Late trading: Stamping it out

Putting an end to late trading of mutual funds -- the scandal that New York State Attorney General Eliot Spitzer famously likened to “betting on the race after the horses have crossed the finish line” -- isn’t as easy as ringing a bell at 4:00 p.m.

In December the Securities and Exchange Commission proposed doing just that: To get the current day’s price, orders had to arrive at a mutual fund, its transfer agent or the National Securities Clearing Corp.'s Fund/SERV clearing system by 4:00 p.m. New York time.

That’s known as a “hard close.” And as the SEC has learned from more than 1,000 comment letters responding to its proposal, virtually the entire securities industry is against it. The most serious complaint: Intermediaries such as brokerages would lose the flexibility to submit fund orders after 4:00 p.m., even if customers placed those orders before the deadline. To aggregate the day’s customer activity, calculate breakpoint discounts and perform other administrative steps, broker-dealers would have to receive customer requests by 2:00 p.m. or earlier.

The brokerage and fund industries are equally united in supporting an alternate approach that the SEC has said it will consider: a time-stamping system that, like a postmark, would reliably indicate when an order was entered. “Orders would be considered locked when time-stamped, and any orders received after 4:00 would be rejected,” explains Fidelity Investments general counsel Eric Roiter.

A bank or brokerage using the time stamp would get the same treatment as a fund or transfer agent. Processing could continue past 4:00 p.m. on transactions certifiably entered beforehand.

Some hurdles, however, would remain. Although time stamps have become ubiquitous in the digital age -- they appear on everything from e-mail to store receipts -- their accuracy is only as good as the person setting the clock. “Every server has a clock, and anybody can go in and change it,” says Thomas Klaff, CEO of Herndon, Virginiabased Surety, a ten-year-old company that is offering a secure time-stamping solution for financial services. Its technology, AbsoluteProof, relies on patented algorithms to keep accurate time and prevent fraud.

Similarly, AuthentiDate, a New York based company that operates the U.S. Postal Service’s electronic postmark system, has told the SEC that its technology is suitable for mutual fund timekeeping. To assure that clocks are in sync, systems like AuthentiDate’s take their signals from the National Institute of Standards and Technology.

But even if the technology is airtight, time-stamping still needs to be regulated.

“The problem isn’t a lack of time stamps -- it’s the lack of an efficient, legally binding, trusted time stamp,” asserts Michael Henry, a partner in the New York capital markets practice of consulting firm Accenture. One option is to designate the National Securities Clearing Corp. as the time-stamping authority, but Henry says, “You don’t necessarily need a centralized body but rather a certain way of time-stamping that everyone accepts.”

Brokerage industry officials are ready to embrace the technology because it buys them time at a bargain price. Charles Schwab & Co. deputy general counsel Koji Felton told the SEC that “many intermediaries, transfer agents and fund companies already have in place the systems necessary to time-stamp orders, so the cost of upgrading those systems should be incremental.” In Schwab’s case, that would be $300,000 to $1 million up front, plus $25,000 to $75,000 annually for audits of the controls. By contrast, Schwab estimates that its fees to the NSCC for a hard close -- to cover the more complex processing and accounting functions -- would add up to $4 million a year.

The NSCC -- a utility that passes its costs on to member institutions -- itself would have to spend $5 million on system enhancements in the first year of a hard-close regime. But the organization’s chief, Ann Bergin, offered this piece of advice at a Senate Banking Committee hearing in March: “The flexibility of the current system could be retained” through decentralized time-stamping. “That would leave the responsibility for time-stamping at the intermediary level -- with the addition of new safeguards to prevent late-trading abuses.”

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