to offer the opportunity to sublease office space and provide access to other facility-based benefits. As with more traditional offerings,
participation in any of the concierge services is optional.

In cases of securities lending, ​collateral​ is often required by the prime brokerage. This allows it to minimize the risk it experiences as well as give it
quicker access to funds if needed.

Qualifying Clients
The majority of prime brokerage clients are made of large-scale investors and institutions. Money managers and hedge funds often meet the
qualifications, as well as ​arbitrageurs​ and a variety of other professional investors. In the case of hedge funds, prime brokerage services are often
considered significant in determining a fund's success.
Two common types of clients are ​pension funds​, a form of ​institutional investor​ and commercial banks. These forms of investors often deal with a
large amount of cash for investment but do not have the internal resources to manage the investments on their own.

The minimum account size to open and obtain prime brokerage account services is $500,000 in equity, however such an account is unlikely to get
many benefits over and above what would be offered by discount brokers. For hedge funds or other institutional clients to get the kind of services that
make having a prime brokerage account worthwhile (most notably discounted fees for trading), an account size of $50 million in equity is a likely
starting point. Even so, these services are highly sought after by clients and the best banks only accept the clients that are most likely to be beneficial
to them over time. For this reason a hedge fund would probably need to have as much as $200 million in equity in order to qualify for the best
treatment.

SETTLEMENT CYCLE (INDIA PERSPECTIVE)

In trading, there is a fixed time period for the settlement of trades as per terms of contract. This time period is termed as Settlement Cycle.
For equity trades: Currently all trades are settled on T+2 settlement cycle.
For derivatives/currency/commodities: Currently all trades are being mark to market at the closing price of contract and mark to market requirement
are settled at T+1.
For arriving at the settlement day all intervening holidays, which include bank holidays, NSE holidays, Saturdays and Sundays are excluded.

There are three types of settlements:

Rolling/Normal Settlement
Trade-to-Trade Settlement
Auction

A Settlement Cycle refers to a calendar according to which all purchase and sale transactions done on T Day are settled on a T+2 basis. T = Trading Day
and +2 means 2 consecutive working days after T (excluding all holidays). It simply means that if the customer buys share on 3rd Sept 2012 = T, Then
the transaction will be settled on 5th Sept 2012 = T+2. At NSE and BSE, trades in rolling settlement are settled on a T+2 basis i.e. on the 2nd working
day.

Trade to Trade settlement is a segment where shares can be traded only for delivery. It means Trade to Trade shares cannot be traded on intraday
basis. Each share purchased /sold which is a part of this segment need to be taken delivery by paying full amount
No intraday netting off/square off facility is permitted.

When the seller is unable to deliver the shares, the exchange initiate's an auction to purchase the required quantity of the same share in the auction
market and give it to the buyer.

In case you place an intraday order; it has to be in the same exchange. You cannot buy the shares in NSE and sell in BSE.
If you already have shares in Demat account; then you can sell in any exchange irrespective whether bought in NSE or BSE.

Regulators
On the federal level, the primary securities ​regulator​ is the Securities and ​Exchange​ Commission (SEC). Futures and some aspects of derivatives are
regulated by the Commodity Futures Trading Commission (CFTC).

The Securities and ​Exchange​ Board of ​India​ (SEBI) is the ​regulatory​ authority established under the SEBI Act 1992 and is the principal ​regulator​ for
Stock ​Exchanges​ in ​India​. SEBI's primary functions include protecting investor interests, promoting and regulating the ​Indian​ securities markets.

The ​European​ Securities and Markets Authority (ESMA) is a ​European​ Union financial ​regulatory​ agency and ​European​ Supervisory Authority, located
in Paris. ESMA replaced the Committee of ​European​ Securities ​Regulators​ (CESR) on 1 January 2011.

What Is Clearstream International?

Clearstream International is a leading supplier of post-trading services based in Europe, whose core businesses are settlements of market transactions
and custody of ​securities​. Clearstream International's primary services are to act as an international central securities depository and as a central
securities depository for domestic securities from ​Germany​ and Luxembourg.

The company was formed through the merger of Cedel International and Deutsche Borse Clearing in January 2000 and is presently a wholly
owned ​subsidiary​ of Deutsche Borse, one of the largest exchanges in the world.
Clearstream International was previously known as Deutsche Börse Clearing AG before changing its name to Clearstream International SA in January of
2000.

Clearstream International Explained

Clearstream has developed an especially strong position in the international fixed income market, handling the clearing and settlement of ​Eurobonds​.
It has about 2,500 customers in more than 110 countries, based on its capability to serve as a single point of access for the settlement and custody of
international bonds and equities across 58 markets. Clearstream settles more than 250,000 transactions daily. The scale of its operations is immense;
in 2018, custodial assets exceeded 13.7 trillion euro.

