Middle office takes centre stage as Europe moves to T+2
The introduction of T+2 has marked another milestone in the effort to reduce systemic risk for firms trading European securities. But what about other asset classes, such as derivatives? The inconvenient truth is that the world of derivatives, which some view as a much riskier investment choice, lags a long way behind equities in terms of operational efficiency, writes Steve Grob, director of group strategy at Fidessa.
Derivatives are big business. World markets overshadow equities by as much as ten-fold and they’re used by a dazzling array of organisations to do business – from airlines hedging against fuel price rises to oil companies insuring themselves against adverse weather events. Yet despite the colossal size and intrinsic importance of the market, the behind-the-scenes processing of traded derivatives has languished in a technological backwater.
The process for creating, filling, confirming and clearing a derivatives order is different from equities – and that’s why the two markets are still worlds apart, despite great leaps forward in the available technology. Getting the process wrong in equities results in buyers not receiving their share certificates and sellers not getting their money – a very obvious mistake. So equity markets have built systems to automate this process, making it transparent and relatively low risk. Europe is actually going even further with the recent adoption of T+2 which effectively cuts by a third the time taken to clear and settle trades. It’s also getting cheaper, as open industry standards such as FIX come to dominate equities middle office just as they have in front office trading.
Unfortunately, this technology doesn’t translate easily to derivatives as the post-trade process follows a different route. Rather than just settle cash and the right number of shares in a few days, the derivatives world needs to maintain positions over the lifespan of the contract. This may be months or years and is required so that margin calls can be made to the respective parties by the relevant central clearing house.
Despite these complexities, continuing to do nothing is no longer an option. The twin thorns in the side of today’s financial markets – cost and risk – come to bear heavily on the outdated processes under which derivatives middle offices labour. Manual processes are fraught with human error; they’re slow and tied to bulky physical sites full of people operating within their own time zones. In a globally connected world full of concerned regulators and paper-thin margins, this just isn’t good enough any more.
Solving this issue for derivatives is probably one of the biggest things the industry as a whole can do to reduce systemic risk. The global derivatives market is huge and growing and forms an absolutely vital foundation for businesses of all kinds. And yet, as we saw in the aftermath of Lehman’s collapse, not knowing exactly who is holding which cards at the table can get pretty messy – especially if there is any kind of meltdown. The technology needed to solve these problems is there, but it’s not an out-of-the-box deal – yet. Deploying middle office terminals to buy-side clients is a half-way point. But then buy-sides can’t see what’s going on within the context of their own OMSs, and now they have two systems to keep track of and those systems don’t talk to each other at all. That’s been the issue through time with proprietary solutions. They don’t communicate well with existing systems and require a whole lot of external expertise to maintain. Running and maintaining multiple systems is a headache that both the buy-side and the sell-side are grappling with all the time and any moves need to be away from that and towards a properly integrated approach.
Alternatively, some firms have created centralised middle office ‘warehouses’ to handle all the workflow in one place. Whilst this makes economic sense it doesn’t improve the risk profile at all, and injects extra risk and inconvenience as the tyranny of time zones comes into play.
So how can the derivatives industry learn from its cash equity counterparts? For a start, the use of existing open-source protocols will drive the development of acceptably fast and accurate processing of derivatives workflows. FIX is a great candidate because the language starts at the order level, so the protocol naturally follows the workflow and has a spot for all the pieces of information that will ultimately be needed to clear the trade. It sweeps away the hassle and risk of adding information all the way along the workflow. This persistence of information is now a very achievable goal – and once this is in place, the rest is pretty easy.
Of course FIX was born in cash equities and while newer versions support all the complexities necessary to trade, process and clear derivatives of all kinds, most big buy-sides are running on earlier versions. In order to get around this, a number of technology vendors have added their updates to make it fit-for-purpose for derivatives for the vast majority of firms.
Enabling FIX does two important things for the buy-side. First, that persistence of information drastically lowers risk. Second, it puts power back in their hands, enabling the desks themselves to manage allocations. The role of the buy-side trader is changing to incorporate the full order lifecycle, and with a proper, fully automated system, writing out paper tickets and managing the errors that inevitably follow will become a thing of the past. The front office will have a complete view – and in real time – about the status of all trades, creating a far more intelligent desk to empower the organisation.
This works for the sell-side too, as it can improve its error rate, reduce duplicated allocation methodologies and lower its own risk, all at the same time. So by streamlining the workflow, both the buy- and the sell-side achieve a safer, cheaper and altogether more efficient middle office outcome.
It seems like the direction of travel is set, then. No longer can derivatives trade allocations languish in the ’80s. But, like a lot of firms that embrace new technology later on, many FCMs may very well leapfrog the progress made by their equity market counterparts and, with the path now clear, get there with less friction.