Innovation amid difficult markets is a challenge for middle and back office operations. Even so, ingenuity will thrive in 2012.

The volatile markets in 2011 do not foster the best conditions for innovation in middle and back office operations. However, necessity is the mother of invention and we have uncovered several areas of IT and business innovation, which form the basis for our second set of predictions for the New Year. One intriguing innovation in 2012 will come from established IT providers exploiting New School web and mobile computing technologies to widen access to and from middle and back office operations.

Not all areas of operational concern are slam dunks for innovation. The processing of corporate actions processing, for instance, is a mixed bag of partial automation, manual processes and human error. Even a phenomenon such as cloud computing has encountered some resistance among firms although the cloud is likely to generate innovations and increase its reach within operations.

 For the business side, institutional investors want hedge funds to use more quantifiable management of accounts. At the same time, the ongoing turbulence of global markets will cause firms to better synchronize their front, middle and back office processes. Keeping an eye on innovation is important even for firms that prefer to stay focused on developing the best strategies and rely on third-party providers to oversee their infrastructures. Third-party providers that fall behind state-of-the-art offerings will soon lose clients.

 Our predictions are based upon our reporting on industry issues, FTF events, profiles of key players, opinions from analysts, vendors and firms, and my assessments. Our first set of predictions appeared on Tuesday, Dec. 20.

 Despite the trying times, innovations in operations promise to ease some of the challenges ahead in 2012.

1.)    The Middle and Back Offices Will See a Creative Convergence of Technologies

In 2012, it’s likely that established technologies will start to embrace New School mobile and cloud computing to create new links to middle and back office operations—further proof that financial technology vendors foresee major opportunities beyond the front office.

For instance, order management (OMSes) and execution management systems (EMSes) and automated proxy voting are getting new links to the middle and back offices facilitated by mobile and web technologies.

 

One of the first movers in this area is Eze Castle Software, which is breaking into the middle and back office markets with a mobilized OMS and a data management platform as reported in FTF on Oct. 26. The vendor is broadening the reach of its eponymous OMS via an app for the Apple iPad tablet computer and by adding middle and back office functions.

“We see that the role of the middle office is getting more complicated—increased regulation requiring more transparency, the new Swap Execution Facilities (SEFs) and clearing venues [for OTC instruments],” says Rob Keller, CFA, managing director of global product management at Eze Castle Software, which is a ConvergEx Group company. “The middle office is going to become more and more important. We’re seeing that as a big opportunity.”

Customer demand for just such operational coverage and competition from third-party niche players have Eze Castle Software to reach out to the middle office. “Historically, we didn’t provide [middle office support] so customers were going to third-party vendors,” Keller says. “Our clients are clamoring for it, so we’ll continue into the middle office space. Over the next 12 to 18 months, you’ll see us release more reconciliation support and more functions for post-trade operations.”

In another example, Web and wireless technologies have come together for wealth management clients of Information Mosaic, the Dublin, Ireland-based provider of post-trade automation products. Wealth management clients have every reason to get “more real-time interaction and views of their portfolios?” says Gerard Bermingham, the New York-based vice president of product strategy for Information Mosaic in our Feb. 24 report. Targeting those concerns, the vendor unveiled a centralized communications hub solution IMConnecting at Sibos 2010 in Amsterdam. IMConnecting also offers support for corporate actions processing such as proxy voting.

Merging proxy voting with mobile technologies is arguably a no-brainer but Broadridge Financial Solutions decided to put off creation of a mobile application and to put forth a mobile-optimized website that launched in March. Broadridge provides the infrastructure for web-based proxy voting, works with clients to set up the dates for the online voting and collects agenda items. The company also send outs email notifications about annual meetings and the items under consideration. The web-optimized, mobile access supports a graphical user interface that has been designed to be “very app-like” with large buttons and minimal text. It will work with Apple’s iPhone and iPad offerings, BlackBerry smartphones, and Android phones.

