A framework for build, buy or network in a changing market environment

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This article was originally published on Securities Finance Monitor.

Capital markets firms are faced with tough choices in their vendor and utility selection. But when should firms choose to partner with vendors, participate in industry utilities or insource development altogether? This article provides a framework for thinking through the options.

Capital markets have always been fast moving but seldom have the drivers of change come from so many directions at once.  Both buy-side and sell-side firms are contending with simultaneous pressures to comply with new regulations, find new ways to generate revenues and to cut costs. What makes this environment even more challenging is the interaction between these competing goals. Implementing new functionality to comply with new regulations is not enough; systems and processes also need to adjust to accommodate changes to business models driven by those regulations. New business initiatives have historically gone through due diligence processes of varying degrees of strictness and now need to satisfy control questions from the outside.  All this at a time when technology is evolving at a dizzying pace providing many options that were not viable until recently.

These challenges should not be perceived as all negative because the current environment presents many positive strategic opportunities. From established technology providers to the newest fintech start-ups, there is now an unprecedented choice of technology vendor options. There is a greater willingness than ever by firms to partner and develop industry solutions and to support, and in some cases create, new service providers. Meanwhile, at long last, the breadth of new functionality offered by these providers is matched by their depth of expertise. Solution providers frequently now offer not just “software” or a “service” but a complete solution package.

While capital markets players show increased willingness to turn to others for help in this challenging environment, there is also the recognition that the return on investment from internal technology resources needs to come from genuine differentiators in areas such as trading, data analytics, risk management and client interaction. In this world of both challenge and choice how can firms make the optimal choices without becoming stuck in analysis paralysis? At the most fundamental level they require a framework for deciding when to build, buy or network in collective enterprises.

Assessing internal capabilities

For a capital markets firm, the starting point for creating a framework is a realistic assessment of who they are, where they are going and what they are capable of. Some firms’ strengths may come from getting the basics right in areas such as operations or credit. Others may be innovators, creating new products, being the first into new markets or the first mover in the application of new technologies. Few, if any, firms can be good at everything and the effort of trying can be counterproductive. A realistic recognition of strengths and weaknesses is key.  This analysis needs to be conducted front to back ⎼ including business functions, personnel and technology capabilities ⎼ to ensure the most holistic understanding is developed for optimal decision making.

The next step is for a firm to understand where it wants to go, or more often in the current changing environment, where they need to go. Banks have been constrained by the pressure to build up and conserve capital. As a consequence, many formerly key business areas have shrunk or been closed. On the buy-side, active fund management, a traditionally high margin business, is under threat. Business changes such as the growth in popularity of low-cost ETFs and the rise of the robo-advisor are having major impacts on business strategy, even where the basics are sound. Whether a business strategy is expansive or reactive, or simply aimed at preserving a successful franchise, it has a major impact on a framework for interaction with technology and service providers.

Lastly, firms need to assess the potential of help from external parties versus the strengths of internal capabilities. One of the most significant recent developments has been the willingness to develop shared industry resources. The general driver for this has been a recognition that many parts of a financial sector organization (including the relevant parts of infrastructure) are non-differentiating sources of costs rather than sources of competitive advantage. Though industry utilities have been around almost as long as computers, they have tended to focus on a limited set of functional areas.

The new generation of utilities are appearing across front, middle and back office. Some notable examples include: FIS’s Derivatives Processing Utility which grew out Barclays; Accenture (in collaboration with Broadridge) Post-Trade Processing that absorbed business functions from Societe Generale; and more traditional projects such as Symphony, a collaboration of 16 major financial firms building a secure communication network. Another change of emphasis has been from the traditional regulatory drivers behind major utilities to more commercial drivers. In some cases, superior internal performance may actually create the opportunity for revenue generation by using that capability as the basis for an industry utility.

Creating vendor partnerships – dependencies, commodities and customization

There has been a high degree of consolidation of financial software vendors in recent years. Firms such as FIS have grown through a long running series of acquisitions (notably SunGard at the end of 2015), Broadridge Financial Solutions continues to make acquisitions, and UK based Misys recently merged with Canadian D+H to form Finastra. Consolidation has also been driven to some extent by internal procurement departments, which in many large financial services firms have worked to reduce the number of vendor relationships.

