The Securities Industry Association announced on July 18, 2002, that it would no longer endorse the proposed reduction in the US securities settlement cycle from three days to one day by 2005. Implementing this proposal would have forced a complete modernization of securities processing activities, and without it the industry must look for an alternative way to significantly reduce cost and process risk.

The concept of moving to T+1 was initially very favorably considered, and was supported by industry leaders and regulators. Arthur Levitt, then the chairman of the SEC, said, "I believe that achieving T+1 and straight-through processing is critical to the continued success of our markets. To achieve T+1, all market participants must join in the industry's T+1 efforts and begin preparing their own internal systems for the move to T+1." (1)

In their announcement, the SIA cited various changes in the marketplace that make T+1 less important today than when the program was initiated three years ago. Don Kittell, SIA's Executive Vice President, said that "in 1999, the main issues driving the industry were rapidly growing volumes and inefficient cross-border trading. Today, although the volumes have not decreased as much as the lower market valuations would suggest, the rate of growth has slowed considerably. This slower growth rate, coupled with the tighter budgets in many firms, has caused firms to look more closely at the Return on Investment of all projects." Kittell also said that the SIA would continue to support "a straight through processing program to modernize the clearance and settlement of equities, bonds and other securities."

The work of hundreds of industry volunteers on the STP / T+1 program over the last three years has provided a solid platform and clear direction for industry STP priorities in 2003 and 2004, according to the SIA. This refocusing of the SIA's efforts is a clear reflection of the industry's lack of desire for T+1 today due to the complexity, cost and long-term nature of the project. Firms still need the cost savings and quality improvements that can result from various STP projects, but the need for T+1 is not as widely accepted

BACKGROUND

Securities settlement in the US today is still largely based upon the manual paper-based process that existed in the first part of the 1900's and which was automated in a series of projects over the last forty years. The use of technology reduced the amount of paper, but as it automated the manual steps it also institutionalized the step-by-step process and made it more difficult to implement subsequent major improvements. Over the last several years, firms were only able to make modest incremental improvements in their own process and in their interfaces with other firms. In summary, this evolution from pure paper to today's level of automation was the result of a few major changes that provided huge opportunities and a continuous series of smaller improvements that resulted in smaller incremental savings.

The major changes provided huge opportunities and included events such as the creation of the National Securities Clearing Corporation in 1976 to help brokers exchanges shares and payments among themselves; establishing the Depository Trust Company in 1975 to immobilize certificates and to begin the process of automating the settlement of institutional trades; the shortening of the settlement cycle in 1995 from five days to the current three days; and the establishment of other clearing corporations to automate the settlement of government securities, mortgage-backed securities and other instrument types.

Over the last three years, the industry spent a considerable amount of time and money evaluating the potential to shorten the three-day settlement cycle to T+1 in order to initiate another major event. It was understood that to implement T+1, the entire settlement process would have to be re-engineered with massive changes to existing systems, and the few remaining manual activities would have to be automated. The resulting process would have significantly affected virtually every firm and vendor in the securities industry and would have been a tremendous leap forward for the industry.

The major change the industry made in 1995 by shortening the settlement cycle from five days to three involved extensive changes, but did not require a radical re-engineering of the process. In fact, most firms were able to satisfy the shorter cycle by running their existing batch systems more frequently (i.e., several times a day) and did not rebuild everything. The decision to move to T+3 was based almost entirely on risk-reduction, where the industry accepted that by shortening the settlement cycle by two days, it would reduce the amount of risk in the process by over 50%. However, the only reason that the change occurred was because the SEC mandated it and set a deadline.

The industry took a few years to completely digest the impact of T+3, and in late 1998 started talking seriously about moving to T+1. Everyone realized however that the implementation of a one-day settlement cycle would be much more difficult than the previous reduction from five days to three.

The US settlement process currently requires an automated series of activities and hand-offs that take three days (T+3) from when equities and corporate bonds are traded until they are settled. The SIA evaluated what would be required to change the existing activities and shorten the settlement cycle to one day (T+1), and calculated the total industry investment as well as the reduction in cost and risk.