 

Broadridge took this approach because of the nature of its business, adds Joseph Vicari, a vice president with the business strategy and development unit of Broadridge. “We send out regulatory communications on behalf of our bank and broker clients. We’re sort of once-removed from the end investor—our clients’ clients, if you will,” he says. However, if there is “a large acceptance” for this new avenue for proxy voting, Broadridge is likely to develop a mobile app version. Mobile applications offer many more capabilities such as notifications and reminders that can’t be done via the website, and apps will allow Broadridge to more fully leverage the features of mobile devices, Vicari says.

Sang Lee, a co-founder and the managing partner of market research and advisory firm Aite Group, based in Boston, agrees that a convergence is underway.

“That’s sort of another way of looking at the application of some of these devices,” Lee says. “Not from a client-facing perspective but more from an internal management perspective and I think that’s certainly there. That certainly is a trend. … It’s a movement toward being able to provide on-the-go support for customers. It’s trying to leverage the capabilities of the various mobile devices. Certainly, it’s a very effective way of doing that.”

2.)    Cloud Computing and Operations Will Maintain a Cautious Engagement

A union between private cloud computing and middle and back office operations would appear to be a marriage made in heaven, especially for small-to-medium sized firms. But the industry’s embrace of the cloud is evolving and the financial, operational and time-to-market advantages of the cloud will best be served by specialized providers.

 

Yet embracing the cloud will prove to be a useful exercise for firms because it will compel those with incumbent data centers to choose between operations that are mission critical and those that can be elevated to the he cloud. In fact, those firms just starting out may decide not to build data centers, especially if they have a limited number of applications and systems. Venture capitalists have been urging hedge fund start-ups, for instance, to use a cloud provider rather than spend time and effort on a data center. It’s the ideas and strategies of hedge fund managers and not an IT infrastructure that a VC wants to fund.

One of the gating factors for the cloud’s acceptance is the challenge that the cloud poses to the hierarchical and fiefdom-oriented culture of many firms. The business unit that needs IT resources the most may get priority over other more highly placed groups such as executives needing email support. In order to survive, IT managers will have to make certain that executives are placated while the money-making units get the IT support they need.

IT managers also have to reimagine disaster recovery and business continuity operations when they are moved to the cloud. In particular, they will have to think twice about going to a start-up provider—the consequences could be severe if a new cloud provider goes out of business.

Most of all, firms have to avoid the hype as SunGard’s former CEO Cristóbal Conde asserts in our first profile, dated Feb. 14. “Just because a process is in the clouds doesn’t mean that it’s suddenly able to perform magic,” says Conde, who firmly rejects the grand predictions that the cloud will erase everything that came before it. “Fundamentally, it’s no different than the advent of the PC. Did the PC get rid of the mainframes? No. Client/server, did that get rid of the mainframe? No. Did the Internet get rid of all types of inter-process communications? No.”

The cloud has not erased what came before it and it’s definitely not a “set it and forget it” solution as IT staffs have to take into consideration privacy and security, latency issues, CPU and server power levels, scalability, reliability, storage concerns and internal funding for cloud projects.

So before firms get lost in the clouds, they have to know well beforehand the trade-offs and take the long view on what is an inescapable phenomenon.

 3.)    Corporate Actions Reforms Will Progress Slowly

While the industry will not be completely ignoring the frustrating and costly lack of automation for corporate actions, the basic problem is that much larger issues are pushing the issue to the back burner.

Still, the industry has been crying out for ways to standardize the automation of corporate actions and overhaul highly inefficient, mostly manual systems riddled with expensive errors. Market research firm Aite Group has estimated that large custodians and investment management firms set aside “between 15% and 20% of their custodial services budget to cover potential losses from errors and omissions.” As profit margins, budgets and staffs get leaner, more firms are hoping to spend less to fix the errors caused by manual processes, faulty data and human incompetence.

