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Understanding Futures Transaction Flow

- Basic Introduction
Published on January 6, 2017

Tayloe Draughon Follow

142 11 36
Consultant, Product Manager & Innovator

Over the years, I have heard everything from overly-simplified to overly-complex

descriptions of how listed futures trades are processed. For the purpose of clarity, the
following flow diagram is one that I have used to explain the trade flow process to
many people entering the industry.

However, each Futures Commission Merchant (FCM), Exchange, and Clearinghouse

processes transactions slightly differently.

Note: I am not going to go into the role of the middle office. Execution only,
processing, algo trading, or brokerage commissioning are likely discussions for future
articles.
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1: Trader Enters Order

The buy side trader enters an order into an electronic trading system. Common popular
independent electronic trading systems include Trading Technologies, CQG, Fidessa,
and Bloomberg. (For a more complete list check out MarketsWikis ISV Category.)
Many FCMs also have their own mobile and web-based trading systems.

A basic order includes the following information:

Side - The buy or sell indication

Quantity - The number of contracts

Contract information - Which product and maturity on which exchange

Order Type - Instruction to the broker how to handle the order (Common order
types are Market, Limit, and Stop)

Price - The price where the order should be bought or sold

Time In Force - How long the order stays open (Common times in force include
Day or Good Till Cancelled)

Account Number - the account number identification for the FCMs tracking system
Note: This may or may not be the same account number used in the clearing system.

Once the trader submits the order it is passed to the OMS technology controlled by the
FCM. The OMS technology may be hosted at an independent software vendor (ISV),
however, it is under contract to an exchange member firm and the connection to the
exchange is provided by the member firm.
2: Order Management System (OMS) - Receive Order Sign in

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Once the order is received by the FCMs trading system, it is recorded in the OMS
database and also recorded to a transaction log file (#3). The OMS is responsible for
maintaining the state of the order. At this time, the order state is Pending New, the
order has been received by the broker but not yet sent to an exchange.The order is then
passed on to the Pre Trade Risk Check (#4).

3: Client Communication Transaction Log File

All client communication around the world is required to be kept for at least five years.
All transactions in the communication log should be timestamped so that activity can be
reconstructed by internal or external examiners. The order that is received from the
trader is the first in a chain of transactions that will all relate to this order.

The transaction log should include every order status change with the corresponding
transaction timestamp. These state changes include:

Order Receipt

Order Acknowledgement

Order Acceptance

Order Transmission to Exchange

Order Acknowledgement by Exchange

Order Acceptance by Exchange

Order Rejection

Order Partial Fill

Order Fully Filled

Order Expiration

Order Modification

Order Cancellation

Order Too Late To Cancel

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4: Pre Trade Risk Check

Before the trade is submitted to the exchange the FCM needs to check to see if the order
meets approved sizing controls. Some trading systems use a financial number for this
check. However, it has been my experience, that many use a contract count size limit.
This check is usually at a trader or account number level.

Some of the common checks include:

Fat Finger - This check ensures that an unusually large sized order is not allowed
into the exchange. An unusually large order could affect a price change. This check
is on an individual each order. Many trading systems have different limits for each
contract. (Note: Some FCMs use Fat Finger Limits to prevent someone who
isnt familiar or approved to trade a market from entering any orders.)

Position Limits - This check ensures that the trader does not accumulate a large
position in any one contract. This is typically a count of contracts. Position limits
may be in total or as values for long or short positions. Since many trading systems
do not have a direct link with the clearing system, the position limits are usually for
each day. Position limits typically check to see if the new order quantity plus the
filled number of contracts will exceed the position limit.

Open Order Quantity Limits - Some trading systems limit the number of contracts
that can be in the traders open order book. This is similar to the Position Limits, but
takes into account the total number of contracts ordered. This way a lot of small
orders cannot be entered to get around Fat Finger and Position Limits.

