The industry's need for managing risks and controlling costs has led regulators worldwide to begin moving their markets towards shorter settlement cycles. To attain this goal, each market has started initiatives to implement the necessary changes, and the US will probably establish a one-day settlement cycle (T+1) in 2002 or soon thereafter.While the shorter settlement cycle has not yet been mandated, it is almost a certainty that the SEC will soon require T+1 for the securities that are currently traded in the US with a three-day settlement. And, since Arthur Levitt, the chairman of the SEC and a strong advocate of T+1, will retire at the end of 2002, it is likely that the change will be targeted for that year. Since the industry does not like to make major changes at year-end, the most likely time frame will be in the middle of 2002.Moving from T+3 to T+1 will require an unprecedented effort by the entire US securities industry. The most similar event that has occurred was the move in 1995 from a five-day settlement cycle to a three-day cycle. That change took several years to plan and required almost every firm in the US to make some changes to their processing flows and systems.However, the magnitude of that change is almost insignificant compared to he changes that will be needed to make T+1 a reality. Jill Considine, the Chairman of the Depository Trust Company (DTC), recently said "The move from T+5 to T+3 was a quantitative step; we were able to do things faster and gain some efficiencies. Going from T+3 to T+1 will require a total re-engineering and thinking through how we will do things differently. It is a qualitative change not just a quantitative step."As significant as it is, the implementation of T+1 is not something that will happen in isolation. It is interconnected with a number of other industry trends and initiatives.

VISION OF THE FUTURE

In 1998, The Summit Group evaluated the implications of the trends that are driving the market and established a five-year vision of the future for securities processing. Events of the last year have substantiated these conclusions, with those that are relevant to the implementation of a shorter settlement cycle presented here:

• The volume and complexity of instruments traded in the US markets will continue to grow dramatically. Richard Grasso, the Chairman of the New York Stock Exchange (NYSE), is planning for an average 3 billion-share day by 2003 with peaks of 10 billion shares. Other exchanges are anticipating similar increases in message traffic.Decimalization will be implemented in the US, initially with a $.05 minimum spread, and trading profits will come under increasing pressure. This will continue the pressure brought by the reduction in the minimum spread to 1/16, and move many firms to charging commissions, rather than minimal spreads.Twenty-four hour markets will increasingly be implemented around the world, with additional non-US firms wanting to actively trade US stocks in their own domestic time zones.Utilities such as exchanges, depositories and clearing houses will have to compete in order to remain relevant. They will compete with each other, as well as with vendors.Fewer process steps will be required to complete transactions due to automation and a shorter settlement cycle. This will continue the industry's evolution away from clerical staff towards technically proficient people at all levels who will be in increasingly short supply.The traditional operations functions will disappear as the best people are refocused into areas such as risk management, technology evolution, customer satisfaction, exception processing and new product development.The increased use of standards will make more connectivity possible and increasingly necessary. Increased connectivity will reduce rekeying of data, increase the use of exception-only processing, and establish the opportunity for outsourcing. Businesses that used to make the bulk of their profits from their wide margins in inefficient markets will have to change their product mix in order to survive.Fewer, stronger players will struggle constantly to differentiate themselves but standardized processing will force firms to differentiate in non-traditional ways. A few global mega-players will emerge to dominate the securities processing environment, but their very size will create opportunities for boutique firms seeking niche opportunities.Highly automated processes will reduce costs and control risk, but customers will increasingly require customized solutions that will ultimately require more innovation and automation.Outsourcing will become essential as firms focus their best talent and energy on their core competencies in order to compete successfully. The pace of outsourcing will increase as firms realize that non-strategic functions should be removed from the firm.The Internet and Alternative Trading Systems will increase the potential for automated end-to-end connectivity, where the customer is the start and the finish of a transaction.
• The Internet and other forms of electronic distribution of information to consumers will reduce the need for paper documents and speed up the process.