The company is an international central securities depository (ICSD), based in Luxembourg. In this capacity, it provides post-trade infrastructure and
securities services for the international market as well as the 58 domestic markets worldwide. It is also a central securities depository (CSD), based in
Frankfurt. In this capacity, it provides the post-trade infrastructure for the German securities industry, offering access to a growing number of
international markets.

KEY TAKEAWAYS

● Clearstream International SA is a European-based central securities depository that provides post-trading services for both domestic and
international markets.
● The company is responsible for the settlement and custody of international stocks and bonds throughout 58 markets around the world.
● The company, a division of Deutsche Börse, settles over 250,000 transactions each day, with custodial assets of more than 13.7 trillion euro.

Details of Clearstream International

Clearstream offers asset services including the following:

● Distribution and settlement processing of new issues

● Income and redemption payment processing
● Corporate actions, tax and proxy voting services, and reporting and safekeeping services
● Cash and banking services, such as commercial and central bank money services

It also provides connectivity solutions including CleartstreamXact, a ​web-based connectivity​ channel for smooth delivery of services, and
MyStandards, a web platform to manage ISO messaging standards and market practices.

110
The number of countries in which Clearstream International operates, where it maintains relationships with more than 2,500 customers.
Clearstream also provides global securities financing services, such as global liquidity hub, ICSD, CSD and partnerships services, also TradeCycle and
liquidity alliance, investment fund services, including Vestima, which delivers investment fund services that support the broad distribution needs of
the investment fund industry, and also distributors and fund platforms, and fund providers.

The company also provides issuance solutions that consist of a global issuer hub, issuance models and services, post-issuance services, safekeeping
and vaults, and reference data services. It also offers IT solutions, such as hosting, connectivity, compliance, and operational solutions. It also provides
settlement services, including commercial and central bank money settlement, as well as other settlement services.

Euroclear​ is one of two principal securities clearing houses in the Eurozone. Euroclear specializes in verifying information supplied by brokers involved
in a securities transaction and the settlement of securities transacted on European exchanges.

The other principal European clearing house is ​Clearstream​, formerly the Centrale de Livraison de Valeurs Mobilières (CEDEL).

KEY TAKEAWAYS

● Euroclear is a major clearing house that settles and clears securities trades executed on European exchanges.
● Euroclear also functions as central securities depository, where it is custodian for major financial institutions involved in European markets.
● In addition to stock trades, Euroclear also handles orders in fixed income securities and derivatives.

How Euroclear Works

Euroclear is one the oldest settlement systems and was originally subsidized by Morgan Guaranty Trust Company of New York, which was a part of J.P.
Morgan & Co. It was founded in 1968 to settle trades on the then developing ​eurobond​ market. Its computerized settlement and deposit system
helped ensure the safe delivery and payment of Eurobonds. In 2001, Morgan Guaranty Trust transferred these activities to Euroclear Bank. Euroclear
is publicly owned and governed, and has acquired London Crest, Necigef Netherlands, Sicovam Paris, and Caisse Interprofessionnelle de Dépôts et de
Virements de Titres (CIK) Brussels, following a series of acquisitions that occurred from 2001 to 2007.
Euroclear acts as a ​central securities depository​ (CSD) for its clients, many of whom trade on European exchanges. Most of its clients comprise of
banks, ​broker-dealers​, and other institutions professionally engaged in managing new issues of securities, market-making, trading or holding a wide
variety of securities. Euroclear settles domestic and international securities transactions, covering bonds, equities, ​derivatives​, and investment funds.
Over 190,000 national and international securities are accepted in the Euroclear system, covering a broad range of internationally traded fixed
and ​floating rate debt​ instruments, ​convertibles​, ​warrants​, and equities.

CSD, Delivery and Payment

In addition to its role as an International Central Securities Depository (ICSD), Euroclear also acts as the Central Securities Depository (CSD) for Belgian,
Dutch, Finnish, French, Irish, Swedish and UK securities. A CSD is a financial institution that holds securities, such as bonds and shares, and provides for
safekeeping of these assets. A CSD also allows for the settlement of securities transactions. A transaction is settled once the buyer’s account has been
credited with the purchased shares and debited the agreed cash amount, and the seller’s account has been debited the shares and credited the sales
amount. The credit and debit movements occur simultaneously through a process known as ​delivery versus payment​ (DVP).

Transactions between Euroclear participants are settled in the manner described above on a DVP basis on the books of Euroclear. Securities and cash
transfers between buyer and seller accounts are final and irrevocable upon settlement. Costs and risks involved in the settlement between Euroclear
participants and local market participants are heavily influenced by local market practices. Trades settling through domestic market links settle on a
DVP basis only if DVP is provided in the local market. In the same way, settlement in the Euroclear System becomes final and irrevocable in line with
the rules of the domestic market. As a rule, Euroclear Bank credits securities to participants only if it has actually received the securities for the
account of such participants.

