Philippe Chambadal, CEO of middle- and back-office processing technology provider SmartStream, explains why banks need to pay more attention to asset protection and the separation of client money.

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Q: Let's get the basics out of the way first. When we talk about client money and asset protection, what do you actually mean by that, and why is it important?

A: It is very important, both for the banks and their clients. The concept is to have a proper segregation of the client money [from the institutions] as specified by the UK Financial Services Authority [FSA] as well as the Commodity Futures Trading Commission  in the US and other regulators, so that overnight the client knows that there is protection on their funds, and that there is no inappropriate co-mingling of their funds with those of other clients or with the bank’s own funds.

Q: Why is this a topical issue at the moment?

A: Obviously the issues with MF Global [which filed for bankruptcy in October] have highlighted the fact that, while some of its clients had thought that their funds were protected, in fact they were not, because the money was not properly segregated from the accounts of the firm.

Q: What kind of regulatory consequences could this have for banks?

A: There has been a very visible set of fines up to $50m with large institutions who have had to pay massive fines over the past 12 to 18 months, so the FSA has been cracking down on the financial firms in the UK, but the US and other regulators are also getting people to pay attention to it. The FSA has also mandated that the firms should hire consulting and auditing firms to make sure that they are in compliance, which is another serious cost of compliance.

Q: So this could be a serious internal issue for the banks?

A: It is an internal issue for the banks, but it is also a question of reputational risk and actual protection of their clients’ interests.

Q: At the moment there are so many regulatory and technology demands on bank budgets, could this run the risk of slipping under the radar?

A: The fines are there for people to be taken seriously, and the FSA has also mandated, as part of its Client Money and Asset Return (CMAR) effort, that a nominated senior management member must be personally responsible within the financial institution for implementing a proper solution. That name is then published on FSA’s website, so [the FSA] are really pushing very hard. The fines are one aspect, and auditing costs are another, but I think more importantly clients can no longer simply trust that the bank is taking the management of their funds seriously.

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Q: How does that play into the broader operational risk landscape?

A: The crisis highlighted the fact that the back office is really the last mile of weak automation or non-automation in Wall Street. You see, in very large firms, tens of thousands of people in the back office, but if we had been in a straight-through-processing world, most of these people would be handling investigations rather than doing exception management by hand. We believe that to get proper operational risk control the banks need to agree to move away from legacy systems, have proper real-time cash management tools in place, proper management of the transactions, and proper management of the debt in the first place, to get through to the proper control of operational risk, which today is still lacking in the marketplace. 

Banks are now really investing more in the back office than the front office in the past few years to compensate for the underinvestment over the past 10 to 15 years.

Q: We've had fines, and hopefully that should mean some of the financial institutions actually get their act together, but do you see the regulations actually evolving from here?

A: The regulators are, again, very serious about the topic and they are acting locally and internationally, and starting to work together. We see the US regulators, for example, and the regulators in Singapore and Japan, acting to get the banks in order, to have real-time cash management.

It is really not acceptable that if someone were to go to a bank and ask what its cash position is, that the answer will be ‘we’ll tell you tomorrow morning at 10am’. That is not something that is a viable model, so the regulators are really pushing hard on the banks, across all geographies, in all the major markets.

Q: We've covered some of these things already, but what, in an ideal world, should financial institutions be doing and what, from an operational standpoint, would that look like?

A: We see our clients structuring the trades or the size of the trades according to how good the back office is or how efficient the back office of the counterpart is, and that is the essence of the problem. You’re only as good as your counterpart’s back office, so you can have 50,000 players out there, and the weakest link will break the trade. 

So what we’re suggesting is that a lot of the back-office services should move to a shared service model or a managed service model – call it a ‘cloud computing’ offering if you like – where the non-core, non-
 specific services such as management reference data, management co-productions, management of the trade reconciliation and trade break process should be moved outside the back office and be in the middle of the trade, be in the middle of the prime broker and the hedge funds, the custodians and their clients, and the brokers and their clients. If you do that then you can create efficiency across the whole cycle, which you couldn’t achieve internally.

Q: How much appetite do you think there is among the banks to actually make that happen?

A: There is a huge appetite. We have seen it with our own service offerings, which have gained an increasing uptake over the past 18 months. We have seen that throughout Europe, where there have been, for many years, outsourced back-office service providers. You have obviously the same thing in the US and Canada, but we are seeing a new generation of services being created to create efficiency across the sale cycle, so the appetite is there. 

It is not going to be a case of moving the entire back office of a very large bank to an external resource, but instead having end services in the middle and back office and they’re going to move one at a time. Or there will be a set of services moving out between the banks, and to banks and their clients, and that’s happening already.

Q: So there is definitely a gradual movement in that direction?

A: It is actually happening very quickly. We thought before the crisis there was a need to do that, but as I said, I think the crisis reinforced the fact that non-core functions such as reference data management or coming up with a proper closing price for IBM’s stock price, is nothing unique. What you want is to have the same stock price as everybody else, so why does every firm have to do that many times over and across 10 or 11 data management solutions? I think it’s really asking for a strong move to a managed service model where having proper data management and shared back-office operations makes all the sense in the world. 

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