Post-trade, post-crisis: Smoothing the curve

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In today's volatile markets, where speed and timely settlement information is critical, failed settlements are not only costly, but can negatively damage a firm's reputation and its counterparty relationships. As a result, some banks are now starting to look to transaction processing as a point of competitive differentiation. While industry adoption of standards is vastly improving straight-through processing rates, the industry remains alarmingly reliant on fax-based transactions at a time when regulators are insisting on more detailed, real-time information. In a cash-strapped industry where the true cost of a trade remains opaque, addressing the issue of cost and justifying IT expenditure remains a challenge.

The panel

Michelle Price - Business editor, The Banker and panel chair

Damian Atkinson - UK CIO, ING Commercial Bank

Arun Aggarwal - Managing director for the UK, Ireland and Nordics, Swift

Mark Husler - Head of business development, London Stock Exchange Group

Andrew Mullock - CIO, BNP Paribas in London

Philippe Chambadal - CEO, Smartstream

It is widely accepted that some 80% of the costs found in the back offices of large banks are associated with fixing broken trades. A recent study carried out by industry standards body Swift into the cost of failed transactions for cross-border payments and transactions found that about €21bn annually is wasted due to an industry-wide lack of automation. Although this is a long-standing problem, the trading and liquidity difficulties of the past 18 months have served as a poignant reminder to the industry that trade processes are only as strong as their weakest link. And in the post-trade environment, many weak links remain: the persistent use of faxes for confirmations between the back offices of buy-side firms and banks, for example, is more prevalent than many would care to admit - not just for complex over-the-counter (OTC) derivatives but for mature markets such as equities.

Mark Husler, head of business development at London Stock Exchange (LSE) Group, said that although LSE on-book transactions are relatively automated, the exchange's recent discussions with firms regarding the process of confirming trades with their buy-side clients have highlighted some major inefficiencies. "Confirming trades should be a relatively straightforward exercise, but there is somewhere upwards of half a million equity transactions being faxed each month over to European buy-side counterparties just from one large broker that we're speaking to. That's an enormous cost for brokers and with no positive affirmation coming back to them from the buy-side," he said. "It is not going to be long before the regulators really start to look at the associated risks."

Evidently the industry has a long way to go before faxes are eliminated from the back office. To a large extent, however, this reflects the global nature of the business. ING Commercial Bank only recently switched off its telex machines, Damian Atkinson, UK CIO for ING Commercial Bank, told the panel. However, this is not a reflection on the bank, but on the global nature of its clients and counterparties: a large barrier to the elimination of outdated technology is the lack of infrastructure in less mature markets, he said. "You've still got to operate in that local market the way they do. The infrastructure isn't always there yet to enable you to kill the fax."

Among some key players, however, headway is being made. To a large extent panellists agreed that the industry has no choice: the need for more timely and accurate confirmations is not going to go away. For BNP Paribas (BNPP), the centralisation of post-trade processing IT infrastructure has played a large role in achieving greater efficiency, Andrew Mullock, CIO for BNPP in London, explained: "We centralise as much processing as we can and keep to a minimum that required locally because of different requirements in the different countries. We're constantly looking to improve levels of automation, partly from a cost-base perspective, but also from a control point of view. Once your automated processing works, it rarely goes wrong.

"That is the way we've evolved and I think this has been pretty much in line with the way the regulators have been moving over the past few years," he added.

Finding a common language

The biggest breakthrough in the back-office environment so far and, more importantly, the only way forward for the industry globally, is the adoption and greater use of standards, agreed the panellists. "The solution is a combination of standards and automation, especially when you're talking cross-border. Cross-border, by definition, is more complicated because of the different jurisdictions and languages. So you need some common language," said Arun Aggarwal, managing director for the UK, Ireland and Nordics at Swift. Additionally, the use of industry-shared solutions, such as the LSE's UnaVista trade confirmation portal, which can help eradicate duplicated middle-office costs and help regulators manage risk, will play an important role.

Another key pain point is reference data, said panellists. Following the European Commission's introduction of the Markets in Financial Instruments Directive (MiFID), transaction reporting was rolled out across Europe, which for some countries, such as the UK, was already fairly standardised. However, for other European countries it was a relatively new concept, forcing a significant IT and trade processing transformation.