All securities accepted by Euroclear are eligible for securities lending and borrowing except those that are limited by liquidity, fiscal, or legal
restrictions. Standard borrowings are allocated whenever a borrower has insufficient securities in its account to make a delivery, provided sufficient
securities are available from lending. Borrowings are reimbursed on the first overnight settlement process where securities are available in the
borrower’s account. In the program, all securities made available by lenders are aggregated in a lending pool. Securities are then distributed to
borrowers and loans are allocated among lenders according to standard procedures.

What Is CREST?
CREST is the central securities ​depository​ for markets in the United Kingdom and for Irish stocks. CREST is named after the CrestCo corporation, which
has been owned and operated by ​Euroclear​ since 2002. It is the operator of an electronic settlement system that is used to settle a broad spectrum of
international securities, and can also hold ​stock certificates​ on the behalf of its customers.

KEY TAKEAWAYS

● CREST is the central securities depository for markets in the United Kingdom and for Irish stocks.
● The system operates an electronic settlement system used to settle international securities, and also holds stock certificates on the behalf of
its customers.
● CREST also assists in making dividend payments to shareholders and executes other important functions.
● It can offer same-day clearing for securities transactions since it maintains a clearing system and holds securities.
Understanding CREST
Euroclear was established in the 1960s in response to the emerging ​Eurobond​ market. The company went through decades of growth and expansion,
as well as several ​mergers​ which included some central securities depositories (CSDs) such as Sicovam SA—the CSD of France. In 1993, the CREST
project was launched in 1993. Three years later, the subsequent ​parent company​, CrestCo, was founded. Euroclear merged with CrestCo in 2002 and
took operating control of the company. The new name for the merged companies became Euroclear UK & Ireland.

The word CREST is an acronym that stands for Certificateless Registry for Electronic Share Transfer. It is accessed by a number of different
professionals ranging from investment firms, brokers, and international banks—all of whom allow retail investors to hold securities electronically.
CREST makes it possible for ​bondholders​ and ​shareholders​ to keep assets in electronic form instead of holding physical ​share certificates​. The system
also assists in making dividend payments to shareholders and executes other important functions like putting into effect corporate actions like rights
issues.

CREST allows security holders to keep assets in electronic form instead of holding physical certificates.

CREST also acts as an electronic trade ​confirmation​ (ETC) system through the use of Trax. When two or more parties in a transaction agree upon a
deal, they confirm their sides of the transaction through an electronic transfer. All parties involved are required to submit confirmation of all
transaction details to CREST. If details of the ​transaction​ are not the same for each party, CREST indicates all issues and notifies parties of
discrepancies. This aspect of the CREST system allows for a speedy resolution and faster processing of the transaction.

Because CREST maintains a ​clearing​ system and holds securities, it can offer same-day clearing for securities ​transactions​. The company’s most
important offering to investors is the fast transfer of the securities titles that it handles.

Special Considerations
Registrars who are CREST members hold stocks of British companies, while exchange-traded funds (ETFs) and Irish securities are settled through
CREST members directly. Members are divided into two separate classes on the CREST system: Full and sponsored. Full members are usually inter-deal
brokers, ​pension funds​, and other large ​financial institutions​ that have substantial resources. Sponsored members, on the other hand, are given all the
same rights and the same responsibilities as members. But because sponsored members generally have far fewer technical and financial resources
than full members, they are reliant upon their sponsoring members to interface with the CREST system.

CREST helps connect markets in the United Kingdom and Ireland with others internationally. ​Retail​ and private investors are able to open accounts in
their own name, and are given access to CREST indirectly through their ​broker​ or bank.

LCH​ (originally London Clearing House) is a British ​clearing house group​ that serves major international exchanges, as well as a range of ​OTC​ markets.
The ​LCH Group​ consists of two subsidiaries: LCH Ltd (based in London) and LCH SA (based in Paris).​[1]​ Based on 2012 figures, LCH cleared
approximately 50% of the global ​interest rate swap​ market,​[2]​ and was the second largest clearer of ​bonds​ and ​repos​ in the world, providing services
across 13 government debt markets. In addition, LCH clears a broad range of asset classes including: ​commodities​, ​securities​, ​exchange traded
derivatives​, ​credit default swaps​, ​energy contracts​, ​freight derivatives​, ​interest rate swaps​, ​foreign exchange​ and ​Euro​ and ​Sterling​ denominated
bonds and repos.

The Clearinghouse: An Overview

A clearinghouse is a designated intermediary between a buyer and seller in a financial market. The clearinghouse validates and finalizes the
transaction, ensuring that both the buyer and the seller honor their contractual obligations.

Every financial market has a designated clearinghouse or an internal clearing division to handle this function.

Understanding the Clearinghouse

The responsibilities of a clearinghouse include "clearing" or finalizing trades, settling trading accounts, collecting ​margin​ payments, regulating delivery
of the assets to their new owners, and reporting trading data.

Clearinghouses act as third parties for futures and ​options contracts​, as buyers to every ​clearing member​ seller, and as sellers to every clearing
member buyer.

