A brokerage firm remains in business as long as it continues to earn a profit.
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A brokerage firm is the subject of the article presented below. A client needs a dealer to process his buying or selling a security. A brokerage firm is the dealer. When a securityís trade is done there are many things that happen. Their sequence with all possible interactions constitutes a process. The article uncovers the operational functions of a typical brokerage firm, that is, what happens after the trade is done and the essential elements of that process.

Operational functions of a brokerag firm cover two types of relationships:

  • relationship of operations departments within the brokerage firm itself
  • relationship of operations departments with the outside entities such as:
  • commercial banks
  • transfer agents
  • clearing corporations
  • depositories

 

When a client enters an order with the brokerage firmís representative the order becomes part of a flow of data that the brokerage firm must control. That flow of data becomes a formalised view of what happens after the trade is done.

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Brokerage firm provides services to the clients through maintaining a marketing and sales function. These functions are assured by various actors:

  • marketing people
  • stockbrokers
  • processing area people
  • administrative area people

 

(1) marketing people, who work in marketing departments, determine which types of securities the public is interested in and try to adjust the offer to the clients. The types of securities may include:

  • common stocks
  • corporate bonds
  • municipal bonds

 

(2) stockbrokers (salespersons), who work in sales branches (board rooms), contact the customers and sell the securities or ideas to their clients.

(3) processing area people fulfil the following tasks:

  • booking
  • posting
  • completing of entries for the clients

 

(4) administrative area people assure the following functions:

  • book the commissions on the transactions to a revenue account
  • pay the expenses
  • hire personnel
  • process personnel insurance claims

 

Processing of a brokerage firm area is staged through the following functional unities:

  • order room
  • purchase & sale
  • margin
  • cashiering
  • stock record
  • accounting: the daily cash record
  • dividend
  • proxy
  • new accounts
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I - order room

Order room is the point from which all orders emanate. Orders taken from the clients by stockbrokers situated in the sales locations are passed to the branch or main order room. The order room routes them to the point of execution. If a trade based on the order can be made the order room reports the execution price to the branch. Now the stockbroker may inform the client of the orderís completion. This action completes the order roomís functions. Orders directed to the order roomsí go through the following stages:

  • controlling
  • servicing
  • maintaining
  • recording the execution

 

These stages assure that the orders are:

  • reconciled through matching procedures (*)
  • confirmations of the ordersí execution are reported to the clients
  • pending orders, that is not executed ones, are organised and dealt with accordingly

(*) Reconcilement in the order room comprises matching execution reports coming from the trading area with the orders. Order room assures that all of customerís original criteria have been met. Based on the reconciliation the stockbroker advises the client on his order. Through this step a change of the order by the client is possible.

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II - purchase & sale

Purchase & sale department is responsible for the following tasks:

  • recording
  • figuration
  • comparison (reconcilement)
  • confirmation and booking

 

A CUSIP identifier (or in-house number) is associated with each trade. It enables to handle the trade through all cycles of its processing. Some supplementary codes are attributed to the trades that designate the type of operation, the execution point and all possible details enabling the straight through processing (STP). Thus recording of the trade is done.

Selling and buying involves certain computations. For certain types of debt instruments (bonds, notes, bills, CDs) the accrued interests are calculated. These computations are called figuration.

Customersí trades are balanced (reconciled) against the opposing brokerage firmís (street-side) transactions. All trades are processed through electronic data processing (EDP) centres. Certain output computer reports are sent to the clearing centres of listed exchanges or over the counter centres (OTC) for further processing. When both sides agree on the trade with all discrepancies removed we say the settlement and thus the comparison (reconcilement) is done.

A customer receives a written notification from the brokerage firm for confirmation. What follows is the booking procedure that consists of entering trade data (fees and commissions) into the firmís records.

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III - margin

Brokerage firms must maintain the clientsí accounts in accordance with the rules of Securities and Exchange Commission (SEC). Clients are rarely aware of these rules and they depend entirely on the brokerage firms who act as their watchdogs. The majority of customer-firm rules are enforced by a department known as margin (or credit) department. They assure that all operations concerning customerís purchasing and selling that involve the accounts are within the framework of the regulations. Customers may purchase through two types of accounts:

  • cash accounts
  • margin accounts

 

Customer pays in full when purchasing in cash account.

When using a margin account a client uses a loan obtained from the brokerage firm that covers part of the buy. The securities bought on margin account are used as collateral in the operation. They cover the risk of the loan provision by the brokerage firm. The purchasing power of a client is computed whenever buying on margin. It reflects the percentage of the price that could be covered through a brokerage firmís loan. The purchasing power is the amount of the clientís cash and all his securities that could be transformed rapidly into the liquidities (cash).

The daily margins functions cover many other operations. Certain of them are as listed below:

  • computing clientís account excess
  • computing clientís purchasing power
  • computing and adjusting special memorandum account (SMA)
  • filling for extensions
  • issuing delivery or transfer instructions
  • preparing and issuing sell-out/buy in notices and orders
  • answering stockbrokers inquiries
IV - cashiering
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The responsibilities of the cashiering function include:

  • receiving and delivering
  • vaulting
  • hypothecation of security for margin accounts (bank loan)
  • borrowing and lending money and securities (stock loan)
  • issuing delivery or transfer instructions
  • securities transfer
  • keeping track of reorganization among issuers

 

Receive and deliver section assures that the securities flowing through their area are in good deliverable form. The dirty (rejected) stocks are to be returned and the payment is withheld. Rejecting a non conforming security is cheaper for the brokerage firm than go to the expense of bringing it up to good deliverable form.

