The focus for many firms in 2015 will be on weathering the regulatory storm in anticipation of brighter market conditions to come. SunGard’s John Omahen explains how derivatives market participants are preparing their businesses (and post-trade operations) to take advantage of volume growth and new revenue opportunities in the future.
Weathering the regulatory storm & the new normal
Historically, financial institutions have been focused on investing in operations to support business expansion plans including a move into new markets or rolling out new business, all of which require a re-tooling of infrastructure to manage greater volumes and business growth. However, in the last two to three years this focus has shifted away from growth and towards regulatory compliance.
Hit by various regulations including Dodd Frank, EMIR, Basel III, MiFID II and others, operations managers at banks of all sizes are focused on weathering this regulatory storm by allocating the majority of their resources and budgets to either support the compliance required or reduce operating costs in order to boost overall efficiency.
Regulatory compliance projects, which were once a one-time line item, are now a permanent budget fixture gulping up more of the total resources available. The costs associated with compliance and regulatory change is huge and also ongoing. Plus, firms must deal with the condensed timeframe in which regulatory rules are being introduced but also address any new issues that crop up in the meantime.
I think most firms have accepted that this is the new normal and in fact, this isn’t a change from the last year, however, firms have now resigned themselves to the fact that this is how it is going to be for the foreseeable future until the market turns a corner.
Budgeting for operations and ‘defensive spending’
With the primary focus on regulation, naturally there is less of the IT and operations budget left for non-regulatory projects, which is fuelling a focus among most firms on cost cutting and efficiency improving projects. If there are investment dollars available, banks are weighing the investment against reducing costs over the next one to five years.
Most firms are talking to us about ‘defensive spending’ such as shoring up costs, adopting outsourcing, streamlining processes and increasing their levels of straight-through processing (STP).
Growth again – Interest rate & trading volume increases ahead (we hope)
Looking ahead the eventual increase in interest rates and trading volume ultimately will determine when the derivatives market will move back to the pre-crisis market conditions. There is the expectation that there will be a big uptick in cleared over-the-counter (OTC) derivatives volumes at some point as regulators slowly roll out mandatory margin requirements on bilateral positions and enforce mandatory clearing around the globe.
Also, we have been in a low interest-rate environment for quite some time. The U.S. Federal Reserve has ended its quantitative easing program raising the question of when interest rates will go up. And if, and when they do, they do not necessarily solve all the problems, but theoretically will help the revenue side of the equation.
Survival strategies: business model changes & cost reduction plans
Although we know that things will improve over time with higher volumes and better revenue opportunities, the question remains: How many financial institutions will be left to take advantage of the shift when things return to the historical norm? Some firms are better suited to weather the storm in the long term and others probably are considering changing their business models.
The ability for a financial institution in the derivatives industry to be well placed to prosper when pre-crisis conditions return really comes down to business models and how they have coped thus far with the high-cost regulatory and low-revenue environment the industry is experiencing today.
Business models are already evolving in various ways. For instance, there are numerous announcements of mergers and acquisitions amongst industry players and cases where Futures Commission Merchants (FCMs) have changed their model to become introducing brokers after realizing that the high regulatory cost of holding client funds does not make sense in terms of revenue. Financial institutions have and will continue to adapt their business to support where the most revenue can be achieved.
For those firms keeping with their chosen path and business model, they are working diligently to employ strategic cost reduction plans to ensure that their overall operation (especially middle and back office) is as efficient as possible. That way, once they achieve those and volumes and interest rates rise again, these firms will be in a great position to turn their attention to growth knowing the scale is already there. Of course, the longer that this low revenue/high regulatory cost environment drags on, there will be less competition for customers and a more profitable market for the surviving firms. So the focus remains solely on survival rather than competitive edge at this stage. The question remains: who will make it through these tough times?
Cost cutting strategies today start with a hard look at the status quo
Most firms have already undergone some sort of cost reduction exercise and this will continue in 2015. Most operations and business managers start by asking themselves: “If we have to save this percentage of costs, what are some ways we can do it? What are the critical areas of our business that differentiate us and which parts do not?”