Clearing House
The clearinghouse enters the picture after a buyer and a seller execute a trade. Its role is to accomplish the steps that finalize, and therefore validate,
the transaction. In acting as a middleman, the clearinghouse provides the security and efficiency that is integral to stability in a financial market.

In order to act efficiently, a clearinghouse takes the opposite position of each trade, which greatly reduces the cost and risk of settling multiple
transactions among multiple parties. While their mandate is to reduce risk, the fact that they have to act as both buyer and seller at the inception of a
trade means that they are subject to default risk from both parties. To mitigate this, clearinghouses impose margin requirements.

A ​clearing house​ is a financial institution that acts as an intermediary between buyers and sellers of financial instrument. They take the opposite
position of each side of a trade, acting as the buyer to the seller and the seller to the buyer. For example, if Wendy and Nathan enter into a
transaction in which Wendy agrees to sell 100 shares of AMZN to Nathan for $1,180 per share, Nathan will have to pay $1,180 x 100 shares =
$118,000. The clearing house credits Nathan’s account with 100 AMZN shares and deposits $118,000 to Wendy’s account. Clearing houses, thus,
ensure that the financial markets operate smoothly and efficiently. One of the world’s largest clearing houses is Euroclear.

What Is a Clearing House?

A clearing house is an intermediary between buyers and sellers of financial instruments. It is an agency or separate corporation of a futures exchange
responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery, and reporting trading data.

Role and Function of a Clearing House

A clearing house takes the opposite position of each side of a trade. When two investors agree to the terms of a financial transaction, such as the
purchase or sale of a security, a clearing house acts as the middle man on behalf of both parties. The purpose of a clearing house is to improve the
efficiency of the markets and add stability to the financial system.

The futures market is most commonly associated with a clearing house, since its financial products can be complicated and require a stable
intermediary. Each futures exchange has its own clearing house. All members of an exchange are required to clear their trades through the clearing
house at the end of each trading session and to deposit with the clearing house a sum of money sufficient to cover the member's debit balance.

Clearing House Examples

There are two major clearing houses in the United States: The New York Stock Exchange (NYSE) and the NASDAQ. The NYSE, for example, facilitates
the trading of stocks, bonds, mutual funds, exchange-traded funds (ETFs) and derivatives. It acts as the middle man in an auction market that allows
brokers and other investors to buy and sell securities to people by matching the highest bidding price to the lowest selling price. Unlike the NASDAQ,
the NYSE has a physical trading floor.
National Securities Clearing Corporation (NSCC), which is a subsidiary of the Depositary Trust Clearing Corporation (DTCC), was established in in 1976
and provides clearing, settlement, risk management, central counterparty services and a guarantee of completion for certain transactions for virtually
all broker-to-broker trades involving equities, corporate and municipal debt, American depositary receipts, exchange-traded funds, and unit
investment trusts. NSCC also nets trades and payments among its participants, reducing the value of payments that need to be exchanged by an
average of 98% each day. NSCC is regulated by the U.S. Securities and Exchange Commission (SEC).

Options Clearing Corporation (OCC) is a U.S. clearing house based in Chicago. It specializes in equity derivatives clearing providing central counterparty
(CCP) clearing and settlement services to 15 exchanges. Instruments include ​options​, financial and commodity futures, security futures and securities
lending transactions. Like all clearing houses, the OCC acts as guarantor between clearing parties ensuring that the obligations of the contracts they
clear are fulfilled. It currently holds approximately $100 billion of collateral deposited by clearing members and moves billions of dollars a day. In 2016
cleared contract volume totaled 4.17 billion making it the fifth highest annual total in OCC's history.

The 10 Big ​Emerging Markets​ (BEM) ​economies​ are (alphabetically ordered): Argentina, Brazil, China, India, Indonesia, Mexico, Poland, South Africa,
South Korea and Turkey. Egypt, Iran, Nigeria, Pakistan, Russia, Saudi Arabia, Taiwan, and Thailand are other major ​emerging markets​.

The Clearinghouse in the Futures Market

The futures market is highly dependent on the clearinghouse since its financial products are leveraged. That is, they typically involve borrowing in
order to invest, a process that requires a stable intermediary.

Each exchange has its own clearinghouse. All members of an exchange are required to clear their trades through the clearinghouse at the end of each
trading session and to deposit with the clearinghouse a sum of money, based on the clearing house's margin requirements, that is sufficient to cover
the member's debit balance.

KEY TAKEAWAYS

● A clearinghouse or clearing division is an intermediary between a buyer and a seller in a financial market.
● In acting as the middleman, the clearinghouse provides the security and efficiency that is integral for financial market stability.
● To mitigate default risk in futures trading, clearinghouses impose margin requirements.
Futures Clearing House Example
Assume that a trader buys a futures contract. At this point, the clearinghouse has already set the initial and maintenance margin requirements.

