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 Matthew Nelson
Director, Market Intelligence
In the first quarter of 2009, Omgeo interviewed over a dozen of our largest U.S. clients, representing all segments of the industry. The purpose of these interviews was to better understand how institutions are coping with the current conditions, how they are planning for the future and to gather their opinions on the future of the industry. Six common topics emerged from these interviews; planning and prioritization, the changing role of operations, relationships, risk and regulation, changing business models and emerging as a stronger industry. This series of articles will discuss each of these topics and our discussions with the participants.
Risk in all of its forms has seeped into every crack of the securities industry; never before has the industry been so risk-aware. Although counterparty and credit risk are getting all of the press, portfolio risk, currency risk and the many types of financial and operational risk present are being measured and monitored. “Systemic risk” has become one of the most popular terms in both financial services and government since the crisis began. Regulators in the U.S. have proposed measures that will impose a higher set of standards on firms that are perceived to pose a systemic risk to the industry should they fail.
Many institutions interviewed by Omgeo have become acutely aware of operational risk in the current environment. This is not to say that they’ve not measured operational risk in the past, however the new concern over counterparty risk coupled with the market volatility has shone an intense spotlight on this risk. Conventional wisdom said that the relatively short period between trade and settlement date in the U.S. market provided a comfort level regarding the settlement of securities; not much can go wrong during the settlement cycle and if it does, the impact won’t be significant. However in today’s environment, anything can happen in three days and markets can move significantly over this period. The cost of a failed trade for institutions has risen considerably and this has brought heightened attention to the management of trade breaks and fails management. In light of this, all institutions, buy and sell-side alike are paying more attention to trade errors and are looking to shorten resolution times and streamline issue escalation procedures.
Additionally, firms are being asked to do more with less; smaller budgets and flat or shrinking staffing levels. Although trading volumes are down in 2009, activity level (as measured by client activity and complexity), hasn’t decreased at all. Indeed, with all of the focus on trade errors and issue resolution, the activity level of most firms has increased considerably.
When interviewed by Omgeo, a global asset manager described how in normal times, they could react to an increase in activity by augmenting staffing levels in line with activity levels, maintaining sufficient coverage and spreading the workload between more staff. However in today’s environment, augmenting staffing levels is not possible; on the contrary staffing levels are shrinking. This divergence, has introduced a new type of operational risk in many firms. Dealing with this risk is a challenge for everyone and has resulted in some cases in resetting client (internal and external) expectations and in some cases, adjusting service level agreements to reflect the new reality.
Regulation has always been present for securities firms, but the regulatory environment over the past several years has been particularly challenging to navigate. From decimalization, to Sarbanes-Oxley, MiFID (for firms operating in Europe), and the separation of research and investment banking, securities firms have had a number of regulatory changes to comply with. Compliance is labor-intensive and money consuming and has no benefit to the bottom line of the business, on the contrary it pulls resources away from potentially revenue generating projects.
That said, it is clear that as a result of the sub-prime crisis, the perceptions around the use of complex derivatives, the failure of regulators to detect and stop Ponzi schemes and the general belief that Wall Street is the cause of Main Street’s problems, regulation is coming. In fact, most firms interviewed by Omgeo believe that over-regulation is coming. The knee-jerk reaction of regulators and politicians who have constituents to answer to and polls to monitor, will be to regulate too much of the securities industry’s business. Perhaps the most obvious case in point is the anticipated regulation of the hedge fund industry, which most people agree had little, if anything to do with the current crisis.
Traditional asset managers and custodians are expecting little regulatory impact directly on their businesses. However banks are expecting, and in fact are already being subjected to significant regulatory pressure. Those firms that took (or were forced to take) money from the U.S. governments Troubled Asset Relief Program (TARP) are under significant pressure (and as a result are anxious to repay the funds!). Perhaps the most intense pressure is being placed on compensation. Courtesy of the public furor over AIG’s $165 million bonus payout, Wall Street’s traditional compensation model is under severe scrutiny. Caps on executive compensation and taxes on bonuses have set an uneasy tone which has damaged morale in banks. Many banks interviewed by Omgeo cited fears over their ability to attract and retain good staff and the impact that this “shallow bench” of talent will have on the future of the industry.
Further complicating the regulatory issue is the now-common acknowledgement that this is indeed a global industry. This requires global solutions to regulatory challenges. Global cooperation, if not followed will multiply the compliance costs and will allow for regulatory arbitrage weakening certain financial centers at the expense of those with a more favorable regulatory scheme. This path will cause more harm than good to the industry and will have significant ramifications on global financial centers.
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