GC Friday Interview: Omgeo's Tony Freeman on the Move to T+2

On October 6, 23 markets in Europe will shorten their equities settlement cycle from three days after the trade date (T+3) to two (T+2), which should improve liquidity and reduce risk but could pose some operational challenges initially. Tony Freeman, executive director of Industry Relations at Omgeo explains where the financial industry is generally at in preparing for this major initiative.
By Jake Safane(2147484770)
On October 6, 23 markets in Europe will shorten their equities settlement cycle from three days after the trade date (T+3) to two (T+2), which should improve liquidity and reduce risk but could pose some operational challenges initially. Tony Freeman, executive director of Industry Relations at Omgeo explains where the financial industry is generally at in preparing for this major initiative.

GC: How ready is the industry for the move to T+2?

TF: There was a huge focus on the implementation of derivatives reporting in Europe up through February/March of this year, but because the deadlines were tight, firms were unable to devote as much attention to this issue (T+2) as they would have wanted to. Since then, however, firms have begun to focus on the October 6 implementation deadline because it represents a re-engineering of the processing cycle.

Further down the line, there are two other events that will follow on: firstly, the implementation of TARGET2-Securities in mid-2015, with Italy the first large market to go-live on the T2S system. As this is a high-volume market that most mainstream investors have some interest in, the implementation will impact a large number of individuals.

Later in 2015 is the implementation of the settlement discipline regime, which is a component of the CSD Regulation. The settlement discipline regime is a polite term for a penalty regime to incentivize firms to reduce the number of failed trades. While there are some penalties in place in Europe today, they’re not punitive. For a long time, a 99% settlement efficiency rate was considered acceptable, but policymakers want to reduce that to as close to 100% as possible.

In some ways it’s convenient for the market in that they’re implementing T+2 well ahead of the implementation of the settlement discipline regime, because it is fairly widely expected that some segments of the market will actually struggle with T+2 and the number of failed trades will increase, but they have potentially a year to get used to the new T+2 environment before the penalties kick in and buy-side firms, which are the root cause of those trade failures, start to incur penalties for their ability or inability to settle a trade in two days versus three days.

Overall there are three segments of the market. There’s a segment of the market that is very aware of this change and they’re prepared. There’s a segment of the market which is playing catch-up; they are aware of the change and they’ve only recently started doing the work necessary to re-engineer their processes. But unfortunately I feel that there is a segment of the market that is unaware and unprepared, and those are the people that will struggle most come the October 6 deadline.

GC: Who would you describe as being unprepared?

TF: These are generally people in Europe who are not properly automated in the middle office. They’re still using legacy forms of technology to do their post-trade processing, to allocate the trades, to agree the trades with their broker counterparties. It’s hard to quantify how many there are, but some estimates are that 20-25% of the market across Europe is not fully automated in the middle office. There’s still a surprising number of fax instructions being used, for example. There’s a lot of email, a lot of spreadsheets. The widespread view is that these are not robust processes. They don’t work in a streamlined, effective way, and the people who are using those processes will be the cause of operational problems post October 6.

GC: Other than the buy side, are the market infrastructures, custodians, etc., up to speed?

TF: Yeah I think they’re generally up to speed. If you look at the different segments, for the CSDs I don’t think it’s a big issue. For them, they already operate multiple settlement cycles, so they know they can settle trades in two days. It’s their participants that need to change their behavior. I would say generally the broker-dealer industry is very well prepared. The global custodian industry is very well prepared. But this is a community business. It does rely upon your clients and counterparties to work at the same speed and level of accuracy as you do. It takes two to tango. You can only move as quickly as your counterparty; you can be highly efficient, have all the technology in place, you’re on the ball from an operational perspective, but if you have a client in say parts of the world where they’re not very aware of this change–potentially clients in Japan or in the U.S., for example, people well outside the European market–they may not be ready in time because they haven’t been brought into the discussion and they haven’t been educated by their custodians or brokers as to what the requirements actually are. But it’s very, very hard to judge the level of readiness for these people. It could all go smoothly, it could be quite bumpy; we really don’t know.

GC: Will this have an impact on trading decisions? Would managers outside of Europe want to trade less in those markets?

TF: They won’t trade less. You can’t allow an operational issue to determine where you invest and how you trade. I think they have to find a way to make this work. It may in the short term be somewhat painful. People might find it difficult, they might have to throw resources at it, they might have to work much longer hours, for example, or out-of-hours processing might become much more prominent. But I think ultimately things will settle down and those operational processes will have significantly improved.

It’s the Asia buy-side that probably has the biggest challenge because they’re so many hours ahead of Europe. But it isn’t just people who are ahead of the European time zone that will be impacted. Firms located in later time zones will also face challenges because the TARGET2-Securities (T2S) system has a settlement cycle that runs overnight. With T+2, the 2 actually starts in the evening of T+1. As a result, the optimal processing cycle is for trades to be submitted to the T2S system by 7:30-8 p.m. Central European Time on T+1. This is why I sometimes jokingly refer to the T+2 settlement cycle as T+1 ½ because it actually starts the day before.

So if you’re in New York, the 7:30 p.m. settlement window is 1:30 p.m. in New York; you have to deliver the trades to your custodian at least a couple of hours before that settlement window closes. If you’re in the Midwest or on the West Coast, it obviously gets more difficult as the window gets earlier. What this means is that trade-date processing is effectively mandatory. If a firm is trading from the States into Europe and routinely processes its transactions in the morning of T+1, that may not be viable going forward. Firms will need to complete those transactions on the trade date itself, meaning essentially extended working hours well into the evening on trade date. If they don’t do that now, they’re probably going to have to start in the future.

Some managers may have gotten used to the idea that an unmatched transaction can wait to T+1 to be remedied when the staff in the U.S. are in the office and the staff in the European counterparty are in the office; I am not sure that is viable. Most of the clients can operate on a real-time or near real-time basis if they choose to, but many of them don’t. They’ll batch things up and process once or twice a day. That will likely not be enough in the future environment.