The initial margin can be viewed as a good faith assurance that the trader can afford to hold the trade until it is closed. These funds are held by the
clearing firm but within the trader's account, and can't be used for other trades. The intention is to offset any losses the trader may experience in the
transaction.

The maintenance margin, usually a fraction of the initial margin requirement, is the amount that must be available in a trader's account to keep the
trade open. If the trader's account equity drops below this threshold the account holder will receive a ​margin call​ demanding that the account be
replenished to the level that satisfies the initial margin requirements.

If the trader fails to meet the margin call, the trade will be closed since the account cannot reasonably withstand further losses.

In this example, the clearinghouse has ensured that there is sufficient money in the account to cover any losses that the account holder may suffer in
the trade. Once the trade is closed, the remaining margin funds are released to the trader.

The process has helped reduce default risk. In its absence, one party could back out of the agreement or fail to produce money owed at the end of the
transaction.

In general, this is termed transactional risk and is obviated by the involvement of a clearinghouse.

Stock Market Clearinghouses

Stock exchanges such as the New York Stock Exchange (NYSE) have clearing divisions that ensure that a stock trader has enough money in an account
to fund the trades being placed. The clearing division acts as the middle man, helping facilitate the smooth transfer of the stock shares and the money.

An investor who sells stock shares needs to know that the money will be delivered. The clearing divisions make sure this happens.

An exchange traded fund (ETF)​ is a type of security that involves a collection of securities—such as stocks—that often tracks an underlying index,
although they can invest in any number of industry sectors or use various strategies.
National Association of Securities Dealers Automated Quotations exchange
The ​Nasdaq​ is also a term that can refer to two different things: first, it is the National Association of Securities Dealers Automated Quotations
exchange, the first electronic exchange that allowed investors to buy and sell stock on a computerized, speedy, and transparent system, without the
need for a physical.

DTCC CTM
The CTM solution is DTCC's global platform for the central matching of cross-border and domestic transactions automating the trade confirmation
process across multiple asset classes.
The CTM platform for the central matching of cross-border and domestic transactions automates the trade confirmation process across multiple asset
classes, such as equities, fixed income and repurchase agreements (repos).
ABOUT
The CTM solution provides seamless connectivity from trade execution to settlement, including direct connectivity via FIX from front office to middle
office trade processing as well as via the SWIFT network to a full community of custodian banks for the purposes of settlement notification. And, when
used in conjunction with ALERT, you can automatically enrich trades with account and standing settlement instructions (SSI), ensuring all account
information is accurate.
BENEFITS
The CTM solution is industry owned and governed
High transparency and consistency for your post-trade processes
Connecting to the CTM platform means connecting to almost 2000 counterparties in 52 countries
Support of multiple asset classes on one platform, such as Equities, Fixed Income, Repurchase Agreements (Repos), Synthetic Equity Swaps and
Exchange Traded Derivatives
Incorporation of industry best practices, such as SMPG, AFME, ISITC and user community best practices
Improved regulatory compliance and risk management
Direct links to depositories in Canada (CDS), in Chile (DCV), in Korea (KSD) and in the US (DTC)
CTM is a regulated service for the central matching of trades in the US and Canada
WHO CAN USE THE SERVICE
The CTM service helps buy side firms – including investment managers, hedge funds, private banks or outsourcers – and broker/dealers to efficiently
match and confirm trade details, to increase transparency and to mitigate risk. It also allows trading parties to send settlement notifications or copies
for information to custodians and other third parties to achieve straight-through processing.
HOW IT WORKS
With the CTM workflow matching happens on both blocks and allocations/contracts. A block level workflow allows investment managers and
broker/dealers to tie trades back upstream providing better parity between front and back office systems. Investment managers can submit a block
and then submit allocations against the block. Broker/dealers submit a block and corresponding contracts. For matched trades the CTM platform will
send status updates to both counterparties. If no match is found for a trade, an exception occurs. Each counterparty is then automatically updated on
a change in the trade status and given the possibility to amend the trade. This allows to catch trade exceptions prior to settlement, saving valuable
time and helping to reduce costs.

DTCC RTTM
Real-Time Trade Matching (RTTM®) enables dealers, brokers and other market participants to automate the processing of their fixed income securities
trades throughout the trading day.
Real-Time Trade Matching (RTTM®) enables dealers, brokers and other market participants to automate the processing of their fixed income securities
trades throughout the trading day.

