Operations directors at fund management firms are starting to review post-trade communications, securities lending, liquidity management, and corporate actions as the critical processes keeping them awake at night when preparing for a one-day settlement cycle (T+1) for US securities in May 2024.
Analyzing internal workflow and interactions with broker-dealers and custodian banks is essential to ensure that buy-side firms won’t be hit with massive cleanup costs from an increased number of fails and claims, say operations managers and consultants. The steps involved with settling a trade haven’t changed; they just have to be done a lot faster and mistakes must be caught a lot earlier or preferably not made at all. “The T+1 accelerated cycle will compress post-trade processing windows between fund managers and their service providers, shortening timeframes for communication and exception processing,” says Alexandra Wood, a partner in the Financial Services Consulting & Advisory Practice of global consultancy Cognizant.
In February, the US Securities and Exchange Commission finalized a rule to shorten the settlement cycle from T+2, or two days after a trade is executed, to T+1. The regulatory agency pushed back the compliance date to May 28, 2024, which is the Tuesday after the Memorial Day weekend from the previous intended date of March 31, 2024. Canada, which was planning to shift to T+1 at the same time as the US, does not have a three- day weekend in late May so it will begin settling T+1 trades on May 27, 2024. The SEC’s move comes six years after T+2 was implemented and is two months after the regulatory agency’s initially proposed date of March 31, 2024. The financial services industry had proposed a date of September 3, 2024.
The Securities Industry and Financial Markets Association, Investment Company Institute, and Depository Trust & Clearing Corp. (DTCC) have devised a proposed “playbook” for how buy-side and sell-side firms should prepare for T+1 on the premise that an ounce of prevention is best. Industry-wide testing is planned, but since that involves only market infrastructures and members of DTCC—banks and broker-dealers– fund managers will be left out of the loop. As a result, they will need to test the workflow process with broker-dealers and custodian banks on their own or face a higher number of fails.
“We have created a T+1 steering committee with representatives from multiple business units to interact with counterparts at broker-dealers and custodians,” says one operations manager at a US-based fund management firm in a stance echoed by other operations managers who spoke with FinOps Report. The shift to T+1 is expected to hit harder for smaller fund managers which have fewer employees dedicated to operations and rely heavily on legacy batch systems that may not be able to cope with increasing trade volumes.
The higher the number of trades that fail to settle on time– otherwise known as fails — the higher the cost to fund managers and the lower the potential return on investment. “Unlike the case with Europe’s Central Securities Depository Regulation which requires European securities depositories to fine member banks and broker-dealers for not settling trades on time, US regulations do not call for any mandated penalties other than clean-up costs,” says David Smith, managing director at technology giant Broadridge Financial who heads up the banking and capital markets division of its consulting arm. Ultimately, investors will end up paying the price if fund managers don’t pay attention to their funds’ shortcomings. Some operations managers say that fund managers might even find themselves in regulatory hot water if an SEC exam reveals they are not allocating and affirming a sufficient number of trades in a timely fashion. Operations managers at two dozen fund management firms contacted by FinOps Report weren’t willing to disclose their current fail rates or predict how high the fail rate could rise after T+1 becomes implemented. However, all agree that more work needed to be done in mapping out potential landmines. “We are evaluating the trade lifecycle with broker-dealers and custodian banks,” an operations manager at one East Coast fund management firm tells FinOps Report. That means determining who is at fault when a trade is not matched in time.
Ensuring the correct economic details of a trade are matched between the fund manager, broker, and custodian bank early enough goes a long way to ensuring the trade settles when it should. Trade details must be confirmed by the broker-dealer and affirmed by the fund manager after allocating the correct number and value of securities to the right underlying fund client. For now, the affirmation rate hasn’t reached 100 percent on 9 PM EST on the day the trade is executed which is where it needs to be for all trades to settle under a one-day settlement cycle. By industry estimates at least twenty percent of trades are still being affirmed the day after they are executed. That is fine under a T+2 timetable but not under a T+1 schedule.