The first results of this study were published in December 2000 in a White Paper (2) that identified the objectives and approach that would be needed to implement a one-day settlement cycle. The White Paper looked at the critical areas of change, including Trade Capture, Trade Reporting, Trade Matching, Trade Guarantee, Netting, Settlement, Stock Borrowing and the introduction of standards. It also discussed what would have to happen to actually transition the industry from T+3 to T+1. In July, 2000, the SIA followed-up on the White Paper and presented its business case, saying "The case for moving to T+1 settlement is strong and is based on several factors." (3) The four factors cited were:

1. Reduce settlement risk
2. Enable the US to maintain its global competitiveness
3. Serve the interests of the US investor by synchronizing
clearance and settlement across asset classes
4. Support increased volumes

At that time the SIA estimated that a move to T+1 would save the securities industry $2.7 Billion annually. This savings would be realized after an investment of $8 Billion. Given the volumes the industry was experiencing, and the bottlenecks that were developing in the existing process, this seemed like a good investment.

From 1999 through early 2002, the SIA supported a variety of committees that defined a T+1 and STP architecture and looked at what would be needed to implement T+1. These committees developed the Institutional Transaction Processing Model that can be seen on the SIA's website. However, while the committees were identifying what needed to be done, the industry changed significantly. The record profits of 2000 were reduced in 2001, and the 2002 profit forecast is now 4% lower than 2001 (and less than one-half of 2000) (4).

After discussing the results of the study this year with industry leaders, the SIA concluded that the time is not right for this all-encompassing solution. While this is probably the right decision in today's environment, it leaves the industry without any current opportunity for dramatic improvements in cost, which is even more critical today than it was when profits were much higher.

When the industry began discussing the benefits of an even shorter settlement cycle, it was perceived as the best way to address the main issues that were driving the industry at that time: rapidly growing volumes and inefficient cross-border trading. Today, although the volumes have not decreased as much as the lower market valuations would suggest, the rate of growth has slowed considerably both within the US and in cross-border transactions. This slower growth rate, the impact of decimalization, and overall economic weakness has resulted in tighter budgets in most firms, and has caused firms to look more closely at the Return on Investment (ROI) of their projects. Without an immediately compelling business case, the industry has agreed that the potential long-term benefits of T+1 are not worth the short-term cost. At this point in the business cycle, operations and IT managers don't have the luxury of investing today for a savings next year. While the SIA's announcement that they wish to postpone T+1 is significant, the final arbiter is the Securities Exchange Commission.

SEC Chairman Harvey Pitt spoke to The Bond Market Association several months ago and continued to indicate his support for the shorter settlement cycle, which was initiated under his predecessor. The SEC will probably request comments on T+1 later this year as planned, and they will undoubtedly receive the same types of input that the SIA obtained. As the SIA talked to firms throughout the industry, they found that there was no broad consensus on the need for T+1 or on how to implement it. In general, the SIA concluded that the least automated firms are the ones that will resist this additional automation effort the most, and that, most important, many firms felt that the cost savings that could result from T+1 could be obtained in other ways with less investment. Therefore, it is probable that the SEC will not push for T+1 without the industry's co-operation.

Without an industry push or a regulatory mandate, T+1 is dead for now. This is a lost opportunity for the securities industry since, in the process of moving to T+1, significant long-term efficiencies and streamlining were achievable in many areas within firms, and these changes would have resulted in decreased costs.

Instead, the SIA will sponsor smaller projects with well-defined short-term goals in areas such as Institutional Transaction Processing, Corporate Actions, Stock Loans, etc. The effort will focus on improving the timeliness and accuracy of post trade matching, standards and codes of practice, and will all be conducted with the support and cooperation of various other industry organizations, such as the Depository Trust & Clearing Corporation (DTCC) and The Bond Market Association.

The new STP committee will be led by Jeffrey Bernstein, senior managing director from Bear Sterns & Co. This committee, which will build on the work of the STP/T+1 committee, will look at specific STP projects rather than on how to implement a shorter settlement cycle. However, by working with key firms, associations and the infrastructure now, the SIA hopes to help the industry make short term improvements that will help their profitability and which will not preclude the possibility of T+1 at some time in the future. Allen Morgan, Jr., chairman of SIA's Board of Directors and CEO of Morgan Keegan & Company, said "The industry needs to focus on more effective straight-through processing before it is in a position to fully evaluate a conversion from T+3 to T+1 settlement. We believe that the settlement period should be evaluated again in 2004."

The SIA's continued support of STP is good, but it is not enough.

RECOMMENDATION

It is time to expand the role of the DTCC to include supporting processing functions that no longer provide any competitive advantage for banks and brokers, and which can significantly reduce their processing costs when centralized. The dream of a common back-office for Wall Street has been discussed for many years but was perceived as impossible due to the competitive nature of the business and the people involved. This dream could now become reality if the industry would empower the DTCC to fully assume the technical support role for ALL of the common, non-competitive, processing functions that are performed by firm after firm throughout the US. The time for this change has come.

