Competition, cost pressures and regulatory change continue to drive decisions among capital markets participants. In today’s challenging market environment, the need to invest in operational infrastructure to lower risk or implement industry best practice — even if it translates to cost savings and increased efficiency in the long term — is generally outweighed by the immediate need to reduce spending or meet increasing capital requirements.
Investment in certain industry best practices, such as the trade confirmation process and the account and standing settlement instruction (SSI) processes, leads to fewer failed trades, lower costs, and reduced risk for the markets overall. Yet without immediate incentive, regulatory or otherwise, firms sometimes lack sufficient motivation to invest in these areas. It’s like going to the gym: we all know we should do it and that it’s good for us, yet sometimes it’s impossible to self-motivate until someone offers us an incentive, like a ten-year reunion.
There’s a critical need for more immediate drivers, such as a more compelling value proposition to adopt these best practices through product innovation and incentive-based pricing models. While regulation is an effective driver, regulations take time, and the market needs to lead by example while we wait for regulations to come into effect.
Same-day affirmation (SDA), which refers to verifying trades on the same day they are executed (trade date + zero days, or “T+0”), is widely recognized as an industry best practice. Trades verified on T+0 have a 26 percent higher chance of settling on time and are less likely to fail, making SDA a key contributor to improved settlement efficiency and an important enabler of shortened settlement cycles.
Such statistics could lead us to believe this was a widespread practice, but in the United States, SDA rates are one of the lowest in the world, at just 46.9 percent. This is partially due to the fact that, in the US and unlike any other country in the world, firms can settle trades in the market without a “match,” or the formal agreement of the economic details of a trade between the buyer and seller. An industry move to an automated central matching process in the US would facilitate settlement matching, requiring the match. This would eliminate unnecessary risk from the process and vastly increase efficiency.
Centrally matched trades achieve higher SDA rates (93 percent) than locally matched trades (36 to 72 percent) but again, it is not an inherent practice today. Industry analyst firm Aite Group recently reported that 65 percent of brokerage firms still conduct trade matching by email or phone, while only 13 percent use an automated solution. It is clear that without a regulatory push, or a move to shorter settlement cycles, the market is unmotivated to change, despite knowing the benefits.
Improved data quality is another area that begs improvement among market participants. A recent study by Omgeo found that settlement failure rates can be as high as 10 percent for equities and 7 percent for fixed income and identified a lack of accurate SSIs as a key reason for trade failure. This inaccuracy can be attributed to manual processes in SSI trade lifecycle. Annually the cost of these failures translates to $976M to $2.9B in 39 major equity markets and $308M to $925M across 35 major fixed income exchanges. Obviously, automating SSI processes and data quality is critical to reducing risk and saving money. Regulators are devoting much attention to scrutinizing market structure and areas that pose potential systemic risks. We may see regulation written in the coming months and years that will enforce industry best practices. Ultimately, once defined, regulation is the most efficient way to drive change, and would be a welcome improvement to the global post-trade environment. In the near term, vendors should continue to deliver increasing value while incenting best practice through innovative pricing that rewards firm-level behavior, for the benefit of the overall financial markets
Clare Fraser is managing director of strategy, at Omgeo. She is responsible for driving Omgeo’s five year strategy, identifying new market opportunities, forging strategic partnerships and entrenching the Omgeo brand across asset classes, client segments and new markets. She oversees the global marketing function, while providing strategic direction on the firm’s business worldwide.