European Central Bank

As their global operating models evolve, what do investment managers need from their service providers and what can they do to help themselves?

It is a tall order, but buy-side institutions seem to want it all these days. While the global financial industry continues to grapple with increasing regulatory pressure for greater transparency, better management and controls in all aspects of cross-asset class risk, buy-side institutions still want to reduce cost and inefficiency in their trading operations.

At a recent forum for buy-side traders hosted by Bloomberg Tradebook, buy-side executives said that the most important factors in selecting an agency broker are the provision of independent research and trade ideas that keep them abreast of the latest trends. When asked what kind of support they want most from their broker dealers, the group said more information on stocks and the market, followed by a trading desk to work orders and evaluations of the effectiveness of potential tools and algorithms.

Buy-side executives at the forum also said that their future success depends on access to better algorithms, better workflow integration, and better insight and education. In regards to pre- and post-trading tools, the group noted that they rely on transaction costs analysis in real-time and end-of-day reports for additional transparency.

Value adding

Buy-side traders are under intense pressure and expect their agency brokers to add value to the trade, give them high-quality market intelligence and provide innovative technology research and development to help maximise their performance, according to Ray Tierney, president and CEO of Bloomberg Tradebook.

One of the biggest challenges, and the biggest contributor to cutting operational costs, has been automating post-trade operations. Founded 10 years ago, Omgeo now connects 6000 financial services clients around the world and has played a substantial role in lowering operational risk in the securities industry with the provision of trade lifecycle automation.

Omgeo, jointly owned by the DTCC and Thomson Reuters, was formed in 2001 when the US was preparing for a potential move to a settlement cycle of the transaction date plus one day (T+1). While this ambitious plan was subsequently abandoned, Europe is now discussing a move to T+2 in a bid to harmonise the different settlement periods for central securities depositories across the continent, possibly by the end of the second quarter 2013 and in time for the launch of Target2-Securities (T2S), the European Central Bank’s future IT platform for the settlement of almost all bonds and equities that are traded in Europe, slated to go live in 2014.

A shorter settlement period will require higher levels of automation across the industry, as well as securities lending and faster confirmation of trades, perhaps on the same day.

Manual challenge

Tony Freeman, director of industry relations for Europe, the Middle East and Africa at Omgeo, says that while many of the biggest global buy-side firms are highly efficient and can process trade confirmations around the clock – statistics on same-day affirmations published by Omgeo last year showed that 70% of all trades in its central trade management platform finished within three hours – there is still a large segment of the buy-side that is still processing manually. In a shorter settlement cycle environment they are likely to find this type of processing more difficult.

He says: “They are likely to be hit by a double whammy: if, as legislative proposals going through Brussels at the moment suggest, there is a reduced settlement cycle and, higher penalties for failed trades, this manual segment of the market will need to review its processes quite thoroughly to see how it can cope in an increasingly time-constrained and complex market.”

Faxed communications between fund managers and custodians not only prevent successful implementation of a T+2 settlement cycle, they are costly and difficult to sustain with the new reporting requirements coming from regulators for position, risk and liquidity management.

Mr Freeman adds: “I don’t think there are huge barriers to achieving shorter settlement cycles, the technology is available and the biggest issue here is behavioural. Costs tend not to be a huge barrier either as these organisations are often quite sophisticated in terms of trading technology.”

Similar to the backlog crisis in the over-the-counter (OTC) derivatives market a few years ago, Mr Freeman believes the solution is not to be overly prescriptive but instead to mandate certain targets and standards. “The market should have same-day affirmation mandated,” he says. “Transparency in the process is also vital. Regulators need to be collecting information about how fast trades are processed and tracking improvements as we move towards the implementation of T+2.”

While the implementation of T2S will have very little direct impact on the buy-side, it will reduce the timing down to two days from three, and will mean the buy-side will have a much shorter window to instruct their global custodians on the trades they have done.

Custodial role

Scott Dickinson, head of sales asset manager solutions at BNP Paribas Securities Services, says that T2S's desired objectives for the funds industry are positive, such as the harmonisation of fund settlement across Europe, accessing cross-border securities more easily and less expensively, all resulting in increased transaction volumes and harmonisation. However, these objectives are not at the top of asset managers' agendas because they are expecting their custodians to be addressing these issues already.

“That said, as the owners of assets, the buy-side is interested in any initiative that will increase market efficiency and reduce risk and costs. Practically, they are supportive of positive infrastructure changes and are clearly in favour of anything that contributes to a more efficient exchange of assets. They place a great deal of emphasis on straight-through processing to ensure minimal exposure at any point in the settlement cycle,” he says.

Mr Dickinson adds that there is a marked change in what the buy-side is looking for from providers. Today, they only want to deal with providers that have clearly defined strategies to cope with market infrastructure changes and are playing a role in manufacturing solutions to the changes.

Leaner, faster

Simon Hazlitt, information director at Majedie Asset Management, is on the panel at the Swift International Banking Operations Seminar, which discusses buy-side operations and what investment managers want from their providers. As a relatively small fund manager, Mr Hazlitt says it enables the organisation to be leaner and faster than most. According to Mr Hazlitt, 99% of transactions are completely automated and a move to T+2 would not cause any problems.

