Trades On Time

Late trading of mutual funds after the market's close, which violates the mandate that all shareholders in a fund be treated equally, made its way into the annals of business scandals last year. Suggestions for combatting the practice include a hard cutoff of 4 p.m. for trades to arrive at mutual funds, enhancements to clearance and settlement systems, and greater transparency between mutual funds and intermediaries. No matter the solution, one thing is guaranteed: Technology is a vital weapon in enabling Wall Street to win its battle against late trading.

The proposal from the Securities and Exchange Commission for a 4 p.m. deadline would create both challenges and opportunities for third-party intermediaries, such as broker/dealers and financial advisers, which handle the majority of shareholder investments, as well as the National Securities Clearing Corp., which clears and settles many trades. Kevin McGovern, VP of Rydex Funds' transfer agency, says the fund receives direct trades by 4 p.m. each day, but a stopover at the NSCC can create about a 2-1/2-hour delay, which he estimates affects nearly 70% of the fund's trading volumes. The potential delay from the NSCC and slow back-office processing technologies at some broker/dealers mean they may need to cut off trades even earlier in order to get transactions out the door in time to meet the deadline, he says.

Agile back-office processing technology at broker/dealers may soon be a competitive factor when investors choose mutual funds, says Joanna Haigney, VP of compliance at Rydex Funds. "It puts a lot of pressure on back-of-house processing, such as the speed with which you can gather data, conduct processes, and feel that it's accurate," she says.

Another issue with a hard 4 p.m. cutoff is the reality of exceptions processing, cautions Gene Kim, a senior analyst at Financial Insights, a technology-research firm for the financial industry. "Often, there can be errors in processing or at the point of sale," he says, citing the possibility of a technology failure or miscommunication. These errors, he says, can go undetected for hours or days, and adjustments must then be made at every point in the workflow. "There are all sorts of issues around 'as of' pricing, but it has to be allowed for and done because there can be breaks in systems," Kim says. "Exceptions will have to be documented clearly, with detail to the nth degree as to why they need to go through."

In a response to the SEC's proposal for a hard cutoff at 4 p.m., the NSCC issued a statement saying there were "various processing solutions we might be capable of offering through enhancements to our NSCC subsidiary's Fund/Serv processing system." The NSCC, which processed 83 million mutual-fund transactions through its Fund/Serv platform in 2002, offers multiple alternatives for processing orders, ranging from batch to real-time processing. The statement suggests a possible time stamp-verification process that could indicate when the Fund/Serv system receives each file order. The NSCC says it's too early to comment further on the issue.

While a 4 p.m. hard close may be difficult to implement, and the role a clearing and settling system would take has yet to be determined, there are other options. Many agree that stringent time stamps at every leg of the workflow would be an effective method for policing the timeliness of trades. Brian Graff, executive director for the American Society of Pension Actuaries, along with others in the industry, has called for strict time-stamping procedures at various points along the cycle. "Each of these systems date- and time-stamp every trade, which would allow independent parties, including the SEC, to easily verify the timeliness of any trades," he said in a November comment letter to the SEC.

While most systems already have time stamps, they've been manipulated or ignored, says Financial Insights' Kim. "Every broker/dealer generally time-stamps orders, if for nothing else than from a customer-management point of view as to when they placed that order," he says.

"The real issue is, are the existing requirements being enforced?" says former SEC chairman Harvey Pitt. Frequent compliance inspections and independent audits at mutual funds, as well as tougher enforcement actions when problems are found, are more effective ways to police the issue than drumming up new regulations, he says.

However, with regulation at some level likely as early as this month or next, Pitt suggests taking a proactive approach. "Funds have to do what brokerage firms have done with great success: develop sophisticated risk-assessment capacities," he says. If you worry about what could go wrong, he says, "you can save a tremendous amount of grief."

While risk analysis is vital, Rydex's Haigney stresses establishing a compliance culture. The SEC "doesn't just want to see the policies; they want to see how they are being followed," she says. "If you're not taking a proactive approach, you'll have a rude awakening when the SEC comes."