January 2000 Newsletter
Issue One, Volume One

WELCOME TO THE JUNGLE

By Mike Gasior

Well it is with great excitement and anticipation that I offer you the first edition of this newsletter. Since founding American Financial Services over 11 years ago I have wanted to offer the members of our industry insight and information to help them perform their jobs more efficiently, but the expense and delay involved with producing a hard copy newsletter always made it prohibitive. Although many of you clearly know my viewpoint on the ludicrous values being applied to Internet companies, I have never been a doubter of the power of this new venue for information. Obviously it is allowing me to communicate what I hope will be valuable information to you instantaneously and at minimal cost and no one can argue with the power in that. My hope is that you will enjoy my ramblings and they may actually enable you to become more productive, and in turn, a more valuable member of your organization.

It is my intent to produce this newsletter on a monthly basis on various securities topics and deliver it free via e-mail. If you would like to print a copy of a pretty HTML version of any month’s issue we will be archiving them at our Website which you can visit at http://www.afs-seminars.com. Also, please feel free to forward this to anyone you desire. The only thing I ask in return is that anything you thought was good enough to rip off, please just give me credit for it.

"Welcome to the Jungle"

I spent the better part of 1999 warning the audiences in my seminars that the next three years were going to "kick your ass in ways you cannot imagine". Not only do I stand by those strong words, I have actually become more frightened by the moment. The people who attend my programs tend to be the "soldiers" of the securities and financial world; the people who are actually charged with the task of getting the job done. As I spend day after day with them I can’t help but get the impression that the "generals" who watch the bigger picture were concentrating on the current battle which at the time was Y2K. I am not one of those who subscribe to the idea that Y2K was a non-event. A serious meltdown was averted at midnight of January 1st because of the diligent job done by systems professionals around the world who prepared for it. That’s why it was a non-event. It is always lovely of the media to minimize the contributions of the millions who worked long hours for all of our benefit.

But now the real adventure will begin for all the systems, accounting and management professionals who have chosen to work in the securities field. I’m not kidding in the least when I tell you that for this audience, Y2K will have been like Pee Wee’s Big Adventure. The events that are going to occur during the next 900 days will shape this industry like nothing has since the 1970’s. Let’s look at the list:

--Companies which must follow U.S. GAAP accounting standards probably began following the new FAS 133 accounting standard on January 1st. It’s already too late to get ready for this if you haven’t already done it. The impact that this standard will have on the derivatives market might be substantial since firms will have to begin marking the majority of their derivative holdings to market. I anticipate that this might effect whether or not some firms even continue legitimate hedging activities. The fear will be that once these gains or losses are run through the balance sheet, the public relations nightmare may be more than some senior managers will be able to stomach. We should get our answer on that reasonably quickly. I have always hated regulations that give a disincentive to do the "right thing". This is one of those times and I think this accounting standard stinks. But who cares what I think.....

--Trading hours have been extending and will continue to extend. Many in the industry expect the trading day to reach 20 hours a day within the next two years.

--Trading volume is exploding. In 1995 daily volume in the U.S was about 750 million shares a day. Last year volume exceeded 2 billion shares almost routinely. Most expect volume to reach 4 billion by the year 2002. Even more interesting is that nobody seems to pay attention to the massive increase in trading activity in the fixed income markets.

--Right now securities operations areas have about 17 hours to process transactions while the markets are closed. Expect that window to shrink to 4 hours or less. Never mind if your firm does any global transactions. I have been warning my audiences for over a year that the securities operations area will be running in three shifts. I can also promise you that senior management of many companies have made no provision for any of this nor have they budgeted for it either. Good luck to them.

--You will be trading these securities in decimals. This is set to begin imminently.

--All of the above will be handled with "straight through processing" in a T+1 environment on an express track toward a T+0/real time environment. Like I said.."Welcome to the jungle".

Last year while addressing a conference, Ms. Jill M. Considine, CEO of the Depository Trust Company (DTC) said "Any one of those changes would be significant in and of itself.....all of them packed into the next 36 months will alter virtually everything about our business."

Because I think it is the most radical change and the one that will impact my audience the most, I will spend this month discussing T+1.

The Move to T+1

The date appears to have been chosen and it’s June 2002.

We went through a similar change back in June 1995 when we moved from a T+5 to the current T+3 standard. Although it had a serious impact on everyone involved with securities settlement it will pale in comparison to what the next change will entail. I hate to take even the most simple things for granted so let me take this opportunity to define that the "T" is the trade date and the "+1" is how many business days until the settlement of a trade. Any securities that already settle T+1 or faster will not be impacted at all; options, T-Bills and futures to name a few. Back in 1995 the shortening of the cycle from 5 business days to 3 business days really only required firms to make their current settlement process more efficient. Things will not be so simple this time. The relationship between the front office and the back office is going to need to be seamless and perfect. And that might only be the beginning.

Here is a concept you should become familiar with even if you don’t work in the systems area since it is going to affect every aspect of securities operations: "Straight Through Processing". This means that if you haven’t moved to a ticketless trading environment, you are going to shortly. "Straight Through Processing" will be an environment where a fully automated flow of a transactions information will move seamlessly from the point of trade execution to the settlement with effectively no human involvement. That does not at all resemble the current situation where humans tend to be involved almost like an assembly line and the transaction is handled by an array of different systems and protocols. I have particular concerns that many of my "buy side" clients might already be in a position of playing catch up with regard to preparing for this change.

Here are a couple of chilling statistics, which illustrate why I’m so worried.

--Prior to the change to T+3 in June of 1995 approximately 5% of orders were NOT confirmed by trade date.

