Imagine you are the inventory manager of a high-volume store that is getting busier every day. You are constantly off to check the back-room stock, hoping you have enough to meet the demand on the show floor, praying that you haven't accidentally promised already-sold merchandise to a new customer. To make matters worse, many of your customers keep returning items, negating revenues that were factored into upcoming budgets.
Sound familiar? If so, you might be an operations professional on Wall Street, managing your firm's movements of securities and cash through one of the Depository Trust and Clearing Corporation's settlement platforms.
The DTCC, a holding company which oversees the Depository Trust Company and National Securities Clearing Corporation, recently released a white paper entitled, "Straight-Through Processing: A New Model for Settlement," written by Director of Strategy Implementation John Kiechle, in which it is proposing to change the way inventory managers do their job. According to DTCC, the current model for settling securities in the United States must change if the industry is ever to reach its goal of a one-day settlement cycle, slated for June 2005.
Today, institutional trades are verified by a series of time consuming and error-prone steps -- referred to as confirmations, affirmations and confirm/affirms between investment managers, broker/dealers and global custodians -- before they make it downstream to the depository. All these steps, which take place over the three days allowed to settle a trade, are performed to assure that, once at DTC, no party to a trade has any reason to cry foul.
Unfortunately, these steps don't always mean that every time securities are moved, it is done in the correct amount to the correct counter party. Thus arises the need for a nasty remedy in the world of securities processing: reclaims.
Reclaims occur when the receivers of institutional trades, who currently have no real mechanisms for rejecting incorrect deliveries before they enter their inventory, wish to undo a transaction -- in essence, exercising their right to return merchandise they never ordered. By their very nature, reclaims destroy any hopes of STP wherever and whenever they occur. DTCC says they are all too common and have to go.
According to Kiechle's white paper, "Today, there are about 10,000 reclaims with a value of $7 billion to $10 billion on an average day...Of the total value of settlements at DTCC -- about $750 billion on a typical day -- about 40 percent could be reclaimed, and about 1 percent actually are."
Reclaims are an important tool in today's operating environment, where receivers have limited ability to shield their books from incorrect deliveries, but ultimately "(liquidity and position) risks are created for the deliverer and the system as a whole" as a result, writes Kiechle.
In fact, the issue of eliminating reclaims and arriving at a point in settlement processing where once you've got it, you're stuck with it, is so sensitive an issue that Kiechle writes, "Our vision for inventory management doesn't include any material change in the service that DTCC offers to customers for the authorization of securities they expect to receive."
However, eliminating reclaims, though explicitly outside DTCC's immediate goals, is unquestionably a long-term aspiration of the depository and its hierarchy.
Donald Donahue, a managing director with DTCC, says that to rid the industry of reclaims, passive authorization on the receiver side could be introduced into the depository's functionality. It might work something like this: "Unless I tell you not to (accept) that specific (delivery), I am authorizing you to do it. The system would say here's the 3,000 things that we know are coming to you today and unless we hear from you by 10:00 a.m. these are coming. So at 9:59 a.m. you come in and say, 'I don't really know items 2501 and 2709.' So you have targeted those two and the rest are passively authorized," says Donahue. "At that point, you can arguably say, 'Look, you had the chance to keep this out of your account so you can't reclaim.' That's the whole argument."
Charles Taylor, also a managing director with DTCC, says that once matching models (Omgeo, GSTPA, SunGard) are verifying trades, with receivers then passively authorizing the inventory into their system, eliminating reclaims should not be far off.
Matching utilities look to centralize the back-and-forth messaging transmitted between investment managers, broker/dealers and global custodians by providing a central-information hub through which all parties can interact to verify trade information.
Taylor says, "When the message comes out of the matching model and into the settlement system you know, effectively, that the receiver has had their chance. They have had their day in court."
But Donahue doesn't think the road to eliminating reclaims is going to be easy. "It has been amply discussed and the (response is), 'I can go with you nine steps out of ten and that's the tenth step. I'm just not ready for that yet.'"
Jeff Potter, vice president of the worldwide products group at Northern Trust, a global custodian with $1.6 trillion under custody and a presence in 37 countries, says that he may never be ready to relinquish the ability to reclaim. That's because having no ability to reclaim means taking on a whole new level of risk.
"We are not in favor of passive authorization on the receiver side, not until we can see a clear need and benefit," he says. "The reason is that you are really talking about irrevocability and as soon as you are talking about irrevocability for a custodian bank, you are making them part of the trade because I can't DK (don't know) the trade. If I accepted in error I have no recourse. I am exposed to the market."
DTCC's Kiechle says that custodians will still have a chance to reject a trade before settlement. "Once the trade is matched in one of the new utilities, that trade will be sent to DTC where, at that point, it can be authorized (by the custodian), if it needs to be authorized, because at that point the investment manager may have only been dealing with the broker and the matching utility may tell the custodian that this trade is going to be coming down the pike."
"Then the custodian (the deliverer), at that point will say, 'Yes. This is good.' How they do that is up to them because DTC will offer active and passive (authorization) with different flavors. That's the flow," says Kiechle.
James Lafaman, a managing director with Morgan Stanley's prime-brokerage business, which acts as an operations and financing service for many hedge funds, says eliminating reclaims -- in theory -- is just fine with him. "If a trade has been matched and settled, I don't understand why someone would want to reclaim it and I don't want them to have the ability to do that," he says. "If the only way you can make a delivery is if you both match, you wouldn't need the reclaimation process."
But Lafaman worries about not having a chance to say, "Yes. This is good," or "No. This is not good," for his clients' trades. He is only comfortable with eliminating reclaims if prime brokers continue to acts as conduits for their hedge-fund clients to link with post-execution services (matching utilities and the depository) thus being able to monitor trades which prime brokers are ultimately a party to.
"Omgeo's proposed model doesn't work for me. It would have my clients, (hedge funds), and executing brokers matching up and pushing transactions to settlement before I, as prime broker, ever saw the trade, which is very different from today's operating environment. Under that model I would never want trades to be irrevocable."
He says that Omgeo's model would cut out the prime broker from settlement by tying its hedge-fund clients directly to the depository. "Today, none are members of DTCC, all of them come to me and I do the matching with the executing broker though DTCC, so Omgeo is saying that the client would go direct."
An Omgeo spokeswoman disagrees, contending the company's future model can keep the prime broker in the pre-settlement loop. She says that if prime brokers wish to do post-trade matching on behalf of their clients, they can sit between a hedge fund and Omgeo's Central Trade Manager. If they don't, hedge funds can pass trade information to their prime brokers after matching trade details with executing brokers though the CTM.
Though dealing with the receiver side of institutional transactions is a longer-term goal of the DTCC, developing a new inventory-management system (IMS) for the deliverer of those securities is what the current white paper, offered up for comment until March 27, is all about (DTCC's white paper can be found at www.wallstreetandtech.com/resourceCenters/stp).
On that side of the equation, the number one problem to be solved is not reclaims but exemptions.
Exemptions (the act of removing a trade from an automated-settlement flow for manual examination) are also a hindrance to the realization of STP. "Of the 700,000 or so deliveries that settle at DTCC's subsidiaries daily, about 250,000 are institutional ... of these about 50,000 are exempted," says the white paper.
According to DTCC, the IMS would level the playing field among participants, which vary widely in the functionality they have built to interact with the depository. With it, all participants would have a new set of tools, built by DTCC, to manipulate the way authorizations, deliveries and payments are made.
The IMS would offer deliverers three levels of control over their outgoing inventory, or specific portions of their inventory (particular securities or cusips): green, yellow and red.