Old Habits Die Hard

Tony Freeman, executive director of industry relations, DTCC, considers why some market participants are still resistant to post-trade automation.

Most people believe that the use of fax machines died out years ago, along with VHS videos, CDs and manual tape recorders. In the consumer world this is largely true. The majority of us now send important documents by scanning them in and sending them via email. Unfortunately the same cannot be said of post-trade processes and in particular, trade confirmation. Despite the technology being available to automate the trade confirmation and allocation process, manual processes are still heavily prevalent and without a regulatory mandate, the industry is unlikely to change.

To illustrate the risk which these manual practices create in the financial markets, let me use a consumer industry analogy. Confirming the economic details of a trade is most analogous to booking an airline ticket: as a consumer, once you have confirmed all the details of your flight, you receive an automated email which confirms details of your travel. Imagine if, instead of receiving the email, you were faxed over the details of your travel – this would require a manual process from the airline of faxing over the confirmation and a manual process at the consumer end in terms of receiving the confirmation – both of which would make the process prone to error.

Trade confirmation by fax is still used by many small buy-side firms, when confirming and allocating trades, despite the availability of technology which enables the central matching of the economic details of the trade. The importance of timely confirmation of trades was highlighted during the collapse of Lehman Brothers when market participants scrambled to understand what their counterparty exposure was to the troubled investment bank. It surprises me that this event alone did not spur all market participants to address operational inefficiencies and implement automated trade processing.

The fact of the matter is that without a regulatory or economic imperative, the behaviour of market participants will not change because there is no business case to do so. What is even more concerning is that at present, regulators are not monitoring this issue and therefore have little or no sense of the scale of the problem. This, in large part, is due to the fact that since the global financial crisis, policy makers and regulators have been extremely focused on financial risk rather than operational risk, even though as in this case, operational risk can evolve into financial risk.

That said, in Europe at least, policy makers have recognised the role that efficient operational processes play in reducing counterparty risk, by mandating T+2 settlement in the form of the Central Securities Depository Regulation (CSDR). However while this requirement creates a need for automated trade processing for T+2 to be achievable; it does not mandate it and therefore it will not change the behaviour of all market participants. The same applies in the US where the industry is pursuing migration to a T+2 settlement cycle by September 2017.

One of the best examples of a regulatory mandate being needed to change market practices is the implementation of legal entity identifiers (LEIs). While LEIs have been heralded as one of the key pillars of systemic risk management, in Europe, only a small number of firms had applied for an LEI before they became mandatory in derivatives trade reporting under the European Markets Infrastructure Regulation (EMIR) in February 2014, at which point numbers increased exponentially.

This is clear proof that the most effective way of changing the behaviour of market participants is a regulatory imperative and even then it takes time. Without such a regulatory mandate in the area of trade processing, I fear that the use of manual processes amongst smaller buy-side firms will continue. This means that unfortunately, for now, the fax machine will live on!