While these trends affect the use of industry resources and priorities, once mandated, T+1 is going to be a critical consumer of resources.

IMPLICATIONS OF T+1

Moving to one-day settlement will affect processing activities from the trade through the asset servicing phase of the Trade Life Cycle that is shown in Figure 1.

Figure 1. Securities Trade Life Cycle

Trade

The trade segment of the life cycle is affected because of the pressure that will be placed on firms to connect trade activities electronically to all of the post trade steps. Each of the various vendor-supplied and proprietary order management and trade management systems will have to be fully integrated with the rest of the processing applications of each firm.The use of Electronic Crossing Networks and Alternative Trading Systems will increasingly initiate transactions in electronic form and increase the accuracy of the data being processed. Once electronically matched, trades will be less likely to fail although they will still need some enhancement of information for settlement.Post TradePost trade activities will be significantly affected for institutional and for retail customers.

Institutional Post Trade Processing

When the US market moved the basic settlement period from five days to three days, the industry was forced to make a significant number of changes. These changes affected the thousands of banks, brokers and investment mangers throughout the country. Each firm had to identify the impact of the shorter settlement cycle on their firm and then implement the changes by the specific industry deadline.

Figure 2. T+5 Process Compared to T+3

As a result of this change, firms lost 40% of the time available to enter trade-related date and to check on the progress of the trade. Without this cushion, firms now have to get trades entered on trade date (or no later than the morning of T+1) and had to ensure that all institutional trades were affirmed by the end of T+1 (or certainly no later than noon on T+2).To implement this shorter cycle, most firms merely ran their batch system more frequently and installed additional interfaces between their own systems and between their firm and the industry infrastructure. Many of these interfaces also moved information in batch.As difficult as these changes were, the move to T+1 will make the T+3 implementation look easy. To fully implement T+1, many firms will have to make significant and fundamental changes to their primary systems and will have to move towards real time processing.In a T+1 environment pre-trade activities, which today could have until noon on T+2 to be completed, will have to be completed on trade date.

Figure 3. T+5 Process Compared to T+3 and to T+1

The change to a next day settlement cycle (T+1) will require firms to consider real time processes for many activities and to process transactions less linearly and more in parallel. Today's sequential process, as shown in Figure 4, requires that each step be completed before the next can begin.

Figure 4. Current Sequential Settlement Process

This model evolved from the industry's historic paper-based model, and the subsequent automation of the individual processing steps. While it was possible to move from T+5 to T+3 without modifying this model, it will not be possible to further shorten the settlement cycle to T+1 without radically revising the processing steps. The solution may be to eliminate the existing series of sequential steps and implement a form of parallel processing that has been proposed by the Depository Trust Company (DTC) for transactions within the US and by the Global Straight Through Processing Association (GSTPA) for cross-border transactions.The DTC solution is based on a series of services called TradeSuite.

DTC TradeSuite

In 1998, the Depository Trust Company introduced DTC TradeSuite, which has been described as a comprehensive family of post-trade messaging, matching, settlement, and communications products. The product which aggregates man of the existing DTC services has an open architecture, provides expanded connectivity and includes the post-trade processing functionality of DTC's Institutional Delivery (ID) system, Standing Instructions Database (SID) and the DTC Hub.These products provided support for over two million post-trade and settlement messages daily to more than 10,000 institutional investors, broker/dealers and custodian banks in 1998. Since DTC's existing trade messaging and settlement services are incorporated into TradeSuite, the users of DTC's ID, SID, Matching, and DTC Hub services automatically became TradeSuite users, and were given the option of also using TradeSuite's new communications services.TradeSuite consists of four products:

• TradeMessageTradeMatchTradeSettle
• TradeHub

These products are available using a variety of standards and protocols, including FIX, S.W.I.F.T. or DTC formats, and TCP/IP, SNA or x.25 protocols.

Trade Message

Trade Message automates the exchange of post-trade messages between brokers, custodians and institutions, including block trade notices of execution, allocations, trade confirmations and affirmations.

