 |
 Kevin Arthur
Director, Fixed Income
The phrase "necessity is the mother of invention" has proven itself true when it comes to the adoption of straight-through processing (STP). Over the past several years, trading volumes have ballooned, making automated processing of those trades a must-have rather than a nice-to-have. But while the benefits of cost savings and risk reduction have been realized across much of the equities world, the fixed income space has lagged behind, resulting in unnecessary high cost and risk for the debt industry. Now more than ever, a commitment across the community is required to bring more market participants to the fixed income electronic highway, so they too can realize dramatic reduction in cost and risk.
According to Z/Yen, a risk/reward research firm, the cost of processing a fixed income trade globally can range widely from USD 5 to 61 per trade and averages at USD 28 per non-automated trade. This contrasts to USD 4 per equity trade in an automated environment. There is clear correlation between automation and lower cost of processing, and yet only 30 to 40 percent of fixed income trades are automated, where the average is much higher for equities.
"If it ain't broke...?"
So why is the fixed income market so slow on the uptake of STP compared to its equity counterpart? Taking a look at the past might help us understand the issues. For the equities market, trading volumes grew so dramatically in the 1990s that many operational functions were overwhelmed and inefficient. The paper crisis of the 1960s had already illustrated that without proper infrastructures in place for settling trades, increased trade volumes often spelled trouble: unsettled trades and sky-high risk. Back-office automation, therefore, moved much further up the agenda for many securities firms in order to relieve this pressure and add scale.
So, while the equities sector was busy building out automation in the early 1990s, the fixed income space was still evolving. Debt trading volumes were not as high and behavior and process changes, along with post trade automation, were not a top priority for the fixed income community. The mentality at the time was mostly the "if it ain't broke, don't fix it" type.
Later that decade, however, as fixed income trade volumes increased and debt instruments became increasingly complex, firms gradually began to embrace automation, reflected by an increase in electronic allocations, particularly in Europe, at that time. However, just when momentum was gaining, Y2K compliance consumed significant resources, and then a global economic recession followed the burst of the Internet bubble and events of September 11, 2001. The adoption of the Euro and decimalization also shook up the markets. Consequently, technology budgets came under intense scrutiny and fixed income back-office projects stood little chance against projects in the front office during a period of scarce resources.
Front-office evolution
So what's the outlook today? Fixed income volumes are on the rise as investors see the space as more appealing than ever to diversify investment portfolios and provide more predictable returns. In the continuing search for liquidity pools, front-office technology is being harnessed to enable more innovative trading strategies. The adoption of multi and single dealer to client electronic platforms along with broker Direct Market Access (DMA) systems means trades across the global fixed income community are being executed in nanoseconds.
But while technology has fueled speed and efficiency in the front-office, much of the back-office still remains in the dark ages, filled with cumbersome back-and-forth labor-intensive communications for allocation/confirmation, static data enrichment, notification to clearing agents and, finally, settlement/exchange of beneficial ownership. This process can take as long as three days, which means excessive risk exposure. The more time between trade execution and settlement, the greater the risk of trade failure.
Omgeo recently undertook a poll of eight large global fixed income brokers in the U.S. and Europe and found that roughly 30 to 40 percent of fixed income trades are automated. While this marks significant progress from a few years ago when automation was practically nonexistent in the space, it also means that 60 to 70 percent of trade processing is still left to manual methods for settlement. Buy and sell side firms and their clearing agents still have large middle- and back-office staffs processing fixed income trades via phone, fax or e-mail. The more human intervention in the lifecycle of a trade, the more susceptible it is to error. High error rates mean high costs.
So, if the financial industry stands to save an average of USD 24 per trade by automating the settlement process, and operational risk can be drastically reduced by cutting time between trade execution and settlement, why aren't more fixed income players heading in that direction?
The answer is three-fold:
1) Lack of awareness that automated solutions exist;
2) Adversity to change within the industry; and
3) Lack of trust in the automation process.
Until these three challenges are addressed, fixed income trade processing will continue to be a risky, costly burden to financial operations.
Spreading the news
The market is now starting to see a renewed focus on automation of fixed income trade processing and awareness that solutions exist is becoming more widespread. For investment managers, fixed income instruments are the next logical step in the quest to automate 100 percent of their trading books. For brokers, automation can reduce significant pain points, such as increased staffing needs to maintain manual processing and added costs of confirming and settling fixed income trades with manual counterparts. Brokers continually aim to spread awareness through the investment manager community to adopt automation to help ease these pain points. Automation is gradually being achieved through awareness of various STP solutions, but the pain points that come with increased costs and resources have not yet been entirely eliminated.
Overcoming adversity to change
As technology continues to prove its value to the front-office, the back-office is beginning to catch on. Operations teams these days are much more reliant on technology to expedite processes. They are realizing that the traditional, manual methods for settling trades are not efficient, and they are more open to changing the way things get done. Omgeo has seen enormous growth in the number of electronic allocations passing through its systems: 132 percent and 70 percent increases in 2004 and 2005 respectively. So far in 2005, 30 percent more brokers and 20 percent more investment managers have signed up to automate their fixed income trade processing than last year.
Trust the automation
According to one of North America's largest broker/dealers, up to 40 percent of all fixed income trades require same day settlement (through instruments like commercial paper). Many traders still use the telephone to see these trades through from execution to settlement, being accustomed to the feeling of familiarity that a telephone brings. However, the same broker estimates that it is typical for a firm of that size to manage 7,500 of these same-day settlement trades each month. If all of them are settled manually, i.e. by telephone - with trade information agreed verbally rather than electronically, there is a huge opportunity for increased error and risk. This error and risk potential, due to miscommunication and the lack of audit trails translates into increased costs for their firm and for their clients. Therefore the "peace of mind" associated with manual processing is not what it seems. Operations staff are now turning to automation to help eliminate the risk, but solutions providers need to continue to partner with the industry in order to build trust to eliminate the telephone and other antiquated, high risk methods.
While the fixed income industry should be pleased with the achievements made so far in automation for processing trades, much work still remains to be done to expand the STP community. Efficiency and cost gains will only then be realized for all parties to a trade and for the global fixed income industry. We are already beginning to see a divergence between the competitiveness of firms that embrace automation in their back-offices and those that don't. Those that fully implement STP solutions, (and not just in the front-office) will be able to remain at the cutting edge of innovation trading, delivering best execution and flexibility. Those who remain resistant to technological evolution could, however, find themselves left behind.
Back |
|
|
|