 

Vaulting is keeping track of securitiesí ownership.

 

A brokerage firm uses clientís securities through hypothecation only when it pledges a portion of it at a commercial bank to finance customerís debit on margin account. That part of the clientís securities is referred to as free stocks. The remaining part that may not be used for brokerage firmís need is called segregated (seg) securities. Money managers try to obtain the most favourable loan from the commercial bank on the securities pledged in order to cover the hypothecation. These loans are called collateralized and are charged less than the uncollateralized ones as a result of guarantee for the loan provided.

 

Sometimes a brokerage firm borrows securities from another firm using cash as collateral. A specialised firm called finder lends the required securities for a fee. In other cases the brokerage firms enters a repurchase agreement (REPO) lending its own securities in order to borrow some cash.

 

Registered securities are transferred to the transferred agents (banks that maintain the companyís list of owners). Securities transfer assures that any change of securitiesí ownership is reregistered. The registration may be in either beneficial name or nominee name.

 

The corporations get reorganised during their life cycles. The change is reflected through the modification of the corporationís stocks. We call the process a corporate event. The reorganisation (reorg) section keeps track of these changes and makes the appropriate changes in customer account.

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V - stock record

Central depository keeps track of all securities movements through customersí and vaults accounts. The stock record must be in balance and no breaks (when only one side of an entry is recorded) are allowed. Frequent audits look for any discrepancies between the physical count and the stock record position.

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VI - accounting: the daily cash record

The accounting department records, processes and balances the movement of money within a brokerage firm. Dual-entry bookkeeping assures that each movement breaks into two entries: debit and credit. The final step of the accounting process is the daily cash record that contains all the money movements that occurred in the firm on the previous day.

All accounting in a brokerage firm may be broken into the following phases:

  • constitution of the accounting journal
  • creation of the trial balance document
  • adjustment of the trial balance
  • generation of business reports

 

All entries into the daily cash record (accounting journal) are posted to individual ledger accounts. These ledgers are then reconciled to the accounting journal and all debit and credit, as posted to the ledger, must net out to zero. The netting operation is reflected in the updated balances of the individual ledger accounts. Reconcilement makes certain that all entries have been posted properly.

 

Al least once a month all ledger account balances are copied into a document known as trial balance. Any discrepancy between debits and credits (netting not equal zero) leads to correction of individual ledger accounts and regeneration of the trial balance.

 

Trial balanced when completed is adjusted for accruals. Accruals are the items incurred during a period but payable or receivable at another. Taxes are a typical case for accrual adjustments.

 

Two primary business reports are generated:

  • profit and loss (P&L) statement
  • balance sheet

 

Profit and loss statement is generated based on the accounts in the adjusted trial balances that reflect revenue (income) and expense. A profit or loss is for the firm the difference between the debit and credit totals taken from the adjusted trial balance.

 

Balance sheet describes the firmís assets, liabilities and net worth taken from the accounts in the adjusted trial balances. The balance is set so that the total of assets equals the sum of total liabilities and net worth.

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VII - dividend

Employees of the dividend department figure and credit dividends and interest paid on debt instruments. Dividends are paid to stockholders who are registered owners on the night of the record date. The record date is the latest day to buy the stock and thus become its legal owner. That date is announced by the corporation distributing dividends on the declaration date. The date of the actual dividend payment (payment date) is provided as well. As the process of settlement takes certain time, the buy of a stock that allows for dividend must take place before the ex-dividend date (ex-date). For cash dividend it might amount up to four days before the record date. On ex-date the price of the stock, as quoted on the stock exchange, is automatically reduced by the amount of dividend.

 

The essential duties of the dividend department are:

  • make certain that the rightful owner is paid the dividend. Careful recording of the firm securities is essential to reconcile firmís record date with the physical securities on hand.
  • credit and debit accounts with interest payments on debt instruments
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VIII - proxy

Proxy area of a brokerage firm assures that all communication from the securityís issuer is sent directly to the client when the security detained by him is registered in the street name. Otherwise, when the securities may is registered either in the clientís name, itís the issuer that sends all communication directly to the client.

Communication managed by the brokerage firm, who acts as a nominee for the issuer, covers:

  • proxy statement (proxies) enabling the shareholders to vote
  • distributing yearly statements, audit reports, semi-annual reports
  • any other document that corporation wishes to present to its shareholders
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IX - new accounts

The task of the new account function is to assure that the clientís account is opened properly and show to the client that his business is being taken care for. With the account open, the client may enter an order. Principal types of accounts managed by the brokerage firm are:

  • individual cash account
  • margin account
  • joint account
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Note of comment

The principal source of the information for this article is David M. Weiss book ďAfter the trade is madeĒ. The inspiration for its writing was my recent interview with a head hunter for a bank consultant position where certain knowledge of brokerage form activities had been expressed. Itís also a personal need for condensed information thatís useful when applying for a post in the banking area and by the same time an occasion to share it with other applicants. For a thorough comprehension read the entire David M. Weiss book.