With just one working day to go before the T+1 transition, the perspective is shifting from preparation to mitigation – what will the key pain points be once the US settlement cycle is shortened, and where should firms be focusing their efforts? The FIX EMEA Committee talks exclusively to Global Trading about why T+1 issues right now are “basically a game of whack-a-mole”.
The upcoming transition to T+1 in North America has been a central talking point for so long that it might seem as though there’s nothing else to be said. But these discussions often end at the point of implementation. In reality, though, “there’s still a lot of work to be done after the fact. When you look at the migration of T+1, we’re only at the starting point,” – or so says Matt Coupe, co-chair of the FIX EMEA Committee.
“We will get over the line,” affirms Rebecca Healey, managing partner at Redlap Consulting and Coupe’s co-chair; but just like India’s transition last year, “there will be some papering over of the cracks”. While the initial implementation will work, it won’t be sustainable in the long term, they suggest. As such, the industry needs to identify its pain points now – and prepare to fix them as soon as possible.
Perhaps the most [visible] issue is that different parts of the industry are viewing the transition in silos, focused solely on their own cog in the machine. It’s not just a back-office issue, though, as Coupe points out. While some in the front office might be keen to pass the responsibility over to back office teams, such a major overhaul requires participation across the whole business.
“It has to be a complete conversation,” Healey adds. Because the settlement cycle covers the whole trade lifecycle, “there’s always going to be an issue that you haven’t thought of. You constantly have to rethink and reengineer what your workflow process needs to be.” FIX can help with this, she says, bringing people around the table to collaboratively improve workflows.
The plumbing and pipes are important, but the real difference will be seen in how business processes evolve after the go-live, Coupe continues. “That’s when you start shaking things out, and you start to see things really changing.”
Pain point #1 – Have I got the funds to make the trade?
“The first thing we need to look at is two different settlement cycles. One is the funds settlement cycle, and one is the transaction settlement cycle,” explains Coupe. On the fund settlement side, most funds are operating on models between T+2, T+3 and even T+4, while the securities settlement is in T+1.
While end investors may expect that once their money is put into the fund the trade is realised, this structure means that the fund does not actually get the money for a number of days. “But if you don’t actually have the cash, and you have a settlement cycle that’s operating in T+1, then what do you do?” Coupe asks. “This is the first pain point.”
“Everybody’s operating within a different fund system and fund structure, which means the impact is going to be different based on what the setup is and how the firm chooses to respond,” Healey adds. “This is part of the reason that we’re in this predicament, and why there isn’t a simple solution to the problem.”
The options are to delay the investment – “which would lead to a very interesting conversation with your end investors”, Coupe notes – or to finance it — which comes with a cost, especially given the fact that interest rates are hitting historic highs, or running higher than normal cash deposits, which will also drag on performance.
Delaying or extending the settlement would require agreement with both dealers and brokers and certainty as to how the process will function on a systematic basis. “Some people already have extended settlement built into their trades, but a lot of this is done manually,” Coupe says. “The amount of flow that’s going to go though this is going to increase, but it is difficult to estimate the full demand, and the cost…” and with more information comes the need for more automation.
“Today’s processes have been refined to a point where they work within the existing timeframe,” adds David Pearson, co-chair of the FIX Global Post-Trade Working Group, and product manager at Torstone Technology. But with the compression that T+1 will bring, there’s going to have to be a change of approach. Rather than elements of the workflow being completed sequentially, some tasks will need to be completed simultaneously. “In order to do that, you’ve got to apply real-time processing, system automation and workflow automation.”
“This is where FIX can help,” continues Pearson. “It can supply standardised messaging and workflow that allows those points down the food chain to receive the information they need earlier, removing manual processes.”
FIX can also help move data further upstream, Healey notes. ”Rather than waiting for the completion of the matching process to happen in the back office, its moving more information relating to the trade upstream in front office matching processes at a more detailed level.” If E-OMS teams can clarify the information they need using standardised messaging, then workflows could be far more efficient.
Pain point #2 – Fund structure
The second pain point that emerged during workshop conversations was fund structure. If structural changes mean that market participants need to spend more to invest in a product, Coupe muses, what is the best way to proceed? “Do I need to start looking at different asset classes or products to trade? Are there like-for-likes I can look at, are there derivatives that I can leverage which might give me a more effective outcome? That starts off a whole different number of questions in terms of funds structure,” says Pearson.
As some consider trading alternatives as an interim solution, firms must focus on “the boring but essential” elements of their activity, Healey adds. “Have you got your agreements in place? Does your fund mandate allow you to do what you want to do?” she
asks. Agreements need to be put in place with relevant counterparties, and with the fund. “It’s not just flicking a switch and saying, ‘we’re going to trade derivatives for 24 hours of exposure’,” she says.
There’s a lot that needs to be considered before what may seem like a ‘quick-fix’ solution can be put in motion. And once the preparations are done, “then you’ve got to start looking at the performance,” Healey continues. “Is it actually beneficial for the outcome of your fund performance? You may think you’ve got the solution, but actually it doesn’t pan out the way that you anticipated.”