Fund managers point the finger at broker-dealers for late confirmations, while broker-dealers counter that some fund managers are relying on old-fashioned paper and e-mails for affirmations and allocations, which must occur by 7 PM EST. “The current T+2 settlement cycle affords trading partners a two-day window to share trade details for allocation, confirmation, affirmation and settlement instructions,” explains Cognizant’s Wood. “The T+1 accelerated cycle means trade managers must communicate trade details within T+0 [the day the trade is executed] intraday windows and complete allocations without exception to meet overnight and settlement date cutoffs.” As a result, she says, communications between fund managers and service providers must be “time-boxed” for business-as-usual activities and continuous to resolve exceptions and avoid settlement fails.
The earlier deadlines for post-trade communications will be more difficult for buy-side firms in Europe and Asia-Pacific to meet, due to time zone differences. The European markets will have closed well before the US market ends and the Asia-Pacific markets will have closed before the US market opens. “We currently see a significant portion of affirmation take place on T+1, due to many clients based in Europe and Asia,” says Stanislas Beneteau, head of the financial intermediaries and corporates client line at custodian bank BNP Paribas Securities Services for the Americas based in New York. About forty percent of investment in US markets comes from overseas, by industry estimates.
Solutions for fund managers include adding operations staff and using a central matching service, such as the US DTCC’s CTM which offers a match to instruct (M2i) tool to automatically trigger trade affirmation and delivery of securities to the US’ securities depository Depository Trust Company (DTC) for settlement. About 1,900 buy-side firms and 1400 sell-side firms are using the CTM, according to DTCC, which says the no-touch workflow processing of M2i facilitates a nearly 100 percent affirmation rate on the day the trade is executed (T+0). The problem is that not all fund management firms have embraced the CTM. “Some fund management firms have been relying on the good graces of broker-dealers to accommodate them or sending affirmations too late in the day and allocations afterwards,” says Michael Hartig, managing partner at New York-headquartered Capital Markets Advisors, a financial services consultancy specializing in technology, risk management and regulatory compliance operations. “Broker-dealers will need to crack down on fund managers which don’t provide them with all of the necessary post-trade information, including allocations and settlement instructions even before an order is executed.” The possible answer– not accepting the order. Beneteau says that BNP Paribas Securities Services, which also provides middle outsourcing services, is reaching out to counterparties to determine why certain trades are affirmed late and why some parties do not send confirmations — a prerequisite for the bank to affirm post-trade instructions.
Five of the two dozen operations managers at fund management firms who spoke with FinOps Report say they are using DTCC’s CTM, while three others say they will consider doing so. BNP Paribas Securities Services’ buy-side outsourcing department uses the CTM to match trades on behalf of fund manager clients before instructions are sent to custodian banks. Two fund management operations managers say they will add more employees and will extend their shifts past 7PM EST at least for the first month after T+1 becomes effective. “[For non-US based fund managers] resource loading and overlapping hours during peak hours will compress communication delays, but workforce automation and intelligence will be critical to scale without duplication of staff in US time zones,” says Wood.
Even if the economic details of the trade are accurate and match up, the final step in the post-trade acknowledgement process might be wrong. That last step before settlement is the “standing settlement instructions” (SSIs) which refer to information about the securities depository and bank account in which the funds and securities involved with purchases and sales should be transferred. The fund manager needs to have the same information as the custodian bank. The DTCC’s Alert database is the most popular centralized system for SSIs and several custodian bank operations managers tell FInOps Report they are encouraging their fund manager clients to use Alert or allow their custodian banks to do so on their behalf. Custodian banks can update SSIs for fund manager clients through the Global Custodian Direct Service using ISO 2022-compliant messages; BNP Paribas, JP Morgan, and Brown Brothers Harriman are among those users.
