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On the road to T+1

Preparing for the STP world

www.ac.com

Imagine finishing a 26-mile marathon run - only to find out that you were actually competing in the Ironman Triathlon and still had the swimming and biking legs to complete.

This is what most financial markets firms will have faced when they woke up from celebrating their successful Y2K change programs in early 2000. They will have then been forced to face the reality of major industry initiatives such as decimalisation and, perhaps more critical, the SEC's declaration of T+1 (trade day plus one day) compliance by June 2002.

The challenge - completely restructuring traditional systems and processes to create an automated, end-to-end vehicle for processing trade transactions with unprecedented speed and accuracy - seems overwhelming.

In fact, developing and implementing a system that moves a trade from execution to clearance and settlement through a single, hands-off electronic system that ties together the buy side, sell side and custodian banks (a practice better known as Straight Through Processing (STP) ) requires an unparalleled investment. Current estimates of annual spending on STP initiatives are between $3 billion and $4 billion a year for the next two to three years in the United States alone. Global STP investment will be comparable, together far surpassing the amount spent by the industry to prepare for Y2K compliance and the Euro conversion.

The Need For STP
Despite the challenges, the global financial services industry has little choice but to adopt STP. Today's method of trade execution is inconsistent with the new e-world in which we live. Currently, when an investor makes a trade, that order sets off a multi-day process that involves numerous back-and-forth faxes and phone calls between broker/dealers, asset managers, custodians and other players. Although a simple domestic retail equity order is relatively 'clean', a single cross-border trade can touch as many as 25 different function points - people, processes and systems - before it's finalised, and most of these points add no value to the process. Additionally, explosive trading volumes and increasing settlement-fail rates are affecting quality customer service and hindering competition, especially on cross-border trades. The Securities and Exchange Commission has suggested T+1 settlement in the United States by June 2002, down from the current T+3 environment. Global standards are expected to follow suit, and T+0, or same-day settlement, might not be far down the road.

The need for STP is clear - and the benefits of STP are equally evident. By accelerating the entire trading process, STP will enable the industry players to handle more transactions, eliminate redundant processes and reduce the number of fails. This is especially important in the face of e-Commerce; as on-line brokerages and ECNs (electronic communications networks) increase in popularity, consumers are finding it easier to buy and sell securities. Thus, trading volumes and customer demand for services are on the rise, providing tremendous opportunities for new business.

How Can Companies Best Implement STP?
Theoretically, effective implementation lies in a collaborative, industry-wide approach supported by all players in the trade process, with global cooperation and consensus. Industry initiatives such as the Global Straight Through Processing Association (GSTPA) and the Financial Information eXchange (FIX) are providing the first steps.

The GSTPA - a 57-member group of investment managers, broker/dealers and global custodians - plans to coordinate development of a 'transaction flow manager' (TFM), a generic piece of software that will serve as a pipe to transfer information between the various parties involved in a trade. At a minimum, the TFM will supply a standard method of communication, eliminating many of the telephone calls, faxes and system interfaces currently needed to complete a cross-border trade; eventually, it could serve as a data warehouse for global transactions.

Additionally, the TFM is FIX-compliant. The FIX protocol, which began as a standard format to send securities messages between buy- and sell-side traders, has since been developed into an international standard for communication among financial institutions. Bloomberg, Reuters, Bridge and other industry players are FIX-compliant, and the emerging Electronic Communications Networks (ECNs) are also adapting their systems to support FIX, which will ease the delivery of their services to on-line brokerages. Without standardisation, it is highly unlikely that T+1 cross-border trading can be achieved. But even this might not be enough. As industry-wide efforts evolve, individual firms must re-invent themselves as well, creating in-house STP systems or outsourcing the work.

New Roles For Key Players
Achieving STP is technologically straightforward, providing you do not have hundreds of legacy systems and thousands of legacy employees to re-tool. What will be far more difficult than the technology solution is adapting to a new way of doing business, as an STP-enabled world will redefine the roles of all industry players.

The role of the broker/dealer, for example, will change dramatically. A great deal of what individual traders now do within broker/dealers is manually intensive, and STP can automate much of that work. As sophisticated investors increasingly trade directly and use discount brokerage firms, the role of the broker will focus almost entirely on advice-oriented work.

