Before the invention of computers, financial practices were conducted with reliance upon tangible forms of security and personal insights into the character of those who were pledging collateral. Digitization of securities, currencies and recordkeeping has created new traditions, with new regulations. Examining the evolution of financial market traditions over time helps us understand how we should conduct business in the 21st Century realm of digital innovations like blockchain and distributed ledgers.


Tuesday, March 5, 2019

Securities Processing: Big Tasks Lie Ahead

by Ed Blount (Reprinted from the Banking Journal of the American Bankers Association, May 1981)

Author: Ed Blount

The nature of the securities business has changed dramatically in the last decade. A full understanding of those changes is necessary in order to appreciate the challenges facing the industry in the Eighties. Impressive strides have been made since the days of the back-office disaster scenes in the late Sixties and early Seventies that forced over 100 brokerage firms to go "belly up." Virtually all major brokers have automated their order entry process. Many have also developed the ability to interface these front-end systems with clearing banks, other brokers, and with industry facilities such as the Trade Comparison Service, Continuous Net Settlement System, and Institutional Delivery System each of which was introduced in the last decade.

 We can date the modern securities operations era from July 1968, when the first trade settlements were processed through the New York Stock Exchange's Central Certificate Service (CCS). This was designed to centralize the storage of stock certificates and process securities deliveries by simply crediting one broker's account and debiting another's. It was somewhat hobbled by the general upheaval in the industry at the time, and by the exclusion of banks from the book entry system.


DTC arrives. An improvement came in 1974, when CCS was succeeded by the Depository Trust Co. (OTC), a joint venture of the brokerage community, the banks, and the New York and American Stock Exchanges. While this participation greatly expanded DTC's prospects over its predecessor, a successful securities depository system would have been impossible without the development of standard identifying codes for the hundreds of thousands of securities traded in the market.

 The necessary numbering scheme, the CUSIP system (named for the Committee on Uniform Security Identification Procedures), was introduced by a bipartisan banking and securities task force in 1969. A complementary program to create a financial institutions numbering system (FINS) followed the successful adoption of CUSIP in the early 1970s.


Automation drive. Armed with these standards, brokers and bankers alike launched an unparalleled drive to improve operations through automation. Industrywide support systems were designed and introduced during the same period that most institutions were wrestling with the automation of their general ledgers.

The problem of redundant New York clearing facilities was resolved during this period through formation of the National Securities Clearing Corp. by the NYSE, AMEX, and National Association of Securities Dealers. One NSCC facility the Trade Comparison Service, spotted inconsistencies in the buy and sell sides of a trade as reported by participating brokers. Another NSCC facility, Continuous Net Settlement, reduced all trades among participants to a single plus or minus position for each issue in the member's depository account.

The Institutional Delivery System (ID), a DTC service, automated confirmation of trades, and simplified the instruction entry process to the depository.


Other depositories. Overseas, Morgan Guaranty Trust created Euroclear to act as a Brussels-based depository and clearing facility for foreign securities. Not to be outdone, a consortium of European banks established CEDEL in Luxembourg to compete with Euroclear.

Domestic market competition also surfaced when the regional stock exchanges established their own central securities depositories. However, even the largest of these, the Midwest and the Pacific depositories, have yet to achieve a small fraction of the support received by their New York counterpart.

Despite this aggressive competition, a variety of steps were taken during the Seventies to tie market participants closer together for the benefit of the investor community.

By act of Congress, the Securities and Exchange Commission was charged with responsibility for fostering creation of a National Market System. In view of all the controversy over such a system, the SEC understandably has taken a go-slow course of action.

Other steps in this direction have yielded similarly conservative results. Instinet, a privately developed network for direct trading among institutional investors, has not achieved the customer activity base necessary to provide the liquidity such a block trading market requires. And the Intermarket Trading System, intended to offer the best possible execution price for trades in NYSE-listed securities on participating exchanges, has also achieved only modest support to date.

Note the focus on institutions, not individuals, and this brings us to the core of the challenge.


Trading explosion. Institutions have largely supplanted individuals as the chief traders and trading activity has not merely increased; it has exploded. Money managers looking for the "fast horses" have moved in and out of positions so quickly that bank transfer agents had hardly reregistered the securities when the bank clearing agents were forced to re-deliver the same securities to another custodian bank.

