While not the panacea to all that ails the financial services industry, the move to straight through processing (STP) offers opportunities to support current business requirements, provide a competitive advantage and pave the way for the future. STP is not an end in itself; it is the means to increase profitability and efficiency through improved client services, reduced operational cost/risk, and uninterrupted business continuity.
Figure 1: STP role in increasing profitability and shareholder value
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Working with our clients, Jordan & Jordan has defined these capabilities as follows:
Expanding client services
Buy and sell side firms alike seek to innovate both products and services in order to meet and exceed client expectations. With the focus on costs and the expectation that firms will leverage new technologies, firms need the internal infrastructure and processes as well as the external connectivity to meet demand for new products, electronic trading with intelligent order routing, integrated service offerings, and real-time services. Furthermore, a straight through processing model positions firms to adapt to fundamental changes in the business, including globalisation, new market participants and new distribution channels.
Reducing operational cost/risk
The increase in cross-border trading and overall trade volume strains brokerage and buy-side operations that are dependent on manual intervention and batch processes. Moving towards T+1 and shortened settlement cycles in other markets reduces exposure to settlement risk. Given the increased volatility of the markets, the cost of fails goes beyond reputational risk, potentially resulting in significant market risk to the liable party. Reducing errors due to multiple data entry and shifting to exception-only processing enables firms to push trades from execution to settlement in a timely manner.
As depositories continue to develop their clearing and settlement services, firms have an opportunity to take advantage of the liquidity management, risk mitigation and the efficiencies of netting frequently offered by the central counter party services.
Ensuring business continuity
The events of 9/11 have served as a reminder to financial services firms and renewed focus on the need for executable business recovery plans at the firm, industry and community level. Firms are looking to STP to reduce data loss in the event of a disruption by electronically capturing information real-time and storing it at multiple sites. Additionally, the adoption of real-time matching and reporting distributes trade information across firms and provides a clear understanding of trade status for all participants.
Getting to STP
As firms and industry associations have been gearing their organisations to tackle STP, it is clear that every firm has different needs based on their current environment and particular STP goals. However, any successful STP project should consider that simply 'connecting the dots' of the trade cycle with electronic rather than manual processes does not get you to the STP promised land. Outside of simply establishing connectivity, firms are evaluating the need for real-time processing, streamlined workflow, standardised architecture and behavioural/organisational changes. In order to address these aspects of T+1, Jordan & Jordan recommends determining the focus of STP efforts through analysis, implementing STP enhancements by activity and across functions, and testing.
While incorporating many of the same elements of any technology project, the move to straight through processing expands the scope of the effort to include vendors, counterparties and industry utilities. Addressing this broader community, the Financial Information Forum brings service bureaus, clearing firms, order routing and market data vendors together to review STP/T+1 issues and assist in preparation. In order to assist buy and sell-side firms on STP/T+1 activities, Jordan & Jordan works with clients to plan, implement and test the enhancements required in order to achieve T+1 goals.
Planning
Perform gap analysis
As a precursor to developing a business case for STP/T+1 activities, firms must assess where the opportunities for STP improvement exist within the trade process. Many firms have existing documentation describing information flows, systems, and processes that may need to be updated in light of increased use of alternative trading systems (ATSs), cross-border order routing and other internal and industry initiatives. Upon detailing the current environment, this documentation should be analysed in the light of STP/T+1 goals. Various industry white papers discuss best practices against which a firm can assess their readiness.
Jordan & Jordan was responsible for drafting the STP/T+1 Codes of Practice for Fixed income instruments trading in the United States. We found that while not every T+1 issue has been resolved, there is enough information and regulatory guidance to begin the process of STP/T+1 readiness planning and project initiation. While many STP initiatives will help firms reach T+1 settlement, firms should be aware that T+1 may impose additional requirements on planned STP projects.
Develop business case
Back office operations typically have not been the subject of boardroom-level discussions. However in the current market climate and era of industry consolidation, the ability to streamline operations, reduce risk and integrate with other firms is a strategic competitive advantage. In order to gain funding and focus STP efforts, Jordan & Jordan recommends introducing executive level staff to the regulatory and competitive motivations for addressing STP in the organisation in order to increase awareness that beyond T+1 efforts, regulatory reporting, transparency disclosures and customer expectations are driving STP efforts.
In addition to obtaining corporate buy-in and sponsorship, development of a more detailed business case will support a sound strategy and foundation for project planning and management of resources required to direct the STP/T+1 effort. While STP projects can be seen as a series of discrete projects, the need for firm level coordination is justified in light of the cross-organisational dependencies and requirements for compliance at the firm level.
