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Five Priorities for the Middle and Back Offices, from the Financial Crisis

March 22, 2010
Chris Kentouris

Regulators want it, investors want it, and financial firms are now beginning to understand they need it.

“It” constitutes a far-better understanding of just what trades in which types of securities Wall Street firms are executing and processing, with whom else and when.

If fund managers, broker-dealers, banks and regulators learned anything from the financial crisis it was that they didn’t have access to timely or accurate information.  Data coming in from multiple and contradictory sources made it difficult to understand just what their exposures to risks – like the disappearance of a trading partner – were.

Now, to get it right – aka satisfy securities watchdogs and possibly avoid another financial meltdown—they have to make hefty operational changes, fairly fast.

“It will be a significant year for middle- and back-office professionals as they adopt more efficient practices to ensure a holistic view of risk,” says Lloyd Altman, senior executive in the capital markets practice of global consultancy Accenture in New York.

The more efficient practices will also ensure that firms can reduce their operating costs and regulatory capital requirements. “Doing so ensures that the middle and back office are no longer viewed as cost centers but as potential profit-making centers,” says David Kubersky, managing director of New York-based SimCorp USA, a front-to-back office investment management software provider.

Those views were bolstered by the results of a survey released by the U.S. trade group International Securities Association for Institutional Trade Communication (ISITC) last week. The survey of 72 buy and sell-side firms showed that close to 70 percent will be focusing attention in 2010 on achieving operational efficiencies. The group, which specializes in creating post-trade communication messages and procedures, will be discussing just how the financial crisis has prompted changes to the middle and back office at its fifteen annual industry forum that starts today in Boston.

In speaking to securities operations professionals as well as the technology firms and consultants which service them, Securities Industry News came up with the following five priorities for middle and back office executives this year.

Ensuring the Accuracy, Consistency and Flow of Data

The pursuit of increased efficiency – and transparency – in the middle and back office is beginning to play out in increased attention to how data is managed.

Transaction data that originates in trading or portfolio management systems typically moves downstream through a series of analytical and recordkeeping applications, stored in various databases, sent to service providers and utilities and aggregated for regulatory reporting.  The goal now: to ensure that the data is accurate and consistent between multiple databases so that firms can obtain an enterprise-wide view of risk – in as close to real time as possible. Incorrect data can result in incorrect calculations on market, counterparty and credit risk exposures.

“The psyche of financial firms on how to gain a competitive advantage has changed from the single-minded goal of traders executing more orders to having a 360 degree view of its data,” says Mike Meriton, chief executive of GoldenSource, a New York-based enterprise data management provider.

Meriton says that beginning late last year his firm has experienced an uptick from fund managers and broker dealers for its enterprise-wide data management software product which creates a consistent and centralized view of its security master, position and transactions across the entire company. The “golden copy” created can then be fed into risk management software system to measure market, counterparty and credit risk firmwide.

Yet another approach now being embraced by some broker-dealers is to consider  placing “data as a service (DAAS)” online. By viewing  data elements – discrete units such as names, exchange codes, time and price – as resources separate from applications that use them, it is possible to not only organize workflow better but to reduce redundant data sources.

“More forward- looking institutions see the benefit of looking at the larger data picture and establishing more standardized data handling processes to support the entire workflow,” says Vijay Oddiraju, chief executive officer of New York-based Volante Technologies, a supplier of data messaging solutions. Volante, as well as Progress and IBM, offer metadata-based data integration platforms that provide much of the technical foundation for DAAS.

Ensuring More Efficient Processing of Over-the-Counter Derivatives

Broker-dealers, custodians, and traditional and alternative asset managers will need to improve the technology and operational infrastructure that supports over-the-counter derivatives. “Not doing so will prompt regulatory scrutiny, investor angst, and increased risk,” says Dayle Scher, a director at research firm Tower Group in Needham Mass and a board member of ISITC.

Unlike equities, OTC derivatives don’t settle in a three-day timetable and their lengthy duration means that the terms of their contracts must be updated continually to ensure the correct and timely payments are made. Errors in confirming and affirming the details of an OTC trade could end up exposing a firm to counterparty, liquidity, and settlement risk.

And with regulators potentially mandating central clearing of most OTC trades, firms are now investing their time and money in keeping closer tabs on the life of an OTC derivative from the time it is traded through an order-management platform until it is settled; that includes its collateral requirements.

“Central clearing will require broker dealers and fund managers to install systems to calculate value at risk and other risk-metrics, as well as margin and interest payments, “ one operations executive at a New York based broker-dealer told Securities Industry News. He predicts that workflow management software for OTC derivatives will become popular this year.

Among the other services being embraced by some fund managers and broker dealers: Euroclear Bank’s DerivManager as well as Markit and Depository Trust Company’s post-trade processing platforms; third-party valuation vendors; and reconciliation software to keep track of OTC positions between counterparties and administer collateral requirements efficiently.

The benefit, according to Tim Lind, managing director of Omgeo: fund managers and broker-dealers minimize counterparty risk and optimize the use of collateral to reduce their regulatory capital requirements. Specializing in post-trade communication services, Omgeo recently launched a new service to offer reconciliation and dispute management, margin calculations and collateral inventory management for OTC derivatives.

