New technologies and new business models, as well as regulatory drivers such as MiFID II and Dodd-Frank, are contributing to a transformation in the post-trade landscape. From a regulatory standpoint, the push towards central clearing of OTC and bilaterally traded instruments presents firms with a number of challenges but also new opportunities, as clearing firms and technology vendors innovate to overcome some of the obstacles associated with these changes.
In this Financial Markets Insights report, Dan Barnes & Mike O’Hara of The Realization Group hear from Julie Carruthers of TP ICAP, Rob Scott of Commerzbank AG, Philip Simons of Eurex and Paul Fermor of Software AG about the choices that the leaders in the post-trade industry are making in order to align themselves with a customer-centric post-trade landscape.
Digital technology is enabling leaders in the post-trade space to move towards a ‘customer first’ approach, allowing the traditionally conservative business to be more agile and responsive in its service delivery. Faced with competition from non-traditional providers, and fuelled by a combination of smart systems and a revolution in data processing, post-trade businesses are breaking out of the straightjacket of regulatory-enforced change. New technology is addressing three broad challenges within the financial services post-trade environment.
In addition to adopting new technologies and business models however, firms must also develop a strategic view of their post-trade operations if they are to move from a position of reactive management and into one of leadership.
“Most – if not all – banks and brokers are currently in ‘technical debt’ within the post-trade space,” says Julie Carruthers, Global Head of Operations at TP ICAP. “Businesses have spent years just doing what needed to be done. However, as an industry, we are now acknowledging that debt and I believe the investment needed to overcome it is coming.”
‘Post-trade’ captures a range of middle- to back-office businesses, from bank processing to market infrastructure operations. Their complexities differ depending upon the instruments being traded and the market participants.
What they share is a range of activities designed largely to provide security to the safe and efficient operation of capital markets. However, with safety as the primary concern, efficiency and innovation have often taken a back seat to rigour.
“There are no shortage of people working in the middle office/back office who are able to recognise systemic inefficiencies and scope to develop new innovations,” says Paul Fermor, UK Solutions Director at Software AG. “But the combination of the operational importance of the environment, along with its legacy technology and technical debt has made prioritising significant change and innovation in this space a hard sell”.
“There are no shortage of people working in the middle office/back office who are able to recognise systemic inefficiencies … but legacy technology and technical debt has made prioritising significant change and innovation in this space a hard sell.”
Paul Fermor, Software AG
Consequently, investment in these processes has focused on maintenance. Change carries risk. Although the finance industry as a whole has seen considerable innovation in technology, disturbing the middle- and back-office was often delayed.
“For example, during the past decade, when derivatives exploded into mainstream trading combined with the growth of exchange traded business and areas of structured products and commodity trading, much of the core investments have been in the areas of front office and in their booking, risk and credit applications. The focus has been less on the back and middle offices which have often been configured to accommodate these products but, not always in an optimal front to back manner,” says Rob Scott, Head of Custody, Collateral & Clearing at Commerzbank AG.
Some of the most significant changes have been forced through as a result of new regulations, which have imposed new ways of working upon the securities markets.
The 2010 Dodd-Frank Act in the US and the European Markets Infrastructure Regulation (EMIR) contained the legislative guidelines for central clearing and risk mitigation for over-the-counter (OTC) derivatives, the framework for central counterparty (CCP) operation and rules on post-trade interoperability, reporting obligations and the requirements for trade repositories.
They were conceived differently, but both were intended to support the objectives set out by the G20 countries in 2009 at their Pittsburgh summit; “All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”(1)
More recently in Europe, MiFID II has imposed open access between CCPs, offering both cost savings and complexity for post-trade processing. Many CCPs have delayed their implementation of these rules until 2020 due to the complexity and risk involved. However, firms cannot assume their existing business models will prevent disintermediation from tech-savvy competitors. Formalising post-trade processing is driving the need to invest in technology that can connect to and manage interactions with market infrastructure.
“There is a real demand for people to be able to move historical trades’ position risk between counterparties. Can you imagine if you did a 50-year swap, and you’ve got to leave it with the same counterparty or CCP for 50 years?”
