Plan sponsors long have had the luxury of being able to concentrate on the task of picking the best performing managers for their plans' investments.
But the proposed process of T+1 - settling security trades the following business day - will require that plan sponsors look past the easily quoted rates of return to the more difficult to determine issue of the operating capability of their investment managers. To participate in this newly emerging, incredibly automated and integrated industrywide process, an investment manager's operations capability will be just as important as its investment decision capabilities.
Fact: T+1 is coming.
Regulatory bodies have been concerned about systemic risk in the industry since the sharp selloff of October 1987. The initial concern was with the credit and bankruptcy risk of a counterparty between execution and settlement date. Further increasing the pressure on the system, in terms of time and volume, is the growth of after-hours and off-exchange trading, and decimalization.
The Securities and Exchange Commission originally suggested 2002 for the implementation of T+1 settlement. After careful study, the Securities Industry Association has proposed a mid-2004 implementation date and the SEC is likely to require its acceptance via regulatory order.
Fact: T+1 changes all the rules.
Today, investment managers, trustee/custodians and the industry utilities have two full business days, plus part of the trade date, to bounce messages back and forth. If all of the data are in place, the trade settles; if not, it is listed as a failed trade. A critical, though often transparent, part of the process is the investment manager's block trade allocation. The allocation process often does not occur until T+1 or even T+2, yet is essential to allow the manager and the broker to issue settlement instructions to their clearing agents and custodian banks.
In a T+1 environment, much of the back-office process will move to the trader's desk by necessity. Investment management organizations certainly don't want their traders bogged down with administrative detail, but to play in the institutional investor marketplace, a new level of internal and external rules will have to be honored. Plan sponsors should be concerned about how their managers solve this problem.
Fact: T+1 very likely will have a slight negative impact on total plan performance.
It is somewhat ironic that an industry effort that began as a risk-reduction measure will most likely cost plans a few basis points of performance, at least during the development and "shakedown" period.
What we know of the models proposed to date indicates strongly that at least four areas could be a drag on plan performance: cash management; securities lending; increased management costs; and increased custodial costs.
What is the essence of T+1?
Much more difficult than European monetary union and Y2K, successful implementation of T+1 will be a long and challenging process. It will require an enormous industrywide cooperative effort, rather than each firm taking on its own data-scrubbing or code-review project. The conversion to T+3 from T+5 meant doing things faster. The conversion to T+1 from T+3 means doing things differently.
Under the current environment, execution takes place on trade date, and the next two business days are taken up with a series of largely sequential steps.
In a T+1 environment, the trade and every supporting task must occur virtually simultaneously. If settlement is to occur the day after trade date then:
1. Trade details must be matched immediately.
2. Block allocations must occur within minutes (including late-in-the-day trades).
3. Settlement details must be in place in advance and accessible immediately by all parties.
4. Lent securities must be returned or the loans reallocated immediately.
5. Funding must be made available overnight.
All of the steps required to confirm and settle a trade must take place on the trade date. Achieving T+1 requires straight-through processing, the "holy grail" of the securities movement industry.
Why worry now?
Meeting the 2004 target date means making important decisions in 2001. The rationale is as follows:
* All participants, large and small, must be ready to do business in this new model by mid-2004.
* According to the SIA, implementing a fully tested and integrated industrywide system will require at least 15 months of testing.
* To do industry testing in early 2003 means physical implementation in 2002. For many, this will require a complete restructuring of their existing operations.
* Implementing a new operating structure or technology platform in 2002 mandates that key decisions and project planning occur in 2001.
It is also a fact that the Depository Trust & Clearing Corp., among others, will be making substantial changes to the process starting in 2001. Therefore, investment management organizations will be forced to address some aspects of T+1 on a piecemeal basis, which might not be in their clients' best long-term interests.
Each investment manager must assess its own internal operating and technology architecture to determine the specific impacts that T+1 will have. Organizations also must assess the importance of the operating functions and determine where their core competencies lie and how much management time and attention to devote to T+1 processing issues.
