Recent research has shown that failure to interpret corporate action information is costing the securities industry billions of euros a year. Frances Maguire reports on efforts to build a consensus on how the information is presented.
It is estimated that close to one million corporate actions take place every year worldwide, without including scheduled fixed-rate interest payments and maturities, of which more than three million are processed annually. Rights issues, tender offers, conversions, takeovers, mergers, early redemptions and dividend payments are just a few examples of the most common categories of corporate actions, but there are believed to be anything up to 85 different events – all of which can affect share prices.
Corporate actions are risky because the non-mandatory events are rarely standardised, contain complexities unique to that issuer or company and are deadline-driven.
While it is more-or-less accepted that an estimated 10% of the annual cost of processing corporate actions comes from “write-off” funds reserved for losses, (amounting to at least millions of dollars), the US Depository Trust & Clearing Corporation has sponsored a study by economic consultants Oxera in an attempt to quantify these losses. The resulting survey and study – Corporate action processing: what are the risks? – at last attempts to put some industry-wide figures on the levels of losses.
Significant risks
The study concludes that failure to handle single, complex corporate actions could result in a loss running into tens of millions of euros. The risk is highest for the individual custodian firms because they safeguard large amounts of assets on behalf of many different investors, but fund management firms also face large potential problems.
The study also concludes that corporate actions risk is not limited to the back office: because the dissemination of corporate action information is complicated, temporary arbitrage opportunities, and risks, arise in trading. Failure to interpret corporate action information correctly may lead to sub-optimal trading decisions by brokerage and fund management firms for clients or for proprietary positions.
The risk to firms’ front offices from sub-optimal trading decisions is estimated to be in the region of E1.6bn-E8bn a year globally. The actual losses due to processing failures are somewhat lower, because firms in the industry invest so heavily in failure prevention. Available data on the European fund management industry indicates that firms in Europe incur total actual costs in the region of E65m-E140m a year. This would imply an annual cost of E300m-E700m to the fund management industry worldwide.
Global issue
While part of the survey focused on the European markets for practical reasons, participants interviewed noted that the issues surrounding corporate actions are common to most markets. James Femia, managing director of DTCC Asset Services, says: “Europe and the US, and other regions across the globe, face many of the same issues. When dealing with corporate actions, true automation, translated to mean true STP, is virtually non-existent anywhere. True proxy practices, as they relate to corporate governance schemes, are more advanced in the US [in the US proxy voting is mandatory, whereas in Europe it is considered ‘best practice’].
“However, in another way, with its greater acceptance of ISO 15022 messaging, Europe has achieved a higher level of automation as compared to its US counterpart. The differing market practices, language, securities law and, though mitigated somewhat by the euro, currencies, tend to make the European market more complex.”
The necessity of co-operation
When it comes to working towards a solution. Mr Femia stresses that no single organisation can really tackle the problem; it requires industry co-operation. He says: “Both the International Securities Services Association (ISSA) and the Securities Industry Association (SIA) in the US are promoting initiatives to provide clear, consistent and uniform corporate action information in prospectuses and proxies. Other organisations are also involved in this, while securities markets groups all around the world are working to develop best practice guides for the use of the ISO 15022 corporate action message standards.”
The spaghetti of industry organisations trying to come together to reach agreement of standards and processes does not end there. Another one, the European Securities Forum (ESF) – made up of some 20 European banks which want to have a say in the final shape of the EU’s single capital market – has also put corporate actions at the top of its list of priorities. Werner Frey, CEO of ESF, says that the cost of having to observe the differences in corporate actions data, country to country, has prompted banks to set themselves a target of 2005 to agree a single format of the record and expiry dates used in corporate actions.
Michael Kempe, a director in Euroclear’s Business Model and Harmonisation division, says that corporate actions have always impacted both the front and the back office. To some extent, the introduction of a central counterparty (CCP) for equities by the London Stock Exchange (LSE) provided an opportunity to address some of these issues. Mr Kempe says: “When CrestCo was building the CCP with London Clearing House [now called LCH.Clearnet] and LSE, we had an opportunity to put in place rules for corporate actions that have helped to reduce the problems they can sometimes create between the front and back offices. We effectively based the process around the transaction – the trading and settlement cycle – bringing buyer and seller protection to both the trade and the corporate action.”
