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Clearing up settlement

Historically, plan sponsors, investors, bankers, traders and regulators haven’t paid much attention to clearing and settlement. These proprietary systems with their in-country attributes reside, in most cases, in the asset manager’s back office. However, the growing consensus on the need for global straight-through processing (STP) has changed that. Underscored by the US-driven expectation of a trade day plus one (T+1) settlement by June 2004, proponents of global STP have pushed these vital functions to the forefront of industry dialogue.
For their part, asset managers have become saddled with an increasingly burdensome secondary role. Acting as clearinghouses passing information between broker/dealers and custodians to facilitate settlement, hundreds of management firms are now expected to accommodate near-future demands by creating STP conditions primarily for the benefit of others. This high-cost expectation will drain resources from their principal role— generating value through investment performance. To date, the results have been mediocre STP rates, particularly in the cross-border space, an environment facing collapse under the exacting demands of T+1.
Due to the shift in the global economy towards equity-based financing, the industry must acknowledge that its strategic imperative is global, integrated, end-to-end STP. In the very near future, every trading participant, whether institutional or retail, will need to make radical and fundamental changes to their workflow procedures. Those who do will benefit from improvements, such as reduced risk, a 50% reduction of fails in the T+3 environment and a rein on operating costs.
Any player of reasonable size that doesn’t achieve STP cannot remain competitive as the environment moves to T+1. Increasing volume, increasing complexity and increasing virtualisation already threaten the industry’s current trade processing model, which lacks uniform, end-to-end communication standards, is labour-intensive and involves fragmented manual practices that burden all parties with errors and fails.

New models
New trade processing models are under development by entities including, but not limited to, Omgeo (a joint venture of Thomson Financial ESG and the Depository Trust & Clearing Corp) and the industry-owned GSTP AG. The question is how these and other similar entities will interoperate efficiently for the benefit of all parties. At the time of writing, Omgeo and GSTP AG had begun talks on this subject.
What we do know is that tomorrow’s operations model will be a redesign, both collective and radical and that it will connect multiple players and processes much more efficiently. Along with better information management and valuation, anticipated improvements have the potential to eliminate 50% of fails in a T+3 environment.
These expectations for STP are inevitable as the global economy becomes more ‘wired’ each day. Some 50% of US households now own equity shares, either directly or through mutual funds, 401k plans or directly-managed pension plans. In Britain, the percentage is roughly 25%, in Germany and France less than 20%, yet the numbers across Europe are increasing. Recent reports for Germany show a 60% increase in the number of shareholders from 1997 to year-end 2000. Cross-border equity flows account for a growing share of all capital flows and help determine the course of exchange rates and the balance of trade. So fast, reliable and secure data flows that match capital with investments benefit all parties in numerous ways.
Straight-through processing poses significant challenges to fund managers in the areas of operational risk, IT spend, staffing, and balancing profitability against rising costs. Combined data1 from two independent studies conducted in the UK in 1999 show that 64% of all trading tickets are in paper form with no automation to traders and the back office. Some 60% of trade confirmations are partially or fully manual; 50% of data feeds are rekeyed manually; 62% of custodian reconciliations are manual and 30% of all related communications are relayed via fax. Given that volumes are expected to skyrocket, managers have no choice but to apply technology or hire additional resources.

Choices
To achieve STP through a technology solution, managers have a handful of choices. They can retool existing architecture, invest in transformational change programmes and recoup costs from other revenue sources or leverage new architecture through divesting, selling, outsourcing, partnering or a combination of these.
When deciding whether to upgrade or replace existing technology, considerations should include the number of components in question, vendor support and/or existing products, management capacity, human resource implications, further development that may be necessary, and, in certain situations, long-term financial considerations. The technology and human resource costs alone require substantial capital investment for which managers may not necessarily get payback.
Investment operations outsourcing and more complex, highly customised outsourcing solutions are new offerings that have evolved from the global supplier’s traditional menu of custody and related services, fund accounting and administration. Scottish Widows and PIMCO were among the first to outsource the entire suite of integrated services that support their back office. Such complex, carefully crafted partnerships can involve moving staff and systems from the investment firm to the global third-party supplier.
Global suppliers that have committed themselves to technology and expanded service models to support the entire investment spectrum are best equipped to leverage multiple clients and rationalise core processing functions on a central or regional basis. Effective management over such operations requires the expertise that ensures satisfactory systems implementation while allowing the business to remain competitive. Those who can support the back office keep asset managers’ critical applications running, including those that ensure accurate data maintenance and those supporting client servicing, risk management and regulatory compliance. Investment firms gain predictability of processing costs and the provision of ‘best of breed’ solutions.

Front and middle office
New outsourcing models can totally support the front and middle office as well. Functions include position record keeping, data maintenance, broker and custodian processing and management, fund accounting and daily valuation. Data warehouse capabilities will support client reporting and servicing, performance, risk, regulatory and compliance reporting. Information technology resources will be managed and supported both for development and network management. Experienced staff drawn from investment management backgrounds will run these processes and ensure that service levels meet and eventually exceed client expectations.
These solutions are not for the faint hearted. They involve an integration process of those products that individual investment managers want to use to create a seamless process for their business. Economies of scale come into play by the way the supplier creates the integration process. Economies will be created through process flow improvements, rather than the supply of functional applications.
Trust is critical. Generally suppliers need to demonstrate high levels of service capability before managers will trust their investment operations to them. Suppliers will also need to demonstrate a degree of independence from their traditional businesses, especially where these include custody and accounting. In many cases the parent custodian will only be one of a number of custodians and administrators the investment manager interfaces with, although in the majority of cases it will be the largest relationship. The investment manager will want the supplier to maintain the impartiality that exists today in the back office.

Implementation
Deals such as PIMCO and Scottish Widows entail the transfer of the manager’s human and technical resources to suppliers that are concurrently building robust integrated systems and processing solutions. In these scenarios, the manager’s operation continues to run as before with the same staff and systems, and the supplier may introduce some immediate enhancements and efficiency improvements. More traditional vendor deals involve services transfer to the new processing system with no accompanying staff or systems.
In whatever way the outsourcing partnership develops, the transition to the supplier is critical and requires controlled management. No single transition plan suits all situations. In some cases transitions are by function; in others, by account. A single transition involves multiple milestones and is a significant exercise in project management.
The transition time for a total investment operation may take considerably longer than transitioning traditional custody and accounting. From the first approach, through initial analysis followed by an extensive programme of due diligence, to contract negotiations and closure, can take upwards of nine months. The transition itself can take a further six months or more before completion. Firms considering this route should not underestimate these timeframes.
Maintenance of staff attention and service levels is one of the most significant challenges to both the investment manager and the supplier during this extended period. It is a mutual challenge, as the supplier will not want to assume responsibility for an operation if key staff have left, processes have suffered, and client service has become an issue.
Industry trends, initiatives and emerging trade matching utilities will keep the pressure up on infrastructure. The requirements to adapt and remain competitive will continue to stretch the resources of investment firms, vendors, suppliers and the new industry utilities themselves. New outsourcing models are pathways to straight through processing. If they are accomplished through wise partnership, they can focus investment managers’ attention on generating value for customers.
John Campbell is managing director of State Street Investment Manager Solutions Europe
1 Operational risk and efficiency audit by Global Investor and Latchly Management (1999) and Investment Management Survey by PricewaterhouseCoopers (1999)

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