RTTM provides a common electronic platform for collecting and matching trade data, enabling the parties to trades to monitor and manage the status
of their trade activity in real time. Through RTTM, the parties can track a transaction from trade entry through to clearance and regulatory reporting.
The result is an immediate confirmation for trade executions that is legal and binding. The confirmation also serves to initiate Fixed Income Clearing
Corporation’s (FICC’s) guarantee of trade completion. RTTM is available as a mainframe communications service or through an Internet-based service
called RTTM Web.
RTTM provides a common trade capture and matching platform, a single communications pipeline, and International Organization for Standardization
(ISO) interactive message format for the entire U.S. fixed-income marketplace. This includes not only U.S. Government and mortgage-backed
securities settled through FICC, but also corporate and municipal bonds and Unit Investment Trusts (UITs), which are settled by National Securities
Clearing Corporation (NSCC). Both FICC and NSCC are subsidiaries of The Depository Trust & Clearing Corporation (DTCC).
WHO CAN USE THIS SERVICE
Members of FICC’s Government Securities Division (GSD) and Mortgage-Backed Securities Division (MBSD) or members of NSCC are eligible to use
RTTM. In addition, through FICC’s Executing Firm feature, which permits introducing members to submit trades on behalf of non-FICC members such
as institutions and correspondent firms, it’s possible for non-FICC members to benefit from RTTM as well.
 BENEFITS
RTTM addresses the industry need for automation, interactive communications and risk mitigation in the traditionally fragmented over-the-counter
debt markets. Covering the breadth of fixed income instruments that customers trade, RTTM brings members closer to achieving the many benefits of
straight-through processing, including:
Reduced execution risk by automating manual post-trade processing procedures;
Further risk reduction through centralized trade date matching and the establishment of legally binding confirmations in real-time,
Reliable communications and standardized interactive messaging;
A cost-efficient consolidated platform that supports all highly-traded fixed income products;
A web-based front end allowing members to enter trade-related activity and obtain real-time status information, along with user-friendly search,
query, and reporting tools;
Specified pool trade matching
Exception-based screens, allowing members to focus only on discrepancies rather than on the entire post-trade processing flow;
Standardized procedures across fixed income products, minimizing the number of specialized systems and personnel needed to support your
operations;
Ability to comply with business and regulatory demand for more timely and transparent trade reporting;
Full alignment with business continuity plans by providing for the safe storage of trade data; and
 HOW THE SERVICE WORKS
Customers can submit their trades upon execution in real-time, exchange trade status messages, access and transmit reports, and cancel or modify
trades in RTTM using one of two methods: via RTTM Web, the web-based user interface, or via mainframe-based interactive messages.
RTTM Web is a web-based interface that serves as a single point of entry, providing transaction management and screen-based error resolution across
fixed income instrument types. The application is a secure, browser-based trade entry/management tool that incorporates robust search capabilities,
statistical reporting, and exception processing.
Through RTTM Web, customers can enter trade-related activity and, regardless of input method, obtain the real-time status of all transactions
received and/or updated by the RTTM system. RTTM Web’s user-friendly search, query, and reporting tools help members proactively identify and
resolve processing exceptions that, left undetected, could lead to costly trade discrepancies.
Regardless of how trades are submitted, FICC will generate output to RTTM users when trades are compared (whether comparison occurs as a result
of matching, or trades are recorded as compared upon receipt). Comparisons generated by FICC evidence a valid, binding and enforceable contract
between the trading member counterparties, and also represent the point at which MBSD’s trade guarantee goes into effect.
RTTM routes compared trades to the appropriate destinations for further downstream processing for netting and settlement and regulatory agencies
for price transparency reporting. RTTM also supports trade reporting to TRACE and the Municipal Securities Rulemaking Board (MSRB).
RTTM will send matched NSCC-eligible obligations that qualify for netting to NSCC’s Continuous Net Settlement (CNS) system, Balance Order system or
the Trade-for-Trade Accounting system. The vast majority of trades settle in CNS, which nets transactions for each participant and facilitates the
book-entry movement of depository eligible securities in a centralized, controlled and automated environment.

DTCC OW
Obligation Warehouse (OW) is a non-guaranteed, automated service of NSCC that facilitates the matching of broker-to-broker ex-clearing trades and
provides Members with the ability to track, manage and resolve their failed obligations in real-time.

ABOUT
OW facilitates the matching of obligations submitted by Members for U.S. securities classified as equities, corporates, or unit investment trusts. The
centralized service supports bilateral matching of ex-clearing and failed obligations in real-time. OW is not a guaranteed service of NSCC.
OW stores eligible unsettled obligations (including securities exited from NSCC’s Continuous Net Settlement (CNS) system, Non-CNS Automated
Customer Account Transfer Service (ACATS) items, NSCC Balance Order transactions, and Special Trades) in a central location and provides on-going
maintenance and servicing of such obligations, including daily checks for CNS-eligibility and periodic updates for certain mandatory corporate actions,
until such obligations are settled, cancelled, or otherwise closed in the system. OW will also provide enhanced and more frequent RECAPS processing
on a pre-announced schedule.
WHO CAN USE THE SERVICE
All NSCC Members can use the OW service. Full service broker dealer Members are required by FINRA Rules to use RECAPS.
BENEFITS
Promotes transparency by providing a complete view of virtually all open obligations traded in the U.S. marketplace for equities, corporates,
municipals, and unit investment trust securities.
Provides one common repository for failed obligations.
Mitigates counterparty risk and reduces net capital charges by reconfirming and re-pricing failed open obligations to current market value on a more
frequent basis.
HOW THE SERVICE WORKS
Members submit their ex-clearing trades to OW for real-time matching by the contra-party. Once the submitting party enters the required transaction
information, an advisory is sent by OW to the contra-party requesting that they respond by submitting identical transaction details to facilitate a
compared obligation, or by affirming the obligation via the OW Web screen. The matched trade is then considered an open obligation.
Open obligations are tracked and maintained in the OW until those obligations are settled, cancelled, or otherwise closed in the system. A daily
maintenance function will apply certain mandatory corporate action events, and will forward to CNS those open obligations stored in OW that
become CNS-eligible. However, OW is not a guaranteed service, and an obligation forwarded to CNS will only be guaranteed to the extent that the
Member meets its settlement obligation on the date the item is originally scheduled to settle in CNS. Additionally, the non-CNS obligations being
stored in OW are re-priced to the current market value and re-netted during the periodic RECAPS cycle.
Firms can submit real-time input and receive real-time output using MQ messaging as well as within the OW Web browser screens. Firms will also
receive end of day reports reflecting their positions.

