In a Q&A, Celent analyst Scott Sullivan helps sort out the reasons why the protocol needs to reach beyond the front office.

(Editor’s Note: This is the first in a two-part series about the FIX electronic trading and messaging protocol and the FIX Protocol Ltd.’s efforts to expand the reach of FIX into the realm of post-trade processing. FTF News recently spoke to Scott Sullivan, Senior Analyst, Securities & Investments Group, for market research firm Celent about the reasons behind the expansion of a protocol so closely identified with the front office. The second part in this series will focus on the concerns of buy-side and sell-side firms as they embrace FIX for post-trade operations.)

What is your impression of what is being proposed—FIX for post-trade processing?

I think what’s particularly driving a push is not only from FIX, but a push for pre- to post-trade integration in time for the regulations that are coming such as Dodd- Frank connectivity to new market infrastructures such as CCPs [central counterparty clearing houses] and Basel III’s capital charges. For the latter, Europe has adopted Basel II and II-and-a-half, but the United States is going from Basel 0 to III. We didn’t do any of these stops in between.

The biggest effect Basel III will have for the sell side is that … anything they keep on their books they’re going to experience huge capital charges. The use of their balance sheet is going to be difficult going forward.

What Basel III is doing is forcing banks to basically mark to market their derivative portfolios. This is for everybody. Nobody is risk free whether it’s Fidelity, a small asset management firm, Bridgewater Capital or one of the largest funds in the world, they’re going to have to add a credit value adjustment to the derivative that they engage in.

FIX is usually used for equity trading, but investment banks are trying to free up as much capital as they can. In my opinion, I think it’s going to be very devastating to their fixed income, commodity and currency (FIC) business … Very few investment-grade or municipal bonds are done on an agency basis where somebody calls you up and says I want to sell G bonds and instantaneously you find a buyer of them on the other side and you collect a small fee. Usually, you’re taking on some kind of risk; you’re putting them on your books for an hour, a day, a week, a month just to make markets. You have to put your capital at risk. That’s going to become extremely expensive

If the information isn’t exchanged instantaneously [for an equities transaction], the trade hasn’t settled out there—it’s T+3. The whole theory behind the FIX protocol is to make sure things are almost straight through protocol (STP)—almost instant settlement.

I think there’s a push to improve FIX in preparation for greater electronification and connectivity so that it’s not only on the front office but also can complete on the back office of a trade.

The sell side’s incentive is to have settlement occur as quickly as possible and to have it as streamlined as possible and trades can be channeled via CCPs so that the least amount of capital is taken up. From the buy side’s perspective, this is going to be regulation applied to the sell side and the banks should bear this charge. But banks aren’t going to take the charge. They will pass them onto the buy side. The buy side is unprepared for these charges that are going to come.

Do you foresee any pitfalls for FIX in post-trade processing?

I do on the buy side. I think it’s more important for the sell side, given the new rules, that they are the ones that are going to have to report instantaneously or know what they should charge for CVA or know what their capital charge is.

Banks in the future are going to have to manage their balance sheets significantly more actively than they have in the past. They’re going to have to know what their    exposures are, how much capital is at risk, where they’re using their capital. Before 2008, capital on the balance sheet was almost free; they would charge Libor which was basically zero. There was almost no thought to how much capital is being tied up.

The banks that are going to succeed and maintain their returns on equity are going to be the ones that can micro-manage how their balance sheet is allocated. There will be extreme charges … once those are on their books, they are going to be hit with an enormous charge for a risk perspective—it’s going to tie up a huge amount of capital.

So firms will have to revamp their IT to accommodate pre-to-post-trade integration?

The sell side firms are well aware that it’s very worth their while to spend that $1 million to revamp their FIX protocol implementations and get their systems up to speed. For the buy side, there isn’t as much urgency to have things in complete order.

I think until [buy-side firms] get the charge they’re not going to be worried to pay the theoretical $1 million to shape up their systems. Right now, they don’t care. I don’t think the buy side is hugely worried about counterparty risk on the sell side … The whole irony of the 2008 financial meltdown is that before [it happened] there was the argument that everybody was too big to fail. Now, everyone is ten times bigger.

I think that there’s more worry about that on the sell side that an individual fund will be too leveraged or a mutual fund firm …There could be default risk.

Many say that firms with FIX will only have to extend their architectures. Is that glossing over some major changes to come?

I guess it depends on the firm. For firms like Pimco and Fidelity that already have FIX systems, is hiring a few FIX experts to go in and tweak things a big deal? No. For Goldman Sachs, a firm of 30,000 to 40,000 people, is it a big deal? No.

[But] the further down the buy-side food chain it’s going to become more cost prohibitive or more painful to actually implement these changes.

So I don’t think the changes for the largest firms are going to be restrictive or that many of them will think twice about it. I think firms like Fidelity, Pimco and BlackRock will see the benefits immediately and will easily pay $2 million to have a couple of specialists and get themselves really ramped up.

It will be the middle and smaller tier buy-side firms that will be harder to convince to invest in the infrastructure. … It doesn’t cost 1,000 times more to get that $ 3 trillion firm to be FIX compliant as its does for the $30 billion firm. There are economies of scale. It’s one system—you have to make the coding adjustment and you have to have the specialists. … So for some of the smaller firms, it will be cost prohibitive or less cost efficient.

What will this mean for vendors?

I think there will definitely be a race to become compliant. … There’s enormous competition among trade order management systems—both for the front office and back office workflow. I think they’ll have no choice—whether they think it’s a good thing or bad thing—to bring themselves up to latest FIX protocol. I don’t think you’ll see resistance from them. … It’s a competitive necessity.

I think there will be consolidations within the software and IT vendors … I think you will see them try to leapfrog each other as far as technology.

Are some buy-side firms expecting the sell side to pick the slack?

The buy side always wants to do that. They don’t see an urgency. … One thing that happens when you have a relationship with a technology vendor is that you might have to ask for a custom enhancement.

In many cases, some are waiting for the impetus to come from the sell side to go to the vendors and demand their products are upgraded to the latest FIX protocol and piggyback off that …

Not only are you seeing standardization via FIX but I think the buy-side firms are going to have to consolidate the number of technology providers. I think the days of best-of-breed are over and buy-side firms are looking toward purchasing end-to-end solutions. For example, to have multiple trade order management systems or multiple front or back office solutions customized for different areas [within a firm]—these could be more difficult to justify.

A paper I am writing now shows that buy side firms are spending over 80% of their IT budgets on maintenance and less than 20% on new investments. We have a situation where people are trying to maintain antiquated systems. I think that’s reaching a tipping point where everybody is going to have make some significant new investment spending and improve their systems overall.

Where will they spend their money first?

One of the main areas is data. …Data is not standardized across the firm. I think firms will be spending more money than before on consolidating position, collateralization, risk, security masters files and compliance data. It’s no longer going to be acceptable that the hotshot manager in high yield maintain his own system and the CEO doesn’t know in aggregate what the firm’s positions in securities are and who they’re trading it with.

It has become more essential to link up solutions, with the ability to monitor various assets and consolidate all firm-wide exposures such as the management of exposure across prime brokers, as well as multiple cash and derivatives trading venues, CCPs and counterparties, in a timely manner.

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