Turning Point for Financial Services in 2011

Crystal balls in hand, industry watchers predict that in 2011, the new best-of-breed trading systems will be those that integrate front-, middle- and back-office functions; third-party technology will trump in-house-built systems; flexibility in back-office systems will be crucial; and risk management technologies—already popular in the wake of the high-profile risk management meltdowns of the recent past—will continue to see widespread adoption.

“This year was the watershed year for the community at large, with a multi-year agenda of broad transformation, through better integration of front, middle and back offices,” says Frank Liddy, partner and head of Capco’s packaged integration business. “What we’re seeing now more than ever is not just a committed but a very coordinated effort between the business, operations and technology teams in many of our clients, to better integrate the front, middle and back office—and not just for cost-reduction purposes.”

As integration of front-, middle- and back-office functions can improve trading systems, firms want to integrate end-to-end infrastructure to support a more centralized management philosophy, says Luther Klein, head of North American banking risk management at Accenture. The centralized philosophy, says Klein, “has a greater reliance on availability of accurate, reconciled and centralized information from all business lines, including capital markets.”

Increasing Risk Management Sophistication
Integrating the front through back offices also feeds into advancing risk management technology capabilities, says Michel Finzi, global head of business development at RealTick. “For instance, if someone is taking an order and routing a portion of it from one broker to a couple of venues, and taking another portion of it and routing it through another broker to more venues, each one of those endpoints could conceivably have its own view of that order, but they don’t have a view of the overall picture,” he says. “The logical extension is that the risk view needs to migrate up the technology curve for that particular firm, based on their strategy for the product they are trading.”

Cloud computing, enhanced simulation technology, stress-testing solutions and enterprise-wide systems are technologies that will emerge or continue to emerge in shaping risk management operations, according to Klein.

“We’re starting to see cloud computing provide granular information in a timely fashion, improving line-level, front-office decisions,” he says. “We’re seeing enhanced risk simulation technology in the industry, focused on more granular and detailed information to provide and calculate your risk data, which is improving capabilities around operational risk and credit risk. It’s aligning the risk appetite of the organization to transaction-level decisions of your trader or relationship manager.”

With stress-tests five years ago, firms had only been able to simulate stresses around a few variables, according to Klein. “Banks are expanding their capabilities across the entire enterprise to look at a true portfolio view and breadth of variables that stress their portfolio, for capital and management purposes.”

When firms are looking for real-time risk management service providers, they will want ones that can demonstrate an informed perspective in a solution around dealing with risk across multiple asset classes, says Liddy. And 2011 will see firms discussing, coordinating and organizing personnel for risk management functions, as well.

“Next year will be the start of a deeper implementation and execution of those intentions,” he says. The projects that emerge will be less about installation and upgrades of individual packages, and more about reducing the number of applications across front, middle and back offices as an effort to drive down costs, improve transparency and rationalize the target operating levels.

Walking the Regulatory Line
Risk management may also be achieved in 2011 through setting position limits. The implementation of the Dodd–Frank Wall Street Reform and Consumer Protection Act could proscribe this, or the industry or individual firms may set their own limits to pre-empt regulators that would dictate what the limits should be.

“A lot of people are looking at that regulatory regime and do not want to find themselves in a position where they cannot meet the minimum criteria,” says Liddy. “They are asking where they can go above and beyond the marketplace, and still be competitive in it—not just meeting the intent of the regulation but creating transparency.”

In practice however, when it comes to position limits and a discretionary trader approaches a limit and a trading algorithm starts operating, the risk management and compliance implications are unclear, according to John Barun, managing director and CIO of Geneva Trading, a Chicago-based global proprietary trading firm. “Are we going to be self-policing or will there be an external body monitoring this in the exchanges or futures commissions merchants? All these questions have a big implication in terms of which technology we implement,” he says.

The key to transparency or visibility lies in reporting systems, according to Sean Barry, managing director at derivatives trading systems provider Patsystems. “We have been very conscious all along—before some of these regulatory discussions took place—of assuring reporting systems were always extremely strong,” he says. “These give even more visibility but also satisfy regulatory requirements. Now regulators want the visibility into the firms themselves as well.”