Ex-Clearing

Ex-Clearing is a manual comparison process that is performed by the brokerage firm’s Purchase and Sales Department when the traded security does
not meet the eligibility standards of the designated clearing corp.
On settlement date, the firm’s Settlement area will create a Fail Record on the firm’s accounting books and records to represent the open receivable
or deliverable. The Settlements area will ‘set-up’ a Fail-to-Deliver for securities sold and a Fail-to-Receive for securities purchased.

The transaction is concluded when the selling firm delivers the sold securities to the buying firm, and the buying firm pays the selling firm for the
delivered securities. At such time, the open fail record is removed from the firm’s books and records. The ultimate removal of the open receivable or
deliverable is referred to as a "Clean-Up".

http://www.brokerage101.com/

Mutual Funds vs. Hedge Funds: An Overview

Both ​mutual funds​ and ​hedge funds​ are managed portfolios built from pooled funds with the goal of achieving returns through diversification. This
pooling of funds means that a manager—or group of managers—uses investment capital from multiple investors to invest in securities that fit a
specific strategy.

Mutual funds are offered by institutional fund managers with a variety of options for retail and institutional investors. Hedge funds target
high-net-worth investors. These funds require that investors meet specific accredited characteristics.

Asset-Backed Securities (ABS) vs. Mortgage-Backed Securities (MBS): An Overview

Asset-backed securities​ (ABS) and ​mortgage-backed securities​ (MBS) are two of the most important types of asset classes within the fixed-income
sector.​1​​ 2​​ ​MBS are created from the ​pooling of mortgages​ that are sold to interested investors, whereas ABS is created from the pooling of
non-mortgage assets. These securities are usually backed by credit card receivables, home equity loans, student loans, and auto loans. The ABS market
was developed in the 1980s and has become increasingly important to the U.S. debt market.​3​​ Despite their apparent similarities, the two types of
assets possess key differences.

The structure of these types of securities is based on three parties: the seller, the issuer, and the investor. Sellers are the companies that generate
loans for sale to issuers and act as the servicer, collecting principal, and interest payments from borrowers. ABS and MBS benefit sellers because they
can be removed from the ​balance sheet​, allowing sellers to acquire additional funding.

Issuers buy loans from sellers and pool them together to release ABS or MBS to investors, and can be a third-party company or ​special-purpose
vehicle​ (SPV).​4​​ Investors of ABS and MBS are typically institutional investors that use ABS and MBS in an attempt to obtain higher yields than
government bonds and provide diversification.

KEY TAKEAWAYS

● Asset-backed securities (ABS) are created by pooling together non-mortgage assets, such as student loans. Mortgage-backed securities (MBS)
are formed by pooling together mortgages.
● ABS and MBS benefit sellers because they can be removed from the balance sheet, allowing sellers to acquire additional funding.
● Both ABS and MBS have prepayment risks, though these are especially pronounced for MBS.
● ABS also have credit risk, where they use senior-subordinate structures (called credit tranching) to deal with the risk.
● Valuing ABS and MBS can be done with various methods, including zero-volatility and option-adjusted spreads.

Asset-Backed Securities (ABS)

There are many types of ABS, each with different characteristics, cash flows, and valuations. Here are some of the most common types.​5​​

Home Equity ABS

Home equity loans are very similar to mortgages, which in turn makes home equity ABS similar to MBS. The major difference between home equity
loans and mortgages is that the borrowers of a home equity loan typically do not have good credit ratings, which is why they were unable to receive a
mortgage. Therefore, investors need to review borrowers' credit ratings when analyzing home equity loan-backed ABS.

