After a topsy-turvy year, middle and back office operations have garnered a new respect as we move into the New Year.
While we at FTF think that 2011 was “The Year of Waiting,” it’s likely that 2012 will see a lot more movement for middle and back office operations. In fact, as the new Dodd-Frank regulations take effect, particularly for the over-the-counter (OTC) derivatives markets, revamping and updating the middle and back offices will take center stage—proof of a new respect for the frequently neglected operations that support the front office. The New Year may cause us to long for the limbo of 2011 as the global political and economic uncertainties could intensify into extremes. A presidential election in the US, the ongoing European sovereign debt crisis and a frail recovery from the Great Recession will likely wreak havoc on global securities markets. But even as market turbulence will give securities firms ongoing agita, there may be some sense of relief as clarity comes on the regulatory front.
One of the manifestations of that clarity will be the OTC reforms that will start to take shape as firms assume the role of swap execution facilities (SEFs), major players step forward to help create central counter party clearinghouses (CCPs) and market participants create repositories for data about derivatives. If they haven’t started already, IT staffs at securities firms will be hard at work revamping infrastructures to prepare them for OTC instrument valuation, clearing and execution.
Other regulatory reforms and industry efforts will hit their stride in 2012. The push for the Legal Entity Identifier (LEI) standard will make progress as other initiatives may only make slow progress.
We covered a lot in 2011 and we have put together a two-part series of our top predictions for the New Year, based upon our reporting on industry issues, opinions from analysts and industry players, and my opinionated assessments. The first part will appear today and the second part will follow on Wednesday, Dec. 21.
Despite the rough waters ahead, we wish you a great deal of good luck in 2012.
So, without further ado, here is the first half of our predictions.
1.) The Rewards from the Brave New World of Executed and Cleared OTC Trades Will Come With a Hefty Price Tag and Challenges
Kevin Walker,
derivatives admin. manager,
Nuveen Investments
Despite the confusion and delays of regulatory reform in the US, the new market structure for over-the-counter (OTC) derivative instruments should start to take shape in 2012. But the rewards for this reform come at a price and with fairly daunting challenges.
The price tag for OTC Reform will grow as firms spend more for the rationalization of OTC instrument valuation systems, causing revamps that will result in a spending boost to $383 million by 2014, according Celent, the market research division of Oliver Wyman, Inc. Firms will also be streamlining the fragmented and incompatible systems of their front, middle and back offices.
Celent’s research also asserts that firms across the planet will adopt a multi-faceted approach to the valuation problem with “additional proprietary/internal or third party valuations,” according to the report “Dodd-Frank and EMIR Derivatives Reforms,” authored by Cubillas Ding, a London-based analyst for Celent. (EMIR refers to the European Market Infrastructure Regulation initiatives for Europe.) Our story ran on Nov. 29.
Most firms are fully aware that they have to start preparing for OTC clearing as our May 25 report reveals. An FTF conference panel on the IT needed for regulatory compliance stressed that OTC clearing will compel firms to consider overhauls in three major areas:
- Trading capabilities and connections, especially if they need to conduct transactions across multiple geographies;
- New data reporting obligations to satisfy new CFTC and SEC regulations;
- Additional risk management practices especially in light of the extra collateral required by CCPs.
Firms will face a data overload for their middle and back office operations, in large part caused by the OTC reforms, says Kevin Walker, AVP, derivatives administration manager for global operations at Chicago-based Nuveen Investments, who was featured in a Q&A that ran Dec 6
Beyond the internal price tags, many firms will be taking seriously the question of whether CCPs will fall into the “Too Big to Fail” category. It would be a cruel irony if the OTC reforms led to a concentration of risk in CCPs that could be highly vulnerable.
Lawyer and FTF speaker Andrea Kramer, a partner with the Chicago law firm McDermott Will & Emery, argued that the OTC reform mandates could result in a “choke point” for the industry that could have devastating consequences. “If AIG was too big to fail, we aint seen nothing yet,” Kramer says in our report on July 27. “Huge market swings can result in market failures that could put enormous pressure on the CCPs.”