A preliminary listing of potential impacts includes:
* restructuring of portfolio management and trading operations and technology to provide for immediate matching of trades with counterparties, same-day allocation of all trades and same-day availability of settlement instructions to all interested parties;
* revising cash management and securities lending policies and practices to facilitate having securities and cash available on a next-day basis to settle trades;
* adopting all industry standard security identification codes, message formats and other protocols to assure seamless information integration with other entities; and
* continuous updating and maintenance of industry standard databases and data repositories to assure access to accurate, up-to-date information on settlement agents, account assignments, etc.
What are the risks?
There are two risks - one probable and one possible - of concern to plan sponsors.
First, it is very likely that total plan performance will deteriorate, however slightly, because of lower returns from cash management and securities lending, and because of increased investment and custodial costs.
Cash management and securities lending most likely will generate less income in a T+1 environment. The loss of two business days to prepare for settlement will necessitate that investment managers (and bank commingled funds) will need to maintain higher cash balances for possible next-day settlement. Securities out on loan will have to be handled differently. Also, if T+1 is implemented successfully, loan demand due to fails will decrease. (Actually, all fails resulting from mismatched instructions should disappear, theoretically, since trades will automatically settle, and "trades" that do not get matched at the point of execution will not be accepted by the industry as valid, sending the trader and the broker/dealer back to step one.)
Although the SIA has done an excellent job of making the business case for T+1 by quantifying long-term savings for both investment managers and custodians, it does not appear to fully address the issue of transition. Our experience indicates that the initial capital expenditure for new automation, the cost of internal process review and change, and the staff required to implement change while running the day-to-day operation (over a 15-month testing period) may well be underestimated. The implementation costs for many firms could far exceed any projected "clerical saves" when the industry achieves a steady state basis. With profit margins under severe pressure, we see the potential for investment management and custodial fees rising in the short run.
The second risk that is possible is that an investment manager that is not "T+1 compliant" will not be allowed to participate in the arena. The industry is likely to quickly isolate and avoid doing business with any manager or other organization that is unable to meet the new processing requirements. It would be a severe penalty, and therefore one that plan sponsors must consider.
What to do
While 2004 seems a long way off, it is extremely important that each organization take steps now to address the issue. Key elements of a T+1 response program are:
* Develop access to the steady stream of evolving, up-to-date information on T+1 issues. A host of industry organizations are studying the issues and making decisions that will affect plan sponsors. These include DTCC, the SIA, the SEC and the Global Straight-Through Processing Association among others. These organizations are defining the rules for the industry of the future.
* Set up a T+1 steering committee. The impact of T+1 will cut across all areas of an investment organization. Even if you don't manage assets internally, you will want to confirm that each relevant area in your investment manager's firm is being represented to assure a comprehensive assessment of potential impacts and potential response strategies.
* Start strategic analysis of your program, and follow your manager's progress. Many organizations are likely to choose outsourcing as the most effective way to address the T+1 issue. Those who choose to address the issue internally will need to marshal resources and interview servicing partners.
* Select strategic partners, if appropriate Whether you and/or your investment managers choose the outsourcing route or decide to secure incremental resources of any type, the time for decision-making and obtaining committed resources is now. As with EMU and Y2K, those who wait to secure resources will find them in very limited supply, of doubtful quality and very expensive.
T+1 presents both challenges and opportunities. At a minimum, a plan sponsor needs to perform due diligence with regard to an investment manager's progress in becoming T+1 compliant. Moreover, a case can be made that a higher fiduciary responsibility exists to ensure that the plan does not suffer when a manager becomes disenfranchised by not being T+1 compliant.
However, organizations that are ready will be able to capitalize immediately, saving both money and time. While others are attempting to address T+1, your investment managers can be executing favorable trades and developing and implementing the product and service enhancements that inevitably will come down the pike. You need to address T+1 now so your plan is ahead of the curve, not behind the eight ball.
Michael L. Costa is practice director at The Alliance of Fiduciary Consultants International Inc., in Parsippany, N.J.