According to Mr Husler, reference data accounts for 70% of the individual data items that make up a trade, yet there remain several major challenges regarding managing this data information. As the national numbering agency in the UK, the LSE allocates the international securities identification number (ISIN) and stock exchange daily official list (Sedol) codes, he explained. Yet each financial institution takes in the data in a different way, matches it separately, appoints a specific commercial vendor and generally operates to different standards.

"As a consequence, there's no central way of actually managing this information so even if firms improve their efficiency in house, when they trade with counterparties there's still that systemic risk that the same thing is interpreted differently," said Mr Husler. "So when you look at regulators in light of transaction reporting, it is a very important role that they play in demanding the data in a timely fashion. But unfortunately, there are still a lot of transaction-reporting errors as a result of basic reference data attributes being incorrect. In my opinion, until this is managed as an industry-wide solution, regulatory change alone will ultimately not improve this fundamental data quality issue."

But by bringing together commonality and harmonisation through reporting requirements, particularly from a European perspective, the regulators are moving the industry forward, said Mr Aggarwal. Where fragmentation does exist, the use of standards is beginning to bind the industry together. To this extent, he added, the regulators play an important role in levelling the playing field "so that when you're sticking your neck out in terms of adopting the new standards, you are not literally sticking your neck out, you know everybody's with you. The levelling of the playing field allows the whole industry to move forward. If you don't have that, you lapse back into the lowest common denominator," he said.

Get real

The extraordinary divergence of transaction timeframes between the front and back office has always been a hotly contested issue in the financial services industry and a deep concern for regulators. The financial crisis simply exacerbated it. While market risk is tackled with hyper-speed real-time trading systems in the front office, operational risk is generated in the back office by three-day, or even next-day, settlement. In the foreign exchange market, the realisation that settlement could take up to 10 days spurred the creation of continuous linked settlement and the huge losses that came to light during the credit crunch has spurred an even greater regulatory focus on liquidity risk and the need to narrow, or close, the front-to-back timeframe differential.

For BNPP's Mr Mullock, this issue is not being driven by the regulators alone, but primarily by the state of operational play that the bank is striving to achieve. To reach this goal, he told panellists, the same reference data must be used for confirmations and settlements across the organisation. "If you have common reference data within your organisation, that makes it easy to see what's happening in real time. When you've got to map and translate the same information through multiple different standards to find out what it is - that actually makes it very, very difficult to do anything in real time," he said. However, he warned, losing the time lapses and settling in real time, or near real-time, could create a new level of risk.

Pulling the back office into real time, often regarded as an operational nirvana, would be an enormous task. The reality is that the incoming liquidity risk requirements from the regulators, in particular those unveiled in recent months by the UK's Financial Services Authority, will demand a certain level of intra-day position management, requiring near to real-time settlement information.

Mr Husler said: "To make such a change, to have common data used by every firm with real-time views of the firm's positions, would be a nirvana solution. To move along that journey and deliver this real-time world would probably require our industry to stop and take a step back and maybe a year out - not that we can do that - and make an industry-wide investment. I personally don't think it will happen."

Competitive differentiation

As products become more commoditised, however, there is a possibility that the move to intra-day and near real-time post-trade processing will become regarded by the banks as a point of competitive differentiation. This may even prompt a new technology race in the back office, where banks strive to process faster than their competitors, said Mr Mullock. "I think there is competitive advantage that can come through processing now and I think there is naturally a simplification of products that the banks are offering to clients and you have to differentiate somehow. Processing and level of service will become more important once it is considered to be more of a competitive advantage rather than a utility: then we will get the focus and the investment," he said.

New liquidity-risk regulations will be an industry-wide requirement across all banks. But the problem for the sell-side is, and will always be, that it has to bring the buy-side with it. As Philippe Chambadal, CEO of Smartstream, said: "You can spend billions of dollars fixing your problems but you're only as good as your counterparty." In some instances, hedge funds are starting to calibrate their allocations depending upon the capability of banks' post-trade functions, he said, which proves the case that the back office can serve as a point of differentiation. But, he added, the imbalances between the IT and staffing in buy and sell-side back offices will always exist unless a greater use of outsourcing is employed to cost-effectively and quickly bring the industry up to speed by raising the lowest common denominator.