TradeMatch

TradeMatch automates the comparison of investment managers' allocations with brokers' trade confirmations, which facilitates early trade agreement and identification of potential exceptions, while triggering settlement messaging for matched trades without the need for separate affirmations.

TradeSettle

TradeSettle provides automated settlement processing by electronically enriching allocations, trade confirmations and settlement messages with account and settlement data from DTC's Standing Instructions Database (SID), and then routing settlement instructions to custodian banks and brokers' clearing agents. DTC trades will then settle automatically.

TradeHub

TradeHub provides real-time global communications services between several global networks, as well as numerous order management, portfolio management and ETC systems. The DTC has been very effective at reducing cost and risk in the US settlement process, and the addition of these services could ultimately extend their services more towards the front office and potentially to cross-border transactions settling in the US.Global Straight through Processing Association (GSTPA)The GSTPA model, shown in Figure 5, proposes that each required bit of data will be added just in time, and that the "Transaction Flow Manager" will push the trade to whatever point is needed to confirm and enrich the trade. This means that the TFM will determine when data elements can be obtained as well as where they can be obtained from, and will automatically manage the process of sending and receiving messages to/from the relevant participants. When all of the data elements have been collected, the trade will settle.

Figure 5. GSTPA Process Model

GSTPA has identified several key components that will be needed for this concept to succeed:

• The interactive network that will support this multilateral connectivity.The "transaction flow manager" that will deal with the flow of information through all the steps of the trade life cycle [for each trade].The standards that are necessary to operate this collective process, and the provision of "bridges" between current and future methodologies.Access providers will basically offer market participants the easy interfaces to the network, at the appropriate level of sophistication relative to their clients' needs. This access service is provided for trade processing as well as for information retrievals.
• Functional providers will offer market participants specific features and services that will support them in the processing of their trades, dealing with Notices of Order Execution (NOES), allocations, matching of NOEs and allocations, and matching of net amounts, etc.

RETAIL POST TRADE PROCESSING

Retail customers will be affected by the shorter settlement cycle in two ways: Payments and Physical Certificates.

Payments

When a retail customer purchases a security, they must have the cash in their account, have a margin account with sufficient buying power, or send cash to the broker before settlement. Brokers have attempted to entice investors to leave cash in the account by establishing Money Market Funds and Cash Management Accounts that pay a prevailing rate of interest on the funds, and by opening margin accounts when the customer understands the risks of margin.In most cases, it is impossible today to get cash to the broker within three days unless the customer sends a wire transfer. And, while the broker can grant an automatic two-day extension for the payment, if unpaid, it eventually becomes a formal extension of credit. In a one-day settlement environment, even with a two day extension, it is almost impossible for a retail customer to mail a check and have it arrive and be posted to their account on time. This will further encourage brokers to get their customers to leave funds in an interest-bearing fund or use a wire transfer.An alternative would be to revisit the use of the Automated Clearing House. When the industry moved to T+3, ACH was considered as a way for brokers to debit a customer's cash account at a bank (as long as the customer gave authorization to the broker) for the purchase of securities. However, since ACH rules allowed the customer to rescind the transaction for up to sixty days after the debit, this transaction was not considered a universal solution.

Physical Certificates

When, in 1993, the SEC asked for public comments on the proposed change to the five-day settlement cycle, they received over 1,500 responses. Most of these responses were from individuals saying that they were not concerned about the shorter cycle, but that they did not want the SEC to eliminate physical certificates. Since the SEC could expect the same reaction today, the industry will probably not be able to eliminate certificates, and customers using physical certificates will be unable to settle in one day, just as they are not able to settle in three days at this time.

CLEARANCE AND SETTLEMENT

The DTC and NSCC will have to make significant changes to their processes in order to replace batch processes with real-time and near real-time processes. The existing sequential procedures will have to be revised or replaced. Matched (and affirmed) trades will be automatically enriched by the NSCC/DTC systems, and will be processed and settled without additional input from the brokers or managers.

