Stephen Bruel of TowerGroup talks scale and OTC derivatives
Traditional custody is commoditized, and margins are falling. But a new opportunity is emerging: Investment managers are increasingly attracted to OTC derivatives as an alpha-generation tool. Asset servicers realize that OTC derivatives servicing offers higher margins and provides competitive differentiation. Custody banks will therefore invest heavily to support OTC derivatives, but in so doing, they will deviate from the core principle that scale and standardization drive margins. The challenge, then, is to design, build, and implement a platform that can efficiently manage these new, often esoteric, products. Custodians that enter this business need to understand the need for a new technology platform. What should the technology look like, and how can custody banks capitalize on OTC derivatives?
The custody business is a business of scale, which is part of the reason for the mega mergers between the likes of BoNY and Mellon and of State Street and IBT. Servicing OTC derivatives also requires scale, but scale is not the only point of differentiation; supporting bespoke workflow and complex reporting also provide differentiation. This level of customization is somewhat new for custodians but gives them an opportunity to provide high-margin services above and beyond the typical safekeeping of assets. And that is where the tension lies: between standardization and customization. OTC derivatives servicing is not the same business as traditional custody. Although pricing for OTC derivatives servicing is better than that for traditional custody, the process is less efficient and requires customization. The technology, personnel, and pricing model challenges are different. Custodians that service these assets need to examine the impact on the business and technology models.
Part of the solution is to implement a robust technology platform. Asset servicers need a platform that is flexible and encourages workflow in a straight-through processing (STP) environment to compensate for the low standardization and inherent inefficiencies in the market. Developing such a platform is difficult because, for example, dealers have not standardized the terms that describe OTC equity derivatives. So processing the derivatives is a challenge too.
Many asset servicers will retrofit their existing platforms; others will build or buy modules specifically designed for the unique processing of OTC derivatives. Both approaches can work as long as the platform includes the following characteristics:
– Scalability. Profitable asset servicing requires scale. The technology must be multiclient and handle increasing volumes of accounts and trades.
– Support for Innovation. With the support of OTC products comes the opportunity to provide new products and services such as risk tools or valuation engines. These services will further embed the asset servicer in the investment manager’s process.
– Flexibility. The asset servicer must resolve the inherent tension between standardization and customization. Given the multiclient environment, flexibility is required and must support multiple inbound data formats, disparate workflows (which should be kept to a minimum), and varying levels of client automation.
– Responsiveness. The platform must have the ability to respond to the rapid introduction of new varieties of OTC derivative instruments and minimize time to market.
– Support for Controls. OTC servicing requires a high level of internal controls, including a strong exception management component, real-time reporting, and robust document management.
Of course, the above list is not exhaustive; it just begins to outline the components necessary to process OTC derivatives.
OTC derivatives obviously include a great deal of proprietary risk for those that trade them. Asset servicers do not acquire this risk but do absorb operational risk. As asset servicers manage more OTC products, in terms of both volume and underlying assets, the only way to reduce operational risk and achieve benefits for clients is to invest in technology. Automation of OTC derivatives is a technology-intensive, time-consuming, and expensive undertaking for asset servicers. But it will attract clients. And volumes. So let’s hope it can scale.
*This article is based on research by the Securities & Capital Markets service at TowerGroup, a leading research and advisory services firm focused exclusively on the global financial services industry. Stephen Bruel, Analyst, can be reached at email@example.com. Those interested in learning more about TowerGroup or subscribing to its research services may call +1.781.292.5200 or e-mail firstname.lastname@example.org.