Ensuring Correct and Transparent Valuations

Operations executives, data analysts, valuation experts and IT staff will need to brace themselves to do even more work when it comes to valuing securities correctly, this year. Simply striking a price on assets held by a fund manager, bank or brokerage firm won’t be enough.

Firms will need to prove they made the right valuation decision, says Daniel Simpson, chief executive for Cadis, a data management software firm in London. That means verifying internally sourced prices against external data and comparing external data feeds against each other. And keeping a full audit trail so investors and regulators can know which internal and external data was used to price an asset and why.

Among the two key regulatory initiatives to watch out for: the Financial Accounting Standards Board’s new version of Accounting Standards Codification Topic 820-10 – commonly referred to as the fair-value accounting rule. The controversial two-year-old rule formerly known as FAS (Financial Accounting Standard) 157 dictates a three-tiered hierarchy for how companies should measure and disclose the fair value of the assets and liabilities they hold.

The new rule effective late this year, requires firms to disclose additional information on how they value their assets and liabilities and the reasons they are changing their valuation methodology. That means changes to accounting systems which then feed into financial reporting systems.

Administrators of money market funds will also have to beef up their data management capabilities to comply with the Securities and Exchange Commission’s requirement issued last month that they strike monthly “shadow values” for assets in their funds. And they will have also have to disclose a lot more information on a monthly basis in XML protocol about the holdings of the fund and mark-to-market each of its assets.

Back to STP

Operations executives consulted by Securities Industry News last week say they can’t talk about improving risk management without referring to an over-used term, "straight-through processing” which hasn’t been that popular over the past few years. But it will make a comeback in 2010 as firms start spending more on process automation tools with risk controls, says David Campbell, securities product manager at Fiserv Investment Services, the Jersey City, N.J. division of global technology giant Fiserv. That means flagging securities which have the greatest potential for processing errors  

For some middle and back office functions it also translates into operations executives using standardized rather than proprietary message types or paper-based communications.” Case in point: corporate actions. Swift, the La Hulpe, Belgium-based messaging network provider, is upgrading its ISO 15022-compliant corporate action messages to reduce the amount of interpretation – and potential error -- that financial intermediaries face when they send notifications of corporate events, such as reorganizations, to their fund manager and end investors  

Swift is also introducing in November more advanced XML-based ISO 20022-compliant messages which break down the five ISO 15022 messages for corporate action notifications, instructions, confirmations, status and narrative into 14 new message types. The advantage: no longer will financial intermediaries send long narrative explanations of corporate action events to their clients.

Brokerages and banks will have to follow the new format and put information into dedicated message types with structured fields which their customers can quickly understand and make decisions on faster. Fewer errors translate to reduced operational risk – and financial liability for all parties concerned. But financial intermediaries will have to spend some time – and money – making programming changes to accommodate the new message formats.

Other financial instruments now under the automation radar: investment funds and syndicated loans. Fund managers and distributors are quickly catching up to the merits of using electronic communications of trade and post-trade activities and are signing up with order routing service providers Calastone and EMXCo as well as the national securities depositories within the Euroclear family of depositories and rival Clearstream. Swift message types are also fast becoming the norm to communicate trade orders and redemptions between fund distributors, managers and transfer agents. Last month, ISITC endorsed the use of the ISO 20022 message formats delivered over the Swift network for “trailer fees” sent by mutual fund companies to distributors.

When it comes to syndicated loans, Depository Trust and Clearing Corp and Euroclear Bank are winning business from global agent banks to automate the reconciliation of the details of a loan daily between themselves and the lenders – typically other banks and institutional investors. Rivals Trade Settlement and ClearPar, now owned by Markit, have embraced the automated confirmation or settlement of syndicated loan trades while Markit amd DTCC have partnered to potentially offer a more advanced simultaneous delivery versus payment settlement of syndicated loans by linking ClearPar to DTCC’s LoanServ  Euroclear plans a similar strategy through its competing LoanReach service.

Using Trade Settlement and ClearPar traders – and their operations staff -- no longer need to wait for several weeks to transfer ownership of syndicated loans between counterparties and be subject to a change in market value. Simultaneous delivery versus payment would also allow firms to move cash and securities on the same day at the same time rather than separately thereby facing the possibility of not receiving the cash or securities should a counterparty go bust.

Doing More With Less

Keeping costs to a bare minimum remains critical.

One way is to streamline market data usage – one of the top three operating expenses – by installing systems which keep track of just how market data is being used throughout a firm and whether any redundancies in feeds can be eliminated. That boils down to cutting down the number of data vendors used, renegotiating contracts with market data or reducing access to data by internal staff.

Just as important is knowing just how much it costs to execute a trade order for each customer. At first glance, traders should be able to do so themselves. But keeping track of the fees each trading venue charges, the cost of the trading terminal and how many trades are executed for that customer can’t really be done on a spreadsheet. Such work is often relegated to the middle office.

"What if a financial institution could take all that trade data and calculate just how much it truly costs to service each customer?” asks Nick Fera, chief executive officer of Firm58, a Chicago-based software firm specializing in post-trade financial management services. “A firm would determine whether it wanted to continue doing business with that customer or whether it would be more profitable to change its pricing structure.”

The end result: dropping thousands a month and possibly millions a year, to a financial firm’s bottom line.

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