The buy-side is the main culprit in European equity transaction fail rates, for under-investing in the automation of the verification of trade details. This is the principal conclusion to be drawn from a study published today by Oxera, the economics consultancy. The study, which was commissioned by central trade matching provider Omgeo, concludes that settlement failure rates for automated trade verification processes are up to 50% lower than for non-automated clients. On the basis of the research, Omgeo has estimated that the European securities industry is wasting Ђ200 million a year in cost inefficiencies, even without taking account of the ancillary benefits of reduced risk, increased capacity and redeployment of resources.
As the leading provider of trade matching services to broker-dealers and fund managers, Omgeo has a clear commercial interest in widespread adoption of automated trade verification. The DTCC-Thomson Reuters joint venture sees automated trade verification as a crucial step towards Same Day Affirmation (SDA), or full agreement between both parties to a trade on all of its details – including the date, amount, price, security identification code, commissions payable and settlement procedures – on the same day as the trade itself.
At an event hosted by Omgeo in Brussels today, Omgeo CEO Marianne Brown acknowledged that European policymakers had induced far-reaching changes within the European securities industry at both the trading level (via the Markets in Financial Instruments Directive, or MiFID) and the clearing and settlement levels (via the European Code of Conduct on Clearing and Settlement published by the European Commission and the Target2-Securities settlement utility project launched by the European Central Bank).
However, Brown pointed out that change at the trade and post-trade levels was not yet matched by a comparable level of interest at the post-trade, pre-settlement level where Omgeo operates. “Omgeo will continue to champion SDA as critical component of a more efficient European securities community,” Brown told an audience of journalists, bankers, and trade association and public officials in Brussels. As she explained later, when asked about the importance of trade verification to the T2S project: “At the point of T2S, the trade fail has already happened.”
Though Omgeo would welcome public intervention to spur a greater level of automation of trade verification – the decision by the Canadian authorities to make trade verification mandatory ahead of the shift to settlement on T + 1 has boosted the volume of traffic through Omgeo there – there is no immediate prospect of it happening in Europe. Mario Nava, head of the financial market infrastructure unit at the European Commission, told the Brussels event that there was no prospect of SDA being written into the European Code of Conduct on Clearing and Settlement until public intervention was warranted by a “negative externality” or “problem of co-ordination,” by which he meant a failure on the part of all market participants to invest in a manifest public good. Nava added that the Code of Conduct was signed by the various parts of the financial market infrastructure – stock exchanges, central securities depositories and CCPs – only, and that as a result bi-lateral trade verification between third parties currently lay outside its remit. However, Nava did hold out the prospect that SDA would be explored by CESAME II, the follow-up group to the Clearing and Settlement Advisory and Monitoring Group (CESAME) set up by the European Commission in July 2004.
Diana Chan, CEO of EuroCCP – the DTCC-owned CCP that will support the Project Turquoise multilateral trading platform – told the audience in Brussels that official intervention could have a positive impact. She recalled the increased investment by market participants in trade matching technology in the US market at the turn of the century, after the Securities and Exchange Commission (SEC) mandated a shift from settlement on T + 3 to settlement on T + 1, and the backsliding that occurred after the project was abandoned. “People went back to what they were doing before,” she said. “When the obligation went away, people went back to the old ways.” Noting the positive impact of the Federal Reserve Bank of New York on the backlog of unconfirmed Credit Default Swap (CDS) trades two years ago, which prompted the creation by the DTCC of both Deriv/SERV and the OTC derivatives warehouse, Chan said she thought the combination of a single strategic goal and the threat of a “big stick” by regulators could accelerate progress towards SDA without the need for official intervention to make it mandatory.
For the most obvious of reasons, Omgeo would clearly welcome regulatory support for SDA, but the company harbours no expectations that the European Commission will provide it soon. In Brussels today, Omgeo executives declared themselves satisfied to have initiated a debate on the subject in Europe, pointing out that the ultimately gratifying Canadian initiative was itself preceded by lengthy and detailed public discussion and analysis that “harmonised” the views of the various market participants.