Philip Simons, Eurex
“There is a real demand for people to be able to move historical trades’ position risk between counterparties,” says Philip Simons, Global Head of FI and FX Derivatives Trading & Clearing Sales at Eurex. “Can you imagine if you did a 50-year swap, and you’ve got to leave it with the same counterparty or CCP for 50 years? There must be a mechanism by which you can move this around, close it out more easily, or transform it. I think there is a big opportunity in this particular space for innovation.”
The collective impact of the rules has been considerable. CCPs have taken on a huge increase in clearing business. LCH’s SwapClear, which in 2011 reported clearing US$283 trillion in the interest rate swap (IRS) market, had processed over US$873 trillion in notional during 2017. Eurex Clearing cleared €420 million of IRS trades year-to-date by November 2011, but in 2017 processed €1.2 trillion of interest rate swaps by November. In the first 3 weeks of 2018 Eurex have already cleared over half a trillion in new business, approximately half of what they cleared in the whole of 2017.
Not only was business larger, the collateralisation of trades – as demanded by the CCP model – creates an enormous pressure on buy- and sell-side firms to assess, find and post suitable assets. Real-time and daily margin calculation became the norm for many businesses. The transfer of data and assets between a string of different market participants necessitated investment in IT and by increasing the use of repo and securities lending transactions added further complexity.
“Firms have to look at more efficient ways to collateralise the clearing process,” says Simons. “You have to assume that everyone has more than one CCP and they are acting in more than one asset class. These banks now have the challenge of collateralising multiple liquidity pools. They’re doing it not only for their own house business, but they’re doing it on behalf of multiple clients as well, where they have elected for individually segregated accounts. There are also other options now, such as multiple omnibus pools, where clients can choose to be in a shared collateral pool with their own family of funds or a group of disclosed clients.”
The interconnectedness of operations between organisations and the breadth of potential solutions can be overwhelming for those engaged in reform. However, the increase in costs and potential for excessive complexity in post-trade processing demand that investment be made in new technologies that could potentially resolve these issues.
“Banks are starting to look introspectively at themselves, putting in place more efficient and less silo-led structures,” says Scott. “Many banks are looking to provide optimisation particularly in the areas of collateral management and in the area of mobilising global collateral pools. For example, treasury functions have realised taking better control surrounding updated documentation, optimisation and mobilisation allows for greater commercial advantages and returns”.
Scott continues, “As banks do not necessarily have the balance sheet strength to continue to make investments in acquisitions as they once did, to acquire more volume and scale, that means they have to work on optimising what they have. If there isn’t access to more volume, then cost and efficiency solutions need to be examined.”
“Many banks are looking to provide optimisation particularly in the areas of collateral management and in the area of mobilising global collateral pools. For example, treasury functions have realised taking better control surrounding updated documentation, optimisation and mobilisation allows for greater commercial advantages and returns.”
Rob Scott, Commerzbank
The cost problem is accentuated because businesses are underpinned by legacy technology that is often more than thirty years old, which can be hugely inefficient. If traditional firms do not deliver that service, they face competition from non-traditional firms who will disintermediate them.
“We’re going to need very sophisticated and efficient post trade services that move risk and collateral around from the basins,” notes Simons. “You will see a growth in new technology providers challenging the platforms that were traditionally there.”
New developments are enabling firms to get past the limits of their legacy systems without replacing them in order to develop new levels of service and capability. Digital technologies are increasingly capable of taking data from disparate sources and making sense of it, in order to create a service that either enhances the role of a professional, or fully automates the task. Distributed ledgers, inspired by bitcoin’s blockchain transaction model, can sit between existing systems and provide a mechanism for transactions that requires no reconciliation or internal database.
Their developments and deployment in securities issuance and trading – primarily on private markets – removes the need for post-trade processing to confirm the detail of a deal, potentially removing a significant layer of cost. Their implementation for use between financial services players will depend upon negotiations over ownership, intellectual property rights and standardisation. However, a frictionless transfer which limits additional post-trade activity has clear application benefits.
