This insight was originally published as a guest article in Global Investor. Click here to view
We have previously explored how post-trade represents the next frontier for financial institutions seeking to digitalise their operations. Banks have directed significant investment into the systems supporting the sales and execution portions of the trade lifecycle, due to their greater revenue-generating potential. By comparison, they have largely neglected their post-trade processing systems, beyond nearshoring and offshoring.
That dynamic is particularly acute in the exchanged-traded derivatives (ETD) space. The pandemic triggered widespread volatility and a sharp rise in ETD trading volumes, compounding pre-existing pressures on sell-side post-trade processes. According to the FIA, worldwide volume of exchange-traded derivatives was 4.54 billion contracts in March 2020, up 25.4% from the previous month and up 58.8% compared to March 2019, as a surge in retail equity options added to the steadily rising tide of electronic and high-frequency trading.[1] A survey of brokers found that 58% experienced post-trade processing issues amid this flurry of activity.[2]
Other market and regulatory changes are adding further strain to banks’ ETD post-trade systems. The regulations governing over-the-counter (OTC) derivatives are evolving to require central clearing for standardised OTC products. Key parts of banks’ post-trade infrastructure service both ETD and cleared OTC products. Regulation that drives an increase in the volume of the latter passing through banks’ post-trade systems also reduces their capacity to handle the former.
It is therefore an opportune moment for sell-side institutions who are active in the ETD space to take stock of their post-trade processes and consider where and how they can reduce risk and cost. Most banks will currently be using at least one of the two main legacy systems for ETD post-trade processing, namely GMI or Rolfe & Nolan. These systems can be expensive to run and maintain, particularly as users will have had to implement many piecemeal tactical fixes over time to cater for changing requirements.
It is an opportune moment for sell-side institutions who are active in the ETD space to take stock of their post-trade processes and consider where and how they can reduce risk and cost.
It is neither realistic nor cost-effective, however, for the sell-side to build replacements to these ETD post-trade legacy systems in-house. These systems require a high level of connectivity with numerous exchanges and central counterparties, with each connection tested and certified by the exchange. It would also be practically difficult to win support for such a major undertaking internally, due to the ingrained perception of post-trade as an overhead with little perceived competitive benefit that has caused banks to prioritise the front office.
Instead, sell-side institutions need to look carefully at the new platforms being brought to market by specialist technology vendors to replace the current duopoly of legacy platforms. When evaluating the cost-benefit equation of any platform upgrade, banks should evaluate their current post-trade processes and the potential upgrade in terms of three key criteria: capabilities, process efficiency and cost transparency.
Capabilities, process efficiency and cost transparency: the hallmarks of a state-of-the-art post-trade ETD system. In terms of the capabilities required of post-trade processes, a bank’s systems must be able to support a wide range of activities that can be grouped into three broad categories: exchange-facing, client-facing and intra-enterprise cross-product.
Exchange- and client-facing capabilities are essential to running a successful ETD execution and clearing business. The deeper these capabilities – such as being able to margin clients intra-day or report cleared allocated trades to clients via a FIX API rather than a portal or emailed report – the greater the reduction in risk and the attractiveness of the business to clients. Meanwhile, cross-product enterprise capabilities can aid both clients, via cross-product margining and convenience margining, and the business, via optimised clearing house margin through offsetting listed and cleared OTC positions.
Regulation that drives an increase in the volume of cleared OTC products passing through banks’ post-trade systems also reduces their capacity to handle ETD products.
In respect of capabilities, therefore, a like-for-like comparison of the merits of one post-trade system versus another is relatively straightforward. It entails an assessment of how the currently missing capabilities contribute to diminished client service, satisfaction and retention or to reduced risk management capability, whether measured by intraday fluctuations in exposure and credit, or by volume of settlement fails, reconciliation breaks or client queries.
It can be comparatively harder for a bank to envisage what a new post-trade system with superior process efficiency will look like. We recommended thinking about how post-trade processes will need to be reengineered to reduce costs in terms of a three-step approach: standardisation, centralisation and optimisation.
Brokers will first need to standardise systems and processes across geographies to the maximum possible extent, allowing for load balancing between different locations at peak times and for the embedding of a common cost methodology. They will then need to centralise functions in single locations, concentrating the relevant expertise there, before optimising processes to remove headcount-to-volume dependencies.
As a flow business, ETD is more susceptible to process optimisation through implementing straight-through processing (STP) than asset classes like structured products, where a greater degree of manual intervention is somewhat unavoidable. A predominantly STP-based process with workflow-based exception handling, so that the status and labour-intensity of resolving each exception can be tracked, represents the gold standard for ETD brokers. This kind of process redesign offers significant cost and risk reduction – albeit other chokepoints, such as non-standardised contract identifiers and the variation in fees and commissions between voice and electronic trades, can only be addressed through industry-wide changes.
Finally, understanding how a new post-trade system will aid cost transparency is crucial to understanding whether the project is worthwhile. When the ultimate goal is a reduction in post-trade costs, it is axiomatic that it will be necessary for any new system to be able to accurately and precisely measure cost and therefore demonstrate return on investment.
When evaluating the cost-benefit equation of any platform upgrade, banks should evaluate their current post-trade processes and the potential upgrade in terms of three key criteria: capabilities, process efficiency and cost transparency.
To do this, brokers must be able to regularly and repeatably ascertain and report, via an automated process, the key cost indicators at various levels of granularity, including the cost per trade, cost per exception and individual client profitability.
The pressure on ETD brokers to invest in their post-trade systems had been steadily mounting, before being turbocharged by the pandemic. However, sell-side institutions need to determine if there is a business case to upgrade their systems – in terms of the superior capabilities, process efficiency and cost transparency of the new platform – before committing to a major overhaul.
[1] Mar 2020 ETD volumes – https://www.fia.org/resources/etd-volume-march-2020
[2] Acuiti 2020 report on “The Growing Need to Invest Derivatives Post-Trade”