Straight Through Processing - Just In Time
By Vincent Manning
Straight through processing (STP) - the end-to-end automation of the pre-trade to post-trade settlement process. The holy grail for financial services firms. The fact is this is currently more myth than reality for most firms. However, all of that is about to change. Industry initiatives underway will result in a solid framework for linking all interested parties in the trade life cycle as never before. Investment managers, broker/dealers, clearing agencies, global custodians, and subcustodians will seamlessly share information streamlining the entire trade process.
There are a number of factors driving the market towards STP. Factors include the explosive growth of securities transactions, shortening of the settlement cycle, increased competition, and technological advancements. According to the Global Straight Through Processing Association (GSTPA), cross-border volumes have increased dramatically and are forecasted to reach 600,000 securities trades per day (150 million annually) in 2002 compared with 200,000 trades per day (50 million per annum) in 1998. Domestically, the US equities markets, accounting for 35% of total global market capitalization, had a daily aggregate volume on the NYSE, NASDAQ and AMEX of 0.5 billion shares in 1998. That volume is projected to grow to 3.5 billion in 2002.
As if the tremendous growth in volumes is not enough markets around the world are working with shorter and shorter settlement periods. The move towards T+1 settlement, coupled with ever increasing volumes, will not be possible to sustain given today's operating environment. According to the Security Industry Association (SIA) despite the increased investment in technology by organizations, the number of trades awaiting confirmation on trade date over the last five years has almost doubled. Given the current growth projections for trading volume on the exchanges simple improvements in processing will not be enough to improve operations.
The role of technology in driving volumes higher and creating shorter settlement periods cannot be overlooked. The explosive growth of the internet has given rise to the on-line trading boom, wireless and after-hours trading, and the birth of electronic communication networks (ECNs). According to Fortune magazine the percentage of U.S. investors trading online is now about 12.5% and is expected to climb to approximately 30% by 2002. Moving from overnight batch cycle data feeds to the real-time posting of data on the web has increased the need for better risk management dramatically. In addition, with all of the new players on the market increased competition has put a strain on profit margins. The costs of incorrect or late data have never been higher.
Given the new market drivers, there are currently two major industry initiatives underway to enhance operational efficiencies. The GSTPA is an industry association comprised of worldwide representatives from investment management, global custodian, and broker/dealer firms. The GSTPA's stated goal is "organizing and promoting the efficient electronic flow of cross-border trade information on trade date." To that end, the group has developed a model for future cross-border trading. Axion4, a consortium of vendors chosen by the GSTPA, is in the process of finalizing specifications and identifying firms to participate in a pilot test to begin this fall.
Within domestic markets, the SIA has developed a working model to make T+1 a reality. Similar to the GSTPA, the SIA is comprised of investment management, custodian, and broker/dealer firms along with service providers (e.g., Thomson and DTCC). In addressing the move towards T+1 the SIA's model depends on greater levels of straight through processing to provide volume insensitivity and increased risk management.
While the GSTPA's goal stops short of the SIA's final intent of a T+1 marketplace the models put forth by the two groups are very similar. Behind each model is the notion of just-in-time trade processing. Trade data is shared among all market participants. As the data is passed from one player to the next (i.e., investment manager to broker/dealer) it is enriched with the necessary data to keep it moving and prevent bottlenecks. In order to achieve just in time processing the models rely on a central hub to interconnect all market participants. The central hub allows for the open communication and sharing of data needed to process trades quickly and efficiently.
Within the GSTPA's model this central hub is referred to as the Transaction Flow Manager (TFM). The TFM acts as a network to pass data among participants. At the same time, the TFM will act as an application with built in functionality to enrich trade data. Market participants may choose to connect directly into the TFM or they may go with an outside vendor who is plugged into the TFM. The current TFM model relies on the FIX protocol for pre-settlement communication and on SWIFT messaging for post-trade communication. Current schedules call for a pilot study to begin mid-2001 with an official implementation late in 2001. To date 19 firms have joined the pilot study.
As with the GSTPA, the SIA's model seeks to establish standardized messaging to eliminate current inefficiencies in the trade cycle. The model employs a virtual matching utility that allows for real-time matching of trade data from pre- to post-trade settlement. Like the GSPTA, model pre-settlement communication is based on FIX messaging. Post-trade communication standards have not been finalized. The SIA envisions implementation of a working model within the industry by the middle of 2004. The current working model has been released in a business case for industry review and feedback.
In addition to the SIA and GSTPA initiatives industry vendors are weighing in with STP solutions. The largest player currently is a joint venture between Thomson Financial and the Depository Trust and Clearing Corporation (DTCC). The Thomson/DTCC initiative offers domestic and cross-border solutions seeking to bridge the gap between the two solutions offered by the SIA and GSTPA. The Thomson/DTCC solution is not alone. With no clear industry-wide solution in place more vendors are beginning to offer alternative solutions. However, with more alternatives firms run the risk of having to support multiple solutions.