Auto Loan ABS

Auto loans are types of amortizing assets, and so the cash flows of an auto loan ABS include monthly interest, principal payment, and prepayment.
Prepayment risk for an auto loan ABS is much lower when compared to a home equity loan ABS or MBS. Prepayment only happens when the
borrower has extra funds to pay the loan.​

Refinancing​ is rare when the interest rate falls because cars depreciate faster than the loan balance, resulting in the collateral value of the car being
less than the outstanding balance. The balances of these loans are normally small and borrowers won't be able to save significant amounts from
refinancing at a lower interest rate, giving little incentive to refinance.
Credit Card Receivable ABS
Credit card receivables are a type of non-amortizing asset ABS.​6​​ They don't have scheduled payment amounts, while new loans and changes can be
added to the composition of the pool. The cash flows of credit card receivables include interest, principal payments, and annual fees.

There is usually a lock-up period for credit card receivables where no principal will be paid. If the principal is paid within the lock-up period, new loans
will be added to the ABS with the principal payment that makes the pool of credit card receivables staying unchanged. After the ​lock-up period​, the
principal payment is passed on to ABS investors.

Mortgage-Backed Securities (MBS)

Most mortgage-backed securities are issued by Ginnie Mae (the Government National Mortgage Association), Fannie Mae (the Federal National
Mortgage Association) or Freddie Mac (the Federal Home Loan Mortgage Corporation), which are all U.S. government-sponsored enterprises.​2​​

MBS from Ginnie Mae are backed by the full faith and credit of the U.S. government, which guarantees that investors receive full and timely payments
of principal and interest. In contrast, Fannie Mae and Freddie Mac MBS are not backed by the full faith and credit of the U.S. government, but both
have special authority to borrow from the U.S. Treasury if necessary.

Mortgage-backed securities can be purchased at most full-service brokerage firms and some discount brokers. The minimum investment is typically
$10,000; however, there are some MBS variations, such as ​collateralized mortgage obligations​ (CMOs), that can be purchased for less than $5,000.​7​8​​
Investors that don't want to invest directly in a mortgage-backed security, but want exposure to the mortgage market may consider exchange-traded
funds (ETFs) that invest in mortgage-backed securities.

Notable ETFs investing in MBS include the iShares MBS ETF (MBB) and the Vanguard Mortgage-Backed Securities Index ETF (VMBS).​9​10​​ ETFs trade
similar to stocks on regulated exchanges and can be sold short and purchased on margin.​11​​ Like stocks, ETF prices fluctuate throughout each trading
session in response to market events and investor activities.

Special Considerations
Both ABS and MBS have prepayment risks, though these are especially pronounced for MBS. Prepayment risk means borrowers are paying more than
their required monthly payments, thereby reducing the interest of the loan.​12​​ Prepayment risk can be determined by current and issued mortgage rate
difference, housing turnover, and mortgage rates.

For instance, if a mortgage rate begins at 9%, drops to 4%, rises to 10% and then falls to 5%, homeowners would likely refinance their mortgages the
first time the rates dropped. Therefore, to deal with prepayment risk, ABS and MBS have tranching structures to help distribute prepayment risk.​13​​
Investors can choose a tranche based on their own preferences and risk tolerance.

One additional type of risk involved in ABS is credit risk. ABS has a senior-subordinate structure to deal with credit risk called credit tranching. The
subordinate or junior tranches will absorb all of the losses up to their value before senior tranches begin to experience losses. Subordinate tranches
typically have higher yields than senior tranches due to the higher risk incurred.​14​​

Asset-backed and mortgage-backed securities can be quite complicated in terms of their structures, characteristics, and valuations. Investors have
access to these securities through indexes such as the U.S. ABS index. For those who want to invest in ABS or MBS directly, it's imperative to conduct a
thorough amount of research and weigh​ your risk tolerance​ prior to making any investments.

ABS vs. MBS Example

It is important to measure the spread and pricing of bond securities and know the type of spread that should be used for different types of ABS and
MBS. If the securities do not have embedded options such as call, put, or certain prepayment options, the ​zero-volatility spread​ (Z-spread) can be used
as a measurement. The Z-spread is the constant spread that makes the price of a security equal to the present value of its cash flow when added to
each Treasury spot rate.​15​​

For example, we can use the Z-spread to measure credit card ABS and auto loan ABS. Credit card ABS does not have any options, making the Z-spread
an appropriate measurement. Although auto loan ABS do have prepayment options, they're not typically exercised, making it possible to use the
Z-spread for measurement.

If the security has embedded options, then the option-adjusted spread (OAS) should be used. The OAS is the spread adjusted for the embedded
options. To derive the OAS, the ​binomial model​ can be used if cash flows depend on current interest rates but not on the path that led to the current
interest rate.​16​​

Another way to derive the OAS is through the Monte Carlo model, which needs to be used when the cash flow of the security is the interest rate
path-dependent. MBS and Home Equity ABS are types of interest rate path-dependent securities where OAS from the Monte Carlo model would be
used for valuations. However, this model can be quite complex and needs to be checked for accuracy throughout its usage