New Execution and Clearing Models Bring Value and Savings to the Asset Management Industry

The investment industry has made huge strides in the last 30 years. Electronic trading, taking securities trading to screen-based systems, the development of the global custody model, regulatory changes — these have all transformed the industry.

Despite much progress, one key problem remains: the post-trade world has not kept pace with advances in trading infrastructures and investment practices, which are more international and more diversified than ever.

There is still significant work to do, and this is no easy task given the economic environment, the regulators’ omnipresence and the scarcity of resources. But, at the same time, the need to be more efficient gives us the opportunity to improve internal middle- and back-office processes, which so far have been low on the priority list. Here lies the difference — the secret of efficiency and competitiveness.

New practices bring value and cost savingsThe idea of a client sending an electronic order that is routed across lit and dark pools, filled, confirmed, allocated and sent for settlement within a day is a goal for all STP enthusiasts. The reality is that handling a single order from end to end is possible — at a cost.

Think about a four-jet engine airplane. In normal operation, each engine is only running at 25% capacity. This is because the plane will need to continue flying if any of the other three engines fail. This analogy shows the challenge of building the right infrastructure and associated support and operating platform for an end-to-end execution and settlement service. The platform must handle peaks and troughs without disruption but it must also be cost-effective.

In our quest for efficiency, we would like to introduce two new models that allow a reduction in cost, workload and operational risk.

Broker turnaround trade processing Many intermediaries use executing brokers to access foreign markets. By doing so, they save on the connectivity and membership costs of exchanges and MTFs. How the intermediary accesses the market and how it processes the instructions, including the clearing and settlement, has an impact on the total fee the client — whether retail, private bank or institutional — will have to pay.

Today, two models are being used by intermediaries to ensure the securities purchased get to their clients: turnaround settlement and third-party settlement.

New post-trade processes, designed originally for intermediaries, now offer asset managers the opportunity to streamline their operations, reduce risk and make major savings.

Turnaround settlementTake the case of a Spanish broker, called Iberian Securities. The broker is trading with Citi Global Markets in the US on behalf of Madrid Pension Managers and Barcelona Pension Managers. Iberian places an order to buy 100,000 Microsoft. The shares are purchased by Citi on the exchange and settle in an account belonging to Citi (acting as intermediary), which immediately forwards the securities to Iberian’s custodian. Then Iberian sends settlement instructions to its custodian to allocate 50,000 directly with Madrid Pension Managers’ custodian and 50,000 with Barcelona Pension Managers’ custodian. Here the cost of settlement and processing, together with the management of the positions, sits with Iberian Securities.

Automated third-party settlementIn order to further reduce the costs and the complexity, a new automated model is being delivered by some custodians, including Citi. In this model, Iberian will provide specific instructions in its order placed with Citi (via a FIX Protocol tag), indicating the onward delivery details (50,000 to Madrid and 50,000 to Barcelona). These will be used by the custodian to create settlement instructions automatically once the order is completed. This allows the client to use open architecture standards to advise the custodian of the onward deliveries without the broker having to pay a premium to the executing broker or alternatively invest in infrastructure to manage settlement instruction creation and management.

Not only does Iberian Securities benefit from eradicating its internal settlement instruction process and technology, but all the settlement instructions are sent within seconds of the execution (supporting T+2 settlement), while the static data for commissions, market fees and standing settlement instructions are hosted and maintained by the custodian. Iberian also benefits from the latent scale of the custodian’s technical platform, smoothing out the effects of high- and low-volume processing needs.

2

Turnaround settlement

Iberica Valores

Citi Global Markets

Custodian Iberica Valores

Custodio CGM

Madrid pension manager

Barcelona pension manager

Deliver 5

0

Deliver 5

0

Initial flow

Consecutive actions

BUY 100.000 Microsoft

Instructions to deliver 50 to

MPM and deliver 50 to BPM

Turnaround settlement implies:

• Instructing onward delivery settlement and managing processing.

• Cost of onward deliveries on both sides (market settlement).

• Operational risk and cost of reconciliation.

CONF 100 Microsoft

Deliver 100

Third-party settlement

Iberica Valores

Citi Global Markets

Custodio CGM

Custodian Madrid pension manager

Custodian Barcelona pension manager

Deliver 5

0

Deliver 5

0

Initial flow

Consecutive actions

Instruct to BUY 100.000 Microsoft

Instructions to deliver 50 to

MPM and deliver 50 to BPM

Instructions to deliver 50 to

MPM and deliver 50 to BPM

Third-party settlement implies:

• Simplification compared to Turnaround Settlement.

• Separeate instructions of onward delivery orders still required.

CONF 100 Microsoft

Third-party settlementAnother method of settlement consists in further streamlining the operational process. In this case, Iberian places an order to buy 100,000 Microsoft. These are purchased by Citi on the exchange. Iberian then advises Citi to settle 50,000 directly with Madrid Pension Managers’ custodian and 50,000 with Barcelona Pension Managers’ custodian. The broker never settles across Iberian’s accounts but with the underlying clients.

This solution reduces the number of settlement instructions and therefore the operational costs and risks.

