Seek prevention, or wait for the cure?
29 Sep 2021
Despite stringent and centralised regulation, settlement failures are still a common occurrence within the asset servicing industry, many of them due to middle-office inadequacies. Industry experts discuss why merely plastering over the wounds is no longer what the doctor ordered, and why now is as good a time as any to find a definitive cure for settlement headaches
Image: james_thew/stock.adobe.com
In recent weeks, Torstone Technology released a report in collaboration with GreySpark Partners entitled “Future-proofing the middle-office”, which highlights that 60 per cent of bankers, brokers and the buy-side say settlement failures, attributed to inadequacies of the middle-office, are still a “significant problem” for their business.
Though the statistic may be concerning, is it unfathomable? Hiccups in the workflow of the middle-office are nothing new. The back- and middle-offices have been grappling with data connectivity issues and incomplete matching, among many other ailments, for many years.
However, nowadays, reputation is also measured by an ability to accommodate the next injection of change, whether that be the European Securities and Markets Authority’s (ESMA’s) second Markets in Financial Instruments Directive (MiFID II), the impending Central Securities Depositories Regulation (CSDR) or the possibility of the US T+1 settlement cycle coming from across the Atlantic.
Though you could say juggling all the aforementioned ‘comes with the territory’, when combined with the remote work logistics caused by COVID-19 over the past 18 months, it could become a strategic headache.
So as we emerge cautiously into a post-pandemic world, is now the time for an industry-wide convalescence — essentially where brokers, banks and the buy-side can seek a treatment, or at least a consensus of intervention, that will remove the need to plaster over more middle-office wounds? Can the middle-office find its own effective medicine or reset, and at what cost? That is the challenge.
And, though well-meaning and created with a purpose to produce industry standardisation, could regulations such as CSDR provide the conducive and conclusive cure, or could these types of regulations prolong some settlement headaches?
What’s the diagnosis?
The often overlooked — but essential — middle-office is now front and centre of the capital markets industry’s change management plans, Torstone indicates in its report. But it wasn’t always this way.
There used to be a time when investment in the middle-office often had a means to an end: to comply with regulations such as MiFID II and MiFIR as a consequence of the 2008 financial crisis.
“The scope of middle-office responsibility evolved idiosyncratically for banks and brokers, and this, coupled with the complexity of middle-office workflows, meant that commoditised middle-office solutions were not a commercially viable proposition for financial technology vendors to offer at the time when third-party front-office and back-office solutions began to appear,” Torstone says, giving us some context that explains where we find ourselves in the present day.
“The lack of an off-the-shelf middle-office-specific solution left a vacuum that was partly filled by back- and front-office solutions which strayed into the middle-office space,” Torstone adds.
Though habits and opinions toward regulation are changing and the middle-office is perhaps finally getting the attention and treatment it needs, it still has considerable ‘vacuums’ to be filled because of the holes that were previously filled by the idiosyncratic systems that Torstone describes.
As Ashmita Gupta, director of business intelligence and analytics at Linedata, cites: “Many firms are still using manual systems or are using different systems for the front-office and middle-office that do not communicate well with each other. There is also no data repository.”
The settlement challenges surrounding automation, communication and data efficiency can come in many forms; whether it be automation versus manual processes, workload versus available skillset, or the tallying up of a team’s collective years of experience, or lack of — not to mention the ability to accommodate market and business change at a practical cost, which can drastically differ depending on the size of the firm.
Matt Johnson, director, institutional trade processing product management, Depository Trust & Clearing Corporation (DTCC), gives credence to the understanding that not every bank or broker is starting from the same vantage point and why this matters.
He says: “Generally speaking, the larger sell-side firms have high levels of middle-office efficiency and high successful settlement rates, whereas many smaller buy-side firms are still using manual post-trade processes and hence are likely to experience higher levels of settlement failure.”
When it comes to middle-office inadequacies, why they occur and what can be done to fix them, fragmented automation systems, weak dataflow, failing manual processes, coupled with middle-office communications (or lack thereof) are the four corners that need to be first addressed. If one of these areas is failing, things can snowball, and very quickly.
When asked what steps are required to address these points of inefficiency, Karan Kapoor, head of regulatory change and regtech at Delta Capita, details “it always goes back to the data and the entire process around settlement efficiency management”.
“Big banks are made of layers of system stacks, each dealing with different asset classes and regions. Functionalities overlap to make it even more complicated. Having multiple sources of the same information adds a significant burden to understand what the golden source is.”