Custodians will also undergo significant change in an STP environment. To date, many global custodians have served as the primary providers of securities processing, so custodians could find their core business endangered. However, custodians will continue to supplement their business by offering services such as third-party fund administration, securities lending, accounting, and foreign exchange services. They'll also likely provide bundled outsourcing solutions. Many smaller and/or regional custodians will merge to gain additional processing volumes; achieving scale and global reach is central to custodians' ability to remain competitive.

The most significant effect of STP on the investment management community will be in accounting and reconciliation activities. STP will force these activities to occur on a continuous, nearly real-time, trade-by-trade basis rather than on the current batch cycle. Most investment managers will choose to outsource rather than retool for an STP world, thereby creating a sizable opportunity that will fall into the custodians' laps. The question is: Who will be ready to receive it?

STP will coax exchanges into becoming electronic, multi-currency marketplaces quickly - as we are already seeing in Europe. As trade execution time is shortened, transaction volumes will increase and market data will be sent directly to industry utilities. Exchanges will be required to differentiate themselves from off-exchange trading or ECNs and represent a true market price as they focus on retail customer service and watchdog capabilities. Overall, STP will drive consolidation in the marketplace. We believe that by 2003 the number of regional stock exchanges, global custodians, primary/secondary broker/dealers and major asset management firms will decrease significantly. Of course, so will the number of professionals who spend much of their time on non-value-added tasks; those who remain will increasingly be focused on revenue-generation activities, including product development, sales and customer relationship management.

Individual Choices
We see three choices for companies addressing STP issues, only two of which will allow financial services players to stay in the game. Companies can:

~ Maintain the status quo. Faced with massive costs and limited resources, some companies will try to meet regulatory requirements and market demands by incrementally improving their existing environments. History has shown that these companies will fail because they will be unable to achieve consistent quality service, resulting in dissatisfied customers who will flee to other providers.

~ Outsource operations. Companies that want to focus on their core competencies - customer service and product manufacturing - will turn the processing aspect of their businesses to outside firms (i.e., asset managers outsourcing middle- and back-office operations). This option creates opportunities for existing outsource providers to expand their market share and new entrants to leapfrog the existing models (i.e., faster, cheaper, better).

~ Re-invent themselves. A few large firms will invest in STP architecture and the move to T+1 and eventually T+0, which we believe will become the global standard. These companies recognise that the business case "within the four walls" can't support STP and will therefore expand their service offerings by moving up the value chain (i.e., custodians outsourcing more of the asset managers' back-office functions).

Preparing for change
Evaluating the best option requires that each firm conducts a strategic review of its existing business and determine what it needs to do to remain competitive. Undoubtedly, technology considerations will play an important role in determining future business direction, as technology offers a platform for enterprise computing, real-time and event-driven architectures, application integration, customer connectivity and open systems. It is technology - driven by business imperatives, as well as an operating vision - that enables a business to run the processes and deliver the services that contribute to competitive advantage in a T+1 world.

Right now, most firms have breathed a sigh of relief as the Y2K phenomenon passes. Many will congratulate the Y2K team and send the team members back to their respective business units with the requisite "Congratulations on a job well done." However, the future industry leaders are formulating an enterprise-wide STP team, consisting of the best examples of the new leadership, to answer several questions:

~ What are the scenarios surrounding STP and how each affect our industry as a whole and, more specifically, our firm?

~ What is the order of magnitude of the change program that we need to establish to meet the most likely scenario? What is our current level of readiness?

~ What are the cost/benefits "within the four walls," and what off-setting revenue opportunities might exist?

~ If we had the luxury of starting an STP- ready operation from scratch, what would it look like and how would we achieve "speed to value"?

~ What capabilities do we possess and with whom do we need to partner to offer our "value proposition" to existing and new clients?

One thing that transformational change has shown us in telecommunications, high-tech and other industries is that the strong survive (AT&T, IBM), the weak disappear (Burroughs, NCR), and the new entrants thrive (Sprint, e-Trade). Whether or not the flourish of ECNs survives, the big players have to pay attention. But from where will the new entrants emerge, and how will they crush the weak?

Decisions
At this stage, all financial markets players have serious work to do. The implementation of STP requires the commitment and collaboration of many departments and business partners, and indeed all financial services organisations that want to survive in this new century. All players, from those who initiate trades to those who settle them, will undergo fundamental and far-reaching change as trade cycles are compressed.

Organisations unwilling to face the challenges of adapting to the STP world will soon find that the race is nearly over - and they're still standing at the starting line.

Jim Honohan
Andersen Consulting

 

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