Institutions generally pay a premium on their commission for intermediaries to support third-party settlement as there is additional work that the executing broker, in this case Citi, has to perform. There is of course additional risk. As the recipient of the shares is not the actual trading counterparty to the original trade, there is built-in complexity should any settlement errors occur.

Below are a series of worked examples that use fictional firms to depict the various models in use by the market.

Solutions for the asset management industry

Allocation processingWhat asset managers need is a service that caters for both their in-house flows (where they choose the custodian and broker) and their third-party mandates (where the client chooses the custodian and sometimes brokers for research).

Take the example of an institutional asset manager called Iberian Asset Management, which provides asset management services for a number of its own funds and for pension plans). It will typically have a set of portfolio models that it executes across a number of clients. The underlying pension plan or fund will have its own custodian relationships that will have to be used by asset manager.

In a similar trade to the one mentioned above, Iberian buys 100,000 Microsoft from Citi in the US. Citi executes the order and advises Iberian of the fill. As Iberian’s trades are always configured to be allocated, Citi expects to receive an allocation instruction for the shares. Currently this is generally performed through Omgeo and the services it offers. However, if Iberian sends the order and the allocation via FIX to Citi’s Order Trade Manager (OTM), Citi will match the confirmation and allocation, and create the corresponding settlement instructions to settle against the underlying funds. This process eliminates the cost of Omgeo and also eliminates the need for settlement instruction issuance and management, resulting in productivity gains and cost reduction.

The next step will be for the allocation instruction to form part of the order so that the entire process is automated and processed continuously.

Streamlining the post-trade processSo far, asset managers have been using a relatively complex post-trade structure, having little choice and limited options for improving the efficiency of the process. This is set to change.

The integrated execution-to-custody (E2C) model that Citi has been proposing to the broker–dealer and private bank communities for some years now offers major advantages to the asset management community. This is a model that combines Citi’s brokerage capabilities with its clearing and settlement expertise. E2C automates the post-trade process. By automatically creating the settlement instructions, it reduces settlement costs and operational risks.

Some asset managers are already enjoying a simplified version of E2C where their service provider acts as an intermediary broker in the chain, distributing the trades to underlying brokers. However, the idea with E2C is to reduce the number of intermediaries to a minimum, including at the brokerage level, by directly using Citi’s brokerage structure. Up the chain, the brokerage service can be complemented with research services; down the chain, with integrated clearing and settlement.

E2C is an end-to-end service that offers huge pluses for asset managers. It provides access to alternative trading platforms (MTFs), offering best execution, and the ability to connect to all the relevant clearing houses (CCPs), thereby allowing cross-margining. It offers the most efficient settlement services globally, thanks to Citi’s proprietary network of subcustodians in more than 60 countries. And finally it incorporates the turnaround function, automated third-party settlement and allocation services mentioned above.

Thanks to the allocation and automated third-party settlement functions, asset managers can enjoy this streamlined process and receive the securities directly in their account with the corresponding depository. Reallocation becomes a thing of the past.

As is apparent from the broker–dealer world, there is a strong first-mover advantage here. The post-trade process is becoming an increasing focus of attention and an area where efficiency can really make a difference. A less efficient post-trade process is a cost to the fund and it will affect its ranking.

At Citi, we understand that operations are now a crucial element of competitiveness. The combination of services within E2C presents a major advance for the asset management industry, allowing asset managers to benefit from the same efficiencies many broker–dealers and private banks already enjoy.

With our long-standing involvement in every stage of the securities trade cycle, the breadth of our client base and our commitment to continuous investment, we are well placed to push the boundaries of what is possible in the post-trade world and replace complexity with simplicity wherever possible.

3

Automated third-party settlement

Iberica Valores

Citi Global Markets

Custodio CGM

Custodian Madrid pension manager

Custodian Barcelona pension manager

Deliver 5

0

Deliver 5

0

Initial flow

Consecutive actions

Instruct to BUY 100.000 Microsoft with instruction to onwards deliver of 50 to

MPM and 50 to BPM

Automated third-party settlement implies:

• Simplification compared to turnaround settlement.

• No need for separate instructions of onward delivery orders as they are included in the initial trade order.

CONF 100 Microsoft

www.citi.com/securitiesandfundservices

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GRA24957 03/14

AM industry: Current model

Asset manager

AM global custodian

Intermediary broker

Broker 1

Clearer broker 1

Broker 2

Clearer broker 2

Depository fund 1

Broker 3

Clearer broker 3

Depository fund 2

Broker 4

Clearer broker 4

Allocations — market settlement

Sometimes used

Streamlining the process for AM

Citi Global Markets

Asset manager

Depository fund 1

Depository fund 2

Primary exchanges

Access to 96 markets, of which idrect access to CSD in 60+ markets

CCP

MTFs

Alternative brokersCCP CCP

Citi as Custodian

EC2

More information

Edward DuffE2C Sales EMEA+44 (0) 207 500 1146edward.duff@citi.com

Eugene O'Herlihy E2C Sales EMEA 44 (0) 207 986 0752 eugene.oherlihy@citi.com

Nigel Solkhon E2C Product EMEA +44 (0) 207 508 9215 nigel.solkhon@citi.com

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