Chapter 8: Trade Processing and Settlement

Order Tickets and Requirements

In 2015, a trader at Citadel Securities fat-fingered an order and accidentally bought $15 billion worth of stock in a single trade. The firm caught the error and unwound the position within minutes—but not before it briefly moved markets and triggered a wave of confused calls to compliance departments across Wall Street.

The order ticket is where every trade begins. It's a deceptively simple document—just a few data fields—but it serves as the permanent record of what happened, when, and why.

Essential Order Information

The order ticket must specify the following:

Buy or Sell:

• Buy = taking a long position
• Sell long = selling stock you already own
• Sell short = selling borrowed shares (both "Sell" and "Short" are marked)

Security Name: Typically the ticker symbol—AAPL, not "Apple Inc."

Order Size: Number of shares (usually in round lots of 100), option contracts, or bonds

Duration:

• Day order = expires at market close
• Good-til-canceled (GTC) = remains active until filled or canceled

Discretionary vs. Not Held Orders

A discretionary order gives the representative authority to choose what security to buy and/or how much to trade. If a customer says, "Buy $10,000 of a good high-tech stock," that's discretionary—the rep picks the stock. Discretionary accounts require:

• Written power of attorney from the customer
• Principal approval before the account is opened
• Principal approval of each trade

But what if the customer says, "Buy 1,000 shares of XYZ when it looks good to you"? The security and amount are specified—only the timing and price are left to the rep's judgment. This is a market not held order, which is NOT considered discretionary.

Additional Required Information

The ticket must also include:

• Execution price: For limit orders, stop orders, or stop-limit orders (not required for market orders)
• Solicited or unsolicited: Did the rep recommend the trade, or did the customer initiate it?
• Manager approval: All orders must be approved by a principal—promptly, which typically means by end of day
• Rep's name: Who handled the order
• Customer name and account number

Regulation SHO: Short Sale Requirements

When you sell stock you don't own—borrowing shares to sell now, hoping to buy them back cheaper later—you're selling short. Regulation SHO, adopted by the SEC, requires that:

• Every order to sell must be marked as either a long sale or a short sale
• For short sales, the broker must locate the shares to be borrowed before the sale
• Borrowed shares must be delivered on settlement

Alterations to Executed Orders

Under FINRA rules, changing an executed order ticket requires:

• Written approval from a branch manager or compliance officer
• Documentation of the essential facts and the reason for the change

Prohibited Trading Practices

Now we get to the practices that will end your career and potentially land you in prison. These rules exist because people actually tried—and sometimes still try—these schemes.

Best Execution

When executing customer orders, a firm must obtain the best outcome for the customer. Price matters, but it's not the only factor. Firms should consider:

• The character of the market (price, volatility, liquidity)
• The size and type of transaction
• The number of markets checked
• The firm's accessibility to various markets and quotation sources

Failure to provide best execution violates FINRA rules.

Customer Orders Have Priority

Simple rule: customer orders come first. A firm cannot give preference to its own proprietary trading account over customer orders—that's trading ahead.

Front Running

Front running is trading ahead of large block orders. If an institutional client is about to buy 500,000 shares—which will likely push the price up—the firm cannot buy shares for itself first and profit from the anticipated price movement.

Trading Ahead of Research Reports

If your firm's research department is about to publish a report recommending a stock—which will likely move the price—the firm cannot trade based on advance knowledge of that recommendation. Once the research is publicly disseminated, the restriction lifts.

Acting as Both Broker and Dealer (Hidden Profit)

A firm can act as a broker (agent) or a dealer (principal) on a transaction—but not both on the same trade. If you charge both a commission AND a markup, that's a hidden profit—and it's prohibited.

No Interpositioning

When your firm receives a customer order, you go to the market maker. You do not route the order through another firm that then goes to the market maker—unless doing so would result in a better price for the customer. Interpositioning adds unnecessary costs.

Backing Away from a Firm Quote

If a market maker posts a quote, they must honor it. Backing away—refusing to trade at your posted price—is explicitly prohibited by FINRA.

Market Manipulation

Manipulation of the market is prohibited in any form. Key schemes to know:

Trading Pools (Pump and Dump): A group coordinates to buy a security at successively higher prices, creating false demand. Outside investors pile in, then pool members sell at artificially inflated prices.

Wash Trades (Painting the Tape): Buying and selling the same security repeatedly with no actual change in ownership, creating the false appearance of trading activity.

Marking the Close / Marking the Open: Trading at or near market close/open specifically to manipulate the closing or opening price.

Trade Clearing

After a trade is executed, it must be cleared and settled. These are not the same thing:

• Clearing = verifying that both parties agree on the trade details
• Settlement = actually exchanging cash for securities

The Depository Trust Company (DTC)

The Depository Trust Company (DTC) is essentially the vault where all securities positions are held. Member firms maintain accounts at the DTC containing securities and cash.

Almost all securities are now held in book entry form—electronic records rather than paper certificates. When you "own" 100 shares of Apple, what you actually own is an entry in a database.

The National Securities Clearing Corporation (NSCC)

The National Securities Clearing Corporation (NSCC) handles clearing of corporate securities trades:

1. Both sides submit trade details to the NSCC
2. The NSCC compares submissions to ensure they match
3. If matched, the trade proceeds to settlement
4. On settlement date, NSCC instructs DTC to adjust accounts

Both DTC and NSCC are subsidiaries of the Depository Trust & Clearing Corporation (DTCC).