The impact on the securities operations areas of the large New York banks has been monumental. Item processing volumes often exceeded plan by a factor of five. Turnaround slowed to a crawl. Certificates sent in for transfer never came out. Record-keeping disciplines slipped, particularly when the banks tried to install new computer systems between volume peaks.

The problem was compounded when many of the large New York agent banks recognized an opportunity to provide a new service to their correspondents after the creation of OTC. Since the basic service charges for the depository were higher than most regional banks could justify, the agent banks deposited their correspondents' securities into DTC with their own holdings. The fixed costs of participation were spread over a larger base through this "piggyback" service.


Paper pile up. The effect was an even greater increase in transaction activity at the New York banks, and for piggyback trading, an extra set of hands in the settlement cycle. These hands often turned out to be so busy shuffling paper that they misplaced trades or dropped income payments. The problem was more complex than simply volume, however.

In their unending search for the front runners, the money managers moved into options, Ginnie Maes, futures, foreign securities and securities lending. Now they were not only burying the banks in volume, but also tying them up in complicated, unfamiliar investment vehicles.


Who's on first. Ginnie Maes earned themselves a place in the Trust Operations' Hall of Infamy as a result of the unpredictable nature of their monthly pay-downs (mortgage payment pass-throughs). Options required special safeguards to ensure that the underlying pledge securities were not sold. As to foreign securities, where do you hold them? How do you find out about calls, dividends, or corporate actions?

The speed at which formerly satisfactory accounting and record-keeping systems became obsolete was dazzling.

Regional trust departments, conditioned to clipping coupons and collecting dividend checks for Aunt Matilda's $700,000 personal trust, were suddenly faced with the spectre of $150 million in hot money from the Amalgamated Widget employee benefit fund. The operations impact, particularly the requirement for sophisticated tracking and reporting, could be traumatic, to say the least.


Survey results. A multi-sponsor study of the level of automation among the nation 's 500 largest trust departments was recently conducted by the ASTEC Consulting Group for Dun & Bradstreet. According to Clifford J. Brundage, director of marketing at D&B's Business Economics Division, "We found that only 2% of the largest trust institutions had not automated the accounting function. In addition, the research clearly shows a strong trend toward a shorter life cycle for these systems, primarily as a result of the ever-increasing demands from their customers for more complex reports and analysis."

But Figure 1 shows some results of the study that are far less encouraging. Note that two-thirds of the banks surveyed - again, the nation 's largest - have not automated the securities movement and control function. This process, which controls securities transactions from execution through settlement (usually five days) becomes more critical as trading volumes increase. Furthermore, lack of an automated securities movement system will prevent a bank from participating in many of the improvements planned for the industry over the next few years.


Institutional demands. We also see from Figure 1 that two functions closely associated with institutional accounts – performance measurement and employee benefit trust participant accounting (employee record-keeping) – have achieved high levels of automation within these banks. What might be even more significant, however, is the fact that better than four of every five banks surveyed were compelled to provide these services in one form or another, automated or manually. Clearly, the institutional account has assumed a major role in the trust industry.

The turmoil created by the special requirements of these accounts is serious. One bank in four installed a new accounting system in the last two years. Almost half are four years old or less. The study further revealed that another 32% were dissatisfied with their current systems and planned to replace them in the next two years.


What are the implications? Anyone who has survived the installation of a complex securities system in a bank should be able to appreciate the often cataclysmic disruption caused by such a conversion. Without doubt, banks will be very busy over the next few years.

Higher and higher. As if all this system work were not enough, the trading activity forecast by the NYSE is for a continuous string of broken records through 1985. By 1984, the NYSE considers a high day of 173 million shares a reasonable probability. This may appear astronomical, but we should not lose sight of the market's habit of making acrobatic leaps to ever higher plateaus.

Some of that increase, however, may be absorbed by a continuation in the long-term trend toward larger trading blocks. From the standpoint of a bank securities operations a rea, the transaction activity level is a more accurate barometer of operational strain. While the increase in transactions will not rise as dramatically as share volume, most knowledgeable estimates place the rate of item processing growth in the vicinity of 10% compounded annually.