Firms that integrate front-, middle- and back-office operations will be best positioned to respond to regulatory changes, according to Liddy. “They do it not just to be compliant, but because they realize that being compliant better, faster and smarter, and before their contemporaries, can go a long way toward retaining existing clients, and be a magnet to attract new ones,” he says.

Driving Front- to Back-Office Integration
Transparency joins efficiency and innovation as driving forces around front-to-back office innovation, adds Liddy. “IT represents between 40 and 50 percent of an investment bank’s or asset management firm’s operating expense,” he says. “That environment, against the backdrop of organizations and institutions having to do more with less working capital to meet the shareholder demands, means the need to streamline is the first but not the only imperative driving integration between front, middle and back offices.”

Of course, front-to-back office integration also drives innovation from technology providers or in-house operations departments. “Big organizations are streamlining their operations to be more efficient, while uncovering interesting ways to offer better value to their hedge fund clients, particularly in product reporting and real-time risk,” says Liddy. “Those with these innovations that come from integration are able to commercialize those benefits.”

The demand for comprehensive systems is increasing, according to Finzi of RealTick, which offers post-trade reconciliation services and reporting. “They need solutions that constantly innovate and respond to changes in market structure, regulation or front-office business practices,” he says. “Linking with this is the question of the flexibility of back-office systems taking on more importance. Clients need to ensure that trades flow efficiently from front to middle to back. With respect to over-the-counter (OTC) products such as collateralized debt obligations (CDOs) and credit default swaps (CDSs), we are seeing changes in how those are settled, affirmed, reported and recorded through various exchanges. I imagine that will logically trigger a set of considerations that people absolutely must make to be sure of compliance and understand the value of those trades that are settled.”

Firms building their own in-house systems to get the most cost-effective means of meeting their requirements face a challenge in staying current and innovative once they do so, according to Finzi, who says the trend is to buy or rent components. “When you build all-encompassing systems, you have to maintain and manage them. We see people inquire about getting either one or multiple parts of their problems addressed by technologies. The issue is scanning the market to see if there are adequate pieces or an all-encompassing solution that people want. With the sophistication of trading strategies, it’s hard to have an all-encompassing single product that will do everything for everyone all the time.” So, he says, people will tend to barter with those who can solve some or many of their problems.

Build or Buy?
US firms tend to lean toward transitioning to market-standard systems or off-the-shelf products for front-office, credit, market, and operational risk functions, according to Klein of Accenture. “In contrast, European firms are more likely to leverage custom-built solutions to support their risk infrastructure,” he says.

Firms have to carefully evaluate their capabilities when making buy-or-build decisions, according to Barun of Geneva Trading. “It takes quite a bit of introspection to look at what differentiates us as a firm—where do we add value?” he says. “In what area are we innovators or leaders, and in what area are we the middle of the pack or followers? You can be an innovator in one category and following the pack in others.”

Where a firm is innovating, adds Barun, it will have to build technology itself. In other areas, it can leverage existing technologies, get up to speed very quickly and bring it to new markets, he says. “Many firms go to a default mode of, ‘If we don’t build it here, it’s no good.’ Whenever I see that black-and-white rule of thumb, there’s always something underneath,” he says, adding that firms can always find ways to focus energy on things that make them more efficient, make more money, and allow them to leverage existing technology.

Generally, it is always cheaper to use an outside provider, because they invested millions of dollars in it, says Barun. “If they don’t have some of the capabilities you need, it will be very costly for you to build [that functionality] from scratch.”

In 2011, it appears that decisions to buy or build trading systems and related operations will be made within the parameters of fully integrated front-to-back office systems. Operations professionals will have to weigh and balance cost savings with regulatory compliance in choosing what systems to build or buy, and then deploy. Being up-to-date with new regulatory measures could tangentially result in better support for risk management functions. Technologists will have plenty to consider as external factors continue to shake up the industry landscape next year.