Price Reasonableness Check - This control checks to make sure that the order
being entered into the market is reasonable for the market. This prevents junk or
erroneous orders from manipulating the orderly market process.

If the order passes these checks it is then sent on to the Exchange through the Exchange
Gateway (#5). Orders that fail the order are rejected by the OMS (#6).

5: Exchange Gateway - Send Order

Many trading systems have an exchange specific gateway. This technology is

responsible for translating the order from the Trading Systems order representation to
the exchange required communication protocol.

Any transactions processed through the gateway are required to be recorded and
maintained for five years. This is stored in an exchange specific log file (#7).
6: Failed Pre-Trade Risk Check Sign in

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If, for any reason, the original client order fails to pass the pre trade checks, (#4) then
the order is rejected back to the client.

7: Exchange Specific Transaction Log

The exchange specific transaction log contains all communication between the FCM
technology and the exchange. This includes, but isnt limited to, the following
transactions:

Log On & Log Off

New Orders

Order Modifications (or Cancel Replaces)

Order Cancellations

Fills (and partial fills)

Exchange Rejections

Too Late To Cancel

Cancel Rejections

Exchanges typically have a format where these files must comply. All transactions
should be timestamped to the millisecond level or better and have some sort of
sequencing so that transactions can be reconstructed at a later time by an internal or
external auditor.

8: Exchange Pre Trade Risk Controls

Exchanges operating with a best practice approach as outlined by the Futures Industry
Association (FIA) have their own pre-trade risk controls. These controls exist to prevent
inappropriate orders from entering the electronic market, and are often implemented at a
firm wide level. The controls may also work at account, or account grouping
(sometimes called sub-firm), or at an individual connection.

The exchanges typically have pre trade controls that include:

Fat Finger - Ensures that no order exceeds a predefined and approve quantity.

Price Reasonableness Checks - Ensures that no order is outside an acceptable

range from the last traded or current bid/offer prices.

Intraday Position Limits - Ensures that no single position allows that for the
potential failure of the market participant.

Market Sweep Protections - Ensures that no single order sweeps or matches

with too large of a percentage of open orders in the market.
 Self Match/Cross Protections - Ensures that no order matches with another order Sign in
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Other pre trade risk controls exist. For more information on these controls read the
FIAs Market Access Risk Recommendations.

9: Failed Exchange Pre Trade Risk Controls

If, for any reason, the FCMs order fails to pass the Exchanges pre trade checks, (#8)
then the order is rejected back to the FCM who is responsible for maintaining the
correct order state and for communicating the order rejection to the client.

10: Pass Pre-Trade Risk Controls

Orders that pass the Exchanges pre-trade risk controls are then sent to the Exchanges
matching engine to be processed.

11: Order Management System - Rejection Received

Rejections dont just happen. There are procedures around them. First, the order must
be properly marked as rejected with a corresponding reason for the rejection in the OMS
component of the trading system. Rejections that are created as a result of failed FCM
pre trade controls (#4, #6) need to be sent to the client.

12: Exchange Specific Rejections

Rejections that are received from the exchange pre-trade controls (#8, #9) must be
recorded as rejected in the Exchange Specific Transaction Log.

13: Communicating rejected orders to the client.

The rejected orders need to be communicated to the client. Any communication with the
client needs to be stored in the Client Communication Transaction Log (#14). If the
client is currently logged on, then the rejection should notify the client immediately. If
the client is not logged on, then the rejection should be made immediately available as
soon as the client is connected.

14: Client Communication Log for Rejections

Rejections must be communicated with the client. All client communication around the
world is required to be kept for at least five years. All transactions in the communication
log should be timestamped so that activity can be reconstructed by internal or external Sign in
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15: Exchange Matching Engine

The exchange matching engine is the electronic marketplace where buyers Bid for a
price, and sellers Ask for a price. The exchange will take Bid and Ask orders and match
them appropriately. Orders that are not immediately matched are held in the matching
engine as part of the book of open orders. They wait until a new order arrives that will
match the same price.