On the upside, the Depository Trust and Clearing Corp. (DTCC) will continue to advance its ISO 20022-based reforms for corporate actions throughout 2012. The first milestone of the DTCC’s pilot program was a set of ISO 20022-based corporate actions announcement messages that was ready for the SWIFT Sibos conference in Toronto—and ready for prime time in November, detailed in FTF’s coverage on Sept. 14 and Sept. 22.

Skeptics, however, predict that that DTCC clients and corporate actions vendors will take a wait-and-see attitude before they adopt the new announcement messages because an ISO 20022-based return path for corporate actions is still in the works. In addition, widespread acceptance is likely to be slow in coming as most firms will wait until the full slate from the DTCC is ready, which is years from now.

4.)    More Investors Want Hedge Funds to Support Separately Managed Accounts (SMAs)

Investors, much to the chagrin of those running hedge funds, want their hedge fund assets placed with managed account providers. Most observers say this is because much of the new inflow is institutional money, which comes with many strings attached.

Investors see separately managed accounts (SMAs) as providing them with more input into the fund manager’s strategy, timely reporting, an advantage in negotiating fees and better custody of assets. An underlying truth about the new insistence upon the more quantifiable SMA model is that investors are under intense pressure to perform post-crisis. And, while investors still have the upper hand with hedge funds, they are likely to get what they want.

As we report in a Minding the Gap column from April 27, the SMA model is a mixed blessing for hedge funds because they can result in more opportunities for fund managers and more operational and administrative costs. While many hedge funds have SMA offerings, hedge fund managers object to the costs, trade allocation, reporting and compliance requirements that SMAs incur. They also fear that SMAs will distract investors from taking part in pooled funds.

 

Yet a Greenwich Associates report, commissioned by Pershing, a provider of clearing and execution services, found a new normal: “For better or for worse, fund managers can expect the number of institutional investors requesting more transparency and liquidity to increase in coming months and years.”

5.)    Global Markets Will Remain Volatile, Putting an Enormous Strain on Resources

It doesn’t take a great psychic to predict that securities markets worldwide will be turbulent throughout 2012. Markets will be extremely volatile as the European debt crisis verges on fiasco, the corrosion caused by the mortgage-back securities disaster lingers, and high unemployment, lackluster consumer confidence, and home foreclosures drag down a frail recovery in the US. These horrendous conditions will take their toll on investor confidence, causing investment firms to work even harder to survive and prosper.

As we’ve seen, highly volatile markets have contributed to poor fund performance for many buy-side firms, including many hedge funds. Yet the hedge funds have been hit with a conundrum as I noted on Oct. 25 in a Minding the Gap column: They have to use faster trading technologies and speed up their middle and back offices while hoping to ward off redemptions. But as investors pull the trigger more frequently on redemptions, hedge funds large and small may not have much left for IT infrastructure investments or outsourcers.

The blame for underperforming funds has to rest with the managers overseeing them but some hedge funds have been beaten to the punch because their middle and back office systems—probably mostly manual—have also let them down. In the worst case scenarios, some firms have had to halt trading when volumes have overwhelmed middle and back office staffs, as Phillip K. Lynch, president and CEO of data management provider Asset Control, details in an FTF profile that ran Oct. 19.

All hope is not lost as there are ways around this problem such as using more affordable low latency access to executions and market data through, essentially, a shared utility model. There are also innovations coming such as IPC Systems and its low-latency “express trading route” of network connections to liquidity venues in New York, Stamford, Conn., and Boston—the Acela for speedy trading.

Ultimately, the heavy lifting for many hedge funds and other buy-side firms will be in upgrading their middle and back offices, which represents a major consulting opportunity for the right providers. This pertains even to firms that have outsourced most of their IT infrastructure and/or use a prime brokerage’s services. Whether or not firms have their own infrastructures or that of a third party, no one can rely on outdated middle and back office systems. Outsourcers will have to offer the latest equipment and prudent consulting to help their clients stay ahead of the markets because no one escapes volatility.

Click here to read Part 1- FTF’s Top Trends for Operations in 2012

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