Clearing Firms vs. Introducing Firms

Clearing firms are large broker-dealers that clear and settle trades for themselves and customers. Introducing firms are smaller broker-dealers that focus on customer relationships but rely on clearing firms for back-office processing.

The Options Clearing Corporation (OCC)

The Options Clearing Corporation (OCC) performs a similar function for options trades, recording positions and guaranteeing contract performance.

Trade Comparisons and DK Notices

Each side of a trade sends a confirmation to the contra broker. The confirmations include:

• Trade date and settlement date
• Size of trade and security traded
• Execution price
• CUSIP number (unique identifier for securities)

If there's a discrepancy, the firm sends a DK (Don't Know) notice. DK notices must be resolved within 20 minutes.

Trade Settlement

Settlement is when transactions officially complete—cash and securities actually change hands.

Regular Way Settlement: T+1

As of May 2024, regular way settlement for most securities is T+1—one business day after the trade date. This applies to:

• Stocks
• Corporate bonds
• Municipal bonds
• U.S. government securities
• Listed options

Cash Settlement

Cash settlement means same-day settlement, for trades entered before 2:30 p.m. ET. Typically used for index options and commodity futures.

Other Settlement Types

Seller's Option: When the seller needs more time—gives buyer one day's notice of delivery.

Buyer's Option: When the buyer can't pay by regular way.

When, As, and If Issued: For new securities not yet available for trading.

Good Delivery of Securities

Physical stock certificates still exist, and the exam tests the rules for delivering them. For a physical delivery to be "good," several conditions must be met:

Endorsement Requirements

• Physical securities must be endorsed on the back by the registered owner in exact name
• Alternative: Use a stock power or bond power—separate transfer documents

Signature Guarantees (Medallions)

The customer's signature must be guaranteed by a FINRA member firm, bank, or savings institution. A signature guarantee (medallion) is NOT the same as a notary seal.

Certificate Denominations

Bonds: $1,000 minimum or multiples up to $100,000 maximum per certificate.

Stocks: Must be in round lots (100 shares) or certificates that combine to make round lots.

Example for 400 shares—good delivery:

• 1 certificate for 400 shares ✓
• 4 certificates of 100 shares each ✓
• 8 certificates of 50 shares each ✓ (two 50s = 100)

NOT good delivery: 10 certificates of 40 shares (40+40+40=120, an odd lot)

Mutilated Securities

Damaged certificates are not good delivery unless accompanied by a validation letter from the transfer agent or issuer.

Customer Confirmations

Customer trade confirmations must be delivered by settlement date. Required information includes:

• Customer name and address
• Firm name, address, and telephone number
• Type of account (cash or margin)
• Name of security, size, and price
• Trade date and settlement date
• CUSIP number
• Accrued interest (if a bond trade)
• Commission (if the firm acted as agent)
• Whether payment for order flow was accepted

What's NOT Disclosed

If the firm acts as dealer (principal), the markup or markdown is generally NOT disclosed—except for Nasdaq principal transactions.

Municipal Bond Confirmations

The MSRB requires additional disclosure:

• Issuer name, interest rate, maturity, and if callable
• Whether it's a limited tax GO bond
• Revenue source for revenue bonds
• Yield and dollar price (yield to maturity or yield to worst for callable premium bonds)

Accrued Interest

When a bond is sold between interest payments, the buyer pays the seller accrued interest from the last payment date through the day before settlement.

Calculation methods:

• Corporate/Municipal bonds: 30/360 (30 days per month, 360 days per year)
• U.S. Treasuries: Actual/365 (actual days, 365 per year)

Bonds that trade flat (no accrued interest):

• Zero-coupon bonds
• Defaulted bonds
• Income bonds

Distribution Dates

When a company pays dividends or executes stock splits, specific dates determine who receives what. These dates trip up new investors constantly.

Cash Dividend Dates

The Four Key Dates:

• Declaration Date: Board announces the dividend
• Record Date: Must be owner of record by this date to receive dividend
• Ex-Date: First date too late to buy and receive dividend
• Payment Date (Payable Date): Dividend checks are mailed

Ex-Date = Record Date (Under T+1)

With T+1 settlement, the ex-date and record date are now the same day for cash dividends. Previously they were different.

Sample Question

Price Adjustment and Selling Dividends

On the ex-date morning, stock prices typically open lower by approximately the dividend amount. Selling dividends—recommending purchases just for the dividend—is prohibited because customers don't actually benefit (price drops by the dividend amount).

Stock Splits and Stock Dividends

Forward stock splits increase shares outstanding while reducing price proportionally. A 2:1 split means twice the shares at half the price—same total value.

Reverse stock splits reduce shares while increasing price. Used when stock price gets too low.

Stock dividends are similar to small forward splits—additional shares with proportional price reduction.

Critical Difference: Ex-Date for Splits

The ex-date for stock splits and stock dividends is handled differently:

• Cash dividends: Ex-date = Record date (same day)
• Stock splits/dividends: Ex-date = Day AFTER payment date

Summary & Key Points