MARKET CONGESTION

What the boys in the backroom cost the citizen capitalist

ROBERT APFEL

finance is very much like the trucking business. When you strip away the pin- striped suits, neo-classical columns and an attempted air of sophistication, one discov- ers that finance, in a nutshell, consists of moving money from gents who have it to those who need it. A stock exchange, or dealer market, can be compared to a highway system over which the goods (i.e. money) flow from investors to borrowers and back again.

Like any trucking enterprise, finance relies upon the efficient and cost-effective movement of traffic between borrowers, lenders and intermediaries, if it is to serve the needs of each capably.

Unfortunately, the UK equities market- place is badly snarled in one of the worst traffic jams in its history. The City is sinking in a sea of paperwork attributable to a three-fold increase in the volume of transactions since last October. There aren't enough clerks on hand to process all the paper. Settlement staffs routinely work 60 hours a week at many firms. The problems are likely to get worse as indi- vidual investors enter the market to trade their shares in privatised companies and as foreigners flock to Britain's shores. The City is heading in the direction of a '1968 Wall Street paperwork crunch' of the type which brought New York to its knees and forced the periodic closure of the New York Stock Exchange.

The large corporate issuers of stock, such as Rolls-Royce, British Gas, Telecom and TSB, are in a difficult position as the market's problems mount. While they sup- ported Mrs Thatcher's concept of parti- cipation by the people in their offerings, these corporations are now experiencing high costs for servicing the needs of their millions of investors, including processing certificates, posting dividend cheques, annual reports, tax vouchers, and the like. These costs run in the range of £5 to £10 a year for each investor. Some corporate officers have been quoted as saying that they wish that many of their small investors would just go away. The problem faced by dealers and cor- porations can be traced to the failure of financial market leaders to prepare their nation's operational systems for the tremendous growth in trading volumes and numbers of market participants.

Today's markets were originally de- signed to service a 'carriage trade' compris- ing a small number of wealthy individuals and institutions. In keeping with its archaic roots, the market still relies on the physical movement of engraved certificates each time a bargain is made, much as was the case 200 years ago, before the age of the telephone, aeroplane or computer.

While the 'front office' dealing world has, of late, been modernised through the introduction of the Stock Exchange's new automated quotation and trading system, SEAQ, and the construction of expensive new dealing floors by brokerage firms, the back offices of the dealer firms are still functioning much as they did centuries ago. Armies of clerks can be seen counting, sorting, logging and authenticating colour- ful, engraved certificates which are trans- ported by messengers throughout the City.

Remarkably, a Stock Exchange manage- ment strapped for resources chose several years ago to proceed with the expensive SEAQ system in time for the Big Bang while deferring, for several years, the implementation of new computerised back-office systems. Hence, for the next several years, dealers will be able to race into bargains at the speed of light through their SEAQ terminals, but will have to wait for engraved certificates to follow by hand, to consummate their bargains.

While old-fashioned paper-based approaches may have served the carriage trade well, they are totally out of place today. Transaction costs now run in the range of £100 a trade. A cost of this size would be trivial in relation to a commission on a large block trade undertaken before the Big Bang. However, a broker could simply not afford to do a small retail trade today for a £25 commission when back-

office costs are four times that figure. Rather than lose money on small trades, many dealers are getting out of the retail market. If many more adopt this plan, Mrs Thatcher's citizen capitalists may have a tough time finding a dealer when they want to sell their 100 shares of Telecom.

If the markets are to serve the needs of small investors and the high trading volumes efficiently, after the Big Bang, dealers and issuers will need to become more savvy to the operational side of their business. For a start, they have to stop trucking certificates around from customer to customer. Instead, to serve the mass market, they need to use modern auto- mated techniques, such as computerised customer record-keeping, as is used for bank accounts today. Brokers would keep records of their customers' securities and provide semi-annual or quarterly state- ments. This would cut transaction costs to less than £5 a piece from £100 today. The savings to the UK financial industry would be over £200 million a year.

These changes may not be very far away. The Government's new PEP plans are forcing banks and brokers into the modern age thanks to their requirements that securities be held in book-entry form by firms on the behalf of their customers. Unfortunately, it is going to take some effort by issuers and bankers to learn how to use these systems to full advantage.

A case in point was the recent Rolls- Royce offering. Despite the presence of efficient automated PEP accounts, inves- tors who bought into the offering will have to obtain physical allotment letters or certificates, and go through a lot of expen- sive paperwork before the shares can be deposited into a PEP plan. Perhaps, one of these days, advisers on new offerings like Rolls-Royce's will awake to the fact that PEP plans exist, and they'll design a more efficient way of offering securities into this modern marketplace.

Automation and cost-efficiencies in the hack-office side of the City are inevitable. The important questions are, when will these important improvements arrive, and who will lead the introduction of these changes? We will be watching with in- terest.

Robert Apfel heads his own consultancy in New York, specialising in financial and securities systems.