Orders may match against more than one order. For example:

Time 1: Account SS-1 submits Order #1 to sell 10 Jelly Bean contracts at 75.

The order does not match any buy order, therefore it stays in the open order book.

Time 2: Account SS-2 submits Order #2 to sell 10 Jelly Bean contracts at 80.

The order does not match any buy order, therefore it stays in the open order book.

Time 3: Account BB-3 submits Order #3 to buy 15 Jelly Bean contracts at 80.

This buy order is immediately matched with the 10 contracts from Order #1
resulting in a partial fill of 10 at price 75.

Order #1 is notified that it is fully filled: Sold 10 at 75.

Order #3 is notified that it is partially filled: Bought 10 at 75.

This order is also immediately matched with 5 of the contracts from Order #2
resulting in a partial fill of 5 contracts at price 80. This partial fill will result in
Order #3 being fully filled and Order #2 remaining partially filled with 5 contracts
still in the open order book.

Order #2 is notified that it is partially filled: Sold 5 at 80.

Order #3 is notified that it is fully filled. Bought 5 at 80.

Each exchange matching engine performs somewhat differently. The logic for how the
orders are matched is determined by the exchange. The most common logic is Price-
Time priority. This means that the best price is used to match the order and that orders
that have been in the open order book have priority. This can easily be thought of as
First-In, First Out at each price level.

16: Exchange Matching Engine: Fill Reporting

Every fill involves at least one buyer and one seller. The Exchange reports both fills to
the FCM trading system that originated the order. These reports may go to the same
FCM or they may go to different FCMs. This keeps the order state in the trading Sign in
systems correct and notifies the trader of the execution. Join now

However, this is only a report to the trader. No money has moved into or out of a
clearing account. No position change has been recorded. To record the actual move of a
position, or to debit/credit an account, the exchange need to report the trade to the
Clearinghouse.

17: Exchange Gateway - Receive Fill

Once the exchange reports the fill to the FCMs trading system, that fill needs to be
recorded and reported. The Exchange Gateway (#5) that sent the order will be notified
of the fill. This fill needs to be recorded to the Exchange Specific Log file (#18), and
sent to the Order Management portion of the trading system for proper order state
handling.

18: Recording the Fill to the Exchange Specific Log File

The exchange specific transaction log contains all communication between the FCM
technology and the exchange as explained in #7. The exchanges typically have a format
where these files must comply. All transactions should be timestamped to the
millisecond level or better and have some sort of sequencing so that transactions can be
reconstructed at a later time by an internal or external auditor. Fills typically include the
following information:

Transaction Timestamp: This is the time that the order was filled at the exchange.

Receipt Timestamp: This is the time that the fill was received by the FCM.

Fill Quantity: The number of contracts or shares filled.

Fill Price: The price at which the trade was made.

Account: The account from the order.

Order Number: The order number being filled.

Financial Instrument: the contract that was traded.

Additional order information is typically included in this report. Some exchanges also
include order status information in the fill report. All information received from the
exchange should be included in the exchange specific log.

19: Order Management System - Record Fill

The OMS component of the trading system is responsible for tracking state. The OMS
knows the current state of all orders. In the case of a fill the OMS needs to calculate, or
verify, that the order is either partially filled or fully filled. The number of contracts that
are left unfilled is the new open order quantity. The OMS also typically calculates the
average fill price.
20: Notifying the trader of the Fill Sign in

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The OMS is responsible for communicating the fill to the originating trader. The
communication should happen as soon as possible. If the trader is online, then the fill
should be reported immediately. If not, then the trader should be notified of the fill as
soon as he or she is reconnected. Of course, all communication with the client needs to
be recorded (See #21).

21: Fill Reporting to the Client Communication Transaction Log

All client communication around the world is required to be kept for at least five years.
All transactions in the communication log should be timestamped so that activity can be
reconstructed by internal or external examiners. The fill should contain information
including the exchange transaction time, price, quantity, and current order status.