The way ahead

According to ING's Mr Atkinson, the way forward for the back office is not completely clear yet. He told panellists that industry standards must bed down and coalesce, and there needs to be a little more commoditisation across back-office processes globally before the next generation of back-office technology can be developed. But for Mr Chambadal, there is still a lot that can be done now to raise the level of straight-through processing in the industry. "There is still a lot of room to improve the rates. You have about 16% of trade breaks and the cost, and the waste, at the industry level is enormous. If we can streamline the whole process by helping with the creation of standards for managing reference and counterparty data and managing trade-process management, there are still enormous sums to be saved," he said.

Swift's Mr Aggarwal agreed that technology will play a key role in moving the back office forward and bringing both sides of the trade confirmation up to the same levels of automation. A combination of outsourcing, the availability of software as a shared service and the more widespread adoption of cloud computing will mean that firms no longer need to staff extensive back offices or run large data centres to keep up with the industry. Once the standards are defined, he added, processing capability can be bought where it is lacking. "To get a community to work together to define a standard is a big task and then the issue is forcing that adoption through. The regulators play a role here in terms of levelling the playing field - and then making it easy is a combination of technology facilities and services that are available in the marketplace."

Ultimately, however, budgets have historically tended to favour the front office, and commercial and central factors will be the true drivers of change according to BNPP's Mr Mullock. "The only hard driver of change in the middle and the back-office world is when you have volume constraints or control constraints. Cost does drive change, but not as much as control or volumes. If you can do it but it is expensive, it still tends to get done. The issue is if you can't do it or there are unacceptable controls, then people say, 'right we need to change this area'," he said.

Mr Aggarwal too believes that change is coming to the back office and that the traditional view of the back office is shifting due to the recent events and new regulatory focus. In the current climate, he said, the period of front-office product innovation has come to a halt and the focus is very much on operational excellence, a trend that will benefit the post-trade process. Mr Mullock agreed that this is already happening and that the shift to simpler products in the current climate is already driving banks to compete on service, which means being slicker operationally with fewer errors and faster confirmations and allocations services.

The true cost

During the past three years, there has been a lot of debate regarding driving down the cost of processing trades through greater automation and of gaining efficiency in whittling down the true end-to-end cost of a trade. But as Mr Chambadal said, there is no real benchmark or ranking system for calculating the end-to-end cost of a trade so that a valid comparison across firms can be made. The studies that exist have tended to survey a certain number of banks and firms, so they can only be used as a guide rather than an actual ranking system.

Mr Mullock summed up the difficulties in creating such a standard: "I think it is something we have to keep trying to do, because if you get it right, it is hugely beneficial, but comparing cost is so hard because it seems too impossible to determine what's included in that cost. Is the cost of your premises included? Is your power cost included? You've got your data centre in New Jersey processing your trades in Tokyo - where do you put these costs? And depending on where you put them, where do the competition put them? And you suddenly just get a bunch of numbers that are sort-of interesting but can't really tell you whether you are efficient or not."

Regardless of how far banks are able to simplify the calculation, each institution will always come up with a different answer, added Mr Atkinson. However, the front office has become increasingly interested in back-office operations, he said, which is now starting to be reflected in the profit and loss figures.

The more important question for the industry, said LSE's Mr Husler, is the bigger picture: taking days out of the settlement process has to be a top priority alongside the race to execute trades in micro-seconds.

Moving out

It seems clear that a complete rethink is necessary regarding the operational capability and related cost structure of the back-office environment. A dramatic structural change is required if the back office is to keep pace with the speed of industry change at large - including growing volumes and increasing regulatory oversight. For SmartStream's Mr Chambadal, the only way the industry can move forward at such a pace is through the use of outsourcing and industry-led, centralised utilities, meaning that banks stop duplicating their efforts and instead compete on the products and services that matter.

"In the back office, there are certain aspects and business processes that are critical to the firm, unique and very high value-add, and these should stay inside and the rest should be outside. Some processes and some data should be completely commoditised and managed outside the firm because it does not give you any competitive edge managing it in house. So the question is, what do the banks deem as absolutely critical, must-have in house, versus what should be inside, or what could be outside as a utility service?" Mr Chambadal asked the panel.

Decisions on these critical issues must be tackled sooner rather than later. There is already talk of regulators mandating such a repository if a commercial solution is not found. For over-the-counter derivatives, the European Commission will legislate reporting to trade repositories next year, for example. Ultimately, however, the commercial aspects of inefficiency will likely force the greatest change.

The issues

- outdated trade confirmation technology

- developing cross-border standardisation

- improving transaction timeframes

- competitive differentiation

- rethinking cost efficiency

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