T+2 POTENTIAL POST-TRANSITION WOES: CONFIRMATION / AFFIRMATION

The transition to T+2 settlement throughout the European Union (EU) is scheduled for January 2015. Some countries may transition before this date. Henceforth, from January 2015 equity and bond trades will settle two days after trade date across the EU. This is a major accomplishment as it’s the first region to reduce the time between trade and settlement date from T+3.

One unknown consequence of this change is the impact on Confirmation / Affirmation (C/A) rates.  The C/A process occur between institutional investors (buy-side) and their brokers (sell-side). Institutional trade volumes represent the largest number, and greatest value, most broker’s business. 

The C/A process is the presentation (confirmation) of trade details by the sell-side and approval (affirmation) from the buy-side. The current rate of successful affirmation on or before T+1 is between 60-70%. In a T+2 environment positive affirmation must be made on trade date.

Un-affirmed trades must be reconciled to ensure timely settlement and to avoid failed settlements. In the current T+3 environment manual work-arounds are used to identify and resolve un-affirmed trades. But  in a T+2 enviroment, with one less day, manual work-arounds will be less effective. As a result the industry must respond to this situation to ensure the success of T+2 settlement.

There are alternative responses that can address this situation; one is for the buy-side to review and respond to the confirmation on trade date. Another alternative is for the buy-side to empower their custodians to affirm trades on their behalf. Both will permit sufficient time for exceptions to be resolved and advise custodians of the pending settlements. Both alternatives can be implemented with minimal changes to buy-side internal worksflows and minor technology modifications.

These alternatives are short term solutions to the C/A process. The global industry needs an integrated model so that the C/A process is incorporated into the order-trade workflow. The C/A process should be automated with minimal touch-points required. There are systems in place today that come close to this model, but they have not been fully embraced by the community. The industry must determine why these systems aren’t  fully utilized. They must address these issues or commission development of a system that is acceptable to all order to trade lifecycle participants

What’s your opinion on this situation?

               Any idea why affirmation rates are so low?

                        Are  there other viable alternatives?                        

                        

THE FUTURE OF THE MIDDLE OFFICE

The Middle Office evolved as a result of various issues facing Sell-side firms. Two issues, in common, to these firms were:

1.     a need for additional controls to improve the accuracy of the trade details at the beginning of the trade lifecycle

2.     the need to identify and resolve issues causing trade settlement delays

The response was to establish a function that would be closer to the front office, where client facing activities tak place, than the traditional back office. That’s how the name Middle Office came to be and has stuck.

Eventually buy-side firms, as well as other industry service organizations, also established a middle office function as well. This allowed each to functionally match-up to broker/dealers, custodians and prime brokers. Over time the focus of the Middle Office grew to include accounting, reporting and other control activities. The role of the Middle Office has improved operational efficiencies, reduced the cost of resolving delayed and failed trade settlements.

As the time between trade and settlement date shrinks, the Middle office may again prove to be an essential function in maintaining operational efficiency.  The reduction of time between trade and settlement date results in less time to resolve problem trades. This loss of time will require firms to rethink existing internal practices to ensure that there is sufficient time to identity, analyze the cause and resolve the issues that may delay timely and accurate settlement.

Today resolution of problem trades often requires interaction across various front, middle and back office areas. This can take a considerable time and may result in settlement delays. A shortened trade-settlement schedule may result in an increase in unresolved trades. This will have a negative impact on settlement and post settlement activities plus increase operating costs.  One approach might be to reduce the number of departments or staff involved in trade and settlement processing.

Restructuring operational responsibilities is one alternative to consider. Perhaps moving the activities associated with pre-settlement and settlement, now performed by the Back Office, to the Middle Office may be worth a review.

A new infrastructure might include reassigning functions between the Middle ad Back Office areas as follows:

1.     Middle Office – all post order(trade) execution through settlement functions

2.     Back Office – all post settlement through to asset servicing functions

This change is a huge leap from the structure that has been in-place for years. It is similar it to the introduction to technology in the 1960’s which resulted in new work flows, new departments and procedures. Technology continues to support the business and the impact is the same, with slight variations and the evolving changes are accepted as (business as usual.  

