T+2 in Europe: Smooth Sailing or Turbulence Ahead?

A non-event.

That is how European securities depositories; their bank and brokerage participants, fund managers and software vendors describe the migration of over two dozen European markets to a two-day settlement cycle on October 8.

Yet they are all realizing that they must keep up the good work in ensuring seamless middle office procedures. Relying on extra staff or special workarounds, as many are doing since T+2 came into effect, simply isn’t cost-effective or operationally sound in the long run.

“Fund managers leaned heavily on broker-dealers and custodians to help ensure a faster allocation and confirmation process,” explains Denis Orrick, chief operating officer for Sydney-headquartered back-office systems provider GBST, which allows for automated local matching. “They know they will have to make any necessary workflow changes on their own now.”

October 8 represented a double-whammy in that it was the final settlement day of the old three-day cycle and the first settlement day of the new two-day cycle. Buy and sell side firms were worried about a possible increase in the number of trades which failed to settle on time so they had done their best to prepare. Operations managers at five European fund management shops tell FinOps Report that they set up specific workflow procedures with their broker-dealers and custodian banks, which involved a buddy system of electronically reminding peers about any late trade allocations and confirmations.

Evading Armageddon

In all of the five cases, middle-office operations staff were asked to work extra hours and executives were added to a late night shift to address any discrepancies or transactions which couldn’t be matched. “We prepared for Armageddon and are thrilled it didn’t happen,” says one operations manager.

Granted, market players had over a year to get ready for the two-day settlement cycle so they had plenty of time to make any necessary short-term changes. But they may need a more extensive overhaul of their middle office operations — all of the functions which fall between the time the trade is executed and the time it is settled — if they want to prevent future glitches.

“We were continually meeting with our fund manager clients to provide them with information on best practices for the post-trade communications process,” says Paul McSherry, director of US middle office operations at agency brokerage and institutional trade network provider Liquidnet in New York. Liquidnet, he adds, met its target for timely settlement on October 8.

From the start, European securities depositories insisted that they were fully prepared to handle additional volume of instructions on October 8 and could easily handle settling trades on even a one day-cycle, as long as their bank and brokerage participants could handle the pace. Securities depositories needed their bank and brokerage clients to match the settlement details of their ;trades on time — one day after the trade was executed — instead of the previous two days under a three-day settlement period.

That meant fund manager clients must affirm the details of the trades with their broker-dealers using either a local or central matching process on the same day the trade was executed, instead of the following day or T+1. Local matching requires a back-and-forth communications process between fund managers and broker-dealers while central matching requires buy and sell-side firms to simultaneously line up, or reject, their understanding of trade details through a third-party platform.

Officials at post-trade communications service provider Omgeo in London were not available at press time to provide FinOps with figures on the percentage of trades affirmed on trade date on October 8 through the firm’s central matching Central Trade Manager (CTM) platform. However, from all accounts fund managers were able to match their trade details either through a local or central matching process quickly enough to ensure that the next step — settlement matching — could take place on time. Settlement matching refers to matching the details on how a trade can be settled — or cash exchanged for securities.

Blip in Government Bonds

“We had a fairly consistent settlement fail rate across all of our family of depositories,” says Paul Symons, director of public affairs for international securities depository Euroclear Bank, who wouldn’t elaborate. So also says Tim Werner, vice president of core product management for rival Clearstream in Luxembourg, when asked to comment on the settlement fail rate at his international depository on October 8.

The notable exception: an increase in the fail rate of European government bond transactions at Clearstream, which grew from about 3.5 percent to 4 percent for that day. The hike was in line with an analysis done by the International Capital Market Association (ICMA), the London-based international bond trade group, and was widely anticipated.