Back-office operations managers aren’t the only ones needing a good understanding of the status of their firms’ trades. Likewise, say Nicole Greene, director of global investor and distribution solutions at global technology firm SS&C Technologies, portfolio managers must be more quickly updated. ‘Portfolio managers must know about all of the executed orders, the subaccount allocations and cash flows in real-time to ensure compliance with investment strategies and potential portfolio rebalancing,” she explains. “The information from the trading desk must match up with the records of the broker-dealer and given to the fund administrator to strike the correct net asset value.”
Yet another common reason for settlement fails is that securities aren’t delivered to the counterparty on time. Those securities could be on loan, which means they would have to be recalled quickly from the borrower-typically a broker-dealer or prime broker acting on behalf of a hedge fund manager. The recall could be done by either the fund manager or its custodian bank, which typically acts as an intermediary matching up fund managers with broker-dealers in exchange for a percentage of the fees earned by the fund manager. A broker-dealer may not have the securities needed to meet its settlement obligations and will have to borrow them from another lender. In the meantime, a fund manager may also not have the right securities on hand to meet its settlement requirement and will be left in a pickle. “A fund manager currently may not know what lent securities they must recall until the morning of T+1,” says Broadridge’s Smith. “Under a one-day settlement cycle the recall must occur on the evening of trade date and even if fund manager knows what securities to recall, the broker-dealer borrower’s operations team might not be available to return the securities.”
Several operations managers at fund management firms tell FinOps Report they are concerned about whether they will be able to recall securities faster or manage their inventory well enough. For now, some fund managers are reviewing their inventory management process to ensure they can keep track of securities out on loan and what securities are available. Others say they are analyzing their recall procedures with agent banks or deciding whether to consolidate their securities finance systems for greater efficiency. “It will be important for fund managers to ideally transmit sale notifications to their agent lenders prior to the close of the relevant exchange, typically 4 PM on trade date (T) to ensure that recall due date and contractual settlement date for sale transactions are aligned,” write Thomas Poppey, global head of securities lending and Robert Lees, global head of securities lending trading at Brown Brothers Harriman, in a recent bulletin for clients. They also recommend that fund managers ask their agent lenders if they have sufficiently automated capabilities to ensure a shorter time frame from receiving a sale file to issuing a recall. “Although these enhancements may not automate the process completely, they can significantly reduce the time between receiving a sale notification to issuing a recall,” write the BBH executives in the bulletin which highlights how T+1 settlement will affect securities lending.
Meeting settlement obligations by delivering securities on time is one of the two legs of ensuring settlement occurs on time. The other is delivering the right amount of funds. To manage the potential higher demand for liquidity, fund managers need to have rely more heavily on short-term funding, such as repurchase agreements and money-market funds. To determine how much funding is needed and when fund managers must know the status of an executed order so that the right projection can be made. The wrong data could result in late funding or a costly funding shortfall. For non-US fund managers, the task of liquidity management will be even more daunting due to time zone differences. Investors in US securities in dollar-denominated accounts must execute foreign exchange transactions to fund their purchase or sale from local currencies. The settlement cycle for FX trades, which includes trade matching, confirmation and payment will need to be shortened as to match that of the securities.”Processing US/Canadian trades from international locations will require FX processing to assure cash availability on T+1,” says Wood. However, that processing may not happen in time. “As a result, overseas counterparties and clients will be required to prefund settlement accounts,” says Wood. However, prefunding comes at a cost. “By having to prefund there is a possibility that clients will be unable to deploy capital for trading purposes,” writes Michelle Pitts, head of NAM custody product management securities initiatives at Citi in a recent client bulletin on T+1. “There is also a risk that some firms do not prefund enough.”
Some US fund management operations executives tell FinOps Report they are reviewing their liquidity management procedures to ensure they are intraday instead of the end of the day the trade is executed, or worse the next morning. Real-time liquidity management systems are available, yet they appear to be favored primarily by large banks leaving portfolio managers at a loss for how to get a better grasp of their funds’ cash flows. In a recent report entitled “FX Considerations for T+1 Securities Settlement,” the Global Financial Markets Association recommends institutional buy-side firms outsource their currency management to third party specialists with trading and operations desks in the major trading time zones.
