Tony Freeman
Executive Director, Industry Relations

STP Saves Time and Reduces Cost

Since the advent of mainframes in the financial services sector, the term ‘straight-through processing’ [STP] has been with us to describe the on-going integration of the front, middle and back office, connecting parties to each trade electronically in order to reduce inefficiencies – and risk. 

By allowing the automatic transfer of information from one part of the workflow to the next, and from one party to another, between execution and settlement and without the need for human intervention, firms are able to position themselves to minimise processing times, significantly reduce operational costs and minimize settlement risk.

But, to date, the journey toward STP has been anything but a steady march.  Progress has come in waves, and some parts of the industry have moved faster than others.

Among the greatest promoters of STP have been the brokers, banks and funds vying for market share of the global financial services sector.  They have invested billions in STP processes to power faster and larger trades across multiple markets and regions for an increasingly diverse array of constituents. This competition-fuelled evolution has seen the automation of many front-office functions and structures.

More recently, the global financial crisis has seen a shift in the focus of STP to risk management in the financial services sector’s middle and back offices.  Risk managers, along with investors, asset consultants, auditors and regulators are looking more closely at the risks embedded there.

While the lion’s share of discretionary spend among both the buy side and sell side has historically been directed at enhancing front-office execution, in the aftermath of Lehman’s and scandals like Madoff, there is a growing recognition of the disconnect between trade execution and processing capability within firms. 

Investment strategies engineered for millisecond execution can often still rely on slow, manual systems for post-execution processing.  In our work advising clients on post-trade operations, we still come across the use of spread sheets, phone and fax in the processing of trades between execution and settlement.  This is particularly the case on the buy side where, historically, there has been less focus than the sell side on middle- and back-office automation.

The disparity between the front and middle office creates not only a time lag between trade and settlement for each trade but, in aggregate, a cohort of in-flight, at-risk trades at any given time.  Until they are verified, matched and settled, these trades are at a substantially higher risk of failure, and expose the firm to unnecessary credit risk.  As an industry veteran noted in the early 1990s, ‘nothing good happens between the trade date and settlement.’

Despite the spotlight shining into these parts of the trade life cycle and audit committees combing pre- and post-trade systems for risk, a recent report from the Australian Securities and Investment Commission [ASIC] into risk management practices of asset managers found that ‘most of the selected responsible entities indicated that they had not changed their risk management system as a whole as a result of the global financial crisis’.  Similarly, a November 2012 report from the UK Financial Services Authority into conflicts of interest between asset managers and their clients found that contract clauses are still widely used by fund managers to indemnify themselves from the costs of processing error, other than in the case of gross negligence.  The FSA has also singled out hedge funds for their use of similar tactics. 

In today’s increasingly competitive environment and as due diligence in the selection of funds becomes more comprehensive, we believe a significant behavioural shift is under way.  Manual approaches and the reliance on indemnity clauses to protect firms against risk are increasingly unacceptable in the eyes of regulators, investors and risk managers. As the definition of 'best execution' expands to include back-office costs, it is as vital as ever that efficiencies in the front office are not overshadowed by extra cost in the post trade process. This has been an issue for many markets in Europe adapting to more competitive trading landscapes.

At the same time, markets are facing wholesale structural changes aimed at reducing operational risk.  In Europe, from 1 January 2015, trade settlement cycles will move from T+2 to T+1, shortening the time in which a trade’s ‘in flight’ time.  Outside Europe, obligations on asset managers to fulfil fiduciary duties to their investors and the extended focus of ‘best execution’ to post trade processes are shifting the industry towards self-regulation and the adoption of industry-wide automation. 

At this critical time, it is important for firms to work closely with trusted partners and the industry to ensure their middle- and back-office processes and systems are up to date and incorporate industry best practice.  Clients need to take a more holistic approach to their operations.  Using appropriate matching technologies, asset managers can verify trade terms in real-time with brokers across markets with automated connectivity between EMS [execution management] systems and the back office that allows operations staff to manage post-trade workflows on an exceptions-only basis.  With real-time settlement-instruction enrichment and automated settlement notification messaging to custodians and other third parties, firms can dramatically increase their same day affirmation rates.

Same day affirmation refers to the completion of the entire trade verification process on trade day (‘T’), leaving more time for exception management and clearing and settlement processes within the intended settlement period, which in most markets means on the third day after trade execution (‘T+3’).  This reduces operational risk and costs borne by investment managers, broker/dealers and custodians in the trade verification process and allows lower transaction costs to benefit end-investors, as well as enabling other benefits such as a reduction in counterparty risk and increased liquidity for the market as a whole. It is also a key factor in reducing trade failure.

Asset managers not embracing appropriate technologies to reduce risk in the investment chain are failing in their fiduciary obligations to clients. It is no longer acceptable to expect investors to bear unnecessary excess cost and risk because of antiquated manual solutions when superior automated solutions are available.

This article first appeared in the February 2013 issue of Investment Magazine

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