Impact to Investment Managers
The implementation of STP procedures will require behavioral and environmental changes within the front- and back-offices of investment management firms. In effect, the back-office moves to the front-office. To achieve STP firms need to rethink the current front- and back-office operating models. As trading windows shorten any manual intervention results in costly delays. The GSTPA estimates that 80% of the STP problems experienced by firms are internal and only 20% of the STP problems are between firms. The use of fax and voice messaging to relay information is too time consuming in today's market. In addition, the constant manual rekeying of data into multiple systems is archaic in a 24/7 trading world.
Firms first need to identify all of the participants in its trading cycles. A focus within the front-office should be on automating the indications of interest and notice of execution with broker/dealers. In addition, automated confirmation of trades would continue to streamline the process. While electronic confirmation is readily available domestically, cross-border transactions more often than not require manual intervention. For firms this means tracking the requirements of hundreds of brokers and custodians. Consideration also needs to be given to vendors providing market data. Data from third-party vendors should be reviewed in the context of the entire firm's needs and not just those of an individual department in order to maximize the distribution of data. Finally, the front-office needs to consider the requirements of its back office groups. Adherence to standards in messaging will help create a seamless flow of information to and from the back-office. Just as industry models are attempting to centralize common data firms should look to eliminate islands of information. Central repositories or data warehouses providing accurate, real-time information accessible by the entire firm will help improve internal operations.
For the back-office there should be an urgency to automate and standardize. With the start and end of trading days becoming less clear data needs to move much more quickly back to the front-office. Disparate systems unable to talk with one another only perpetuate existing problems. Wherever possible legacy systems should be replaced or, at a minimum enhanced, to allow the sharing of information. Standardized processes (e.g., security setup, pricing, data cycling) will help eliminate redundant paper and manual procedures. In addition to internal improvements back-office systems should be enhanced to improve communication with third-party market data providers and custodian banks. Taking in and turning around data quickly and efficiently needs to be the goal of all back-office initiatives. Improved data flows will impact all areas of the back-office including position keeping, processing corporate actions, clearing and settlement functions, and risk management.
Management firms will not be on their own in implementing STP strategies. Central to the success of such initiatives will be the options offered by middle-ware providers. Vendors are racing STP solutions to the market to address all areas of trade management. From cash management and order management systems to clearing and risk management systems there are a myriad of systems solutions entering the market. As with any systems selection process firms need to stay focused on the task at hand. Systems should be chosen based on their ability to streamline the existing trade process through the integration of automated systems and the elimination of redundant paper and manual processes.
Return on Investment
STP will lead to a reduction of costs and risks. The reduced costs will be realized through greater efficiencies and productivity while, in the T+1 environment, shortened settlement periods will reduce risk. Numerous studies have identified potential savings. According to Reuters, the handling of the increasing volume of securities trades, without STP, is estimated to cost the securities industry $12 billion annually. Additionally the GSTPA has estimated the failure rate for cross-border settlement is as high as 20%. Assuming 200,000 trades per day, with an average value of $150,000, 5% cost of funds, and 15% failure rate over a duration of four days, the impact of reducing the fail rate to 10% over two days is estimated to be $600 million per year savings in fails. Finally, a recent study prepared for the SIA estimates the industry will spend $8 billion in the move towards T+1. However, the study goes on to say that operating in a T+1 environment would provide approximately $2.7 billion in annual savings for the industry. Given such savings the initial investments would seem well spent.
The industry must come together quickly and settle on a straight through processing solution. Individual firms can only take STP so far internally. Without global solutions in place true STP will continue to be but a dream. Exchanges and firms cannot hope to reap the true benefits of a T+1, STP world if such a world requires supporting multiple, disparate systems. It is time for the industry to come together and chart its course for the future.
While the industry continues to move down the path towards STP and T+1 individual firms need to react internally. Firms need to move towards improving the relationship between front- and back-office operations. There is no question that the quest for STP will be costly. As noted, successful implementation will require significant investment in systems and organizational overhaul. In addition, the required organizational changes will result in fundamental changes to both business and technology models. However, failure to adapt will dramatically effect an organization's ability to compete in the future. Firms that successfully integrate trading operations, from pre-trade to settlement, can gain a competitive edge over the competition and position themselves for the future. That integration needs to start now.
Vincent Manning is a consultant with Venture Financial Systems Group (VFSG), a consulting firm specializing in delivering business and software solutions for the financial services industry. He has managed critical projects for front and back offices at major investment firms. Venture Financial Systems Group is currently participating in a number of straight through processing initiatives. For more information, please call (781-932-7544), visit our web site (www.venturefsg.com) or E-mail us (firstname.lastname@example.org).