This is one approach. There is sufficient time for the industry to ponder the impact of reducing the trade-settlement and explore appropriate responses.

         Do you agree that this is a situation we will face?
 

                Is splitting functions between Middle and Back Offices viable? 
      
                     Can you offer alternative responses?

MULTIPLE SYSTEMS = MAINTENANCE CHALLENGES

The approach broker / dealers adopted early on in the development of application technology was to develop product-centric systems. For example a, equity system fro equities, a government systems for Treasury and a MBS system for mortgage backed securities. As a result, today firm have multiple processing platforms, each supporting specific products. The driver behind this approach was to create a template system that could be cloned to support other product systems. For example if the base fixed income system was the Treasury bond system, it could be used as the foundation for corporate and municipal bonds. Extraneous or unneeded functionality would be stripped while new functionality unique to corporate and municipal bonds would be added. This allowed firms to avoid "reinventing the wheel" each time they introduced a new product and sped up the process as well.

The outcomes were many similar, but different processing systems, each requiring expertise, maintenance and support. For example some products settled one day after trade date, others five days after trade date while mortgage backed securities can settle up to six month after trade date. Differences were pervasive throughout the trade life-cycle as well as in reference data, trade entry, and asset servicing and reporting. This required systems developers and maintenance staff to have current and relevant expertise and knowledge of each product and the related processing functions. The bottom line is that this resulted in increased information technology costs and often delayed new functionality and updates to be applied, even today.

Firms are still struggling to find an approach to address this challenge.  In the past 30+ years have seen many innovations in database design, programming languages and other advances that can provide benefits to financial services firms processing systems. But first they must reduce the number of product-centric systems to facilitate an efficient future environment. There are various alternatives; one is to build a new multi-product system to replace the product-centric systems. But the alternatives require a major effort in cost and resources. And have to be done in the current environment of keeping costs down.

 

         What is your opinion about this?

          Does this cause firms to less competitive?

                                Are there other viable approaches available?

COLLATERAL MANAGEMENT OR MIS-MANAGEMENT……

Depending on the level of preparation, it could be either of the above. Traditionally collateral management was a back office function with little or no impact on the front office. But the Dodd-Frank Act (DFA), European Market Infrastructure Regulation (EMIR) and Basel III require participants to collateralize trades and other transactions.

Broker-dealers have been collateralizing clearing and guarantee funds for many years. But buy-side firms, such as hedge funds and other fund managers, have not had the same experience. They will now be required pledge collateral to support their transactions. If they don’t have appropriate or sufficient collateral they will need their custodians or clearing brokers to locate the needed collateral.

This requires custodians, clearing brokers and industry service organizations to enhance their services. As such it is a new source of revenue to industry service organizations and a new cost for their clients.

Electronic interfaces among the industry service organizations as well as investor will be critical to ensure that transactions are collateralized at minimal costs.

            What are the critical issues facing your firm?

                        How will you optimize the collateral you have?

                                    What are the available alternatives to improve collateral?

WHAT'S UP WITH THE LEGAL ENTITY IDENTIFIER?

It’s been a while since the need for recognizing legal organizations and their related entities has been identified. There have been a number of announcements on initiatives but little definitive movement on a coordinated global response to LEI.

Remember that it was difficult to determine their exposure of derivative trades especially for firms, like Lehman, that were facing a credit crisis. The initial drive for LEI was the Dodd Frank Act (DFA) and European Market Infrastructure Regulation (EMIR). Their focus was to reduce counter-party and systemic risk related to derivatives trading and settlement.

February 12^th was the date for SWAP trades to be processed with LEI. Problems were expected but the news about this event has been sparse.

What are your thoughts, good, bad or neutral, concerning global legal entity identifiers?

                        Are the regulators ready to respond to reported anomalies?

                                 Should a global identifier be extended to other assets?