If there is an area of the business which does not differentiate the firm, this is where managed services can provide the necessary processes while the client manages them like any other vendor through service-level agreements (SLAs). And if the managed service providers can deliver a 15% or 25% savings compared to performing it internally, why not do it? Many firms will do just that this coming year.
The focus on managed services as a cost cutting strategy is somewhat new and represents a wider cultural shift among banks. Five to 10 years ago, this was not even considered because every aspect of the operations really was within the bank and controlled by the bank. Now the banks are getting comfortable with the idea that, to some degree, middle and back office activities can easily be allocated to a service provider. Firms know they can use service providers for support of this plumbing and that the piping doesn’t need to be gold plated – it just needs to work.
I think the biggest change is that firms are looking at their business in a cold reality and are questioning whether these functions need to stay within the firm or can they be turned over to someone who can do it better and in a more cost-effective manner.
Offshoring is no longer enough; technology offers greater cost efficiencies
However, firms are looking more broadly at how they can get more operational savings and changes that are more than just incremental. Just adding headcount in a low-cost location might provide some savings, but it’s not necessarily the strategy firms believe does enough anymore. Many firms have already offshored manual middle and back office processes, thus they’ve played the off-shoring card at this point. Now for banks the focus is more on investing in technology.
As a result, banks and operations managers are reexamining projects or ideas that previously might have seemed too radical, too intrusive, or would involve too much work to undertake – especially in the areas of OTC margin calls and collateral management. These typically are manual processes, like sending out expected payments to clients and reconciling payments, making sure payments come through as expected, and allocating monies for initial and variation margins. From the number of collateral-management conversations we’ve been having, many firms are seriously looking to invest in automating those processes. Specifically, they are considering which technology makes sense to develop internally and where to turn to a vendor like SunGard to bring in a solution that helps them achieve their operational goals.
Integrating listed and OTC silos – efficiencies gained but at a wide spectrum
Over the last couple of years one way that firms have looked to gain efficiencies in their post-trade operations is to integrate their exchange-traded derivatives (ETD) and OTC derivatives middle and back offices. Many firms have accomplished this to varying degrees and I believe that it is an ongoing process akin to any time a company restructures its organization.
Many of the integration projects started at the top. Financial institutions put someone in charge of both business lines with the task of bringing the teams together at the ground level where the work actually is done. This has seen success but there is still work needed in streamlining that process. Some firms have made progress in combining their ETD and OTC teams while others run the businesses separately, but still report into the same person.
The degree and mode of change depends on the type of operational activities each business has. The generic clearing functions common to both asset classes and the IT support around them tend to be the lowest hanging fruit in terms of consolidating operations but many firms will continue to focus on further synergies that can be achieved by integrating the two business lines.
Looking ahead – the cost and opportunity of collateral management
Recently we have been speaking to many of our customers about cross-margining and collateral-management, which I expect will continue to be a focus for firms as we move to an environment with higher volumes. In fact, when regulators start to enforce the mandatory-margin regulations, there is going to be a greater interest in efficiencies in collateral, as well as the individually segregated account initiatives in Europe. There is some real work that needs to be done on the sell side to enable it, but the buy side also needs to educate itself about the actual cost of individually segregated accounts.
As this area of asset safety and collateral management fleshes itself out, there are revenue opportunities for firms due to the complicated nature and optionality in structuring portfolios and selecting which clearing house to use. In fact, there are plenty of areas to optimize across the entire workflow and thus revenue possibilities are there for providers of such services.
I believe that the sell side will embrace this as a revenue stream if volumes return. And buy-side firms will pay if the sell side can reduce the amount of collateral that the buy side would need to post on a daily basis. It could come from optimization or what is known as ‘collateral substitution,’ where the FCM would take a piece of buy-side collateral that is not accepted by a clearing house, change it for acceptable collateral and charge money for the service. If such a service saves the customer money overall then it is good for both the customer and the sell side provider.
Collateral management is clearly an area that should grow. Others have discussed this long before me, but we have not seen it so far because the volumes are not there yet. It’s not been an urgent issue so far, but in the future, it will be. I see it being the lead contender in my mind for ways that sell-side firms could start to monetize this new regulatory environment as we move away from the new normal to the pre-crisis normal in due time.