Despite these trends, there has been little reduction in choice as new fintech vendor firms grow. “Innovation” or “digital” teams across capital markets firms have worked to build bridges to the more promising start-ups. Choice in functionality has been matched by choice in the type of offerings. Capital markets software is often now available as part of a comprehensive package including cloud based hosting, integration and maintenance. Newer fintech firms may not be as big as other vendors but they make up for it with speed of execution, nimbleness and innovation in driving complex challenges. They are able to adopt some of the latest technology innovations much more efficiently than their larger counterparts.

Add to that the management of staff to execute the business process, and one end of the software services spectrum is indistinguishable from a utility. Still, partnering with a vendor creates the bane of any project manager: more dependencies on outside parties can mean more risks, the potential for slow turnaround and reduced control. The alternative, however, isn’t foolproof. Good internal development teams and working in genuine partnership with a business can deliver changes rapidly that are focused on a business user’s needs. However, writing new software or even carrying out the full integration of a vendor package can be a high risk and high cost strategy.

A good amount of the current enthusiasm for partnering with new fintech firms or joining industry utilities come from few key factors:

  • The experience of difficulties rolling out new systems in financial firms’ increasingly controlled and complex environments.
  • Many fintech firms can offer significantly deep domain and technical experience that may not be available internally.
  • Many financial firms have difficulty in finding and retaining top technology talent as professionals have opted to pursue other opportunities in the broader technology industry or fintech space.

This can make it harder than ever to deliver a project to budget, with acceptable timescales and user expectations. Even where a firm shows expertise in one area of technology, it is unlikely to have breadth and depth of resources within its IT function to do everything to the same standard.

Commoditization or specialization

Depending on an honest assessment of the firm, its capabilities and business strategy, different choices may be made about buying, building or collaborating. If a capital markets firm’s need is for relatively standard, commoditized functionality, then the key factor becomes the gap between their offering and the firm’s needs. The wider the gap, the greater dependency on additional work being done and the greater the implementation risk. If a wide gap exists between the firm’s needs and the full range of offerings, it may be worth going back to basics and asking why its needs are so different to peers that make use of software packages or other services in the first place.

If one or more potential partners can provide the desired functionality, the characteristics of the vendors themselves need to be considered. Important variables will include vendor capabilities and skill sets in terms of business domain and technical innovation, reputation in the industry, and extensibility of architecture and offering.  Many large vendors provide full feature functionality but it may be hard to customize whereas some newer fintech firms are leveraging more flexible technologies to make their offering able to meet various needs. If a supplier can provide functionality that can then be extended by an internal team, it may be an advantage as firms don’t always need to rely on the vendor for critical business changes.

If businesses require more innovative solutions than they are capable of mustering internally, it is likely that a partner will be of benefit. But the characteristics of the partner may become the most critical factor. Any partner chosen needs to have a genuine understanding of the firm’s needs. Genuine understanding comes from the combination of both technical skills and real-world experience. Suitable partners also need to understand the value of building a solution that is not just for today but has the flexibility to adapt to tomorrow’s challenges. Regulatory changes, such as the requirement to report securities finance trades under SFTR and margining of FX Forwards as a result of MiFID II, can have dramatic impacts. On the positive side, market changes or the rapid uptake of a new product can still lead to dramatic increases in volumes. In this case, firms need to look for a partner and not just a vendor because they may be able to help them assess their current capabilities and also help define the roadmap based on their understanding of the industry and regulatory landscape.

Utilities will continue to provide their own unique solutions, but the vantage point of a buyer or user should be: “is this process sufficiently commoditized that a utility can meet my needs?” Any truly commoditized process can be outsourced to a utility, while processes that offer or require differentiation should be managed internally by the firm. Firms may also need to have internal capabilities developed in-house or through a vendor to connect to the utility and take full advantage of their services. Utilities have a lot to offer, but firms need to be proactive in making the decision about what is a competitive advantage and what is a commodity service.