CENTRAL COUNTER-PARTIES (CCP) – HOW MANY ARE NEEDED?

With the global focus on reducing counter-party risk the number of central counter-parties has increased in recent years. CCP play a major role in ensuring safe markets and best practices. Their primary purpose is to mitigate risk between trade counter-parties. CCP traditionally provide a broad range of services to support their members. These services may include; trade reporting, trade comparison, collection of margin or clearing deposits.  

As new regulations take effect there may be an increase in the number of CCP.  The industry relies on the CCP to ensure that counter-parties perform as expected. The CCP becomes a critical component during market price swings, asset class scandals and CCP members face market, internal operational or technology challenges. CCP require broad business expertise and technology platforms to enable their ability to recognize, address, contain and resolve these challenges before the “knock-on” impact on CCP other members?

The industry, as well as regulators, continues to address these as well as other issues. It would be helpful for all market participants and regulators to identify and address these issues on a proactive rather than reactive basis.

What’s ideal CCP ratio for a marketplace, transaction or asset class?

Should the costs associated with a CCP be an issue?

What other CCP related issues are you concerned about?

FINANCIAL TRANSACTION TAX (FTT)

Now scheduled to go into effect in mid 2014 if the there is an agreement before the end of 2013 if addressed .by member states.

Additional revenue is always welcomed. Harmonization of taxes across the EU is also a positive step. Another purpose of the tax was for the financial services industry to pay back some of the money they received during the credit crisis.

But will the imposition of this tax drive participants and / or transactions to offshore markets?  Will all transactions be taxed? What about financing transactions such as “Repos” and transaction types that don’t currently exist?

A new tax sends a signal to the business affected and often has negative consequences.  I have seldom seen a new tax or fee that has raised the estimated revenues. In this era of global markets perhaps a better alternative is to reduce or eliminate existing taxes to attract new business raising income levels and in-turn tax revenues.

The following questions must be addressed before proceeding to provide clarity and ensure that undesired effects are avoided.

Does this tax really make sense?

What‘s the purpose?

   What can the unintended results be?

BUY-SIDE - LEFT OUT IN THE COLD

Why has the Buy-side been left out of a process that reduces transaction volumes and protects the securities industry via time-tested risk mitigation processes?

That the buy-side doesn’t participate in the post trade date process, that protects street-side participants and ensures timely and accurate settlement, is an oversight by the industry as well as the regulators. Post trade processes evolved, from the early 1970’s, originally driven by the paper work crunch of the late 1960’s. Today these processes ensure that the industry is safe and capable of supporting substantial growth in trade volumes. These processes include trade comparison, trade netting and settlement.    

But the infrastructure only protects the street-side which leaves buy-side participants outside the process. In turn this exposes the street-side to risk of settlement failures and the need to process additional transactions volumes.

There are alternative methods of buy-side participation; one where the investor would become a member and participate directly. Another is having the investor’s Custodian or Prime Broker represent the investor and participate on their behalf. Both alternatives would require some accommodation by the industry infrastructure and the Buy-side but it would be a “win-win” for everyone.

What are your thoughts?

Do you agree…..or…… disagree?

                             What are the benefits or disadvantages?

HOW DO WE IMPROVE BUY-SIDE TRADE AFFIRMATION RATES? – UNITED STATES

The current affirmation rate for institutional trades is about 80% in the US. In this day of no-or low touch trading and automation this is an anomaly and delays trade life-cycle process improvements. In addition it may be contributing to higher costs.

It’s crucial that the industry, both buy-side and sell-side participants, address the issues that are blocking a 100% affirmation rate. This will deliver control and cost benefits to all participants and make the process safer and timely settlement predictable.  

What drives the Buy-side lack of interest in proactively participating in a process that ensures that the trade will settle as expected and at the same time adds a level of safety to the process? This raises certain questions:

Why isn’t the Buy-side motivated to participate in this process?

Do they understand the importance of the confirmation / affirmation process?

What needs to be done to achieve 100% affirmation by T+!?