If, however, interest rates drop and stabilize in single digit levels, much of the $100 billion in money market funds could flood the equity markets on "repatriation." In that event, all bets are off on trading volume predictions.


The prognosis. Several other trends can be foreseen.

(1)        The role of institutional investors won't diminish in the near future.

(2)        Trades which fail as a result of poor communication between the unprecedented number of parties in the trading and settlement process will continue to cost bank operations officers headaches and interest charges.

(3)        The introduction of new systems at almost one-third of the industry's largest banks will force them to focus internally at the expense of expanding their participation in the depositories, net settlement systems, and other industry support facilities.

(4)        The shortage of trained personnel will be a major concern.

(5)        The institutional customer's interest in maximum portfolio performance, coupled with probable imposition of legislative or regulatory guidelines, will eliminate all vestiges of float earnings on fails income, and free cash balances.

(6)        Exotic investment vehicles will play an ever larger part in the portfolios of aggressive institutional customers.

(7)        The trend toward centralization of securities certificates in depositories will expand.


Support facilities. Fulfillment of many of these trends will place a substantial obligation on the banks to make full use of the support facilities available to them. Yet in the eyes of some industry leaders, the pace at which banks have moved to accept these facilities is disappointingly slow.

"Continuous Net Settlement can tremendously simplify the clearance and settlement process," says Jack Nelson, president of NSCC, "and make participants virtually insensitive to volume fluctuations. Although most major brokers use the system, only one bank is currently aboard."


Tools are there. According to Conrad Ahrens, president of DTC, "The 'DK' problem, where a bank or broker can't identify a transaction before settlement date, is in our opinion the most important single issue facing the industry today. While we can reduce the impact of volume through use of the depository system, the settlement process cannot start in time unless more participants use accelerated trade identification and communication facilities such as the Institutional Delivery System."

DTC, with the support of the brokerage community and many of the larger banks, has started a program to stimulate wider use of the ID system. While this has improved participation in the system, the results of the D&B study indicate disappointingly low usage among the largest trust departments. Only 42% of the banks surveyed reported using the system for any discretionary trades (initiated by the bank's own investment advisory group) and 40% for any directed trades (by outside money managers). Even within this group, however, the success rate was low: banks who did use the system were able to include on average only 25% of their discretionary trades and 20% of their directed trades.


Slow communications. Similarly, Figure 2 shows the low utilization of advanced communication media for trade settlement instructions.

Despite the fact that depositories and practically every large agent bank offer timesharing terminals with direct instruction capability, only 12% of the banks surveyed use this service. Computer-to-computer links, which require more sophistication on the part of the user, are employed by fewer than 8% of these institutions. Expensive, labor-intensive and relatively inefficient methods such as the mails, telephones, and facsimile transmission are used as the primary instruction method by more than three-quarters of these large institutions.

One automated approach which may represent the next generation in trade instruction processing is based on an interface between a regional bank's trust accounting system and its agent bank's trade settlement system. Morgan Guaranty has developed such an interface over the past two years in concert with SEI Corp.

"Our correspondents are able to create a transaction in their accounting system and forward an instruction into our settlement system with the same terminal entry," says Peter D. S. Dale, senior vice president at Morgan. "This linkage not only reduces their operations workload, it improves quality and accelerates turnaround time."


Certificates are fossils. In any discussion of securities processing, however, one key handicap remains glaringly evident. The entire system remains based on an incredibly cumbersome anachronism, the securities certificate. Many calls have been made for its elimination, yet it defiantly endures.

Eliminating the millions of certificates scattered around the country would be a gargantuan task, but at long last, the timing may now be right.

"With the massive concentration of certificates in DTC, we have an opportunity to follow the example of the mutual funds and abolish the certificate at a stroke," says Walter

H. Cushman, senior vice president at Bank of New York and chairman of the ABA's Securities Processing Committee. "The actual proof of ownership resides on the books of the transfer agent, so a simple confirmation of title should be sufficient for most transactions."

All of these tasks represent formidable challenges in bank securities operations. The key to meeting the challenge lies not in computer hardware or software, but in an appreciation of the complex interrelationships in the securities industry. At a certain level, each participant may be considered a customer of the other.