Creating a framework for understanding a capital markets firm’s capabilities and comparing the results to the vendor and utility landscape is the first step in deciding whether to build, buy or partner for solutions in today’s market. The catchphrase of outsourcing is easy; the hard part is ensuring that firms are building flexible partnerships for the long term. At Transcend Street, we find having a great product or solution is a good start but not enough to win the long term partnerships.  Our clients reach out to us because of our team’s broad industry experience, thought leadership and our focus on execution and delivery. Our vision, its alignment for the client’s benefit, and our capacity to be a long term partner in their success is our crucial differentiating factor.

As technology becomes increasingly complex, it is imperative that firms conduct a holistic review of their own capabilities and strategically identify the right partners. Too often, firms focus on features and functionality comparisons across solution providers but not enough on critical internal assessments. In the brave new world, where profits are scarce, cost pressures are high and regulatory compliance is crucial, firms that can master this strategic balance of internal builds and strategic partnerships in the industry will have a significant competitive advantage.

Optimizing Your Collateral Resiliency and Recovery

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This article was originally published in Securities Lending Times.

Balancing collateral optimization and regulatory compliance front to back through “Holistic Collateral Architecture”

July 28, 2017 

Collateral Business Transformation

Financial institutions today are increasingly evaluating how best to manage their collateral needs in the face of dual challenges – how to adapt their business and operational structures to become more efficient and how to respond to and comply with ongoing demands around changing regulatory requirements. These issues resemble a seemingly difficult task, like transferring passengers from one train to another, while both trains are in motion. Firms that approach front office transformation challenges, decoupled from regulatory and compliance challenge, will miss opportunities to solve larger systemic issues in a strategic and integrated fashion. We strongly believe that Technology strategy and architecture can play a critical role as firms evolve to meet these challenges.This article looks at how businesses can strategically address their collateral and liquidity management operations and regulatory needs by adopting a more holistic integration approach that takes into account their organizational complexity, unique business requirements and their compliance mandates. Firms that get this strategy right will establish a competitive advantage and maximize limited budgets by significantly enhancing their front office capabilities, while also meeting regulatory requirements.

Managing Business Transformations and Regulatory Challenges Simultaneously

Global regulations such as Dodd-Frank, Basel, MIFID and EMIR are demanding significant changes to securities finance and derivatives businesses which are primary drivers of collateral flow. An organization’s overall portfolio mix dictates the cost of doing business, and having an integrated view of the complete liquidity situation is critical and can’t be done in isolation. These regulatory and economic forces are driving firms to integrate their collateral businesses that traditionally operated as silos.

At the same time, new global regulations are mandating that firms implement specific capabilities and requirements that are often quite broad, impacting many aspects of collateral and liquidity management capabilities. Consequently, these requirements are quite onerous to accomplish especially because they need to be implemented at an enterprise level.

What is Required for Front Office Optimization?

Typically, financial business units were structured and incentivized to take a highly localized approach to addressing the collateral requirements for their specific business lines. This historical constraint was driven by a need for domain expertise and reinforced by budgeting protocols and performance expectations that were more closely aligned with local returns on capital, revenue and income. In the current environment, making decisions within a single function misses the opportunity to achieve broader benefits to drive valuable optimization across an enterprise. The outlying boxes in the diagram below illustrate the standard, localized organizations that exist in most firms today, where individual business units make collateral decisions without consideration of their sister business’ needs.

Firms that move beyond the silo approach and evaluate and prioritize collateral and liquidity requirements in a more integrated fashion across all their collateral management processes are better positioned to ensure the optimal allocation of capital and costs, realize efficiency gains and enhanced profitability. Some organizations are doing this by establishing collateral optimization units that have a mandate to implement technology and organizational changes across multiple businesses on a front-to-back basis. Potential areas that organizations are evaluating include maximizing stress liquidity, streamlining operational processing, reducing the balance sheet by retaining high-quality HQLA and improving the firm’s funding profile by reducing liquidity buffers against bad trades for non-LCR compliant transactions.

What is Required for Regulatory Compliance?