In the past, firms were able to differentiate themselves by the quality of their processing. As firms have increased their level of automation, the quality of their processing, and the mutual use of many processing applications provided by third party vendors, this is no longer the case. The similarities in processing are significant and the differences are in small details.

Banks and brokers all have many similar processing activities that could be centralized within the DTCC, which would free up redundant resources in virtually every firm in the industry. Every firm has to price its positions, every firm has to maintain corporate action information, every firm has to maintain securities information, etc. The only reason to continue processing these activities in-house is ego and in a few cases to capitalize on market process inefficiencies. It certainly is not good business for the industry.

This strategy could be implemented in a series of incremental steps, starting with the centralization of some specific categories of data and expanding to support the related processing functions. DTCC could develop and run the necessary applications without assuming any additional processing risk.

The operational staff required can either remain within each firm or can be centralized by the firms into a new processing entity. This new business can be jointly owned, and either run as an independent processing business or by DTCC. There could even be more than one independently operated facility, but since they would all use the same DTCC provided applications, the competition would force cost effective processing.

By implementing this approach, firms could move away from their high-fixed cost structure to a highly streamlined and variable cost environment. Even without shortening the settlement cycle to T+1, the industry would still gain enormously by lowering costs and improving the timeliness of processing. Once this new utility concept is in place, the move to T+1 would be much easier and far less expensive.

There are several benefits for the industry if this proposal is adopted and the DTCC's role is expanded rather than creating a new utility. Establishing the new facility and managing it would be easier than developing a new legal entity that would require investment, staffing and management. This expansion builds on the very effective base that the DTCC has established, and no new administrative overhead will be needed since an existing group of senior industry managers can make the decisions regarding which functions should be added. The decisions regarding which functions should be implemented and their timing can be made by the DTCC's existing Board of Directors, so no new costly industry organization is required.

Existing DTCC staff can do most of the business analysis, research and subsequent development, or as they have in the past for other projects, major firms can each second an experienced person to support the effort.

This approach allows firms to either use the new services or continue with their own systems, and it gives them the option of centralizing their non-competitive processing functions using a common technology, or continuing with their own independent processing organizations. And, while offering an opportunity for tremendous cost savings, it avoids a major industry investment at a time when there is no appetite for investment.

The DTCC would be able to fund the cost of the new applications by reducing the percentage of their profit that they normally return to the industry each year, which according to their Annual Report was $177 million in 2001. And, while this would reduce the amount of the refund firms receive, this approach would avoid firms having to ask their management for any additional investment.

CONCLUSION

In the past, whenever the DTCC looked to increase its scope, there were always powerful lobbies that argued against the change, and there will be some firms and vendors who will not embrace this new opportunity because it does not benefit their business.

The Glossary project that the DTC attempted to promote several years ago was doomed because it required the largest firms to fund a process that would level the playing field for the smaller firms. It was also too ambitious in scope since it wanted to include end-of-day pricing, which was fought by the pricing vendors. Clearly this was not in everyone's best interests.

This approach can succeed because it offers significant benefits to almost every firm in the industry, large and small.

Any change this comprehensive will negatively affect the firms that currently make profits by capitalizing on the processing inefficiencies of other firms. But the industry as a whole has a greater opportunity. If STP is to gain credibility as an alternative goal to T+1, the industry will have to demonstrate its commitment by giving up control and responsibility for processing functions that are now redundant and that increase rather than reduce risk.

Any effort of this magnitude will have to be thoroughly discussed, and all of the interoperability issues evaluated in detail to ensure a controlled evolution. However, we must get started. In the current environment of cost pressures and lost investor confidence, brokerage firms and banks need to tangibly demonstrate their resolve by making significant changes at the front and back ends of the industry.

The DTCC has the skills and the technology base from which to work; all we need now is leadership and the collective will to make it work.

1 - Arthur Levitt, Office of the Chairman: Letter to Industry, Regarding T + 1, March, 2001.
2 - SIA T+1 Streetside Processing Committee White Paper, January 2000
3 - T+1 Business Case, SIA, June 2000
4 - SIA Press Release, 8/23/02

Hal McIntyre is the Managing Partner of The Summit Group, a New York consulting firm specializing in the securities industry.

This article is reprinted from The Journal of Securities Operations, 2002.