“Market-wide efforts to ensure timely affirmation and allocations resulted in only one percent of total traded volumes mismatching and subsequently requiring post-trade repair,” says a statement issued by the ICMA on October 15. “Settlement efficiency levels have remained high during the migration, with only a negligible uptick in settlement fails on October 8 and there have been no observable issues with agent and clearing funding, bottlenecks and settlement cycle events.” Also helping to curtail the fail rate were the practices of netting and pair-offs of fixed-income trades on October 3 and October 6 which resulted in settlement volumes increasing by only 50 percent on October 8.

What’s next? After their experience of the first days, many firms will be looking into the technical and workflow bottlenecks that don’t work with a T+2 world. “The two-day settlement cycle will be a catalyst for middle-office change to ensure a correct final settlement leg,” explains Darryl Twiggs, executive vice president of product management for post-trade reconciliations and reference data management firm Smartstream in London.

Reducing Hours

Operations officials at all of the five European fund management shops contacted by FinOps agree. They will be reviewing their local matching and central matching capabilities to ensure they are automated and can meet the quicker post-trade communication deadlines.

“We are doing a forensic analysis of our post-trade communications process of October 8 to uncover just where the weaknesses were,” says one operations manager. “We will be maintaining the extra hours and staff temporarily, until we come up with a better gameplan.”  That new mousetrap, he explains, includes developing a new data management and governance strategy to ensure correct reference data in fewer databases with consistent data models, finding the underlying reasons for the number of trades confirmed and allocated manually, and automating the reconciliation process.

Twiggs agrees that fund managers, broker-dealers and banks are starting to pay closer attention to correct reference data flows between their front, middle and back offices so that there are fewer trade breaks — or transaction details that don’t match on time. Of course, such an interest could ultimately benefit Smartstream which markets data cleansing software.

Although McSherry, who is also co-sponsor of a new middle office committee for trade group ISITC, says that fund managers will need to investigate the reasons for any exceptions in the post-trade process, he doesn’t believe fund managers will be forced to change their current matching strategy based on the shorter settlement cycle. Not so, counters Steve Grob, director of strategy for order and execution management systems operator Fidessa in London.”There are far more options to complete local matching, including the use of the FIX message protocol,” he points out.

So far, most fund managers have embraced Omgeo’s CTM; however the SWIFT securities messaging network and FIX Trading Community, the trade group which develops and promotes the FIX message protocol, are targeting disgruntled Omgeo customers and other financial firms that don’t wish to realign their post-trade operations infrastructure to handle central matching. Last year, Fidessa expanded its sell-side order management system to allow fund managers and broker-dealers to use FIX messages to allocate, confirm and affirm post-trade details with each other prior to trade settlement.

Where’s the Inventory?

Fast-enough communication isn’t the only challenge of T+2. Ensuring enough securities are on hand more quickly could be an even more stubborn obstacle to meeting a shorter settlement cycle, warn some middle office specialists. One operations manager at London-headquartered fund management firm, says that her firm is evaluating its stock lending process to ensure it has the ability to track down just who holds the stock or bonds and how they can be requested back in time to meet the shorter settlement cycle.

“In several instances, securities weren’t returned in time to meet the shorter settlement cycle and our trades failed to settle on time,” the operations manager tells FinOps. McSherry also believes that the “lack of inventory,” rather than mismatched trade instructions led to most settlement fails on October 8, and acknowledges it was the cause of some settlement fails with his firm’s fund manager clients.

If the administrative costs of handling settlement fails aren’t enough to motivate firms to pay attention to their middle office operations, fines imposed by securities depositories will be. The methodology for determining how much to charge, now set by each European national and international depository, will eventually have to be harmonized based on new European legislation calling for depositories on the continent to follow uniform operating procedures.

It is unclear whether the new policies will be more punitive than current practice, but at the very least clearinghouses will also be allowed to implement buy-ins should the settlement fails not be cleared up quickly enough. Fund managers will likely bear the brunt of the additional costs passed along by banks and broker-dealers.

“The rubber will hit the road when we see our first bills from our custodians next month,” says one operations manager at a London-based fund shop. “It’s going to be pretty clear that if we don’t keep settlement fails to a minimum, it’s going to hurt our bottom line.”