ASSET SERVICING

Dividends
The processing of dividends will be affected slightly, since the current ex-date period would be virtually eliminated.

New Securities
When new securities are created today, most firms set up a dummy security number and initiate processing. In batch, over night, the firm typically receives additional information about the new issue from their market data vendors, and the system continues to process the transaction. In a one-day environment, this new security will have to be set up in near real time so that the confirmation and affirmation processing can be completed on the trade date.This will involve new services being provided by the market data vendors and new real time message-based connectivity between the vendors and each firm's processing systems.

Securities Lending
The entire securities lending process will have to be reviewed to take into consideration the coverage of potentially failing transactions. The securities lending business, which is primarily a morning business on T+1 today, will have to become an afternoon-based (or after hours) business on trade date in order to acquire the missing securities in time to settle properly.

WHAT NEEDS TO BE DONE TO MAKE T+1 A REALITY?

To make T+1 a reality for securities processing, the industry must be active on several fronts:

Standards
Today, although there are many different proprietary solutions offered by vendors, there are two major sets of competing standards: FIX and SWIFT. SWIFT has created a set of standard messages that supports post trade processing, while FIX has concentrated on the pre-trade and trade activities of brokers and managers. Both sets of standards are evolving to overlap the other, but they are not yet compatible. Both organizations have recently announced that they are beginning to work towards compatibility, probably based on the use of the Extensible Markup Language (XML).

Connectivity
Firms must continue to electronically connect their internal applications and connect their systems to other firms and the infrastructure. These connections will increasingly be message-based in real time.Message-Based Network Connectivity requires routing, format mapping and protocol conversions. These are functions that are facilitated by Middleware. There are several different Middleware vendors, each of which provides a different solution.ToolsThere are many different automated tools that have been created by vendors. While each tool offers some advantages, most are not designed to work easily with other applications; so, some level of systems integration is required. Some of the tools that are needed are:

• Automated Reconcilement Delivery instruction content and timeliness Central database / data repository
• Electronic workflow for exception processing

Vendor Support
Vendors are actively involved in providing solutions, but vendor solutions are not always compatible or easily integrated with other solutions because each vendor provides their services to make a profit and protect its market niche.

Some of the areas that must be examined are:

• New security issues Retail customer interactivity
• Automated data storage/retrieval

Utility Development
Industry utilities, including exchanges, depositories and clearing agencies, are all trying to extend their services to better support their participants, as well as protect themselves from disintermediation. They must continue to work on solutions such as:

• Eliminating paper by incorporating all instruments into depositories and clearing houses Implementing cross collateralization between infrastructure agencies Matching pre-trade and trade information
• Merging with other industry utilities to simplify procedures and reduce costs

SUMMARY

T+1 will not be implemented without an industry mandate and significant additional work by firms throughout the industry and by the industry's infrastructure.

• Many industry participants would prefer to keep things as they are, following the philosophy "If it ain't broke..." To overcome this inertia, the SEC must mandate the change.Different types of firms (Brokers, banks, and investment managers) each place a different emphasis on what needs to be improved in order to efficiently shorten the settlement cycle. Cross industry communication must continue to identify common opportunities and procedures.Each firm in the industry approaches an event like T+1 from a different knowledge base and a different set of capabilities. Some firms will have to make significant investments in their systems and in training their staff.
• Implementing T+1 will be a significant expense to many firms that have fallen behind their peers in automation and process optimization. Upgrading systems and procedures to support T+1 will be very expensive and should be combined with implementing STP to obtain operational benefits.

The SEC, probably in mid-2000, will require T+1 to be implemented in 2002, or soon thereafter. Most of the changes that are needed to meet the requirements of T+1 will also help firms improve their current processing, so rather than wait until the deadline approaches, firms should be preparing now for the inevitable change to a shorter settlement cycle.