While many front office businesses typically focus on creating optimal technology architecture to improve financial return metrics, there are specific regulatory-focused technology enhancements that additionally need to be implemented. In most cases, these regulatory requirements are implemented by compliance and/or operations areas potentially away from the front office functions. This is a big challenge as these requirements are at the firm level and most firms don’t have a coordinated collateral architecture in the front. In particular, Recovery and Resolution Planning (RRP) requirements, Qualified Financial Contracts (QFC) specifications, Secured Financing Transaction Reporting (SFTR) are few examples that have pressing requirements and deadlines in the near future.

These regulations are creating significant demands on large institutions’ business and technology architecture:

  • Track and report on firm and counterparty collateral by jurisdiction (RRP – SR 14-1)
  • Track sources and uses of collateral at a security level across legal entities (RRP – 2017 guidance)
  • Conduct scenario-planning to simulate market stresses, such as a ratings downgrade or other environmental changes, that estimate impact on collateral and liquidity position in stress scenarios on a periodic basis (RRP – SR 14-1 and 2017 guidance)
  • Deliver daily information on their collateral and liquidity positions. Specific QFC (Qualified Financial Contract) reports will cover position-level, counterparty-level exposures, legal agreements and detailed collateral information. (QFC Specifications)
  • Report on all Securities Financing transactions (SFTR – Europe)

To fully meet these compliance deadlines within the next 12 to 24 months, most firms do not have the luxury of adopting a strategic approach to re-engineer their business and technology architecture and have been forced to take tactical steps to ensure compliance.  However, it is likely that achieving compliance in a short timeframe will create huge business and operational overhead costs, as one-off solutions may not be tightly integrated and may require additional manual work and reconciliations over time. The ongoing need for changes to front office business processes will have an impact on compliance solutions – potentially causing firms to significantly increase the operational overhead of supporting these businesses.

This can lead to a rather unfortunate outcome, in that costs for collateral businesses can significantly increase, despite working hard to drive cost & capital efficiencies.

A BETTER APPROACH – HOLISTIC ARCHITECTURE

Firms that choose to tackle these operational and regulatory challenges head-on and invest to create and establish an integrated collateral architecture across business lines will have a significant competitive advantage. In a dynamic marketplace where business needs and regulatory requirements are constantly evolving, a component-based architecture can be an effective approach. This allows seemingly complex processes to be managed through careful consideration of the distinct business and technology architecture elements of each stakeholder to achieve the appropriate balance for their strategy in an effective manner.

Key Components of Holistic Collateral Architecture

Here are some important drivers to consider in your planning:

  • Real-time inventory management capabilities across business lines that can be leveraged by both the front and back-office. This is a critical component of the strategic architecture, with the key requirement of knowing firm, counterparty and client collateral by jurisdiction.
  • QFC trades repository that is integrated across all Secured Financing Transactions as well as derivatives trades that can be linked with positions, margin calls and collateral postings.
  • Harmonized collateral schedules / legal agreements repository across ISDA, CSAs, (G)MRAs, (G)MSLAs, triparty, etc.
  • Enabling collateral traceability across legal entities with the ability to produce sources and uses of collateral will ensure regulatory compliance, as well as the ability to implement appropriate transfer pricing rules to drive business incentives in the right places.
  • Utilizing optimization algorithms with targeted analytics can maximize a variety of different business opportunities and most importantly recommend actions through seamless operational straight through processing.

This transition can be difficult for firms as it will need to cut across business and functional silos and it can have significant people and organizational hurdles along with technology challenges. One key point is that these changes don’t need to happen all at the same time and firms can prioritize the approach in a phased manner in line with their pain points and priorities as long as leadership is behind the vision of the holistic architecture. Many firms have started this journey and those who can make demonstrable progress in this evolution will have a significant competitive advantage in the new era.

How Transcend can help…

We have leveraged decades of Wall Street experience to develop strategic collateral and liquidity solutions for the largest, most sophisticated banks and financial institutions. Recognizing the unique requirements and opportunities financial organizations have to optimize liquidity and collateral across business units, we have developed solutions that address the need for Collateral Optimization, Agreements Insights, a Margin Dashboard, Real-Time Inventory and Position Management and Liquidity Analytics. Separately or in combination, these tools will help your firm take a more strategic approach to optimizing the best assets across your entire portfolio and businesses to maximize your profitability.

To discuss your firm’s requirements, contact us.

