Global regulatory reform and market changes are impacting how the buy- and sell-side function in the exchange-traded derivatives (ETD) space. The increased focus on central clearing over the counter derivatives (OTC) and trade reporting has placed a large burden on chief operation officers (COOs) and market infrastructure personnel to ensure compliance, even in the face of shrinking budgets and higher trade volumes. However, though there has been an industry wide focus on compliance, many firms have not focused on the operational requirements needed to comply efficiently and without added risk.
In the wake of these changes and as ETD volumes continue to rise, financial institutions must examine their post-trade processes for ETDs, and work to increase efficiency, reduce costs and modernize operations. This will allow firms to sharpen their competitive edge and take advantage of new opportunities in the financial services landscape. To succeed in this market, firms must now adopt more sophisticated technology to support the increase in trade volume.
The push to central clearing that regulations such as Dodd-Frank and EMIR prescribe is forcing both the buy- and sell-side to overhaul their operations to become more transparent and risk adverse. These regulations can most frequently be addressed by the adoption of increased levels of automation in operations. At times the overhaul needed to comply with regulations makes it difficult to carve out a position of strength in the short-term current market environment of unpredictable volumes. These difficulties have been reflected in listed derivatives market activity over the past few years, but the long-term outlook is for an upward trend.
Historically, the front office has been the beneficiary of technology investment to automate and standardize operational trade processing practices. This resulting “electronification” of the front office has created efficient processes with strong risk management controls that can execute trades in milliseconds. The back and middle offices, however, have primarily relied on manual, labor intensive and fragmented systems. Omgeo sponsored a study by Greenwich Associates, a leading research based consulting firm, which found manual processes such as confirming trades via voice and fax are still common, with less than half matching trades on a real-time basis and exposing trades to unnecessary risk. In fact, the bulk of post-trade allocation, confirmation and matching communications between counterparties has been conducted through a disjointed mix of phone, FIX messaging and emailed spread sheets. The majority of trades go through one broker for trade execution and then a separate broker for clearing. This process and reluctance to adopt new technology creates unnecessary risk for trading desks that has not only impacted settlement times, but also made firms more vulnerable to human errors.
Because of these manual processes, the cost of managing middle and back office processes is no longer sustainable, especially as portfolio strategies move beyond traditional equity and fixed-income investments and into derivatives instruments. According to Greenwich, firms spend an average of US$800,000 annually on cleared derivatives processing. In North America, nearly 60% of this budget is spent on human resources, with the rest spent on technology. As these cost pressures mount and market conditions remain turbulent, it is more important than ever firms embrace technology designed to automate manual processes, resulting in more financially efficient operations.
For the sell-side, the complexity and increased use of automated strategies and algorithms by their clients are taking their toll. Many brokers rely on antiquated, manual processes when trading ETDs, which leaves the door open to an increased number of trade discrepancies as well as an even higher operational risk in the allocation management process between counterparties. These problems will need to be addressed by the sell-side, and implementing more robust middle and back-office processing workflows is one way to solve these problems and comply with regulations.
Similarly, buy-side firms need to ensure their middle and back-office processes keep pace with their front-office activities. Without a robust infrastructure, growth could be inhibited and relationships could be impaired. For example, any time there is transfer of trade details between two parties, the potential for exceptions increases. To avoid exceptions, automated solutions can be imposed to make the post-trade process more efficient and reduce the associated risk of trade failure.
The potential benefits of outsourcing middle and back-office functions to assist in the ETD trading process have been well documented over the years. However, the financial crisis and changing regulations that are still being discussed have forced financial services firms to reassess their operations and outsourcing plans. It is no longer just about cost savings and flexibility, but also about complying with regulations and improving competitive positions in difficult business conditions. Those that adopt new, more sophisticated and automated solutions can differentiate their offering from their competitors.