OLD SCHOOL.
Buyside firms may prefer the human touch but regulation is pushing them to the automation future. Heather McKenzie reports.
Despite the technological innovations, buyside firms are still undertaking some key post trade processes manually. The problem is that the number of people who can handle this labour intensive job is dwindling and regulation is calling for a new regime.
The report: Investment Fund Processing in an Era of Heightened Risk Awareness, Increased Regulatory Demand and Financial Austerity was undertaken by Aite Group and commissioned by international central securities depository (ICSD) Clearstream. It found that order placement, confirmation, fund transfer and reconciliation processes were particularly dominated by manual effort. However, it also revealed that fewer people were available to deal with the task of processing investment funds because firms are being forced to keep budgets static or to decrease their spending on running costs. More than half of firms (55%) said they had to support increasing volumes of data without increasing the number of full-time employees and the remainder of firms studied said there had been a decrease in full-time employees.
The report stated: “Low levels of automation generally translate into higher costs and operational risks within the funds processing environment due to the high level of manual intervention. To this end, some key processes within the investment funds and alternative funds universe continue to be dependent on the sending of faxes and even postal correspondence.”
One representative from a European buyside firm said it had straight through processing rates of only 40% for its full investment funds processing cycle. Its previous investment in automated processes had concentrated on the support of its own funds, while the other funds it distributes are supported by numerous manual processes such as fax communications. “This means that sometimes orders are not processed in time across borders, thus resulting in an increase in operating costs such as those related to delayed settlement and potential claims,” states the report.
Low levels of post-trade automation at buyside firms are nothing new. For years broker-dealers and custodians have been dealing with buyside counterparties who use faxes and emails to confirm trades or to communicate.
A new world order
What is new, however, is a raft of regulations and other initiatives coming to the securities industry. Designed in the main to protect investors and avoid a repeat of the financial crisis of 2007-8, these rules could have a profound impact on the middle and back office processes of buyside firms. Two items stand out in the current post-trade agenda in Europe: the European Central Bank’s (ECB’s) Target2-Securities (T2S) platform and the European Commission’s Central Securities Depositories Regulation (CSDR).
T2S was conceived as a platform to enable CSDs to use a common technical service that would execute settlement instructions. T2S will provide delivery versus payment for securities against central bank money. CSDs will maintain their relationships with intermediaries, investors and issuers, as well as their asset servicing function (such as the management of corporate actions), according to the ECB. T2S is an important project for the Eurosystem and for Europe, and will affect every participant in the post-trade space. It will become a key component of the European market infrastructure and is designed to address the costly fragmentation of securities settlement market infrastructure. Put simply, the core intention of T2S is to enable efficient and integrated securities settlement.
The CSDR is closely related to T2S. This aims to create a pan-EU status for CSDs, common governance rules and allow issuers of financial instruments to choose where to settle, regardless of the location of the CSD. The regulation introduces an obligation of dematerialisation for most securities, harmonised settlement periods for most transactions in such securities, settlement discipline measures and common rules for CSDs.
Among the most significant proposals are the harmonisation of the settlement period in Europe to a maximum of T+2, the imposition of penalties on market participants that fail to deliver their securities on the agreed settlement date, user choice in terms of which CSD they can settle in and a passport for authorised CSDs, which will enable them to provide their services in other member states.
T+2 settlement already exists in Germany, but nowhere else in Europe. It is likely to present a significant challenge for some buyside firms that currently struggle with the T+3 regime.
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The Aite Group report lists the key operational changes that will occur as a result of the CSDR or T2S. These include:
• Move to mandatory buy-in in the case of settlement failure;
• Potential processing cycle change for some CSDs (overnight cycle);
• Technology investment to cope with squeezed settlement cycle;
• Potential adoption of new harmonised data standards and message formats;
• Move from voluntary to mandatory processes in certain areas;
• Changes to liquidity and collateral management timeframes; and
• Move to book entry recording for the issuance and transfer of securities.
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Tony Freeman, global head of industry relations at Omgeo, says T2S and CSDR are forcing firms to rethink their operations. “Accommodating T+2 settlement will involve an insignificant technology change for the big buyside firms, but the non-automated segment of that sector will need to address the change. Operationally it will have a big impact on them,” he says. Sellside firms, he adds, are talking to their buyside clients about post-trade automation in a much more serious fashion than previously. “A move to T+2 involves extra cost and risk if you are using manual processes. This has given sellside firms the incentive to go to their buyside clients and say ‘this might not work in T+2’.”
Moreover, the possible imposition of fines, under the CSDR, on firms that fail to settle is another big consideration, says Freeman. “The chance of trade failure among non-automated firms will only increase under T+2.”
In the long term, securities firms will benefit from the introduction of T+2, says Geoffroy Vander Linden, head of product management at Xtrakter, the trade matching subsidiary of MarketAxess, operator of an electronic trading platform for US and European corporate bonds. T+2 settlement will deliver reduced back office costs via harmonised settlement times and a consolidation of CSD venues. However, in the short term, the moves will lead to increased costs as firms will have to adapt their systems to meet the T+2 settlement cycle.
Like Omgeo, Xtrakter believes the key to improving straight through processing rates in post-trade processes is via automation, particularly of pre-settlement elements such as trade affirmation, matching and confirmation. “There are many benefits of trade matching,” says Vander Linden. “In addition to meeting shorter settlement cycles, matching can also help to mitigate risk by finding errors earlier in the trading process.”
Omgeo maintains that settlement efficiency and improved post-trade processes can be achieved with central matching solutions that increase efficiency, reduce risk and promote same day affirmation (SDA), moving trades more quickly to settlement.
“It isn’t costly to automate,” says Omgeo’s Freeman. “We have big, middle and small sized firms as clients. I don’t think technology cost is the barrier to automation. The barrier is behavioural – for many years buyside firms such as hedge funds have relied on their prime brokers to act as unofficial outsourcers of back office processes. But prime brokers are no longer willing to take on the level of risk that represents.”
Automation in the back office of buyside firms won’t be achieved via a “big bang”, adds Freeman. He characterises what is happening today as a “slow burn”. The lead-up to T2S and CSDR has focused minds on automation. “The non-automated firms realise T+2 will have a big impact. I think there will be a lot of activity in this area in the first nine months of 2014. People are waking up to the fact that T2S and T+2 are significant infrastructure changes that will change the way the industry works.”
