How is a stock trade executed?

It doesn't happen instantly

Hello!

Hemant here. As I see more and more of stock trading around myself, over the last few weeks, I'm trying to better understand what actually happens when we trade stocks.

Nowadays, buying and selling shares is as easy as clicking a few buttons on your phone. But what takes place behind the scenes after you click those buttons on your phone? For someone who sells shares, who finds the buyer? And what processes ensure that the buyers pay the seller the money, and don't just run away?

To answer these questions, I decided to understand what happens when shares are traded.

The scenario we'll try to decode today is simple - a BUYER wants to buy shares of a company, and a SELLER wants to sell the shares of the same company.


To understand what happens, let's start with understanding who all are involved during the transaction.

Parties involved in a stock trade

  1. Buyer = the person who wants to buy shares of a company

  2. Seller = the person who wants to sell shares of a company

  3. Stock broker = The middleman responsible to coordinate transactions with a stock exchange on behalf of the buyer or the seller.

  4. The stock exchange = The place where the buyer meets the seller. Examples of stock exchanges are the National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE).

  5. Clearing corporation = Each stock exchange has their own clearing house; which is responsible for ensuring the trade actually happens: that the buyer gets the share certificates, and the seller gets their money.

  6. Depositories = think of these like banks. They are responsible for holding your shares. The 2 most depositories available in India are NSDL and CDSL.

Let's buy some shares

One day, our buyer finds that a stock is heavily undervalued and its price would go up in the coming week. Hence, she decides to buy a 100 shares at the current market price.

She goes to her broker's terminal via her phone. There, she sees a few options to choose from:

  1. Type of trade:

    1. Delivery: You select delivery when you are not going to sell the share on the same day.

    2. Intraday: When you want to buy and sell a stock on the same day.

Because she suspects the price would increase over a week, and partly because she doesn't have the patience to buy and sell on the same day, she decides to place a "delivery" order.

She sees that the price of the stock is Rs. 99. Now she has two options for the price:

  1. Price:

    1. Market: She could pay the current market price

    2. Limit: She could decide to offer a price of her own.

Let's say her research suggests that the price is going to go up to Rs. 150 in the coming week. So, she is ready to pay a higher amount if needed.

She decides to place a "limit" order at Rs 105.

  1. Quantity: She decides to buy a 100 shares.

Once she presses the "BUY" button on her phone and the order is placed, several pieces get into motion.

The process of buying shares

On the day she presses the BUY button, let's say day T, a few things happen:

  1. Her broker deducts the money from her bank account and puts the money into the broker's account.

  2. The broker sends the order to the stock exchange, let's say NSE. NSE is responsible for finding a matching seller for her. It uses an electronic matching system to find a seller. The principle is to match the costliest buy price with the cheapest sell price available at that moment.

Let's say NSE is able to find a seller who can sell the shares at Rs. 105 for our buyer. Tadaa, the trade is executed.

On the next day, T+1:

The broker doesn't know who the buyer bought the shares from. This is where the clearing houses come in. NSE has a clearing house called NSE Clearing Ltd., which is responsible for letting the brokers know this information.

  1. Basically, NSE Clearing would tell our buyer's broker that she bought a 100 shares from another person, the seller.

  2. The money that her broker held, is transferred to a "clearing bank account," an account that a broker holds for sending money to sellers. We'll call this the buyer's broker's account for simplicity.

On the next day, T+2:

  1. The money goes from the buyer's broker's account, as mentioned above, into the seller's broker's account.

  2. The money goes from the seller's broker account to the seller.

Buying of the share is finally completed. She now owns a 100 shares!


Selling shares

4 days later, she proudly smiles looking at a stock chart on her phone. The latest price has shot up to Rs. 160, beating her expectations. But her analysis suggests that from here on, the price is going to decline again.

Thus, she decides to sell.

So, she clicks on the stock's name on her phone, and finds the SELL button. She decides to sell all the shares at the market price.

Again, the T+2 cycle kicks in.

On day T, when she presses the SELL button:

  1. shares are deducted from her demat account, and sent to her broker's account.

  2. NSE will once again find a buyer for her shares.

On day T+1:

  1. NSE Clearing Ltd. will tell her broker's account where the shares have to be sent to.

  2. The shares go from her broker's account to the broker's depository account. Every broker has to have an account with one of NSDL and CDSL. Let's call this the broker's pool account.

On day T+2:

  1. The shares go from her broker's pool account, to the buyer's broker's pool account.

  2. The shares are routed from the pool account to the demat account of the buyer.

Finally, she can boast about the massive returns she has made.


As I learnt this process, the one question that has been ringing in my mind is why it takes 2 days for trades to settle. Why can't it all be instantaneous? With the technological advances we have around us, it should be possible to do with a high level of reliability.

Does anyone know why this is the case? I'd love to learn.


References:

  1. What is T+2 Settlement - video

  2. The role of CDSL and NSDL - link


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Thank you for reading :)

Hemant

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