--There is already statistical evidence that almost 15% of orders are not being confirmed by the trade date and industry numbers suggest that number might increase to nearly 40% by 2002 when the change to T+1 is supposed to occur. You must understand this will spell complete and utter disaster two years from now.

What this means is that we’ve actually been losing ground since the advent of T+3. This time it’s going to take a hell of a lot more than making your current systems and procedures more efficient, which sufficed back in 1995. This time is going to require a completely reengineered environment.

Let’s talk now about who is going to be impacted and how.

Securities Settlement and Operations

Needless to say, this department will never be the same. First of all we can expect this department to be open 24 hours a day during the business week. Trading will need to flow silently and electronically in the background only to rear it’s ugly head when there are errors or problems with trades. All trading will be processed in "real time"; which they might as well get used to since T+0 is already being seriously contemplated by regulators.

Securities Accounting

It used to be important to distinguish yourself as either "trade date" reporting or "settlement date" reporting. It will continue to matter, but less so by the day. Simply enough, there will less time available to process reports and assess risks. Never mind the increase in volume that might follow the change to T+1.

IT and Systems Departments

Maybe it’s not too late to post out to a different department. Saving you the graphic detail, you will be the department who will be counted on to make all of the fabulous changes, which will make everyone else’s job possible. This means integrating the front and back office trading systems; updating the accounting system; implementing some sort of compliance system. All of this will need to happen simultaneously. Good luck to you. The first decision that will need to be made is whether you will try to develop this in-house or buy off the shelf vendor systems. Can you already hear the clock ticking as a thousand different meetings are held involving representatives from 20 different departments all trying to come to an agreement on all of these things? I can. Makes you want to go put a gun in your mouth, doesn’t it? Like I said.....maybe it’s not too late to post out to a different job.

Audit and Compliance

There will no longer be enough slack in the system to wait for some human to monitor the trader or portfolio manager and what they are buying. Somewhere incumbent in this new systems environment will be the need to have some sort of watch dog keeping an eye on what I’m buying, how much I’m spending and with whom I’m doing the transaction. If I am buying something I’m not allowed to buy, or investing more than I am allowed, or doing the transaction with someone I am not allowed to trade with, the order can never leave our house. This might actually turn out to be a boon to the compliance area since it might keep an illicit trade from ever occurring.

Traders and Investment Managers

This might be the only group who is happy about the move to T+1. Since there will only be one days worth of trades outstanding at any given time, credit lines will be more open and that spells relief for trading desks everywhere. The only substantial change here might be the change from paper to electronic tickets; if this change has not occurred already.

Senior Management

Your job is to be keenly aware of the problem and make sure everybody else has the tools necessary to perform theirs. This change is going to take a massive commitment of time and energy by your staffs. Your investment in your human capital will be paramount here. I am trying desperately not to be an alarmist but there really is going to be two different types of companies when this is all over. There will be the companies that were ready, made the transition seamlessly and thrive and grow into the future. The other type of companies will be the ones that are out of business. I’m not kidding there. It seems the human learning curve is completely flat sometimes because we’ve been there before. Perhaps you remember back in the 1970’s when trading volumes began to explode. If not, I’m reminding you. Some firms and even exchanges could not keep up with the increased activity and trading hours were even shortened for a time to give back offices a chance to keep up. During this time many firms began to fail and it was due to these failures that Sandy Weill built Shearson from a tiny, minor firm into the behemoth which became one of Wall Street’s top five firms before ultimately selling out to American Express in the mid 80’s. I remind the people in my seminars of an age-old rule: those who don’t know history are doomed to repeat it. Well here we go again.

Securities Lending

Currently most custodians routinely offer to have any securities that are out on loan placed back into your account within 2 business days of notification by you. The 2 business days wasn’t plucked from thin air, but was to assure your securities will be available for settlement on the 3rd business day. Even now the securities sometimes do not make it back in time and the custodian causes the trade to fail. I will be curious to see how these custodians adapt to the reduced settlement cycle. Maybe they already have it all figured out. Maybe it will be a non-issue. Plenty of people are smarter than me so perhaps it’s just my cynical side coming out again, but I might be hard pressed to keep my securities lending program active when that June 2002 date rolls around. No securities operations area wants to see their "fail list" looking very similar to the Manhattan Yellow Pages. Once again though, senior management will be hard pressed to give up the income generated from this operation. That’s easy to understand since they don’t have to clear up all of those fails. But I digress.....

Resources

There are some fabulous sources of information available on the Web if you’d like to read more about this important topic. Here are a few addresses you may want to visit.

http://www.sia.com

This is the Securities Industry Association site and a critical site for anyone working with, or for Institutional Investors. There are plenty of different documents available about T+1 as well as other securities related topics. The most detailed report I found on T+1 was released by the Institutional Transaction Processing Committee and is called "White Paper version 1.5" and is dated December 1, 1999.

http://www.gstpa.org

The Global Straight Through Processing Association is actively working on protocols and procedures, which will make T+1 even a possibility.

http://www.dtc.org

The Depository Trust Company is world’s largest securities depository and a critical link in the chain for Institutional settlements. They have many different documents available regarding T+1 and every other issue facing institutional investors.

http://www.nscc.com

Most transactions effecting institutional investors will in some way be touched by the National Securities Clearing Corporation. They handled about $45 trillion in participant transactions in 1998 and the 1999 number was certainly higher than that. Their website might offer many insights for visitors to it.

Next Month

I am already working on the February issue in which I will discuss the move to decimalization and extended trading hours. No doubt there will be more of my pointless ramblings about whatever issues that may pop up between now and then.

If you would like to add anyone to the distribution list, or change the e-mail address where you receive this newsletter you can accomplish this by visiting our website at http://www.afs-seminars.com

Copyright 2000, Michael Gasior. All Rights Reserved.

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