Chapter 1 The Business Case for STP 1.1 Introduction The straight through processing (STP) paradigm is a set of business processes and technologies that can be used to create an infrastructure for automated real-time transaction processing. In an industry that has STP, systems at every stage of the trade lifecycle, from pre-trade analytics to order creation, routing, and execution, to post-trade settlement would be seamlessly connected. Manual rekeying of data and information would become unnecessary, reducing trade failures caused by human error; in fact, human intervention would be minimal, and required mainly for excep- tion handling and investigation. The creation of such an industrywide environment CCh001-P466470.inddh001-P466470.indd 1 99/27/2007/27/2007 33:24:55:24:55 PPMM 2 Straight Through Processing for Financial Services would require participants, such as sell-side broker-dealers, buy-side institutional investors, exchanges, and clearinghouses, to make investments equal to millions of dollars in their internal technology infrastructures, and in their external connectivity with each other. This book is a guide to choosing the appropriate technologies when building this STP system. But fi rst, it must be proved that there is a valid business case for undertaking the time, resources, and fi nancial investment such an imple- mentation requires. The US securities industry is the largest such industry in the world, and is exponentially growing in size and simultaneously undergoing rapid change. Its contribution to the US economy is signifi cant, with nearly half of all households in the country holding some of their investments in the stock market, and both businesses and the government relying on it to raise capital. To keep this industry effi cient and globally competitive is so important that the US government regularly mandates policies to stimulate growth and manage risks in the industry. Section 2 provides an overview of the trends in the US securities industry that will dominate the market over the coming years. The purpose of this section is to show how every indicator of the future of securities services is pointing to the trend of increased automation of trade-related processes. The business case for STP can be made by examining what the market views as current and future goals of the industry, and how closely these goals are linked to technology improvements. Technology solutions are always formulated after articulating the business requirements. The discussion on business goals and directions is the perfect segue to an examination of the technologies that would be necessary to achieve them. Section 3 introduces the concept of straight through processing, and the main con- cepts that defi ne it. Coupled with the trade lifecycle outlined in Chapter 2, this chapter provides the business and operations foundation for an STP world. 1.2 Trends in the Securities Industry The securities industry is experiencing dramatic growth in products, services, and markets. Technology and business process improvement have become the need of the hour as fi rms struggle to meet the demands of an exploding market and its risk management. Changes are driven by many factors, including globalization, new technologies, and transformation of marketplaces. This section summarizes the seven main trends in the US securities industry, showing that each trend underscores the business need for better technology and STP (see Figure 1-1). These are: ■ Exploding volumes ■ Shrinking margins ■ Evolving marketplaces CCh001-P466470.inddh001-P466470.indd 2 99/27/2007/27/2007 33:24:55:24:55 PPMM The Business Case for STP 3 Trends in the securities industry 1. Exploding volumes 2. Shrinking margins 3. Evolving marketplaces The 4. Globalization need for STP 5. Changing revenue models 6. New face of buy-side 7. Regulatory pressures Figure 1-1 Trends in US securities industry. ■ Globalization ■ Changing revenue models ■ New face of buy-side ■ Regulatory pressures 1.2.1 EXPLODING VOLUMES The industry is globally growing both in terms of sheer size and also in terms of the volume of trading that occurs daily. That is, not only are more securities being issued, but they are being traded more frequently as well. According to a report published by the SIFMA (Securities Industry and Financial Markets Association), the total market capitalization of equity, debt, and derivatives instruments outstanding increased from $71.1 trillion in 2000 to an estimated $120 trillion in 2006.1 See Figure 1-2.The total number of shares traded daily has also simultaneously risen in all categories and marketplaces. One example of this explosion in trading volume is the growth in the daily share volume at the NYSE, which more than doubled from 1 billion a day in 1997 to 3 billion a day in 2005, a span shorter than a decade.2 See Figure 1-3. 