Being prepared: looking for a solution now to future stumbling blocks

Necessity is said to be the mother of invention. The trick is the ability to recognise when ‘necessity’ exists. Subsequently, the invention or solution may follow.

The investment funds sector is enjoying better times and, while it may be difficult to see the necessity for any change, such times should be used to look around the corner. If we see the current success as based on growing demand and market momentum, future success will depend on resolution of the sector’s often unmentioned Achilles’ heels:

• Lack of standardised settlement procedures;
• Settlement risk issues;
• Free-of-payment (FoP) time lag.

Resolution of these problems could increase the level of confidence in the industry and form a basis for sustainable growth. The improvement in efficiency, if reflected in return to the investor will also post a positive sign to encourage growth. Stating the problem is one thing but wider acceptance of the need for change and then the development of a plan to resolve it are the real hidden challenges in this industry.

Conversely, in a buoyant market it can be hard to justify change, but failure to take action could lead to major commercial accident which could then cause a slowing of growth and endanger what is now the ?5,600bn European investment fund market. The spur of globalisation is not just a geographical phenomenon but a fundamental change in the way business is done in many markets. Combined with continued technological change, it is offering new opportunities whilst simultaneously undermining business models that, until recently, were stars in their sector. The success of the digital camera for example, has left traditional suppliers such as Kodak, its share price half of what it was five years ago, faced with disappearing markets as new consumers across the world have leapfrogged current channels to adopt the new modern methods. The lesson is that suppliers must be able to see ahead and should be leaders in embracing technology, rather than be followers, which nowadays can be too late.

In addition to the much-covered issue of standardisation of processes, there are two further major issues that remain taboo in this industry – settlement risk and FoP time lag (the gap between trade date and settlement date). These two are further complicated by the domestic nature of the markets whereby each has different processes. Both of these issues create a situation that means the fund runs risks that it need not run. A big bang solution would be destabilising and an evolutionary approach needs to be found that allows, initially, for multi-domestic solutions as a stepping stone to the adoption of industry standard processes and possibly systems.

Understanding Risk

Today’s solutions have a high degree of manual content, with many parties involved and a resultant breakdown in the straight through processing (STP) processes. The inherent settlement risk is that a failure of some kind occurs between the time when a trade is made to the time of final settlement. In bond markets, for example, this is managed by effective and secure processes but in investment funds, the number of days in the elapsed period remains largely unknown. This is exacerbated by the free of payment aspect in many processes, the investor has paid his money, the shares have been ordered but it can be days before that investor receives the securities or shares in exchange. The high volume of trade puts several billion euros at risk continually. This figure will only increase and it is certain that the momentum created by Basle II will sooner or later address this risk. Delivery-versus-payment (DVP) solutions are a necessity to minimise risks as already accomplished with other asset classes.

While regulatory rules will help, it remains the industry that must still find a solution to the commercial problems. Such a solution must deliver:

• A modern distribution network that supports open architecture;
• Riskless settlement processes for subscriptions and redemptions;
• Multi-currency capability;
• Lower transaction costs through standardised settle- ment processes.

The question of transaction costs and overall cost of investment is a consequence of current processes and their complexity. Any improvement, it is assumed, would feed back to all parties, including the investor, in terms of lowered costs.

A difficult task ahead

Achieving any degree of STP and DVP necessitates development of an infrastructure both electronic and formal that will not be easy. The industry will need to first structure a forum with the mandate, capability and support to propose and agree appropriate solutions. This in itself will be an important signal to regulators, investment institutions and the finance industry in general, never mind retail investors. It will indicate that the investment funds industry has crossed an important threshold in demonstrating its maturity and its commitment to match its products with best modern practice equating to the needs of the market.

Within Clearstream and across Deutsche Börse Group, we have learnt much about the process of building infrastructure and delivering it to the market from our wider role in the bond, derivatives and equity markets. More recently, with our Vestima+ Order Routing Service we have taken important steps in developing the groundwork for further progress in investment funds. A further factor that we consider to be crucial is the need to listen to and communicate to all parties to ensure that all voices and views are heard.

The first challenge is for the industry to accept the necessity to resolve these issues. Then it must set out its intent and a programme aimed at the development of a model that will eliminate the risks between trade and settlement dates. The introduction of such a programme would build a basis for further expansion and success of the entire industry.

Bruno Zutterling is the director of investment fund services at Clearstream Banking