Michael Kempe: corporate actions have always impacted both the front and the back office
Many intermediary firms have large dedicated corporate actions teams – with between 10-40 staff, depending on the size of the firm – cross-checking the different sources of incoming data, from faxes and unformatted e-mails as well as from data vendors, to create “a golden copy” of the event notification. The problem is, this takes time, and many of the sub-optimal trading decisions are being taken on wrong information, and worse still, rumour, until this golden copy can be verified.
Accommodating all parties
Dr Anthony Kirby, founder of the Reference Data User Group (RDUG), set up to agree industry-wide standards, and market director at London-based software firm, SmartStream Technologies, says: “Fund managers and custodians are yet to be fully persuaded to automate all their flows. The race is on to find appropriate reference data standards which will help to serve the interests of the issuers and end investors, not just the intermediaries.”
He adds that much of the problem could be solved by getting things right at the source of the notification, and for the first time, representation from an association of issuers is included in an RDUG corporate actions working group.
“We are capturing the numbers, involving corporate issuers, slowly, and involving regulators such as the Financial Services Authority. This is very different from what went before, where it has been the intermediaries, and mainly custodians, talking about automation over Swift without the involvement of any of the upstream parties. It’s not easy, but with the right will, it’s at least achievable,” Mr Kirby says.
Time is running out. A survey carried out last April, jointly commissioned by Swift and Smartstream, reported that 51% of the 242 firms that responded expected to put systems in place to automate corporate actions in 12 months. That time is now. In a second Giovannini Group report, also published last April, a two-and-a-half-year timeframe was given for the securities industry to harmonise rules in Europe. This means by the end of 2005, much should have changed to take the risk and the cost out of processing corporate actions.
Building consensus With so much still to be done, the industry is working hard to tackle the challenge. Using a series of working groups consisting of its clients, Euroclear has begun seeking consensus from the five European markets in which it acts as the Central Securities Depository (CSD) to deliver a harmonised solution for all corporate actions, including agreed definitions of the terms to be used for the notification of corporate actions. Michael Kempe, a director in Euroclear’s Business Model and Harmonisation division, says: “While we are trying to harmonise around ISO 15022, the fact is that it does not work for all markets or all users, and we need to address this. We need consistent definitions before we can move forward, and we plan to approach the ISO shortly to try and agree changes with them.” As well as getting everyone using the same definitions, he says consistency in processing is also needed. For example, in the French market, a dividend uses just one date, whereas in the UK, three dates are used. “So, do banks build their back offices around one or three dates? Such changes are fundamental to systems and while market players are willing to invest, they don’t want to have to rewrite everything,” says Mr Kempe.
Euroclear has now published a consultation paper listing the first set of proposed changes that need to be addressed to enable all involved to see the full scale of the problem and start working out a realistic timeline for implementation. Mr Kempe says: “We expect to achieve 85%-95% of corporate-actions harmonisation within the next two to five years with the introduction of our Single Application Platform (SAP). To a certain extent, with five different domestic markets, we may have to accept that 5%-15% of corporate-actions processing may be non-harmonised in the short term. Our experience to date has been that while clients are prepared to accept the complexity of corporate actions, they see the implementation of the SAP as a huge opportunity to reduce the risks of processing, and its one they don’t want to miss. As a result, they are willing to co-operate and willing to make changes to their processes and back offices.”
But with the stakes as high as they are, few brokers, fund managers and custodians have been able to afford to wait until there are agreed standards in place and have been trying to increase automation in the processing of corporate actions for some years, either by building or buying corporate actions systems. Mr Kempe adds: “There has only been so much automation that can be achieved without harmonisation. Many of the systems that have been built to automate corporate actions will have to be re-written once standards and processes are agreed upon across Europe.”