2.) Technology Spending for Middle and Back Offices Will Increase, Driven by OTC Reforms
Frequently, the middle and back offices have been stuck in the role of Cinderella when it comes to IT spending. The front office has gotten the glamor and appropriations. However, as firms large and small grapple with ever-tighter markets, they have streamlined their front offices, which has led to major layoffs, particularly at sell side firms. At the same time, like Prince Charming, the OTC reforms have finally dusted off the middle and back offices and brought them to the ball.
While it’s always tricky to predict how IT spending will go, there are strong signs that firms could and should increase budgets for middle and back office infrastructures, the reference data and valuations processes that will be required for the new regime of cleared and executed OTC derivative instruments.
Sang Lee,
co-founder & managing partner,
Aite Group
As I say in the Dec. 15 Minding the Gap column, the OTC regulatory mandate reminds me of the Y2K push for securities firms. Many IT projects got funding as long as they were under the Y2K umbrella. This concept may well apply to middle and back office projects that were long needed but lacked a compelling mandate. Sang Lee, a co-founder and the managing partner of market research and advisory firm Aite Group, based in Boston, agreed. “I mean there’s nothing better, in terms of pushing for new IT initiatives than a regulatory mandate,” says Lee. However, all bets are off if regulators delay the implementation of the new OTC rules.
Another major driver for increased spending beyond the front office is the simple fact that many middle and back offices have to catch up to the front office, which is using low-latency and high frequency trading infrastructures. The middle and back offices require revamps and upgrades to avoid being disastrously out of sync.
Surprisingly, the new respect for the middle and back offices is not likely to yield a struggle for a new balance of power among the front, middle and back offices, according to Gert Raeves, research director at market research firm TowerGroup, a Corporate Executive Board company.
Raeves says in the Oct. 19 profile of Phillip K. Lynch, president and CEO of data management provider Asset Control, that “what is needed is money spent on automation. But the roles of the middle and back offices are not to curb investment and trading. So, with pain and expense, this problem will be automated away. … Even very stable vendor markets like reconciliation technology are having a bit of a renaissance moment—raising data quality across all types of data and processes is a common denominator across many of these middle and back office bottlenecks.”
3.) The Legal Entity Identifier (LEI) Initiative Will Gain Ground and Will Prove the Power of Sensible Standards
Although much needed for some time, the push for a common LEI got a boost after the collapse of Lehman Brothers made clear that greater transparency was an absolute necessity.
On Sept. 29, FTF spoke to Dennis E. Goodenough III, senior business manager, securities initiatives at SWIFT about the financial messaging services cooperative’s role in the LEI and ISO 20022 standards efforts. As the registration authority for the LEI effort, SWIFT is the source for allocating, assigning and distributing the LEIs.
“This is very similar to what we do with BIC codes,” Goodenough says. “The role of the DTCC and its subsidiary Avox is to capture, store, reconcile and enrich all the attributes related to that legal entity. The attributes are very important because it’s the name of the firm, where they’re incorporated, how they’re incorporated, who requested the LEI and have they updated the LEI.”
All parties behind the LEI push are waiting for global regulators to endorse the solution proposal and to define the reporting requirements. The regulators are likely to come to a decision during the first half of 2012, Goodenough says. “We can’t move too much forward until we receive the endorsement and ultimately the requirements from the global regulators,” he says. “However, despite the regulatory delay, the LEI project is still progressing far faster than it ever did without the regulatory push it now has. The development of an ISO standard normally takes two to five years rather than two to five months, which is the time-frame we are working toward with ISO for the new LEI standard.”
As the standards push advances, several questions have to be resolved such as who needs to apply for an LEI.
“We do know that it’s not intended for an individual. It is intended for firms that are parties to a financial transaction,” Goodenough says. “I am very sure that the initial concentration will be to focus on the SIFIs (Systemically Important Financial Institutions). We know by default that the big banks will most likely be considered SIFIs and they’re going to have to get an LEI. But, there are some serious questions, after the big banks, who else would get an LEI? I would think, logically, that some of the large asset managers that direct trading—they’re investing pensions and so forth—they should be doing it. Large insurance firms. Perhaps exchanges. But the regulators didn’t go to that level of granularity and that is something that is going on behind the scenes now to try and clarify that.”
