Middle Office Takes Center Stage in T+2

Once the unsung sibling of the front and back office, the middle-office could finally get its long overdue recognition as the US prepares to shorten its trade settlement cycle from three days to two.

Squeezed between traders praised for making lucrative deals and operations experts at the end of the line moving cash and securities around to meet settlement obligations, middle-office professionals are taking on a highly visible new role. With expertise in critical recordkeeping, reconciliation and exceptions processing, they will be responsible for supercharging the speed of acknowledging of post-trade details with counterparties.

Five US middle office experts at US fund management and brokerage firms tell FinOps Report they are already in talks with counterparties about changing operating procedures to accommodate a two-day settlement cycle (T+2), now that the US market infrastructure Depository Trust & Clearing Corp. (DTCC) has won substantial industry support for the idea. “We’ve been assigned specific times for conference calls and in-person meetings to iron out the details of how we will work more efficiently with our fund manager clients,” says one middle office operations manager at a New York brokerage shop. “We then have to report to the C-level operations directors on our progress.”

The latest trade group to join the T+2 bandwagon is the Securities Industry and Financial Markets Association (SIFMA), whose long-awaited endorsement last week gave the DTCC leverage to issue a white paper this week outlining the merits of a shortened settlement cycle. The mutual fund trade group Investment Company Institute (ICI), the Association of Global Custodians, and the Association of Institutional Investors have also favored a T+2 timeframe. As evidence of the groundswell of support, a statement issued by DTCC announcing its white paper included brief comments of praise from the ICI and from Patrick Kirby, chief operations officer for custody giant JP Morgan’s corporate investment and bank operations.

While the DTCC’s white paper didn’t offer a timeframe for when T+2 might in effect, it clearly underscores the commitment of the umbrella organization for clearance and settlement to ensuring the US meets a shorter timetable. In discussing changes that must be made to the post-trade process, the document also gives market players the impetus to make the necessary adjustments on their end.

As DTCC notes, the benefits of the US moving to T+2, as highlighted in a cost-benefit analysis conducted by Boston Consulting Group in 2012, include the reduction of buy-side counterparty risk, broker-to-broker counterparty risk, the liquidity needs of DTCC subsidiary National Securities Clearing Corp (NSCC), and the procyclical increases in margin and liquidity needs that can happen during times of volatility — all of which could ultimately free up participant capital. 

Also a driving factor: the European Commission’s mandate that European markets harmonize their settlement cycles to a T+2 timetable in 2015. Ten markets have already said they will voluntarily do so in October 2014, leaving the US far behind. Buy-side and sell side US operations experts tell FinOps they don’t expect the US to catch up until 2016 at the earliest.

DTCC officials declined to provide further details to FinOps and SIFMA officials also wouldn’t elaborate beyond a statement from its president and chief executive Kenneth Bentsen: “SIFMA looks forward to working with all market participants to ensure a smooth implementation that is carefully executed so as not to unintentionally disrupt operations or negatively impact investors.”

Faster Post-Trade Talk

That smooth implementation involves communications between fund managers and broker-dealer acknowledging trade details taking place as quickly as possible after a trade is executed. “We cannot afford to rely on a batch process any longer and need to receive allocations a lot sooner on the day the trade is executed,” says Paul McSherry, director of middle-office operations for agency brokerage and dark pool operator Liquidnet in New York.

No longer will fund managers have the luxury of waiting until the end of trade date — the day the trade was executed — to send their allocations to broker-dealers to match up with the details of trade execution. Broker-dealers, in turn, also can’t delay resolving any discrepancies until the following date. Trade details must be affirmed on trade date, rather than T+1, as is often the case in the US. In fact, despite alleged technological sophistication of its markets, the US has a far lower same-day affirmation rate than its European or Asian peers — largely because it doesn’t rely on an automated central matching process.

But speed alone won’t cut it for meeting T+2. Fund managers and broker-dealers will also need to verify that the post-trade information on the economic details of a transaction and the fund manager’s subaccounts are accurate from the start. “Optimally fund managers and broker-dealers will need to input the correct information up front to reduce the number of exception reports that must be addressed,” says McSherry, who was just appointed the co-executive sponsor for a new middle office operations committee working under the auspices of the trade group ISITC, short for International Securities Association for Institutional Trade Communications.