References:

  • January 2013: Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools
  • October 2013: Basel Committee on Banking Supervision Working Paper No. 24 – Liquidity stress testing: a survey of theory, empirics and current industry and supervisory practices
  • January 24, 2014: Federal Reserve Bank (FRB) released Supervision and Regulation letter (SR letter 14-1) entitled “Heightened Supervisory Expectations for Certain Bank Holding Companies,” and Attachment Principles and Practices for Recovery and Resolution Preparedness
  • SR letter 12-1 entitled “Consolidated Supervision Framework for Large Financial Institutions”
  • SR 14-1: Additional Guidance from Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve System entitled “Guidance for 2017 §165(d) Annual Resolution Plan Submissions by Domestic Covered Companies that Submitted Resolution Plans in July 2015”

Building a Holistic Collateral Infrastucture

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This article was originally published on Securities Finance Monitor.

Following the financial crisis, regulations and their associated reporting have created an opportunity for banks and investment firms to create a single, unified collateral infrastructure across all product siloes. This does not have to be a radical architecture rebuild, but rather can be achieved incrementally.

There are legitimate historical reasons why collateral infrastructure has grown up as a patchwork of systems and processes. For products such as stock lending, repo, futures or contracts for difference (CFDs), the collateral/margining process was generally integral to the products and processing systems. It would not have made sense to break out collateral management into a separate group and hence operating teams and systems were structured around the core product unit. Generally, only OTC derivatives had a relatively clear decoupling between collateral management and other operational processes. Even as business units merged at the top level, this product separation at the collateral management level often continued.

While this situation could stand during non-stress periods, the financial crisis demonstrated the fallacy that siloed, uncoordinated collateral management systems, data and processes could weather any storm. This disjointed view caused a number of specific problems, including: an inability to see the full exposures to counterparties; a lack of organization in cash and non-cash holdings; and substantial inflexibility in mobilizing the overall collateral pool. Even before the crisis, inconsistent or “zero cost allocation” for collateral usage meant that collateral was not always being directed to the parts of the business that needed it most. After the crisis, with collateral and High Quality Liquid Assets at a premium, this became unacceptable.

Today, few banks and investment firms have completed the work of integrating their collateral management functions across products (see Exhibit 1). Some of the largest banks are focused on building capabilities to achieve enterprise-wide collateral optimization, while others are just starting on this effort, at least on a silo basis. Some have bought or built large systems with cross-product support, although this has proven costly. Others are evaluating organizational consolidation. Whatever their current state, a new round of regulatory reporting requirements in the US and Europe means that letting collateral infrastructure sit to one side is no longer viable to meet business or compliance objectives without adding substantial staff. One way or another, long-term solutions must be achieved.

Exhibit 1: Moving past the siloed approach

Source: Transcend Street Solutions

 

The next round of regulatory impact

While nearly all large firms have digested the current waves of regulatory reporting and collateral management requirements, the next round will soon be arriving. Among these are the Federal Reserve’s regulation SR14-1, MiFID II (Revision of the Markets in Financial Instruments Directive), and the Securities Finance Transactions Regulation (SFTR). It is worth looking at some of these requirements in detail to understand what else is being demanded of collateral management infrastructure and departments.

The Federal Reserve’s regulation SR14-1 is aimed at improving the resolution process for US bank holding companies. It includes a high level requirement that banks should have effective processes for managing, identifying, and valuing collateral it receives from and posts to external parties and affiliates.[1] At the close of any business day banks should be able to identify exactly where any counterparty collateral is held, document all netting and rehypothecation arrangements and track inter-entity collateral related to inter-entity credit risk. On a quarterly basis they need to review CSAs, differences in collateral requirements and processes between jurisdictions, and forecast changes in collateral requirements. Also on the theme of improved resolution rules are the record keeping requirements related to “Qualified Financial Contracts” (effectively most non-cleared OTC transactions).[2] These require banks to identify the details and conditions of the master agreements and CSAs applying to the relevant trades.

