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STP - operational efficiencyIt is unusual for nearly all parties in the securities industry to agree on anything but straight through processing (STP) as a model for operational efficiency in securities processing has that unusual status. When you consider the benefits that is believed to bring, this is understandable - reduced operational risk through minimal human involvement; and the speeding up the trading lifecycle to meet ever shorter settlement periods. However, this unanimity cracks when considering how this is best achieved.
Whichever proves the best way to achieve STP, most firms are sufficiently convinced of the need to do so to be actively pursuing strategies to raise the levels of STP in their securities operations. The commonly adopted approach is to invest in open systems, implementing the best of breed applications to meet functional needs, and connect these using message routing middleware to form a single integrated solution. Middleware and communications solutions also provide connectivity to external systems such as to clients, exchanges and clearing agents.
As a concept this now seems rather obvious, but achieving it continues to place a heavy burden on time and resources. There are still many aged systems running overnight batch processes, and many gaps in the complete data flow from order capture through to settlement and accounting which are still being plugged by rekeying data, spreadsheet manipulation and clumsy, slow file transfers.
Those firms furthest down the road to achieving STP are beginning to realise the operational efficiencies promised.
They are likely to have many back office functions such as sending confirmations and settlement instructions, accounting and position keeping completely automated. What they are rediscovering is the law of diminishing returns. To close the remaining gaps in the STP flow requires continuing high levels of IT investment, yet this may not produce the same savings and increased efficiency that earlier automation of functions achieved.
However, there are critical business drivers at work pushing the need for ever higher operational efficiency, which mean that these gaps must be plugged. Margins for all sectors are constantly being squeezed. Private, retail and institutional clients expect increased automation and higher trading volumes to mean lower charges to them. The competition for new business is fierce forcing all players to try to match these expectations.
Consolidation of securities firms and investment banks has placed demands on securities operations. A consolidated company generally needs to process a higher volume of trades, and often becomes involved in areas of business new to one side of the merged entity. The integration of the merged entities systems is a major cost, usually without obvious benefits to the clients. There are fewer firms, but individually they process more trades, and they are constantly innovating with new markets and products requiring a significant investment in systems Ů capital costs which have to be paid for by increased revenue and reduced operating costs.
Firms are having to make greater investment in systems in order to service their business. Clients, especially in the institutional sector, are more sophisticated and international in their outlook and want to invest in a wider variety of securities across global markets, resulting in increased demands on a firmís systems. Sometimes this has meant development work, at other times this has meant seeking new more flexible systems which are better at adapting to business changes. This has led to a ratcheting up of IT investment by firms.
Looking at the retail side of the securities market there is a similar picture. Retail clients are not prepared to pay high transaction costs. The internet has played a role here in setting peopleís expectations, particularly in the US, where it is having a huge effect in transforming a large number of savers into investors who expect low charges, growing the volume of transactions and potentially placing a strain on the systems which need to process them.
An alternative IT strategy which is gaining acceptance in both the retail and institutional securities sectors is to consider outsourcing parts of the operation. In most cases this means outsourcing the IT infrastructure of the back office, retaining back office staff who connect through to systems provided and run by a service provider.
One of the most persuasive reasons for outsourcing IT infrastructure is the low investment, coupled with predictable running costs which are closely linked to business volumes. The great attraction to firms is that low investment enables capital to be concentrated in providing value added services to clients - for example to provide a first class browser interface for clients with quick, reliable and secure access in the case of a securities retailer; investment in the front office infrastructure or research services in the case of an institutional broker.
Outsourcing has other attractions for firms. It is an obvious option for new setup operations, where there is no legacy systems, or pool of IT personnel to rely on. Similarly, it is particularly suited to new and growing sectors where trading volumes are unpredictable, for example the internet based retail sector. The firm does not need to worry about the volume flexibility of the system - will it have enough capacity in a few months time, or has the firm paid for redundant capacity. Compared to running your own hardware and software, IT risk is hugely reduced if it is outsourced.
Looking to the US, outsourcing is well established amongst both the capital and retail securities sectors, more so than in other regions. The technical solutions to outsourcing for each sector may be different. For example, a retail broker is likely to use browser and internet-based technology for client communication, whereas a broker dealing with international institutions will use a messaging network such as SWIFT, with a sophisticated order management system feeding into the settlement system. What may be common is the settlement system sitting behind these, the part which is most commonly outsourced. So a service provider is capable of readily supplying both markets.
For these reasons, outsourcing is a trend that many predict will grow in all markets over the next few years. The interesting question is which services firms are prepared to outsource. So far this has been largely restricted to the IT infrastructure of the back office.
Current technology may provide clues as to how the outsourcing trend could develop. One of the persistent gaps in STP has been the handling and resolution of exceptions. The majority of trades which settle without problems are relatively straightforward to automate and so this processing can be readily outsourced. What is usually retained in-house is the exception handling, dealing with trades with incomplete data, or which require human authorisation, or in some other way are classified as exceptions.
The most advanced STP systems now provide exception handling and resolution capabilities. Rule-based logic can be built in, modeled on the firmís business rules and resolution procedures. If the exception handling component is generic across all other components in the settlement system and has resolution capabilities, the user is provided with knowledge of the firmís rules and procedures and the tools to be able to resolve the exceptions.
Accepting this picture of exception handling means outsourcing this function becomes feasible, which is in effect the remainder of the back office.
These outsourced operations would be complete settlement factories, run not by the securities firms, but by service providers, with the securities firms retaining personnel only to be escalation points and to audit the service. Assuming that they have more than one client, these settlement factories would provide economies of scale. They could be sited wherever has sufficiently developed communications, suitable personnel and the least cost premises, and with clients operating in different time zones, systems could operate close to capacity round the clock, to maximise the return on the IT investment and reduce transaction costs to the clients.
That may not be a full extent of future outsourcing. Some middle office functions have tended to lag behind the back office in the move to automation. Corporate actions handling, for example, is regarded by many as not being particularly well served by the software providers, perhaps a reflection of the investment priority that firms give this function. Yet these are workflow items with similarities to settlement processing. If a software provider delivers an efficient corporate actions system there seems little reason why this could not also be provided as an outsourced service. Indeed, some firms would be only too happy to see areas of processing such as corporate actions outsourced as this is often regarded as an expensive service that is provided to help gain more lucrative areas of clientsí securities business.
As now there will be reluctance on the part of some firms to adopt large scale outsourcing of their securities operations. Yet outsourcing represents a great opportunity for firms to slim down costly operations and concentrate their investment and resources in the parts of their business that are their areas of expertise, so enabling them to provide value-added services which are different from the competition and which are high fee earners. It enables firms to shift the burden of investment to service providers for the functions that they have to provide to be able to offer a full client service, but which are not real generators of profit.
The challenge for the supporting IT industry is to be able to meet this demand for a greater range of services for these consolidated, thinned down clients, from which they can make money through economies of scale in an increasingly cost conscious market.
by Steve Bloomer
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