1SIFMA, Research Report, November 2006. Securities Industry & Financial Markets Fact Book Global Addendum 2006. 2NYSE website. CCh001-P466470.inddh001-P466470.indd 3 99/27/2007/27/2007 33:24:55:24:55 PPMM 4 Straight Through Processing for Financial Services Global Securities Markets ($ trillions) 2000 2001 2002 2003 2004 2005 2006 Equity market capitalization 32.2 27.9 23.5 32.1 39.1 43.6 49.2 Debt securities outstanding 35.3 36.8 42.1 20.0 57.0 58.3 60.0 Derivatives market value 3.6 4.5 7.3 8.1 10.7 10.8 11.5 Securities industry total 71.1 69.2 72.9 90.2 106.9 112.8 120.7 Figure 1-2 Global securities gross market value. Source: SIFMA, Research Report, November 2006, Securities Industry and Financial Markets Fact Book Global Addendum 2006. Daily share Year volume New York Stock Exchange (NYSE) 1 million 1886 5 million 1928 Highest volume day: 3,115,805,723 shares 10 million 1929 June 24, 2005 50 million 1978 100 million 1982 500 million 1987 Lowest volume day: 31 shares 1 billion 1997 March 16, 1830 2 billion 2001 3 billion 2005 Figure 1-3 Steady rise in daily volume share at the New York Stock Exchange. Source: NYSE website. With trade volumes rising at an accelerating pace, the market settlement exposure also rises because more transactions now have to be processed and settled daily. Settlement exposure is the risk of counterparty default between the time a trade agreement is made and the time the payments are made. It can be divided into two types of risk: credit risk and liquidity risk. Credit risk is the risk that the party defaults on its obligations, whereas liquidity risk is the risk that the counterparty can meet only partial obligation. The longer the time between trade date and settlement date, the greater the settlement exposure. According to the Securities Industry Asso- ciation T+1 Business Case report, in 2000 the total dollar value of T+3 trades await- ing settlement on a daily average basis was about $125 billion.3 Shortening the 3SIA T+1 Business Case. Final Report. Release 1.2. August 2000. CCh001-P466470.inddh001-P466470.indd 4 99/27/2007/27/2007 33:24:56:24:56 PPMM The Business Case for STP 5 settlement cycle by two days, that is, moving to T+1, would have reduced daily settlement exposure by $250 billion. The same report then predicted that given rising trade volumes, the reduction in this exposure would have been about $750 billion in 2004. Obviously, this risk exposure is even more now. STP of the clearing and settlement of transactions mitigates this risk, and is the primary function of central clearinghouses such as DTCC and the central multi-currency settlement bank CLS (Continuous Linked Settlement). 1.2.2 SHRINKING MARGINS Interestingly, even though the industry is experiencing a boom in volumes, this is not translating into greater profi ts for everyone. In fact, quite the opposite is happening for the sales and trading departments in some products. The buy- and sell-sides make revenues and profi ts in the following way: 1. Buy-side—The buy-side manages fi nancial assets for investors, either institu- tional investors such as pension funds or high-net-worth private clients of the kind that hedge funds manage. Investors entrust their money to these managers because they value the business expertise of these managers, and believe they can earn a higher return on their money this way rather than by investing it themselves. Managers charge investors a management fee for assets under their management. Assets under management (AUM) is the total market value of assets that an institutional investor manages and administers for itself and its customers. A mutual fund can charge about 0.5–1% annually on AUM as a management fee. Sometimes, buy-side managers also charge a commission on the profi ts. For instance, hedge funds charge on average 1–2% of net assets, plus 20% of profi ts. In addition, hedge funds may also put in extra charges such as account administration. Since the returns on their investments are high (hedge funds returned an average of 11.6% a year after fees to investors from the period of January 1990 to April 2005; note that the S&P 500 stock index returned an average of 10.6% over this same time period), investors don’t mind paying these high fees.4 2. Sell-side—The sell-side acts primarily as broker-dealers, that is, people who execute trades on behalf of the buy-side, matching buyers and sellers. For this service, they charge a fee or commission per trade executed. In addition to intermediation fees, the sell-side may also add research costs for the advice provided to investors. These are known as soft-dollar commissions as they are implicitly added into the service fee.