Pain point #3 – End of day trading
The industry also needs to consider what needs to be changed in terms of the trading process for settlement to work on a T+1 basis. Coupe notes that equity markets see significant activity at the closing auction. There is also an impact in the credit space, where for a variety of reasons, many trades are also executed at the end of the day. Critically, firms need to understand when they receive the confirmation of trade for block trades or trades that might be done in multiple parts, that they will generally be done after the close.
“From a trading desk perspective, that’s something you need to think about,” he affirms. “That’s going to impact a lot of different operations and departments. Confirmations, allocations and the whole process need to be refined to ensure that everything runs as quickly as possible, hitting cut-off times and preventing run-overs into the next day.”
Pain point #4 – FX and liquidity
This issue leads directly into a further pain point: FX and liquidity. With bank streams cut off and the CME shut, reference prices are likely to be produced on wider spreads. As a result, “there is a blowout at the end of the [trading] day – in some pairs it can be observed that this runs into hundreds of basis points”, Coupe states.
“If you’re doing a trading activity and you’re a foreign investment fund – so if the currency in which your fund is held is not the USD, CAD or peso (to the relevant country), you then need to make sure you’ve got the FX there to deliver the currency and get the trade done.”
Getting the FX trade done as early as possible is key, Pearson confirms, but this can be challenging. “You only want to do the FX based on trade confirmation,” he explains, “once you know exactly what your settlement hours are. But if you don’t get your trade confirmed with your client done by 5, 5:30, then you’ve got a truckload of FX to get done” – and the longer it takes you to get to that point, the worse the spreads get.
As a result, many are wondering about what the alternatives are. Some, Healey reports, are estimating their FX earlier, so they don’t have to put all their risk at the end of the day, and firming it up at the close. The real area to look at is workflow efficiency, she says. Firms should be asking themselves, ‘is there a better way that things can be done so I’m not exposed in a way that I could be?’
On this estimation alternative, Coupe raised concerns that emerged during workshops. “You’ve got to make sure you’ve got the data and the information,” he says. There are a number of pre-trade processes that need to be completed in order for this tactic to work, he explains, and there needs to be interoperability between systems so that the FX department is receiving all the data it needs to make an estimation. “There are a lot of gaps that need to be thought through in terms of data standards and workflow, given that some firms outsource their FX trading, or the FX ownership does not sit on the trading desk,” Coupe reported.
Looking at the broader picture, Healey suggests that this is another step in the multi-asset functionality journey. “The decision that you make in order to trade equities means that you need to make decisions about credit and about FX too,” she said. At the moment, although movement is being made towards more consistent trading approaches, “there are still very distinct ways in how people trade asset classes”, she affirms.
Pain point #5 – The thorny problem of CLS
Continuous Linked Settlement (CLS) is an international, independent, and multi-currency payment system, launched in September 2002 for the settlement of FX transactions. It acts as a third party and settlement agent, making sure that transactions are completed. Owned by 69 major financial institutions worldwide, it settles a large number of trades between multiple counterparties, while also providing CLSNet, a bilateral payment netting calculation service, for FX trades.
Earlier this year, CLS decided that it would not make any operational changes prior to the implementation of T+1 in the US – a controversial decision that had some market participants flustered.
READ MORE: No changes to CLSSettlement ahead of T+1
Using CLS “reduces risk within the broader market, because you’re taking out a lot of trades that don’t need to happen because you’ve netted out your own position,” Healey explains. “Then you go to CLS, and you only have to execute the one trade.”
The company already offers a T+1 service for FX in a dealer-to-client model, giving it an edge when it comes to the North American transition. It also provides a T+0 model for interbank transactions.
However, no solution is perfect. Transactions using CLS have to be processed before 6pm EST, and if that deadline is missed then operations will take place on a T+0 basis. “That means you’re going bilaterally and you are going gross unless you have bilateral netting agreements in place,” Coupe says. Additionally, “not all your FX transactions are going to be centred to one counterparty, so you’re losing efficiencies.”
Another issue is the cut-off of custodians to expect trades, as there have been reports that some custodians won’t accept trade post-4pm CET – yet another thing for firms to consider.
The approach CLS takes to FX essentially moves risk around rather than eradicating it, Healey says. “We’re all part of the same whole,” she continues, so wherever the pressure points are they will impact the entire lifecycle of a trade. “For those that can no longer use the CLS service and have to shift to bilateral transactions, they are going to incur more risk and incur more cost.”
“Essentially, cash is the problem for this,” Coupe states. One angle that firms could take is running a cash surplus in the fund, he suggests, given that the current high interest rate environment “is not massively punitive”. However, if and when they drop, things could get tricky.
A more efficient solution would be the automation of the plumbing behind the trade, he affirms. CLS has a strict cutoff time; “everyone has to submit data, get the settlement structures and get the allocations; and this is leading to more STP and more granular data,” he explains. Automation is key here as the workflow becomes increasingly compressed, “and that’s FIX’s forte”.
With wider implications beyond these initial pain points reaching far into the fields of securities lending, repo markets and broader operational changes (watch this space for further analysis on this topic), there is a lot to think about. Instead of being the end of the T+1 runway, 28 May is only just the beginning.
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