While the regulatory intent is understandable, these requirements are exceptionally difficult to meet without a unified collateral infrastructure. There is in fact no way to respond without a single, holistic view of collateral and exposure across the enterprise. While SR14-1 impacts only the largest banks, it still means these banks have a mandate to complete the work they have begun in organizing their vast collection of collateral information. This will lead to greater collateral opportunities for the big banks, and may in turn encourage smaller competitors to complete the same work in order to exploit similar new efficiencies.

Article 15 of Europe’s SFTR places restrictions on the reuse of collateral (rehypothecation). The provider of collateral has to be informed in writing of the risk and consequences of their collateral being reused. They also have to provide prior, express consent to the reuse of their collateral. Even with the appropriate documentation and reporting in place, a collateral management department has to carefully ensure that the written agreement on reuse is strictly complied with. While nothing is written in the US yet, market participants believe that the US Office of Financial Research will soon require mandatory reporting that may entail overlapping requirements.

Similarly, MiFID II introduces strict restrictions on the use of customer assets for collateral purposes and potentially has a major impact on collateralized trading products. A complicated analysis must be conducted on best execution, but in OTC and securities financing markets, best execution may be a function of term, price, counterparty risk and/or collateral acceptance. Further, any variation from a standard best price policy needs to be documented to show how the investment firm or intermediary sought to safeguard the interest of the client.

SFTR and MiFID II require that banks rethink their entire reporting methodologies, and in some cases must rethink parts of their business model. A wide range of new information must be captured, analyzed, consolidated, and reported outwards and internally. This will likely generate new ideas and business opportunities around collateral usage and pricing for those firms that can digest the large quantities of new information that will be produced.

A holistic foundation for trading, control, MIS and regulatory reporting

The struggle at many firms to comply with regulations while maximizing profitability has led to two parallel sets of infrastructures: one for the business and another for compliance. This creates two levels of cost that duplicate substantial effort inside the firm. Along the way, business lines get charged twice for this work as costs are allocated back to the business. This is an immediate negative impact on profitability; even firms that have completed collateral optimization immediately lose a piece of that financial benefit.

The cumulative impact of regulation means that banks and investment firms generally cannot afford to wait for consolidation projects to deliver a single integrated platform. The fragmentation of teams, data and processes are hurdles for any institution to overcome but so is the old mindset that simply thinks of collateral management as an isolated operational process.

We identify five critical areas for firms to address in order to create a foundation for their holistic collateral infrastructure:

  • Map the full impacts of regulatory and profitability requirements on businesses, processes, and systems.
  • Recognize that collateral management is an integral part of many key activities at the firm including trading and liquidity management.
  • Understand the core decision making processes at the heart of effective collateral management.
  • Organize and manage the data that is required to drive those processes.
  • Build a functional operating model for collateral management.

The fifth recommendation, building a functional operational model for collateral, means being able to connect together disparate business lines to provide an enterprise view of collateral. It includes mining collateral agreements to make optimal decisions or decisions mandated by regulation. It requires the ability to perform analysis of collateral to balance economic and regulatory drivers, and it requires controls and transparency of client collateral across all margin centers.

At Transcend Street Solutions, we are actively working with our clients to help them develop a strategic roadmap of business and technology deliverables to achieve a holistic collateral infrastructure. While there are always organizational as well as infrastructural nuances in every business, we have seen the framework proposed above yield a positive return for our clients. Our technology platform, CoSMOS, is nimble, modular and customizable to accelerate collateral infrastructure evolution without necessarily having to retire existing systems or undergo a big infrastructural lift.

Getting this right is important for more than just regulatory compliance. It means the collateral function and trading desks can perform the forward processes required to support both profitable trading and firm wide decision making. Pre-trade analytics is needed to ensure that collateral is allocated optimally across portfolios and collateral agreements. Optimization is also needed at the trade level to ensure the most suitable collateral is applied to each trade or structure. Finally, analysis needs to be carried out across the whole inventory of securities and cash positions to ensure collateral is used by the right businesses. After all, correct pricing of collateral across business lines is not only essential for firm level profitability but also incentivizing desirable behavior throughout the organization.

We strongly believe that firms that are successful in achieving a holistic collateral architecture will have a significant competitive advantage in the industry. They will be able to achieve optimization of collateral and liquidity across business silos while meeting most global regulatory requirements, and all that with a much more efficient IT spend.