Contracting for STP in the Multi-vendor Environment
In July 2005, the Counterparty Risk Management Policy Group called on investment banks and hedge funds to tighten up back office processes and improve counterparty communications and risk management practices in the OTC derivatives markets. Almost simultaneously, the US-based Asset Managers Forum published their 17 best-practice recommendations for improving straight-through processing in OTC derivatives.
The recommendations from the two groups overlap considerably and highlight both the growth in the spread of financial products and the need for urgent action to automate the back-office trade settlement procedures. So once again the Holy Grail to achieve straight through processing has been highlighted. STP is becoming more of a possibility through new real-time order execution technology. But what actually is STP and how should such functionality be purchased?
STP is the potential solution to the risks raised by the competing desires to automate trading, avoid fraud and transact the largest number of trades in the quickest time.
With the growing popularity of alternative means to execute trades, broker/dealers face the challenge of retaining business. As such, the financial community is developing new products to build upon their traditional fare. Using technology to increase connectivity to market utilities and market data via FIX capabilities, as well as through business operations such as outsourced clearing and settlement services, organisations can leverage the industry-wide moves towards increased disintermediation leading to pure STP.
Straight through processing technology is being used to compress the trade settlement cycle, while at the same time striving to increase efficiency through increased automation. This requires work within an organisation to tie disparate systems together and bring the operation up to real-time status as well as external links to improve data flow both pre and post-trade, as well as among counterparties, clearing agents and custody providers.
STP is the automated processing of security transactions between broker/dealers and investment/fund managers. A virtual matching utility (VMU), a middleware application, matches the demands of investment/fund managers with the availability of stock held by brokers/dealers and conducts the whole transaction without any manual intervention by the parties.
For true STP success, four types of standards are required:
At an international level, the ISO (principally Working Group 11) has been striving to implement ISO 15022 in order to harmonise the disparate standards landscape. In practice this means that a broker/dealer can poll the available best prices as between its own position, a retail service provider on a private exchange or a stock exchange itself. Order routing occurs between brokers to connect to different markets or between brokers and an exchange, the orders being (literally) routed between the various systems.
This all means that straight through processing itself is the concept whereby all the various players in the exchange market are linked and a deal is done without intervention. A deal being done automatically without human intervention raises a number of issues such as knowing the identity of the party with whom you are dealing, the possibility of fraud, specification of identity, denial of service issues and encryption technology. Speed of transaction is another factor.
Network service providers sell STP services to retail service providers. It is important to look to the terms offered by such network service providers, as they seem to have several things in common. A key issue, common to these terms is that the service is offered on an ‘as is’ basis. i.e. the seller of the service is making no representations as to its usefulness or to its performance or functionality and in fact is disclaiming all liability from the service altogether. This is an interesting perspective on service provision and reflects the market dominance of the network service providers such that they are able to insist upon such terms.
So, given that the providers of STP services may enjoy a unique position of leverage, when contracting for STP there are a number of key issues to keep in mind. Firstly, do you need a contract at all? Given the fact that the supplier may disclaim all liability, is there any point in entering into a written contract? Clearly contracts can be entered into by performance and activity without ever being written down but in order to avoid the uncertainty of implied terms it is best to enter into an express contract to realign the implied term liabilities as between the parties. So while this may be a valid consideration when faced with seemingly non-negotiable terms, it is likely that you will conclude that your risk and liabilities would be best minimised by contractual terms. The following is intended as a checklist of the most important issues to consider in any STP contract:
Each participant is responsible for ensuring that the party’s data that they record is correct. The investment/fund manager and the broker/dealer will have primary responsibility for ensuring that the respective parties to any transaction have been identified and their details recorded. This runs concurrent with money laundering obligations under the FSA.
The apportionment of liability is a core issue. In an increasingly automated system where there is less opportunity for human supervision, who is liable in the event of error, omission or fraud? The responsibility will shift to technology providers with new obligations to guarantee the performance of the software, but equally, providers or resellers will wish to position themselves as a conduit for the underlying trade, escaping liability themselves. As such the risk could pass back to the contracting parties, very much on a ‘take it or leave it’ basis.
Pinpointing the exact time at which a binding contract is concluded, where such a contract is concluded electronically, can be tricky. Is the sub-custodian deemed to have received the global custodian’s instruction or is the global custodian merely an agent passing on the instruction of the manager. The enactment of the Contract (Rights of Third Parties) Act 1999 in the UK introduces a new dimension to this: unless specifically excluded, the Act allows third parties who stand to benefit from the performance of a contract to enforce that contract themselves, turning the chain of relationships into a web.
It may be that you are unable to negotiate the terms offered (depending upon your negotiation strength and position). In such a case the Unfair Contracts Terms Act 1977 may apply. Section 3 of UCTA will apply if a seller of STP services contracts on its own written standard terms of business or the buyer acts as a consumer. If section 3 applies, section 7(3) provides that any exclusion or restriction of liability must be reasonable. While this may be a useful protection if the contract is made under English law, it may be that (in order to buy the relevant STP technology) a buyer has to contract under the law of another country (the US in many cases). In such instances UCTA will not help.
Case law has held that section 3 of UCTA only provides limited protection rather than total prohibition of exclusion clauses. As such, an organisation obtaining STP/middleware services by contract which offers the service on an ‘as is’ basis will not be able to close its eyes to the risks of system failure. It seems that ‘as is’ clauses may be held as being reasonable in such contracts.
Security is a key issue in an STP contract, security of data and the principles of the Data Protection Act 1998 will be very important. Equally confidentiality will be of huge importance and the buyer will want to know the conditions for access into the STP provider’s system.
Reliability and warranties will be key and will dovetail into questions of level of service themselves. The question to ask will be what constitutes acceptable downtime? All systems require a certain period to be maintained and monitored and this may be unproblematic for the buyer provided that he knows in advance.
In terms of maintenance it will be critical to establish what is in and what is without the scope of maintenance services being offered. For example are proactive services included? It will also be key to establish at what point the maintenance agreement commences and whether that is immediately or at the end of some warranty period.
In conclusion, a successful technology transaction is directly proportional to the amount of preparation, diligence and attention to detail. The commercial and legal interests in securing STP (or other) technology are inextricably linked which means that there is no one size fits all, no one model contract. Careful consideration of the risks and rewards offered by the contract terms applicable to the technology will be essential to the success of the transaction.