Just over the horizon there are several big market changes that could substantially grow capital markets and test existing post-trade infrastructure.
In the next few years, capital market volumes are set to grow as both the industry and policymakers push to attract more everyday investors.
Exchanges on both sides of the Atlantic are looking to attract the retail trading audience, with the NYSE and Nasdaq planning on launching 24-hour trading, while in Europe, the London Stock Exchange is rumoured to be mulling a similar push.
European policy makers have likewise zeroed in on this constituent. A desire to grow market share by making the EU a more attractive destination for investment has given fresh impetus to unlock retail savings into the European investment economy through the Savings and Investments Union.
If successful, these two changes would lead to an expansion of the capital markets sector, by volume and value, whilst also necessitating running round the clock technology and operations. But legacy post-trade infrastructure and processes will struggle to deal with the increased activity that more trades or larger batch orders would bring over longer hours.
On the surface there are already a couple of unanswered questions on how the market will need to adjust to allow for 24-hour trading. For example, many corporate actions such as dividend payments are determined at market close. The industry would likely have to agree to cut-off times in lieu of the current hard close.
It would also require significant upgrades to financial infrastructure.
We are already seeing the substantial effort it takes to modernise post-trade systems. It took over 3 years and close coordination to prepare the US for T+1 and is likely to take just as much work – if not more – for Europe as it prepares make a similar switch in 2027.
A move to 24-hour trading would require a similar level of resource commitment. European policymakers have discussed using the move to T+1 as an opportunity to “future-proof” systems to tackle real-time settlement in one go. While this is a worthwhile goal, it is likely out of reach for most firms who cannot devote the time or capital needed to go from T+2 to real-time in two years.
More trades, more trade fails
Middle and back-office functions may struggle to deal with higher trading volumes if changes are not made in how the industry thinks about settlement.
Trade fails do not scale linearly with activity but as a multiple. Research from Euroclear found that when trading volume tripled, trade fails rose by a factor of five. The industry needs to address fails or they could become unsustainable as activity grows. Firms already allocate considerable resources to keep fails at a minimum but according to the European Securities and Markets Authority, equity trade fails sit at around 5-6%.
Industry consensus indicates that approximately 70% of trade settlements are processed through straight-through processing, without requiring human intervention. Manual intervention is required in around 25% of trades, which is where most effort is spent. The 5% fail rate are trades that slipped both the automated and manual nets.
With the percentage of fails growing faster than volume, firms need to increase the share of trades that are fully automated if fail rates are to remain the same, let alone reduce. Systems will need to not only automate more trade settlements but also predict trades at risk of failing, allowing firms to reroute orders to counterparties with higher settlement rates, preventing trade fails altogether.
To bring fail rates down further, more of the trades that currently require manual intervention need to be automated to allow for operations teams to focus on the harder to solve 5%.
Firms with global operations could rely on their colleagues in other time zones for around the clock coverage to resolve fails that occur during a 24-hour trading day. However, that can only occur if everyone is working from a single source of truth built around a centralised database tracking the entire trade and settlement lifecycle.
A bigger capital market lifts all boats. Both 24-hour trading and the EU SIU have the laudable goal of making it easier to invest. In theory, the everyday investor should see better returns on their savings in capital markets while growth companies and the real economy will get the funding they need.
This goal is only attainable if the industry addresses the side effects of increased trading on legacy infrastructure. Strengthening capital markets also involves investing in the underlying infrastructure of financial systems and reconsidering current approaches to post-trade processes and settlements.
If you would like to discuss how we can assist in optimizing your post-trade operations, please contact us at MeritsoftCapMarkets@Cognizant.com.