Marianne Brown argues that the costs to end-investors of not adopting automated trade verification, and the risks borne by broker-dealers when trades are unsettled, are unacceptably high at any time – but especially so amid the current turmoil in the money markets. She says she hopes the Oxera findings will “create a call to action and bring this issue to the fore of the European policy agenda in order to create a more efficient community in Europe.”
The Oxera research, which was based on a combination of analysis of Omgeo transactional data and discussion with broker-dealers on the costs of verifying trade details with both automated and non-automated clients, certainly makes a predictably compelling case for trade verification to be taken seriously by European policymakers as well as market participants. Oxera analyst Leonie Bell described automated trade verification as a “pre-condition” for SDA, which she argued would reduce risk and operating costs, increase the insensitivity of market infrastructure to rising transaction volumes, and cut costs to end-investors. Though the study was confined to the equity markets, Bell told the audience at the event in Brussels that its lessons applied equally to other instruments.
Bell pointed out that the efficiency of the trade verification process was still undermined by a surprisingly high level of manual intervention, in the shape of faxes and telephone calls, especially on the buy-side. Simon Haggerty, a managing director at UBS in London, disclosed that “UBS still despatches several million fax confirmations a year. In our experience, trades with such non-automated clients have a settlement failure rate twice as high compared to our automated clients.” The Oxera report notes that a “large European broker-dealer” puts the proportion of failed trades with non-automated clients at 13%, against just 6% for automated counterparts. Bell added that the trade verification process lacked both standardised processing and a target date by which market participants had undertaken to achieve SDA.
The reluctance of the buy-side in particular to abandon manual processing and commit to a standardised verification process is well-attested, and of longstanding. Unfortunately, the Omgeo brief to Oxera did not permit the consultancy to analyse extensively why this is the case. However, the report does speculate tangentially on the issue, and a number of possible explanations did emerge during the event in Brussels. One is that fund managers have a poor understanding of their post-trade costs. A second is that those costs are borne by the funds they manage rather than the fund managers themselves, giving the buy-side limited incentive to change its behaviour. Though there is mounting evidence that broker-dealers are prepared to punish non-automated fund managers by charging them higher prices, it is largely anecdotal in nature. Mario Nava speculated that fund managers may even retain clients for whom manual processes were essential.
The Oxera research suggests that the stasis caused by an environment in which fund managers do not bear the costs of the current inefficiency, but would bear directly the costs of investing in a more efficient process, is compounded by negative network effects. “Trying to get an individual firm to see the benefits of this to the whole marketplace is challenging,” says Marianne Brown. Unlike broker-dealers, which are acutely sensitive to the risks on unsettled trades as well as the costs of fixing failed trades, fund managers seem influenced primarily by a reluctance to incur costs whose benefits are not immediately obvious to them. As the Oxera report concludes: “Since the benefits depend to a large extent on the degree of automation of a firm’s counterparties, the investment may not be worthwhile at current levels of automation in the market, but would become worthwhile if automation (using standardised or interoperable systems) were introduced on a market-wide basis.”
However, there may be a more immediate explanation for the limited take-up of the central matching services provided by Omgeo. Asked whether the price of Omgeo services was prohibitive for some fund managers, Omgeo CEO Marianne Brown explained that Omgeo was working on a number of initiatives designed to reduce the “total cost of ownership” to fund managers. She agreed that the rise of algorithmic trading and direct market access (DMA) heightened the importance of SDA to fund managers, since it made a major contribution to increased levels of straight through processing (STP). Naturally, Brown is hopeful that the Oxera study will “raise marketplace awareness” of the benefits of automated trade verification and SDA. Although Omgeo is too polite to over-emphasise the point, the company will certainly be expecting the broker-dealers to increase the pressure on the buy-side to increase its levels of automation.