However, with this in mind, do bankers and brokers always have the freedom, understanding or indeed resources to find the right data and/or technological solutions to rectify these ailments? Of course, the willingness to examine and identify settlement failures requires an open-mindedness to change — as the saying goes: “you can lead the horse to the water, but you can’t make it drink”.
Less than half of asset managers asked in Torstone’s survey (45 per cent) say they intend to change their middle-office system entirely — unfortunately that means more than half are not planning to, or simply cannot.
In the middle-office’s defence, Delta Capita’s Kapoor affirms: “There is a lack of established processes that provide the right guidance for settlement failure prevention. It is less about inadequacies of the middle-office teams, and more to do with the tools and information that these teams are set up with to manage the settlement efficiency.”
New prescription?
When looking specifically at data flows, just over a third of participants in Torstone’s survey say they were unsatisfied with the speed of data transit from back-office to the front-office.
“Whether the issue is due to inadequate software, bad data or poor connectivity, the only way out is automation — preferably straight-through processing (STP),” notes Torstone.
Highlighting the need for improved data flows, David Pearson, product head for middle-office solutions at Torstone, says: “The reality is accurate and cohesive data is required to drive the entire workflow chain, and successful re-engineering projects to achieve STP and automation throughout the post-trade operation will consider how best to provide the data these systems need.”
It is widely hoped that further integration with third-parties, combined with the utilisation of technologies often already available in-house, will help dataflow and ease the process of STP as many of the matching, allocation and settlement issues begin and end in the reconciliation of front-, middle- and back-office data.
And as Kapoor indicates: “Data flow must be a joint effort. Good data at the top will result in good data further on in the settlement lifecycle.”
If this is not the case, this can lead to the allocation of trades to incorrect legal entities, failed settlements and the need for significant manual intervention to rectify issues, an understanding that Torstone reitierates in its survey.
Those who took part in Torstone’s survey say that 23 per cent of the reasons for settlement failure were due to operational or technology issues, exacerbating a need for technology updates.
But, as previously mentioned, the industry is far from a consensus.
“While a number of asset managers are leading the way, we are not yet seeing an industry wide increase in investment across the board”, says Alan McKenna, managing director, global head of middle-office services at Apex.
“However, there is a greater appreciation of the service providers in the market who offer the services and products market participants need, with all the integration already done which clients can benefit from,” he adds.
Of course, the first step toward technology improvement and refined data flow is communication — arguably the first and most important hurdle for different offices to jump over — and in sync.
“If the front-office wants to trade security and does not inform the middle-office correctly, this creates delays that affect both parties”, explains LineData’s Gupta. “Efficient communication between teams is important, and this can only be resolved by collaborating and communicating with a common view.”
Regulation: What the doctor ordered?
Regulations have perhaps been the prerequisite for the increasing need to streamline the settlement process. But would the industry be in such a rush to streamline if such a high volume of regulation had not been issued to the industry over the last decade?
“CSDR poses some potential headaches for bankers and brokers, especially when one considers the potential punitive fines and buy-ins that could occur for brokerage houses that are already operating on paper-thin margins,” indicates Apex’s McKenna.
At present, the European middle-office’s closest upcoming obstacle is to tackle the changes required by the third phase of the EU’s CSDR, known as the Settlement Discipline Regime (SDR II).
Commenting on what SDR II means for the middle- and back-office, John Omahen, head of securities processing at FIS, says: “The introduction of SDR II in 2022 will force firms to increase their focus on reducing settlement failures as failures will incur penalties and a new and costly buy-in process will be triggered.”
He adds: “With increased financial penalties there is now a greater incentive to address long-term settlement problems.”
Though the UK announced it would not implement this part of the regulation last year, Torstone’s report says this “[signals] perhaps the beginning of a regulatory divergence, creating both uncertainty and opportunity for firms operating in the UK”.
But for Europe at least, the CSDR regulation aims to ease operational hardships of the settlement process and evoke quicker settlement. However, there is still some industry concern that its introduction may cause some hardship — opening up the operational wounds it was prescribed to heal.
As Torstone’s Pearson indicates: “What we may see is the ‘sticking plaster’ approach to patch up the fixable scenarios leaving operations staff to deal with the individual issues as they occur.”
Some of these individual issues could need “total digital transformation or small scale changes to legacy technology and operations”, details DTCC’s Johnson. He also outlines the buy-in process as an “area which is causing concern”.
“Banks and brokers need to be prepared to process partial settlements where and when applicable and support their clients when a buy-in occurs,” he says.