Implementation -- improve efficiency by activity
Coming out of the planning process, firms should have an understanding of which STP initiatives will provide the most benefit. While STP attempts to look at the complete order lifecycle, it is not practical to structure projects at this conceptual level. Instead, we have found that focused projects aimed at improving an activity are more successful so long as interaction with other parts of the trade process is considered. Within each phase of the trade process there are a number of expected changes and opportunities as highlighted below.
Pre-trade
One of the key benefits expected from STP is the ability to shorten settlement cycles. As the US prepares for T+1, for example, it is important not only to automate activities, but also to consider when activities take place in order to catch errors early in the trade process.
While most of the STP and T+1 efforts focus on post-execution processing, firms may want to consider internal procedures to populate trade information as early in the process as possible. Certain reference data, such as International Security Identification Numbers (ISIN) and CUSIPS (for US domestic securities) should be accessible by the front office upon making the trade or even at the point of order entry. The front office may require access to BIC codes for indicating counterparties, settlement instructions, and other detail supplied by the back office or outside source in order to expedite the trade for matching or continuous net settlement (CNS).
Additionally, buy-side firms are considering the need for pre-trade compliance in order to submit allocations on a timely process. The implications of performing pre-trade compliance go beyond implementing system changes to modifying behaviour among front-office staff (portfolio manager and buy-side trader).
Trade execution
Applying STP technology and processes in trade execution allows firms to offer a more sophisticated level of service in the form of intelligent order routing while complying with newly imposed disclosure rules by the SEC in the United States.
Intelligent order routing
Trading venues are proliferating. Order handling rules and reporting requirements are increasingly stringent. Fragmentation is occurring in sources and systems. Trading venues are providing unprecedented quantities of market data and execution tools on the same platform. Firms must respond to best execution and STP settlement obligations in this increasingly complicated trading and information landscape. In the case of equities, finding the best price may no longer be a matter of looking at the national best bid offer (NBBO), since decimalisation has reduced the usefulness of the NBBO. The true depth of market becomes more and more elusive as important information on ECN and ATS activity is often missing from the NBBO. In the options market, no NBBO yet exists.
Regardless of the security type or market, firms want to improve their order routing behaviours, processes and systems to include parameter-driven, rules-based, direct-to-market automatic order routing. These intelligent order routing systems should take into account where an order routes based not only on price, size, and trading venue but also on pre-established customer preferences, security type, time to execute, high touch versus low touch order handling, and numerous other prioritisation schemes. These systems must also include the market data and other information required to get the order routed, executed and settled. Increasingly, firms are looking to outside vendors to provide sophisticated and intelligent order routing tools.
Measure and report execution quality
Led by the SEC in the US, even the FSA (UK's recently consolidated regulatory authority) is examining trading costs and opportunities to increase transparency. The EU Commission is addressing significant attention to this matter. The SEC remains steadfast in its position that investors are assured access to the markets and receive 'best execution' on their trades. As non-traditional trading becomes more active, broker--dealer firms, exchanges and service providers need to accommodate interfaces to these markets in a consistent manner that is in the best interests of their customers.
SEC Rule 11Ac1-5, which began a phased implementation schedule on May 1, 2001, requires market centres (including market makers, alternative trading systems, and exchanges) to make electronic public disclosures on firm's order execution and execution quality for Nasdaq NMS and listed equity securities. SEC Rule 11Ac1-6 applies to broker--dealers routing orders on behalf of customers. These firms must prepare quarterly reports identifying which venues orders were routed to, relationships with markets such as payment for order flow, and, when requested by a customer, where that customer's individual order was routed.
How these reports will be used by financial institutions to make order routing decisions is, as yet, unclear. However, the availability of this information is sure to increase awareness of the impact of order routing on execution quality. Firms will need to electronically capture and analyse this information. As rules evolve and the products designed to satisfy requirements are refined, a trend may develop to obtain and process the required information in a more real-time way. Even if the reports must only be filed on a monthly or quarterly basis now, the mechanism to capture the relevant information is likely to figure in STP and may find a home on front office systems, alongside order routing, order management, and real-time market data.