“It should lend itself to variation margin, which is a zero-sum game; you’re passing it from one end client through the CCP to another end client, then onwards to multiple others,” notes Simons. “Two seconds later, it could be going back the other way because the markets have moved. Theoretically, you’d be moving that collateral backwards and forwards and as close to real-time as you can. One would envisage that a distributed ledger would work well for that.”
Robotic process automation (RPA) is allowing firms to automate complex, rules-based activities which would previously have required skilled human oversight. Robotics and algorithms are being employed to automate relatively simple processes and push exceptions out to more complex decision-making systems. Longstanding use in the securities market has automated front-office trading decisions, but these same technologies can be effectively employed in the middle and back offices.
At the high end, artificial intelligence (AI) and machine learning (ML) tools are being used to assess complex data patterns and deliver a response that goes beyond rules based understanding. That removes the need to recalibrate systems as circumstances change.
“When agreeing a new rate card with a customer, this is then input into our systems by a human and the language and taxonomy used between the parties is often not the same and the scenarios can be complex so there is a level of interpretation needed. It is this interpretation and rules that AI can help us with. RPA is also helping us where we have sets of data that need to be updated in several systems”.
The advantage that new digital technologies provide is their capacity to overcome differences in systems and data. Application programming interfaces (APIs) and messaging standards are providing gateways between systems where there used to be barriers. Now digital data layers can be laid over the top of multiple systems to aggregate and publish data for use within automated processes or for human consumption via graphical user interfaces.
“In the derivatives markets some firms have moved to self-clearing as opposed to going through a tier one clearer, who may impose minimum monthly fees and onerous conditions on posted margin and collateral. It can be more efficient and cost-effective for some firms to post money internally rather than externally,” notes Fermor.
Not only are new technologies more easily integrated within existing technology stacks, many technology providers have developed the expertise to provide services to specialist financial services firms.
“The change that’s come about in the last four to five years is that the big technology companies have come to the fore who specialise in delivery, process optimisation and BPO,” notes Scott. “Once you’ve realised where your core differentiation is, you are now able to go and outsource to a non-competitive organisation, and know that if you put trust in that organisation they’ve got the financial strength, balance sheet and delivery capability to be able to resolve any problems.” To ensure they are able to move at the front of the market, avoiding a reactive strategy, post-trade service providers can either innovate with technology-savvy partners as a supplier of a product, or as a supplier of a service. “The worst thing you can do is just put a technology layer over bad process,” says Carruthers.
Firms need to engage with partners to analyse and optimise process before they introduce new systems and technologies says Fermor. “If there’s been a dispute or collateral settlement failure, what is the reconciliation process? Even after proper analysis, it may stubbornly remain an onerous, manual multi-step task,” he observes. “However, if the steps are relatively prescribed that’s when you can leverage ‘low code’ technologies like RPA, and take a hitherto human operation and have it automated in a low cost manner”
“We’ve all acknowledged we’re in technical debt as a natural consequence of what we’ve built and acquired. To resolve that, you need to actually invest and spent time and money on building services. Those services then give you a capability, and that is something that you can then use as a commercial advantage..”
Julie Carruthers, TP ICAP
For post-trade operations, growth is replacing regulation as a driver of transformation. The higher costs imposed by compliance with new rules have led the industry to explore innovative new technology. As compliance has been met, and new ways of working have bedded down, the potential of IT is being realised in new ways.
It is client demand that will see new technologies flourish. As regulators are the stick, increased revenues and cost savings are the carrot, allowing big firms with sturdy legacy systems to avoid disintermediation.
“It’s a maturity curve,” says Carruthers. “We’ve all acknowledged we’re in technical debt as a natural consequence of what we’ve built and acquired. To resolve that, you need to actually invest and spent time and money on building services. Those services then give you a capability, and that is something that you can then use as a commercial advantage.”
Bringing technology expertise in early can help a firm to realise not only greater profitability from existing services, but to develop new services by unlocking hidden value within existing data sets and relationships, using tools such as streaming analytics around margin management and risk management for example, in order to add value to the services they traditionally provide.
“If they wish to avoid a race to the bottom, firms are going to have to provide other services beyond simple process in order to justify the charges they levy to clients,” observes Fermor.