Also serving on committee, which has yet to appoint a chair, are ISITC veterans Michael Fiscella, an executive director for Morgan Stanley, and Evelyn Galeano, a vice president at Standard Chartered. While the middle-office group won’t endorse a specific type of matching protocol — either local or central — it will be coming up with workflow recommendations for speeding up the communications process between fund managers and broker-dealers.

“Fund managers may ultimately decide to inform broker-dealers about the existence of their underlying customers far earlier in the trade lifecycle — as soon as they are onboarded,” predicts one operations specialist at a US fund management firm. “Such a scenario does presume we verify the information we have on our files with that held by the broker-dealer and improve the onboarding process.”

If fund managers and broker-dealers find that they can’t live up to their new requirements as quickly as they would like, playing the shame card might be a last resort. A broker-dealer operations specialist tells FinOps his firm will be sending all of its fund manager clients more frequent “performance reports” outlining just when tasks are completed and how far they deviate from the optimal timeframe. “We’re looking to get rid of consistent outliers,” he says. “While we won’t reject their business, we will show metrics for just how they compare with their peers and explain what they are doing wrong.  That should provide some incentive.”

DTCC is also offering up same-day affirmation as part of the laundry list of secondary enablers to achieving the shorter settlement timeframe. “Institutional trades must be matched by noon on T+1 with same day affirmation on T+0 as a best practice,” says its white paper.

The core primary enablers, according to DTCC, involve changes to its rules and operations while other secondary enablers include improving the accuracy of Omgeo’s Alert standing settlement instructions database, reducing the number of physical certifications out in the market, and extending the prospectus “access and delivery” process for all products. A subsidiary of DTCC, the post-trade communications service provider Omgeo operates Alert database of critical details used by financial firms to transfer cash and securities on settlement date. Get the information wrong and the wrong assets, wrong value of funds, or wrong destination will foul up settlement.

Putting Muscle in the Requirements

While the same-day affirmation process between counterparties falls outside the DTCC’s direct jurisdiction, another type of matching, settlement matching, provides DTCC with serious clout in the process. At the end of 2014, DTCC will be requiring both sell-side participant counterparties to acknowledge details to settle a trade, according to its whitepaper.

The US is apparently the only major market which doesn’t mandate settlement matching, subsequent to institutional trade matching between fund managers and sell-side firms. The US permits settlement instructions sent by only one of the two counterparties for uncleared trades to be accepted for settlement. That’s a far cry from European practice, and if the European Commission has its way, European depositories following new legislation requiring them to adopt more rigorous unified operating procedures, can fine participants who don’t comply within a designated timeframe for settlement matching. Doing so, the EC reckons, will ensure they can meet T+2.

Trades processed through NSCC are already prematched and locked-in so they don’t require settlement matching, according to DTCC. In documentation appearing on its website explaining how it would phase in the requirement for settlement matching in 2013 and 2014, the DTCC said that all unaffirmed institutional trades and other transactions submitted by its participants would be eventually need to be processed through its Receiver Authorization Delivery (RAD) Process, which enables a participant to either approve or cancel the transaction. In addition, affirmed institutional transactions processed by Omgeo or another qualified vendor offering matching capabilities would be sent to DTCC in a straight-through manner allowing a trade match to automatically generate a settlement match. To address the need for clients to ensure funding is available from their customers prior to taking in securities, DTCC would introduce an “exemption functionality” to allow receivers to pause or hold the transaction from settlement. until the appropriate credit decisions are reached.

McSherry isn’t certain that settlement matching should be required for the US to move to T+2, nor that Depository Trust Company, the DTCC’s subsidiary depository,should immediately fine participants for matching settlement instructions too late. Nevertheless, he does understand the long-term benefits to a punitive approach. “I think T+2 could occur even without a match-to-settle requirement at DTC, but it will certainly help the cause,” he says. “Financial firms should understand the operational costs of failing to settle a trade on time, but it might become necessary for even more incentive.”