Middle office
Much of the focus of STP initiatives is on the middle office. The services of Omgeo and GSTP, while originally designed for cross-border trade matching, are also key elements of the US domestic T+1 initiative. As part of the T+1 effort in the US, the Securities Industry Association (SIA) is resolving interoperability issues and the viability of new processing models incorporating matching utilities referred to as VMUs (virtual matching utilities). Jordan & Jordan assists The Bond Market Association (TBMA) in addressing differences associated with fixed income instruments. Regardless of the outcome of these discussions, Figure 2 clearly illustrates that the post-execution processing performed in the middle office could benefit from automation and streamlined processing where possible.
Figure 2: Trade agreement from T+3 to STP/T+1
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Electronic match at the block level
Upon completion of a trade, broker--dealers need to communicate the net price (typically referred to as net monies) including commission, market fees, and taxes of the block-level order. The requirements for this calculation are instrument- and market-dependent. Oftentimes, this procedure is performed over the phone and, in the case of equities, at the end of the day. Given the shortened T+1 settlement timeframe, there is an urgency to identify errors at the block level without waiting for the investment manager to submit allocations. By matching the broker--dealer's notice of execution (NOE) with the investment manager's block order notification (BON), errors associated with security or net amount can be resolved. For equity products, the requirement for matching at the block level can also be satisfied by the investment manager submitting allocations that can be rolled up to compare to the BON. Because of the lack of centralised exchanges in the US fixed income markets, NOE to BON matching has been recommended.
The most common method identified for achieving block level matching has been through participation in a VMU (virtual matching utility), e.g. Omgeo or GSTP. However, alternative trading systems are considering offering this service as well. Firms must evaluate which matching services are best suited for their needs taking account of product and client requirements. Considering that many of these services are still at some stage of development, firms also have an opportunity to participate in the product development process by providing input to users and industry associations. We have found that providers of matching services have been responsive to addressing issues raised by the clients we represent.
Electronic allocation level match
The allocation level match consists of investment managers sending allocation details electronically via the VMU, with the VMU matching the allocated net monies to the block level NOE. Today, allocation details are conveyed manually, either by fax or phone, between broker--dealer sales staff and investment management (IM) trading operations staff. Not only will the inclusion of the matching utility automate activities that are currently manual, it will also standardise the agreement of trade details, which has traditionally been at the discretion of counterparties involved in each trade. In addition to these changes, it has also been suggested that allocations are sent by the IM within one hour of trade execution.
Industry issues relating to streamlining the allocation process must still take into account suitability and 'know your customer' rules, which broker--dealers must adhere to and which are becoming stricter as a result of recent world events. Firms must not only work with their counterparties to make sure they provide allocations in a timely manner but also examine internal processes to see that due diligence issues are resolved quickly. The implications for new account processing are discussed in the next section. In addition to due diligence issues, system integration between the VMU and in-house systems is required to make sure the trade process continues in an automated fashion.
Append settlement instructions
Outdated, inaccurate, or missing delivery instructions are consistently cited as the source of many failed trades. In resolving the settlement instruction issue, there have been competing models introduced as to how settlement instructions should be sourced, either centrally or within each firm. Despite differences in methodology, there appears to be common agreement that custodians should take responsibility for providing this information. Firms must work with counterparties to identify the most appropriate methodology. Many in the industry feel that investment managers and custodians will want the option of either methodology, especially in cross-border scenarios.
Back office
New account opening process
Typically, the back office is responsible for completing the new account opening process. Even if the counterparties are the same, new sub-account set-up may be required. In today's environment, new account opening is typically a manual process that is initiated after the investment manager sends in allocations at the end of trade date. In a T+1 environment, there will not be time to set-up accounts after the trade is made. Firms may need to modify existing new account opening processes, considering not only internal procedures and systems but also their counterparties' use of automated account and settlement instruction databases.
Maintain current security master
Trading a security for the first time often requires a new record to be established in a firm's security master file. In today's environment, there is plenty of time to receive the information needed to populate the record, usually from a vendor in an overnight batch process. Now required on trade date, it may become necessary at the point of trade-entry to supply the relevant details of the security being traded and the counterparty information including settlement instructions.
Market data vendors may be among those in a position to supply access to standard reference data, security identifiers, cross-reference services, and other types of descriptive information. This information may be accessible in real-time via queries to a vendor's database or to a central database maintained in-house.
Apply corporate actions
Corporate action information typically includes payment of interest and dividends, reorganisation data, name changes, splits, tender offers, calls, etc. This information remains critical to a firm's ability to service assets held in inventory and customer accounts in a timely manner. T+1 effectively narrows the window to correctly apply corporate actions before settlement, thereby increasing the importance of accuracy and completeness in the provision of corporate action information by a market data vendor. Corporate action information in the US is typically reported and collected by the vendors with at least a week's advance notice, due to industry regulations. 'Last minute' announcements are a significantly larger problem with international companies.