Although corporate actions do not directly involve the settlement of transactions, they will be impacted by the shorter settlement cycle as settlement fails could increase the number of claims. Under a two-day settlement timetable, the ex-date will typically occur one day before the record date, or the date investors in stocks or bonds are identified for the purpose of corporate action entitlement. If an investor sells shares before the ex-date, it forfeits the right to the payment. Under a T+1 timetable the ex-date and record date will occur on the same date and should a settlement fail occur the seller, instead of the buyer, could receive the payment. “Settlement failures could cause the wrong party to receive a dividend, income or other stock/cash payments requiring the custodian bank to file a claim for the return of the payment to the counterparty,” explains Kamal Kannan, business transformation manager for securities services at S&P Global Intelligence, a division of S&P Global. “The claim process within the custodian’s back office will come under pressure as the custodian will be forced to process multiple claims with different counterparties.”
Operations managers at fund management firms tell FinOps Report they are also concerned about receiving corporate action information in a timely fashion with the correct ex-date and record date information while operations managers at some custodian banks say they are worried about whether their fund manager clients will implement their instructions for voluntary corporate actions by the designated deadline. Kannan recommends that fund managers and custodian banks review any hard-core logic within their IT systems with respect to ex-dates and record dates. S&P Global Market Intelligence’s Managed Corporate Actions platform offers pre-verified data from multiple sources and can derive the correct ex-dates and record dates along with the cover/protect expiration date to be included in the golden copy of the corporate actions information.
The purpose of the cover/protect process is to allow investors to participate in voluntary corporate actions, such as exchange offers, tender offers, and redemptions even if they don’t hold the securities in their accounts at the time the corporate action expires. Establishing a protect expiration date on a voluntary corporate action depends entirely on the issuer of the security which establishes the terms of the corporate action in the offering document. Buyers of securities file protect requests when purchasing securities based on agreements sellers deliver to them before the date the protect request expires. “The cover/protect process involves significant reconciliation of trade files and under a two-day settlement cycle firms have sufficient time to reconcile trade files, submit instructions to DTC, and send liability notices,” says Kannan. “The move to T+1 means the cover/protect period will shorten and the liability process will be compressed.” The cover/protect period under T+1 will lapse in one day, instead of the current two days after the expiration date of the corporate action. That is the date by which an investor must make a decision. The party which does not have securities on hand to participate in a corporate action will file a liability notice to a firm which fails to deliver securities on time.
Regardless of which process is impacted by the US’ shift to a one-day settlement cycle, reducing the potential for settlement fail will all come down to completing three tasks– making certain the data input into any system is accurate, communicated as close to real time as possible, and corrected quickly if necessary. Kannan recommends that fund managers automate the flow of information between their front and back offices and to their custodian banks. “Front-office systems should pass the trade details immediately after the day of execution to back-office systems, which should automatically identify the SSI and other trade details,” he says. “The settlement instructions should then be sent to the custodian bank in an electronic format agreed between the fund manager and custodian bank, which could be in an ISO-compliant format over the SWIFT network or FIXML”
Automation can go a long way to preventing settlement fails, but it isn’t a panacea. “Fund management firms will need to develop a strategy for reconciliation and error management,” says Daniel Viola, a partner in the regulatory and compliance practice of the law firm of Sadis & Goldberg in New York. “There still needs to be enough manual intervention to correct mistakes.” Operations managers at several US-based fund management firms tell FinOps Report that they are reviewing their reconciliation technology and exceptions processing. “We might decide to add staff and/or centralize our exceptions processing management teams,” says one operations manager at an East Coast-headquartered fund management firm. “Ultimately, we need to reduce the number of exceptions to a bare minimum or ideally none,” he acknowledges.