Background and aims

When individual investors invest in equities, they typically place an order themselves through a securities company. The equity and cash settlement processes are usually decided in advance between the investor and the securities company, and at no stage is there any requirement to complete hundreds or even thousands of orders in a single day. Accordingly, once a trade is executed and the investor receives a trade report, there is no need to reconcile the settlement conditions for each trade, and settlement can proceed according to the agreed conditions. (See chart 1)

However, in the case of trades by institutional investors, investors’ functions are segmented and complicated;it is rare that one person can handle a trade from order to settlement in the same manner as an individual investor, and the number of trades is also far greater. This is shown in the following diagrams 2 and 3, using the example of trading by a pension fund.

Pension funds are managed and invested in various ways. One commonly used method of investing the fund’s money is via a specified money trust. In a specified money trust, the customer (the pension fund) does not usually make investment decisions; instead, the fund entrusts its assets to a trust bank, and entrusts management of its asset to an investment advisory company. An investment advisory company may manage the assets of various pension funds, and will typically place an order with a securities company on behalf of multiple customers (pension funds) simultaneously. The securities company executes the order and then informs the investment advisory company of the results of the trade, whereupon the investment advisory company divides up (allocates) the executed portion of the trade among its customers’ accounts (or funds). (In some cases, the securities company carries out the allocation.)

When the securities company places the order with the exchange, the executed prices may split up. In Europe and the U.S. it is general practice to report these trades by using the average price; in Japan, however, this allocation process is very complicated, as execution prices in Japan were not reported as the average price until July 2003 (*). In either case, when the allocation is completed, the securities company prepares a trade report based on the trade results and issues it to the trust bank, where the pension fund assets are entrusted. Since the pension fund may not have entrusted their assets to the same trust bank, the trade report is sent to each trust bank involved. Next, the securities company and the trust banks confirm the settlement details for each fund. This series of steps is known as “matching.”

As such, settling trades by institutional investors necessitates a complex process for each trade, or to be more precise, for each fund. In Japan, however, almost all steps in this process have commonly been performed manually, involving faxes and telephone calls. Checking each step in this non-electronic system is inefficient and costly; moreover, there is the constant risk of human error.

How is this checking process performed overseas? In the U.S., the DTCC (Depository Trust & Clearing Corporation) and Thomson Reuters set up a joint venture called OMGEO, which provides a computer-networked service to process every step, from post-trade matching to settlement instruction matching.

PSMS is necessary from the viewpoint of reducing settlement risk.

The G30 recommendations on securities settlement systems and the amended recommendations of the International Securities Services Association (ISSA) make nine proposals on ways to improve securities settlement systems. One of these is the use of Delivery Versus Payment (DVP), or “simultaneous, final, irrevocable and immediately available exchange of securities and cash on a continuous basis throughout the day.” In the DVP settlement process, both the receiver and the deliverer of securities and cash send settlement instructions. If these two sets of instructions do not match, the settlement is immediately nullified. This is why the pre-matching of settlement instruction data is so important.