Clearing Quarterly & Directory, a supplement of Traders Magazine, recently caught up with Omgeo’s Tony Freeman and spoke with him about what the clearing industry can do better. As director of industry relations, he focuses on working with the industry to improve settlement efficiency and reduce risk. His company works with investment managers, broker-dealers and custodian banks.
The securities industry, with all the talk of going to a T+2 standard, is moving toward better clearing and settlement standards, but it still has a way to go in improving them. If better procedures were used, the trade failure rate could be lower. Those are some of the opinions of Tony Freeman, director of industry relations with post-trade processor Omgeo.
What is going wrong? Why do trades blow up? Standing settlement instructions, or SSIs, are often the problem because they are not updated frequently enough.
According to Omgeo research, “39 percent of sub-custodian banks and 23 percent of global custodian banks and investment banks cite inaccurate SSI data as the most significant cause of trade failure in the major market, with many firms leveraging manual SSI processes. Market participants reduce this risk by adopting automated SSI solutions, enabling them to share accurate and compliant data automatically worldwide.”
Freeman says the industry can do a better job of decreasing the number of failed trades.
How?
More trade details should be available sooner, Freeman says, before the trade is settled. For instance, he says that American markets have a poor same-day affirmation (SDA) rate-a T+0 standard. The SDA is only 46 percent. That is half the rate of many other advanced markets.
In a recent paper, Omgeo officials noted that while trade speeds have consistently improved, clearing and settlement speeds haven’t kept up. Indeed, clearing and settlement procedures are falling behind trading.
“Why, in 2013, does it take milliseconds to execute a trade, but three days to settle a trade in the United States and in other major markets around the world? The most likely answer is simply because that it is the way it has always been. Surprisingly, some operational processes, which originated in a bygone era of physical certificates and limited technology, are still in use today,” the Omgeo paper said.
Manual processes, Freeman believes, should only be allowed to survive in the short term. How should that be achieved?
Freeman prescribes a combination of regulatory pressure and technological innovation will drive automation and standardization. But in the short term, the industry must work on a system that today still has too many failed trades.
CQ&D: Is it true that, after all the system upgrades and changes of the past years, 10 percent of equity trades today can still fail?
Tony Freeman: I’d say that statistic is correct. There are a lot of reasons why trades fail.
CQ&D: Why?
Tony Freeman: There are still a lot of manual processes. There are still a lot of antiquated technology practices in the business. There’s still a lot of faxing and emailing of trades allocation. So there are a lot of processes that need to be automated.
CQ&D: Any other reasons trades are failing?
Tony Freeman: There’s a lack of communication between the parties and inaccurate and missing settlement trade instructions, all of which cause fails.
CQ&D: And you believe there aren’t enough penalties discouraging poor clearing and settlement practices?
Tony Freeman: Yes, there is a lack of financial penalties imposed on fails. There’s no real incentive for firms to clean things up.
CQ&D: You have just given some examples of typical failed trades. How could the industry change that?
Tony Freeman: First, and foremost would be trade matching, or what is called same-day affirmation. That is very important in reducing the rate of fails.
CQ&D: And why would same-day affirmation improve things?
Tony Freeman: Incresing same day affirmation rates, which means that firm use a T+) standard, would provide a much better chance of avoiding trade fails.
CQ&D: Then why is there resistance to same-day affirmation?
Tony Freeman: Well, it is not something mandated in the U.S. presently. But we are going toward shorting settlement cycles.
CQ&D: You mean going to T+2?
Tony Freeman: That would increase same-day affirmation rates in the U.S.
CQ&D: And how do our SDA rates compare to the rest of the large markets?
Tony Freeman: If you look at some other countries across the globe, they have a 90 percent-plus same-day affirmation rage. But we’re still just at 47 percent.
CQ&D: So same-day affirmation is important to getting improvement. Why so?
Tony Freeman: You will find many of the potential problems with a trade before they happen.
CQ&D: Same-day affirmation can do that in what way?
Tony Freeman: Because typically, all the details of the trade are completed and done by T+0.
CQ&D: And those critical details of same-day affirmation are…?
Tony Freeman: It’s basically an agreement on all the details of the trade on the day of the trade between the broker and the investment manager.
Two Decades for Freeman
CQ&D: And what could go wrong between the trade and the settlement dates, whether on the same day or two days later?
Tony Freeman: Well, you can have bad instructions. You can have bad quantities. You can have bad money as well as bad securities instructions. There are a lot of things that could go that could cause a trade to fail.
CQ&D: What about simply requiring that every transaction goes to a same-day affirmation standard. Wouldn’t that push the industry below the 10 percent fail rate?
Tony Freeman: Well, if you look at, for example, Canada, they went to an accelerated affirmation process. And their failures rates, I believe, have gone from 3 percent to 1 percent.
CQ&D: And what about the movement to require a T+2 standard? How much would that reduce the failure rates?
Tony Freeman: A lot.
CQ&D: Why?
Tony Freeman: Because you’re taking a day out of the process. That means a lot of the manual processes would need to take place on the trade date to clean up any problems.
CQ&D: Please describe how the trade affirmation process works.
Tony Freeman: The broker-dealer, the investment manager and the custodian agree to all the terms of the transaction before the transaction actually takes place.
CQ&D: And that means they are more likely to find things that could cause problems later.
Tony Freeman: Correct.
CQ&D: And so we come down to the basic problem that is sometimes putting our markets at risk: not have the most effective way of identifying trade problems before they happen.
Tony Freeman: The United States is the only major marketplace where same-day affirmation isn’t required.
CQ&D: That makes it sound as though we are lagging behind a lot of advanced marketplaces in the world.
Tony Freeman: Yes, in the United States, trades settle regardless of whether there is a match or an affirmation or not. And that’s really the issue.
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