“Firms need to have selected and onboarded a buy-in agent by the time the regulation is implemented. If this is not done, market participants could face challenges in complying with the regulation.”
T+1
DTCC launched a two-year industry roadmap to shorten the settlement cycle for US equities to one business day (T+1) in February of this year. Most countries operate on T+2 or two business days after the transaction date, which Camille McKelvey, head of business development, STP at MarketAxess, says “still leaves a fairly sizable gap between execution and delivery of securities.”
She adds: “If we can continue to bring execution and settlement closer together then we will be able to gain even more efficiencies. There is a lot of talk about a move to T+1, and this would be a great step forward.”
However, there is a wide consensus in the industry that the turning toward T+1 or even T+0 for greater STP will not solely provide the cure for settlement inefficiencies.
FIS’s Omahen suggests that “innovative technologies like predictive analytics will need to step in to really achieve the efficiency gains and risk reduction that the industry needs”.
Of course settlement cycle choices and technology adoption is a decision to be made by regions and independent businesses respectively, but what else can regulators in different regions do to enhance industry collaboration for settlement processes?
Torstone’s Pearson claims: “The regulators are doing enough right now. Brokers, banks, and buy-sides need some breathing space to target their own strategies, rather than being led by the incessant regulatory changes that demand time and budget.”
When asked the same question McKenna reflects: “Regulators can monitor, control and discipline where needed, however real innovation comes from recognising opportunities that efficient process data can provide.”
Settlement cure?
The ongoing pandemic resulted in a need for social distancing and remote work, for longer than anyone may have first perceived, or indeed liked, back in March 2020. On the one hand, isolation made growth more difficult to achieve for almost all businesses across the world.
Though, on the other hand, it certainly highlighted the importance of business process resilience in asset servicing and specifically the streamlining of settlement trades of which there appears to be no looking back.
As DTCC’s Johnson says: “The need to achieve settlement efficiency ahead of SDR implementation, combined with last year’s COVID-19 pandemic-induced volatility, is causing many institutions to improve middle-office efficiency.”
MarketAccess’ McKelvey concludes that the best way to seek more settlement efficiency is for all offices, front, middle and back, to work together.
“Utopia would be no exception and a 100 per cent settlement rate”, she says, “but as an industry we have a long way to go. In the near-term, all parts of the chain from the front- to the back-office need to be working together to drive efficiencies and reduce risk.”
Though the statistic may be concerning, is it unfathomable? Hiccups in the workflow of the middle-office are nothing new. The back- and middle-offices have been grappling with data connectivity issues and incomplete matching, among many other ailments, for many years.
However, nowadays, reputation is also measured by an ability to accommodate the next injection of change, whether that be the European Securities and Markets Authority’s (ESMA’s) second Markets in Financial Instruments Directive (MiFID II), the impending Central Securities Depositories Regulation (CSDR) or the possibility of the US T+1 settlement cycle coming from across the Atlantic.
Though you could say juggling all the aforementioned ‘comes with the territory’, when combined with the remote work logistics caused by COVID-19 over the past 18 months, it could become a strategic headache.
So as we emerge cautiously into a post-pandemic world, is now the time for an industry-wide convalescence — essentially where brokers, banks and the buy-side can seek a treatment, or at least a consensus of intervention, that will remove the need to plaster over more middle-office wounds? Can the middle-office find its own effective medicine or reset, and at what cost? That is the challenge.
And, though well-meaning and created with a purpose to produce industry standardisation, could regulations such as CSDR provide the conducive and conclusive cure, or could these types of regulations prolong some settlement headaches?
What’s the diagnosis?
The often overlooked — but essential — middle-office is now front and centre of the capital markets industry’s change management plans, Torstone indicates in its report. But it wasn’t always this way.
There used to be a time when investment in the middle-office often had a means to an end: to comply with regulations such as MiFID II and MiFIR as a consequence of the 2008 financial crisis.
“The scope of middle-office responsibility evolved idiosyncratically for banks and brokers, and this, coupled with the complexity of middle-office workflows, meant that commoditised middle-office solutions were not a commercially viable proposition for financial technology vendors to offer at the time when third-party front-office and back-office solutions began to appear,” Torstone says, giving us some context that explains where we find ourselves in the present day.
“The lack of an off-the-shelf middle-office-specific solution left a vacuum that was partly filled by back- and front-office solutions which strayed into the middle-office space,” Torstone adds.