Firms are examining their corporate action workflow to determine efficient ways to reconcile corporate action information across data sources as well as to identify tools to automate the process.
Interface with new CCP (central counter party) systems
Clearing and settlement utilities in the US and Europe are taking significant measures to innovate the liquidity management process for their member firms. Custodians and sell-side firms have new opportunities to manage their settlement obligations. As a result of these new utility features, member firms may be able to retire existing systems with similar functionality. Potential functionality such as DTCC's proposed Inventory Management System, intended to centralise the order and timing of deliveries, need to be examined in the context of firms' internal processes and liquidity management requirements. As CREST moves to real-time delivery versus payment they too will offer liquidity management tools that must be addressed by member firms.
Implementation -- connectivity and interoperability
In addition to streamlining and automating the discrete activities required to settle an order, connectivity between activities and systems is implied by straight through processing. In order to minimise the cost of linking systems and promote flexibility within a firm's system architecture, standardisation at the message and content level as well as a robust architecture are highly encouraged.
Adopt messaging standards
Industry-wide support is growing for the use of open standards in interface design, data definition, business rules, and message protocols. In a few short years, much progress has been made in this area with the increased use of FIX for Indications of Interest and trade orders for equities, and the expansion of SWIFT and ISO 15022 to accommodate a more complete array of message types for communication of settlement and delivery instructions with custodians and depositories. Numerous industry groups are working to develop content definitions and data formats for business-related information and data elements. Many view the implementation of industry standards as a necessity to achieve STP.
Highlighting the need for standardisation is the call for interoperability among the services that will be offered to process institutional transactions. One of the cornerstones of the T+1 initiative is the establishment of a virtual matching utility for the efficient processing of institutional trades. While Omgeo and GSTP AG are expected to offer competitive services, they must be fully capable of interfacing with one another and any other new products introduced for this purpose. There are also efforts to coordinate with FIX and SWIFT to ensure interoperability with related functional processes. Interestingly, FIX version 4.2 includes some support for market data, and future versions may include support for corporate actions.
Our clients take an active role in working to develop standards that meet business and technical requirements for efficient processing. Working as part of the joint TBMA/FIX Fixed Income Working Group, Jordan & Jordan has worked closely with the business practitioners to define the requirements for fixed income trading protocols for all major instruments.
Enhance infrastructure/address capacity
Efficiencies in securities processing under STP and T+1 and the accommodation of higher volumes could add to the capacity problems at the front end. Expanded quantities and sources of real-time data will be required to support order handling and execution as automation in the industry evolves. As our projections at the Financial Information Forum show, capacity requirements for market data will be pushed even further by real-time limit order books from multiple market centres, and front office applications for order routing and management will consume additional capacity as they process more and more information to satisfy customer needs and reporting obligations.
Adopt standard symbology for STP data management
The ability to exchange information across platforms in a way that provides consistency and supports harmonisation is required to achieve STP. Counterparty risk management, compliance, and surveillance systems, updated and accessible in real-time, will become a more integral part of the front office. All efforts to improve consistency will result in more effective use of data from the front to the back office. STP demands for consistency will spur efforts on both in-house and external data reconciliation and will incorporate the use of emerging standards as well as continued support of some legacy and proprietary formats.
Data is purchased from multiple data vendors, derived using alternative calculation methods, and defined in different ways. Vendors' proprietary data and symbology formats, as well as their value added offerings, allow competitive differentiation and accommodate the specific needs of clients; however, integrating multiple feeds can be a challenge for firms. It is not likely that vendors will abandon proprietary formats or symbology but, driven by industry needs to streamline processes and promote higher data integrity, vendors appear to be open to the adoption of alternative standards.
Testing
Testing for STP readiness will include standard testing procedures as new systems and processes are implemented. For T+1 to be accomplished in the US, testing at the industry level may also be required to ensure that counterparties and utilities are able to achieve a complete settlement cycle on time. Coordinated and synchronised industry testing has the potential to identify potential breakdowns that only surface when all participants and activities are being performed.
Innovating STP
STP is not one project but a series of projects that bring firms closer to efficiency and automation. Prioritising objectives and re-evaluating needs in the light of the current environment are consistently required to refine and improve your firm's STP capabilities.
Manisha Kulkarni can be contacted at kulkarni@jandj.com.
Thomas Jordan can be contacted at tjjordan@fif.com.
