The focus of policymakers on both sides of the Atlantic – on post trade infrastructures as a way of reducing risk in the financial markets – is absolutely the right one. A transparent and efficient post trade process provides industry participants with the real-time visibility of exposure that is required to manage and understand risk.
In terms of the focus thus far, mandating the central clearing of OTC derivatives has been policymakers’ preferred route to mitigating risk. This will ensure that credit risk is centrally managed and should therefore, in turn, reduce the probability of market failures. Such post trade initiatives should go some way to restoring investor confidence in the securities industry and therefore should be loudly applauded.
In addition to this, there are other post trade processes that are upstream from clearing and settlement, where implementation would further bolster the robustness of the financial markets infrastructure. Trade verification is a good example of this. If essential details of a trade such as date, deal price and the number of securities bought or sold, can be agreed on the date the trade is executed, then there is a much higher likelihood of that trade settling successfully. However, for ‘settlement certainty’ to be achievable, the trade verification process must be automated so that it is volume insensitive and enables a standardized exchange of trade information between counterparts.
Trade processing automation is being widely achieved amongst broker dealers and large investment managers; it is amongst the small investment managers and hedge fund where the issue of manual processing still exists. One European investment banking client told me that trades with non-automated clients have a settlement failure rate twice as high as that compared to non-automated ones. Failed trades as the ‘poster child’ of operational risk and inefficiency need to be minimized if we are to make our financial markets a safer place in which to conduct business.
The varying levels of post trade automation holds true across asset class as well as size of industry participant. Rates of automation in fixed income are far lower than in equities. In the main this is due to the over-the-counter nature of the fixed income market, which comprises a complex set of instruments, ranging from US treasuries to interest rates and corporate bonds, each with their own terms and conditions. That said, there are frequently traded fixed income products such as treasuries, newly issued corporate bonds, agencies and sovereign foreign debt that are much more suitable for post trade automation. For these types of products, wider adoption of straight through processing would significantly mitigate operational risk.
The focus on central clearing by policymakers has been a healthy exercise in that it has raised awareness of the importance of post trade infrastructures to the safety of the financial markets. However, it must be remembered that ahead of both clearing and settlement are middle office procedures that, if not conducted in an efficient manner, can significantly slow down, or even worse, inflate operational risk. Automating upstream, as well as downstream, is well worth considering.