Though habits and opinions toward regulation are changing and the middle-office is perhaps finally getting the attention and treatment it needs, it still has considerable ‘vacuums’ to be filled because of the holes that were previously filled by the idiosyncratic systems that Torstone describes.
As Ashmita Gupta, director of business intelligence and analytics at Linedata, cites: “Many firms are still using manual systems or are using different systems for the front-office and middle-office that do not communicate well with each other. There is also no data repository.”
The settlement challenges surrounding automation, communication and data efficiency can come in many forms; whether it be automation versus manual processes, workload versus available skillset, or the tallying up of a team’s collective years of experience, or lack of — not to mention the ability to accommodate market and business change at a practical cost, which can drastically differ depending on the size of the firm.
Matt Johnson, director, institutional trade processing product management, Depository Trust & Clearing Corporation (DTCC), gives credence to the understanding that not every bank or broker is starting from the same vantage point and why this matters.
He says: “Generally speaking, the larger sell-side firms have high levels of middle-office efficiency and high successful settlement rates, whereas many smaller buy-side firms are still using manual post-trade processes and hence are likely to experience higher levels of settlement failure.”
When it comes to middle-office inadequacies, why they occur and what can be done to fix them, fragmented automation systems, weak dataflow, failing manual processes, coupled with middle-office communications (or lack thereof) are the four corners that need to be first addressed. If one of these areas is failing, things can snowball, and very quickly.
When asked what steps are required to address these points of inefficiency, Karan Kapoor, head of regulatory change and regtech at Delta Capita, details “it always goes back to the data and the entire process around settlement efficiency management”.
“Big banks are made of layers of system stacks, each dealing with different asset classes and regions. Functionalities overlap to make it even more complicated. Having multiple sources of the same information adds a significant burden to understand what the golden source is.”
However, with this in mind, do bankers and brokers always have the freedom, understanding or indeed resources to find the right data and/or technological solutions to rectify these ailments? Of course, the willingness to examine and identify settlement failures requires an open-mindedness to change — as the saying goes: “you can lead the horse to the water, but you can’t make it drink”.
Less than half of asset managers asked in Torstone’s survey (45 per cent) say they intend to change their middle-office system entirely — unfortunately that means more than half are not planning to, or simply cannot.
In the middle-office’s defence, Delta Capita’s Kapoor affirms: “There is a lack of established processes that provide the right guidance for settlement failure prevention. It is less about inadequacies of the middle-office teams, and more to do with the tools and information that these teams are set up with to manage the settlement efficiency.”
New prescription?
When looking specifically at data flows, just over a third of participants in Torstone’s survey say they were unsatisfied with the speed of data transit from back-office to the front-office.
“Whether the issue is due to inadequate software, bad data or poor connectivity, the only way out is automation — preferably straight-through processing (STP),” notes Torstone.
Highlighting the need for improved data flows, David Pearson, product head for middle-office solutions at Torstone, says: “The reality is accurate and cohesive data is required to drive the entire workflow chain, and successful re-engineering projects to achieve STP and automation throughout the post-trade operation will consider how best to provide the data these systems need.”
It is widely hoped that further integration with third-parties, combined with the utilisation of technologies often already available in-house, will help dataflow and ease the process of STP as many of the matching, allocation and settlement issues begin and end in the reconciliation of front-, middle- and back-office data.
And as Kapoor indicates: “Data flow must be a joint effort. Good data at the top will result in good data further on in the settlement lifecycle.”
If this is not the case, this can lead to the allocation of trades to incorrect legal entities, failed settlements and the need for significant manual intervention to rectify issues, an understanding that Torstone reitierates in its survey.
Those who took part in Torstone’s survey say that 23 per cent of the reasons for settlement failure were due to operational or technology issues, exacerbating a need for technology updates.
But, as previously mentioned, the industry is far from a consensus.
“While a number of asset managers are leading the way, we are not yet seeing an industry wide increase in investment across the board”, says Alan McKenna, managing director, global head of middle-office services at Apex.
“However, there is a greater appreciation of the service providers in the market who offer the services and products market participants need, with all the integration already done which clients can benefit from,” he adds.
Of course, the first step toward technology improvement and refined data flow is communication — arguably the first and most important hurdle for different offices to jump over — and in sync.
“If the front-office wants to trade security and does not inform the middle-office correctly, this creates delays that affect both parties”, explains LineData’s Gupta. “Efficient communication between teams is important, and this can only be resolved by collaborating and communicating with a common view.”
