Posted in: Institutional Broking and Clearing
Article published in Asset Servicing Times
September marked seven years since Fannie Mae and Freddie Mac went into conservatorship and Lehman Brothers filed for bankruptcy. These and other events at the time tested the resiliency of the world’s financial markets in an unprecedented way, exposing stresses not previously seen.
This was especially true in US financial markets, and in the wake of the 2008 credit crisis, policymakers, regulators, creditors and investors agreed that there was a clear need for developing and enhancing ‘de-risking’ mechanisms.
In the past, the post-event response would likely have centred on putting regulations in place such as Basel I and II, the Sarbanes-Oxley Act and the Markets in Financial Instruments Directive (MiFID). While there is still some discussion around regulatory controls with MiFID II and Basel III, as well as the Volcker Rule and the Financial Conduct Authority’s changes to the Client Assets Sourcebook, the global emphasis now is more on reducing reliance on manual clearing and settlement processes by improving controls and the supporting technology.
With this, the securities industry is moving toward establishing central clearing products that support increased transparency, lower risk of fails and operational losses, and shortened settlement cycles. There is a particular focus on T+2 settlement, which has been implemented in a variety of markets around the world and is currently gaining attention in the US.
Nothing is as unsettling to an operations manager than leaving for the day without knowing that outstanding risk and exceptions have been closed out. Yet this is the environment we live in today.
While technological advances have simplified processes in every other aspect of business, not much has changed from an operational standpoint where securities processing is concerned.
Generally speaking, the financial services industry is weighed down by ‘technical debt’. Historically, technology spend has not been a priority unless a significant issue arises. Even then, only the system causing the problem is addressed.
As one former senior bank operations and technology head often reminded his team: “Operations is just the part that technology hasn’t gotten around to fixing yet.”
This is not an uncommon viewpoint, as many organisations do not see recurring capital as an opportunity to improve operational inefficiencies but as dollars that can be returned to shareholders or used to drive incremental revenue. They view operational losses as the normal cost of doing business.
As a result, many organisations continue to work on legacy systems that have not kept pace with technology and the industry is plagued with workarounds due to the limitations.
This is especially true where exception management is concerned. Perpetual fails can potentially cost an organisation hundreds of thousands, if not millions, of dollars in real profit and loss under the newer Basel-driven capital rules.
As an industry, it is imperative that we change our perspective and stop looking at technology in terms of what it costs, but of what it can do. While at one time the cost of a technological overhaul was not seen as a commercially responsible decision, robust technology supporting the middle office and operational processing now pays for itself several times by freeing up capital to support growth.
To achieve all of the goals the industry is working toward—greater transparency, fewer operational losses and faster settlement—ideally designed operational processes must be geared toward real-time or, at the very least, near real-time performance and not the current end-of-day or next-day timeframes.
That’s the way it would happen if we were to design a market from scratch today, but of course that’s not economically feasible.
Moving from the T+3 environment, in which many markets still operate, to T+2 brings with it the promise of reduced risk exposure and increased market liquidity since settlement happens faster. There’s also greater visibility into the trade lifecycle with real-time views.
While shortening the settlement cycle does provide an upside in terms of risk management, any industry-wide change such as this receives a lot of attention—and not all of it positive. Apprehension across operational and technology managers is often grounded in the uncertainty of change.
That’s really not the issue where T+2 settlement is concerned since we already know that it works. Not only has T+2 been the standard practice in the repo market from the beginning, it’s been implemented for clearing and settlement in a number of the world’s major markets.
In a letter from Mary Jo White, chair of the US Securities and Exchange Commission (SEC), to the Securities Industry and Financial Markets Association and the Investment Company Institute in response to the June 2015 whitepaper Shortening the Settlement Cycle: The Move to T+2, White said the SEC strongly supports “efforts to shorten the settlement cycle from the third business day after the trade date to no later than the second business day”.
White went on to say: “While current SEC rules do not prevent implementation of T+2, I recognise that updates to those rules could help support the move to T+2 by all market participations, as well as shorter settlement cycles potentially in the future.”
Reading between the lines, this does seem to indicate that the SEC will implement a T+2 rule at some point in the future, and that the market could adopt a T+1 framework in the longer term.
With this, chief administrative officers and COOs are likely facing the question of what comes next. They know that to harmonise with the world’s markets they need to start planning for T+2, taking a fresh look at their current processes in terms of system interdependencies, funding frameworks and processing bottlenecks.
As a part of this analysis, market participants should also be thinking about the risks and obstacles of making the next move to T+1, even if that’s one year from today or 10, to ensure we don’t end up with the same type of legacy technology issues that we have today