Much of this is down to the fact that Majedie uses cloud computing and as a result has an unusual set-up of having no IT staff. What began in 2002 as an application service provider strategy is now becoming more mainstream. He says: “One of the great benefits of ‘the cloud’ is connectivity and standardisation, which are the two things that are the critical building blocks of [straight-through processing], and this is achieved at an estimated fifth of the cost of traditional local area network technology. Ironically, some of our largest competitors can be some of the biggest laggards.”

Issues such as the proliferation of trading venues have not caused Majedie problems because getting the right partners through cloud computing has enabled it to piggy-back on some very large organisations, which specialise in providing connectivity. However, Mr Hazlitt does accept that the need to supply information with increased granularity is not without its challenges. He says: “It is also important that there is the ability to roll up granular data into meaningful buckets and even a business as small as Majedie is always struggling to get a single view of its clients. For a large multinational global fund manager this must be a real issue.”

Mr Hazlitt argues that much of the difficulty is down to the lack of standardisation of data, and the way services and costs are described among providers, particularly custodians, which makes it almost impossible to draw comparisons. This is something that Majedie has to tackle in house but would prefer not to have to.

He says: “Typically a client is often held in multiple designations on the custodial system and they will report to you all those designations but there is no sense of an intelligent grouping of those designations into usable information. We are doing this ourselves but it would be a source of great competitive advantage if the custodians could do this as part of their value-added services.”

“The data presented to us is often in a proprietary format... This industry is quite rightly moving away from being fund manager-centric to being client-centric, with the whole move towards managed accounts so that the custodian can no longer consider itself the whole world for the fund manager. We now deal with many different custodians because our clients want to, that can cause problems because they are so very different.”

Mr Hazlitt believes that custodians can no longer treat the provision of reports as being the source of their value. These are commodities and it is the service that they provide around them that adds the value. “Everyone reports in a bespoke way and sees it as their source of value and it is slightly frustrating for us.”

In response to this, BNP Paribas’s Mr Dickinson says that improved technology is helping to ease the strain. He argues that while all providers have their own interpretation of how reporting data should be presented, the technology is available to help fund managers get a single view across multiple custodians.

He says: “With the emergence of more advanced data-processing technology, the role of master-record keeper has grown in importance so while the buy-side is able to diversify its custodial risk by using different global custodians, they can still benefit from consolidated reporting via the master-record keeper function.”

Investor interest

The hedge fund also has changing requirements in light of the need for greater transparency and reporting, according to a new report by State Street, called Hedge Funds: Rebuilding on a New Foundation. The report argues that hedge funds are reinventing business models in response to regulatory changes and investor demands for enhanced fund transparency, liquidity and efficiency. This is because institutional investors, once preoccupied largely with fund performance, now take greater interest in how hedge funds managers operate, choose administrators and provide governance centred on best practice.

George Sullivan, executive vice-president and head of State Street’s alternative investment solutions group, says: “The biggest factor driving what the hedge funds are looking for from their providers is the institutional investor becoming the dominant investor in hedge funds since 2007. Today, about 70% of hedge funds’ assets are dominated by large pension funds and other institutions, and events of 2008 have really raised the radar of the institutional investor. They are doing much more due diligence around hedge fund managers, agents and counterparties.”

According to the report, post-crisis fund selection will emphasise five critical operational and risk management elements: investment strategy and performance, portfolio liquidity, transparency, a reconsideration of pricing and lock-up periods, and operational due diligence.

Clearing concerns

Clearing of OTC instruments is another complex operational issue facing the buy-side, with the need to trade the previously bilaterally traded products on platforms such as swap execution facilities in the US and organised trading facilities in Europe, then clear through a central counterparty clearing house and report to a trade repository.

Mr Sullivan adds that the advent of clearing means that State Street is helping hedge fund managers adapt to the newly emerging market infrastructure, such as the new requirement to electronically track the less automated OTC instruments.

He adds that institutional investors, fund managers and regulators are looking to third-party fund administrators to provide objective risk assessment and reporting in order to manage risk better and achieve greater transparency. Hedge funds began looking to State Street to host middle-office functionalities before 2008 and this trend has simply accelerated since. 

In response to the findings of the report, Mr Sullivan says that State Street is continuing to address operational risk concerns and looking at responding to the challenges that hedge fund managers may have around liquidity, managing risk and the need for transparent reporting. This includes allowing hedge fund managers to drill down into specific detail to assess areas of potential risk.

He says: “We have built this increased disclosure for hedge fund managers so that they can see right down into the individual instruments, as well as the categories, to analyse and ensure the underlying pricing of the instruments is correct.”

Infrastructural change

With the distinct possibility there will be a move to shorter settlement times and the incoming regulatory requirements around OTC instruments, it is clear the buy-side will have to shoulder some of the infrastructural changes and look at ways that it can help itself. BNP Paribas’s Mr Dickinson says that both buy-side and sell-side participants will need to concentrate efforts on operating models that ensure the efficiency of data distribution.

“Given that buy-side firms operate in a world of increasing globalisation, they must process their underlying transactions within required timeframes. This has prompted many asset managers who have global ambitions in terms of clients, to examine their middle-office functionality in order to optimise transaction processing,” he says.


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