4.) The Industry Will Embrace More Outsourcing as Markets Roil
As many of the Dodd-Frank changes hit in 2012, coupled with the demands of rough markets, many firms are likely to bite the bullet and turn to outsourcers for infrastructure support, applications hosting, and the gathering, analysis and storage of securities-related data for middle and back-office operations.
Our story on Nov. 8 focuses on how more outsourcing could blur the lines among the front, middle and back offices as firms farm out more of their trading-related operations, according to Alberto Corvo, managing principal, financial services for eClerx, an outsourcing company for trade order management, trade enrichment and affirmations.
Recently, eClerx surveyed compliance, operational and risk business units of securities firms on the issue of outsourcing and found that firms will retain control of processes as mandated by regulators. But they want to explore outsourcing because of the cost cutting advantages and the flexibility it allows them to explore business opportunities. Process improvement, better productivity and risk mitigation are the other factors that favor outsourcing.
Another reason to turn to outsourcers is the regulatory pressure to gather, analyze and store securities-related data for middle and back-office operations, Corvo says. This will entail major data management requirements such as the cleaning, normalization, processing and storage of data as well as new ways to access key information.
“Before, it was done in a silo,” says Corvo, referring to data systems designated for certain instruments such as cash or derivatives. “You had a data system that you needed to run and you did what you had to. You were not really linking it outside your own silo. Now, you need this bigger view and to get it is a pretty involved process.”
The survey also found that reference data management and settlement are leading the pack of candidates for outsourcing. The settlement process ranked a close second to reference data in in the survey, Corvo adds. To be clear, firms do not want to outsource their control over payments but there are many steps leading up to the actual settlement—essentially, how much money is tee’d up for the payment, he says.
Another major driver is likely to be the sprouting of new hedge funds as the money that used to fuel proprietary trading on the sell side flows into the hands of those launching funds. This could translate into opportunities for outsourcers, especially those who specialize in serving hedge funds.
5.) Firms Will Apply Mobile Technologies to Internal Business Functions
Securities firms will continue to apply mobile technologies to customer-focused external efforts such as the outreaches via private wealth management and customer care. But firms will also increasingly embrace mobile access to key data about securities transactions.
In an FTF Q&A dated Dec. 6, Aite Group’s co-founder Sang Lee says that mobile and social network apps make sense for the wealth management business units. But mobile and social media technologies at the institutional level are “still sort of at the embryonic stage. … At the same time, there’s no doubt that there’s a lot of stuff driven by things like tablets as opposed to mobile devices. We are certainly hearing a lot from some of the vendors that are in the trading space about clients asking for more of the executive-level access to information,” Lee says.
“To a certain degree, tablet-driven transaction capability is still years away,” Lee says. “I think a lot of it is restricted by compliance and risk management reasons. But they are certainly gaining access to real-time information via tablets. I do think that’s definitely a trend.”
Some corporate actions, including proxy voting, are ripe for mobilization, as Gerard Bermingham, vice president, business strategy, Americas, for Information Mosaic, says in our FTF Special Report: Mobile Computing Pushes the Boundaries of Innovation and Security in Financial Services, released Sept. 20.
“Adapting corporate actions to mobile technology offers a way for an investment firm to deliver value-added benefits to its client base via an established mobile distribution channel,” Bermingham says. “Corporate actions processing through the ‘anytime, anywhere’ design of mobile technology offers portfolio managers and clients the capability to receive up-to-the-minute information about announcements on their mobile devices.”
In the same report, Gary Wright, the CEO of London-based B.I.S.S. Research, urges firms to seriously consider the compliance and security challenges that mobilization presents.
“How many boards realize what the threats of mobile devices to their business are and what their communication architecture is?” Wright asks. “Probably very few, as these details are often delegated to middle ranking managers tasked with day-to-day operational support. This, in itself, is a huge risk, as was demonstrated recently by the failings of senior executives within News Corp. International during the phone hacking scandal. So boards need to have a closer understanding of the supporting infrastructures of their businesses and this, of course, includes the communication architecture.”
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