Post-trade industry not out of the woods yet

Operational risks still lurk for the post-trade industry, and only strict oversight of data, legal and pricing risks will guarantee survival.

I was asked recently what I thought the greatest operational threats were for the post-trade business. I suggested data management and, secondly, complex fund pricing. But in discussion we also covered the impact of the standard custodian DDQ and the maintenance of up-to-date legal agreements. Interestingly enough, the traditional fault lines of due date settlement or corporate event management were not highlighted, although I felt that communication of corporate events was still lacking, especially in respect of issuer to investor automation of process.

Data management is a huge problem as the industry struggles with its disorderly, distributed and disparate data pools. Eager talk about monetising this is more focused on new reporting obligations than genuine new data products. And that is not surprising as the industry faces three existential data problems. First, at a corporate level, data is held in multiple pools and is often difficult to assimilate into a single cohesive form; the concept of a homogenous data lake is far from reality for almost every market participant. Second, at an industry level, there are few standards around benchmarks that enable a true cross client cross industry performance analysis. And third, the architecture for data collection and collation is distributed and therefore inappropriate for the production of golden copies. Even with blockchain, which appears conceptually to be the most appropriate option for efficient data management, there have to be questions on the mechanism for ensuring any non-trading data it holds is accurately maintained and accessible to the parties impacted or associated.

Fund pricing was my second issue. Ninety percent plus of fund pricing is drawn from exchange quotations that are easily accessible and almost always compatible, within agreed margins, across exchanges and pricing services. But, especially as the liquidity of funds comes under ever greater scrutiny, there is once again a question over the relevance of a market quote when holdings are several factors of the market size and investor behaviour, at times of crisis, follows the herd instinct. In addition, some pricing is becoming too complex for market practitioners. The problem has been eased, albeit whilst retaining the scale issue, with the migration of much derivative activity to exchange listed environments. But there still remain bilateral transactions which few, other than perhaps the originator or different parties to the transaction, can price effectively on the assumption of a need to unwind the trade. And currency or other overlays are as difficult to assess, not only because of the volatility of their component parts but also because of the size of major funds and their hedged positions relative to market appetite for a trade.

One has to remember that the crunch comes at times of market crisis; prices then are always volatile, spreads inevitably widen and market size declines. Even since Lehman, we have seen a riskier situation developing with greater concentration risk, faster information and analysis, lower risk appetites as well as more volatile and geared risk positions among entities such as the high end high frequency traders. From an operational perspective, there has to be a question of the liability of administrators, even if they are not the primary pricing agent for funds, for any loss of liquidity at a fund which results in serious capital losses in volatile markets for the underlying investor. History says deep pockets pay!

The custodian due diligence questionnaires created by the industry have the upside of producing standard responses in a cost-effective way to core questions at a custodian. They are also easily updated.  But, there is a risk that many are becoming over dependent on the standard answers or, in order to justify their existence, producing a realm of second line queries that risk becoming the focus of their attention. At a due diligence one is looking for issues such as the accuracy of the record, the safety of the asset and the economic performance of the custodian. The dependency on the standard DDQ reminds me of medium- to long-term credit assessments that were overdependent on public credit ratings which can tumble overnight. The standard answers in the DDQs are valid at a point of time but how does one identify and oversee the risk triggers that could negate the answer.

The law is unclear in many countries on issues such as bankruptcy or asset ownership. Choice of sub-custodian, after eliminating the obvious risky providers, is often limited and there is an interdependence and cross contagion risk in all markets. I can recall, when contingency first became the vogue, explaining to an irascible network manager, that if there were three main settlement banks in a market, the immobilisation of one, for whatever reason, would seriously immobilise all activity until they were re-instated. I have also experienced the fear factor when institutions felt bankruptcy laws could be defective, ranging from a demand for guarantees to panic withdrawal from markets leading to severe liquidity challenges. The industry has not really examined the total market risk; if it had there must be markets which it would avoid, at least for those investment vehicles, where it guarantees the safety of assets, often for a quantum well in excess of its own short-term risk exposure appetite for the country and bank in question.

The final issue we assessed was legal and related documentation and, in particular, ageing documentation. This problem is aggravated by the use of side letters by some in the market to comply with new regulations. There are also a myriad of documents including RFPs which could negate the contractual protections placed in the formal legal agreements. I suspect that a careful analysis of client and market documentation would reveal serious risk chasms between the risks assumed in OECD markets versus the risk assumed by agents in emerging markets and between the risks covered in legal documentation and those glossed over in RFPs and marketing materials. Much legal document depends on carefully crafted constructive ambiguity and that rarely works to one’s advantage in the event of a dispute, especially where there may be conflicting documents in circulation. We face the dichotomy of a need to agree wording with clients and counterparties versus a need to protect one’s institution and grow one’s business. And, on another material point, although I am told repeatedly that infrastructure cannot fail, their complex documentation, which is normally non-negotiable, is indeed one of their protections as is the illusion of their permanence.

I started in the industry when settlement in the UK was on a fortnightly account basis, corporate events were sent in paper, dividends were paid by cheque and a global fund invested in the USA and higher risk markets such as Italy! The market has progressed. But the risks have become global, the complexity has grown exponentially and, even though the quality of people is so much higher than a generation ago, I am still waiting for that multi-billion or so loss experience for some misfortunate player in our industry!