Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Shorter settlement cycles: what this means for funds and managers
By Tony Freeman*
In Australia and New Zealand – markets increasingly under pressure from regulatory change, globalisation and cost-pressures – one impending development is going relatively unremarked. It is the global trend towards shorter settlement cycles. This change will have a significant impact on Australasia.
The disparity in global settlement cycles extends across asset classes, exchanges and geographical locations. Settlement cycles can range from five days after trade execution (T+5) to zero (T+0). This lack of harmonisation has resulted in an extremely complex matrix of market requirements.
Surprisingly, some of the world’s most mature markets have relatively long settlement mandates. The US equity market moved from T+5 to T+3 in the mid-nineties and there it has remained, despite all of the advances in technology that have occurred since. Many European markets still settle on T+3, as do Japan, Singapore and Australia. Why does this matter? Well, to begin with, this inefficiency exists in stark contrast to front office trends. When a trade can be executed in a millisecond, why should it then take a three day cycle to settle? Furthermore, the longer a trade remains in flight, poised between execution and settlement, the longer the exposure to operational risk. A three day settlement period can create substantial systemic risk in times of extreme volatility and uncertainty.
The European Union has been working for some years towards a harmonised, accelerated settlement landscape. All 28 member states will be mandated to adopt a T+2 settlement cycle by January 1st 2015, ahead of the June 2015 adoption of Target2 Securities (T2S) – a pan-European settlement system. Three European markets (France, Belgium, Netherlands) have also announced an earlier move to T+2 on Oct 6th 2014, with some Nordic markets expected to opt for T+2 in the near future. US industry bodies have also begun to focus on the potential impact and benefits of shortening settlement cycles across a number of asset classes. Though there is no current talk of mandating the process as there is in Europe, momentum is building and the initiative has many supporters. Asia Pacific remains disparate, boasting some of the world’s shortest settlement cycles as well as some very lengthy ones.
Many operations departments are not as yet prepared for a move to T+2, leaving their firms vulnerable to compliance and operational risk. As the earliest markets to start the global trading day, the impact of shorter settlement cycles in Australia and New Zealand will be particularly acute. A T+2 cycle in the US and Europe would place a great deal of pressure on local investment managers and banks. In order to comply with the proposed changes in settlement cycles, firms only have couple of options ;add significant resources to operations departments and have staff working long hours or introduce automation to post-trade processes across asset classes and markets.
Of these two scenarios, by far the most beneficial is adopting automation. In the post-trade arena, the ne plus ultra of efficiency is a streamlined environment in which trades can flow from execution through to matching, confirmation and settlement with the lightest of human touches. Automating a trade not only reduces the time to settlement; it also alleviates the risk of human error associated with having staff “eyeball” trades after execution. Critical to achieving this best-practice is the implementation of a robust post-trade infrastructure based on technology that represents the latest developments in automation and encourages industry best practice, specifically:
- Central Matching: Central matching refers to a trade confirmation process between Investment Managers and Broker/Dealers where trade information is exchanged non-sequentially and automatically matched according to pre-set tolerances, typically using centrally hosted solution. Central matching positions firms to successfully operate in markets on T+2 or shorter settlement cycles, and provides the infrastructure to support scale across volumes and asset classes.
- Same- Day Affirmation (SDA): SDA refers to process whereby economic details of trades are affirmed by both counterparties on the same day that the trade is executed. Studies have shown that high rates of SDA are essential in achieving shorter settlement cycles.
Central matching is the optimal electronic trade-matching model and delivers exemplary rates of SDA. SDA rates attained via central matching run at 94 per cent versus local matching rates of 72 per cent for cross-border and non-US domestic transactions and only 36 per cent in the US domestic market. Even at times when trade volumes are high, increased automation underpinned by central matching will enable most trades to match and settle without the need for manual intervention. Staff will then have ample time to focus on any discrepancies, thereby ensuring compliance with the strictest of settlement deadlines.
Australasian firms need to consider their plans for T+2. The deadline for Europe may seem quite a while away, but in reality a year and a half is not especially long. At Omgeo, we have been working with our community and other global industry bodies to help firms meet the needs associated with an evolving settlement landscape.
* Tony Freeman is executive director, industry relations, at Omgeo – a DTCC company.
