Tackling The Post-Trade Processing Cost Of OTC Derivatives – Some Perspectives On Driving Efficiency

Balancing regulatory compliance with total cost of ownership (TCO) objectives has been a complex challenge for capital markets firms over the last decade. With infrastructure a by-product of organisational history, bespoke and highly customised systems are the mainstay of most institutions – making it hard for off the shelf solutions to deliver meaningful, cost effective impact. Compliance will always win in a prioritisation process, with the combination of time-bound objectives and complex architecture driving short term or tactical responses. The result becomes additional layers of functionality upon an already complex technology stack, rendering traditional ‘rip-and-replace’ solutions with vendor products unfeasible for the majority of middle and back office infrastructure.

With wholesale internal investment too prohibitive for all but the largest of the universal banks, where ROI can be justified based on retention of market share, alternative approaches are required to deliver meaningful impacts. Of increasing interest to many organisations is attempting to modularise infrastructure into ‘bite-sized’ chunks, addressing processing components in logical groupings to deliver meaningful outcomes from both a TCO and also an automation perspective.

This trend is increasingly evident across the industry, with consolidated offerings for back-office managed services within securities processing (Broadridge) and listed derivatives (FIS) emerging to service components of the process. The attraction of architecting an operating model in this way is that it gives the opportunity to buy different areas of core competence/expertise from different service providers – avoiding a one size fits all solution – whilst also offering the potential to leverage newer technology within a solution. Though the supply of services is still dominated by a handful of organisations, the attraction of the concept is obvious through the benefits of scale and investment mutualisation that clients ultimately benefit from. For the vendor, being able to maintain process standardisation overtime enables revenues to support ongoing investment whilst still generating margin.

Similar managed service concepts are evident within areas such as reference data and reconciliation (though offerings are still at varying stages of maturity), but one area of sizeable cost opportunity for the industry surrounds processing of OTC derivatives. Our experience from working with clients in this space highlights that the uncleared segment of this asset class is a cost drag for many organisations, with most being unable to control the increasing cost of processing. We see a couple of core themes contributing to this:

  • Clearing Is Not A Catch All. Post-2008, clearing attracted a significant amount of focus from regulators as being a risk mitigation tool for OTC portfolios. The efficiency with which central counterparties (CCPs) dealt with the fall-out from the Lehman bankruptcy highlighted this and clearing became a focus under subsequent regulation under Dodd Frank and EMIR. A by-product of clearing is that it also streamlines and brings efficiency to the post trade process, with market infrastructure providers and CCP’s combining to make the process standardised and efficient. As a tool for post-trade efficiency however, it has been unable to solve the processing challenges of bespoke or complex products, with a sizeable portfolio of derivatives falling outside of the capabilities of CCP’s. Effectively, this ‘tail’ of a portfolio is required to be serviced in-house by banks who have to bilaterally manage each trade with counterparts.

The non-cleared market is unlikely to disappear, for the simple reason that firms will always have tailored, bespoke risks they need to hedge’ Timothy Massad, CFTC, September 2014

  • Regulations Keep Evolving. Lack of a steady state over the last 5 years has meant that focus has been on servicing compliance rather than process optimisation. Initially from Dodd Frank through to most recently IOSCO margin rules, organisations have had to continually race to keep up and have had limited time to consider efficiency. Additional requirements such as UTI generation and matching, trade (real time and end of day) and collateral reporting have driven an ongoing wave of enhancements to system infrastructure.
  • Ongoing Complexity Makes Problem ‘Too big to fix’. Successive layering of new requirements – regulatory as well as product driven – on top of legacy architecture has rendered for most technology stacks too complex and too risky to remediate. The cost to rewire has effectively meant that organisations have become stuck with what they have.
  • IT Outsourcing Not Impactful Enough. Replacing software with a vendor product delivers enhanced functionality but the cost impact in isolation is not material enough for most organisations. The implementation effort and risk associated with replatforming often outweighs the financial benefits of undertaking it – certainly where incumbent systems are often cheap to run in relative comparison. Whilst inflexible and complex, legacy architectures in many organisations are relatively cost effective – in terms of cost sitting on a balance sheet – as spend has often been fully depreciated overtime. This makes developing a benefit case for system replacement challenging
Addressing The Challenge

Whilst the market currently lacks mature offerings to deliver meaningful impact within this space, this is starting to change as the industry explores solutions to address the challenges caused by increasing costs of ownership around this process. Several organisations we have worked with are looking at trying to convert in-house processing onto a solution that enhances their efficiency – either through reducing ongoing cost of change or by streamlining their processes. Here are some of our perspectives around how to take a progressive approach to evolving your infrastructure:

  • A Managed Service Approach. IT or process outsourcing in isolation will not deliver the longer term benefits that an organisation requires – senior leaders we have engaged with view the minimum cost benefit as around 30% of TCO to justify the implementation risk and effort. As a consequence, software, infrastructure and operations need to be considered in aggregate to deliver the required cost benefit
  • Explore Best of Breed. Being sold an existing product by a large technology or outsourcing vendor is not the only game in town. Whilst these may seem convenient packaged services, this may not be the optimal solution for your organisation. Many technology vendors are focussed solely on software development – they have little interest in developing capability in other areas – but will often work in partnership with others to deliver a managed service solution. Bringing firms together to deliver a joint-venture is increasingly becoming attractive, certainly where one of the organisations has sufficient size and scale to front the engagement to satisfy vendor risk appetite. This approach is increasingly enabling FinTech innovation to help deliver a solution
  • Embrace Standardisation, Not Customisation. Longer term benefits accrue from usage of a managed service where standardisation of process across clients delivers ongoing efficiency and innovation. This enables the supplier to mutualise investment for regulatory and functional changes across their client base, driving TCO down to a point which a single-client platform could never match. Recognition of this longer term benefit is critical to success, as exporting in-house customisation onto an external platform fundamentally breaks the value proposition. We see many failed programmes where the cost of trying to tailor the vendor solution has eroded the financial benefit. This requires strong governance internally to avoid replicating the problems of the past on the new service
  • Align Technology Within Operating Model. A key failure of transformation programmes to deliver the full benefits is where technology implementation is disconnected from the operating model it needs to support. This can be caused by lack of engagement by all parties or perhaps where leadership for the initiatives is driven from technology rather than process owners. Whilst an obvious statement, it is a common theme that ultimately manifests itself in failure to deliver the benefit case or expensive remediation down the line
  • Modularise The Approach. Though clearing has delivered significant efficiency benefits to the interest-rate and credit space (over 90% of these products are now cleared in one large universal bank we spoke to), the bespoke nature of other OTC products such as equity or commodity derivatives limits this an option. Much of the systems and process infrastructure in many organisations is aligned by asset class and/or region, so breaking execution down into logical shapes de-risks the implementation. Whilst this may elongate the time frame, it gives recognition to complexity of the architecture that is being unpicked. Rarely do the management committees responsible for process or regulatory failure appreciate cost savings as a justification…..

Whilst the marketplace will mature in terms of offerings over time, we believe the more forward-looking organisations will drive their own agendas in terms of exploring strategies for efficiency around processing of OTC derivatives.  With Brexit likely driving additional volume and complexity as portfolios are split across entities, further roll out of initial margin rules to the rest of the market and ongoing cost pressure on organisations, architecting for the future to control TCO becomes essential.


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