Regulation: What the doctor ordered?
Regulations have perhaps been the prerequisite for the increasing need to streamline the settlement process. But would the industry be in such a rush to streamline if such a high volume of regulation had not been issued to the industry over the last decade?
“CSDR poses some potential headaches for bankers and brokers, especially when one considers the potential punitive fines and buy-ins that could occur for brokerage houses that are already operating on paper-thin margins,” indicates Apex’s McKenna.
At present, the European middle-office’s closest upcoming obstacle is to tackle the changes required by the third phase of the EU’s CSDR, known as the Settlement Discipline Regime (SDR II).
Commenting on what SDR II means for the middle- and back-office, John Omahen, head of securities processing at FIS, says: “The introduction of SDR II in 2022 will force firms to increase their focus on reducing settlement failures as failures will incur penalties and a new and costly buy-in process will be triggered.”
He adds: “With increased financial penalties there is now a greater incentive to address long-term settlement problems.”
Though the UK announced it would not implement this part of the regulation last year, Torstone’s report says this “[signals] perhaps the beginning of a regulatory divergence, creating both uncertainty and opportunity for firms operating in the UK”.
But for Europe at least, the CSDR regulation aims to ease operational hardships of the settlement process and evoke quicker settlement. However, there is still some industry concern that its introduction may cause some hardship — opening up the operational wounds it was prescribed to heal.
As Torstone’s Pearson indicates: “What we may see is the ‘sticking plaster’ approach to patch up the fixable scenarios leaving operations staff to deal with the individual issues as they occur.”
Some of these individual issues could need “total digital transformation or small scale changes to legacy technology and operations”, details DTCC’s Johnson. He also outlines the buy-in process as an “area which is causing concern”.
“Banks and brokers need to be prepared to process partial settlements where and when applicable and support their clients when a buy-in occurs,” he says.
“Firms need to have selected and onboarded a buy-in agent by the time the regulation is implemented. If this is not done, market participants could face challenges in complying with the regulation.”
T+1
DTCC launched a two-year industry roadmap to shorten the settlement cycle for US equities to one business day (T+1) in February of this year. Most countries operate on T+2 or two business days after the transaction date, which Camille McKelvey, head of business development, STP at MarketAxess, says “still leaves a fairly sizable gap between execution and delivery of securities.”
She adds: “If we can continue to bring execution and settlement closer together then we will be able to gain even more efficiencies. There is a lot of talk about a move to T+1, and this would be a great step forward.”
However, there is a wide consensus in the industry that the turning toward T+1 or even T+0 for greater STP will not solely provide the cure for settlement inefficiencies.
FIS’s Omahen suggests that “innovative technologies like predictive analytics will need to step in to really achieve the efficiency gains and risk reduction that the industry needs”.
Of course settlement cycle choices and technology adoption is a decision to be made by regions and independent businesses respectively, but what else can regulators in different regions do to enhance industry collaboration for settlement processes?
Torstone’s Pearson claims: “The regulators are doing enough right now. Brokers, banks, and buy-sides need some breathing space to target their own strategies, rather than being led by the incessant regulatory changes that demand time and budget.”
When asked the same question McKenna reflects: “Regulators can monitor, control and discipline where needed, however real innovation comes from recognising opportunities that efficient process data can provide.”
Settlement cure?
The ongoing pandemic resulted in a need for social distancing and remote work, for longer than anyone may have first perceived, or indeed liked, back in March 2020. On the one hand, isolation made growth more difficult to achieve for almost all businesses across the world.
Though, on the other hand, it certainly highlighted the importance of business process resilience in asset servicing and specifically the streamlining of settlement trades of which there appears to be no looking back.
As DTCC’s Johnson says: “The need to achieve settlement efficiency ahead of SDR implementation, combined with last year’s COVID-19 pandemic-induced volatility, is causing many institutions to improve middle-office efficiency.”
MarketAccess’ McKelvey concludes that the best way to seek more settlement efficiency is for all offices, front, middle and back, to work together.
“Utopia would be no exception and a 100 per cent settlement rate”, she says, “but as an industry we have a long way to go. In the near-term, all parts of the chain from the front- to the back-office need to be working together to drive efficiencies and reduce risk.”
NO FEE, NO RISK
100% ON RETURNS If you invest in only one asset servicing news source this year, make sure it is your free subscription to Asset Servicing Times
100% ON RETURNS If you invest in only one asset servicing news source this year, make sure it is your free subscription to Asset Servicing Times