22: The Clearinghouse Records the Trade

The Clearinghouse provides centralized clearing. It operates as a proxy buyer for every
seller and as a proxy seller for every buyer. As a proxy, it is able to guarantee every
trade. That way, if one side of the trade fails to provide a settled trade, the
Clearinghouse will ensure that the other side is not disadvantaged. Centralized clearing
provides transparency and security for all market participants.

Once the trade is recorded in the Clearinghouse system, it is then reported directly to the
FCMs back office system. The back office is responsible for recording all trades,
managing the positions for each account, and managing the money (profit, loss, funds
on deposit, margin) for the trading firm or the trader.
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23: FCM Clearing System Records Trade

The Clearing System at the FCM can be thought of as the central account management
system for each clearing account. If the FCM agrees with the trade, then it reports
acceptance of the trade to the Clearinghouse for settlement (#24). If it doesnt agree
with the trade, it will report the rejection of the trade to the Clearinghouse and go
through a trade break process. Trade breaks arent covered in this report.

The FCM is guaranteeing the trade. All trades processed through the FCMs trading
systems or brokers are guaranteed. If the trading account is unable to settle the trade for
whatever reason the FCM will take the trade into its own accounts.

24: Clearinghouse Settles Trade

Once a trade is accepted by the FCM and accepted the Clearinghouse will complete the
trade settlement process. As stated earlier, the Clearinghouse is a proxy buyer to every
seller and a seller to every buyer. The Clearinghouse uses the acceptance of the trade to
verify that both sides have accepted the trade. If one side doesnt, the Clearinghouse
will work with the FCM to fix the trade break.

25: Clearing System Debit/Credit Accounts

When the clearing system receives a fill, it must correctly change the position and
appropriately debit or credit the account for any change in funds as a result of the trade.
When a trade is reported to the clearing system, it does not contain the accounts
position in the financial instrument. It only contains the new fill quantity. The clearing Sign in
system is the authority on the correctly current position. Join now

26: Clearing System - Calculate Margin

Most accounts in listed derivative trade on margin. This means that the account holder
pays for only a portion of the asset in cash and the FCM, serving as a broker, guarantees
the remainder. This allows the account holder to leverage the funds on deposit for more
investing. Each position that an account holds is subject to margin as determined by
each exchange for its products. Failure to have enough funds on deposit to cover the
margin amount results in a margin call from the FCM to the account holder. If the
account holder is unable to cover the margin then the FCM may liquidate some or all of
the positions to ensure compliance with the margin requirements.

27: Post Trade Risk Checks

The margin calculations from #26 are the most basic form of post trade risk checks.
FCMs typically utilize other post trade position analysis to ensure that the account does
not fail resulting in the FCM having to cover the account holders positions.

Some common post trade risk checks used by FCMs include:

Position Limits: Ensuring that no single account has too much of a given product.
This limit is typically based on the FCMs risk department's review of the account,
its finances and its trading style.

Position Volatility: The value of the position is subject to changes in the market.
Some positions are more volatile than others. Therefore, the FCM is likely to run
any number of analytical processes to determine likely and worse case scenarios
based on the accounts positions.

If the FCMs Risk Department determines that an account is at risk, they will work with
the account to ensure that the positions are changed to meet the FCM.

28: Statement

The FCM produces a daily statement for each account. This statement includes all the
positions and the transactions throughout the day. This is the official books and records
for the account holder.

Contact

Please contact me with questions or inquiries either through the public comments
section or by emailing me directly at tayloe@draughon.us.

Tayloe Draughon
Consultant, Product Manager & Innovator Follow
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Joseph King - 4d
Chairman Of The Supervisory Board, China Asset Management
Accurate and simply explained.
Anyone with limited knowledge on this topic would do well to read this article.
Good work.
Like Reply 1

Jon Jenkins 6mo

CEO at Phoenix Star Consulting Ltd
Very nice overview!
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There are 9 other comments.Show more.

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