The need to transform post-trade operations in capital markets
Published on October 20, 2022 by Ghanshyam Bhambhani
To continue to enhance a sector’s efficiencies, it is important that all processes along the value chain are modernised in parallel. However, this may be difficult for some sectors, including capital markets. The disparity in investment along the value chain has resulted in front-end technology enabling trading in nanoseconds while post-trade processing remains manually intensive, slow and opaque.
The sluggish pace of post-trade processes results in a long delay between execution and settlement, introducing risks to the system — a pain point for sector participants for years. When risk — such as a lack of funds with the broker or being short on collateral — arises, however, clearing houses step in to provide solutions. Nevertheless, such risk may increase in times of higher volatility, as it did during the GameStop incident.
It is not just the slow pace of operations; the performance of post-trade operations lags on the cost front as well. Post-trade operations are very expensive for capital market participants. Middle- and back-office operation costs dwarf front-office and execution costs. This is because companies have to spend large sums each year on legacy post-trade systems and still have to employ a large number of staff for processing, reporting and reconciling trades.
At this point, it is important to understand and accept that the costs and execution time involved in post-trade operations are in part due to their complexity. A single trade creates multiple records for various parties and involves a number of sub-processes including reporting, matching, optimisation, netting and reconciliation. Furthermore, there are multiple vendors involved in the execution of each trade, adding to the complexity and risk involved in the operation. All this has led to complex and opaque cost structures for post-trade services.
One of the important reasons why companies have not upgraded their post-trade systems is that they are afraid technology upgrades will prove to be disruptive and risky. Another reason for delayed investment is that post-trade operations are a cost centre. Capital markets participants tend to direct investments to the front office, where they are better able to differentiate versus competitors. However, this investment bias against post-trade operations is not sustainable.
Need for better post-trade infrastructure
The global capital markets sector needs better post-trade infrastructure for the future. The pandemic-driven volatility has demonstrated that post-trade systems need to be updated to ensure the capital markets ecosystem remains functional and risk-free.
A case in point would be the challenges faced by sell-side participants in the post-trade domain. Sell-side firms use an average of 9.1 post-trade processing solutions due to legacy infrastructure that is fragmented by geography or asset class or both, according to The Case for a Multi-Asset Post-Trade Approach, a 2021 white paper by Firebrand Research. Many firms continue to maintain separate middle- and back-office operations and technologies for dealing with different asset classes. Regional divergence in regulations and market practice has intensified the issue by adding regional silos into the mix, leading to duplication of cost and effort. The survey also pointed out that most sell-side participants felt a lack of proper coverage for newer asset classes and experienced significant pressure to move away from manual processes and silos to a more integrated solution that can offer a single, streamlined workflow and a centralised set of records across asset classes.
Trading volumes are very likely to continue to grow over the long term. Furthermore, industry-wide changes such as the planned move to T+1 settlements in the equity market would drive listed derivatives volumes even higher. This would pressure firms that have set up workarounds and made short-term fixes to their post-trade infrastructure, and drive investment in modern technology.
As a solution, capital markets participants could adopt the practice of sharing middle and back offices. They should move away from isolated, inconsistent and duplicated record systems held at each firm to a model of shared data, business logic and processing by combining middle- and back-office systems. This would enable them to retire expensive elements of their bespoke infrastructure, break down silos and significantly reduce costs, while simultaneously preparing for today’s competitive landscape. This new post-trade ecosystem would drive competition among vendors and offer greater choices for end users. It would also free banks and other financial institutions from the technological binds they have found themselves in for years now, having to undertake unstructured investment in expensive legacy post-trade technology.
Leveraging modern technology
To solve the post-trade problem, capital markets technology providers are offering solutions to digitalise the infrastructure, such as by using distributed ledger technology (DLT). DLT can enable execution of distributed workflow so transacting parties could share a real-time view of the same data because it is stored on a shared digital ledger. The technology enables parties to take control, collaborate and agree on how to execute the distributed workflow.
Using DLT, settlements can be reached significantly faster, multiple times a day or on demand and in a riskless manner. The technology provides the opportunity for parties to collaborate in real time and complete the 24-hour settlement process within a few minutes, reducing risk and costs and generating large efficiency savings. DLT also offers benefits such as tamper resistance, auditability, data lineage, immutability and notarisation of transactions. The parties benefit from non-refutable proof that a transaction has happened.
Examples of developments on the technology front:
- In November 2021, the Swiss stock exchange (SIX) launched the SIX Digital Exchange, a fully integrated trading, settlement and custody infrastructure based on blockchain technology
- Baton Systems has created a network using DLT to automate end-to-end collateral workflow for derivatives. It is already processing an average of USD15–20bn in transactions for traditional finance on a daily basis
- In October 2021, HSBC launched HSBC MarketSpace, a platform that enables clients to access post-trade services and solutions from HSBC and other third-party service providers
While embarking on the journey to advance post-trade operations, the capital markets sector as a whole should agree on a set of standards to which the new solutions should be aligned. A lack of standards would mean that although firms may meet their own business needs, there would be complexity and friction in their interactions with other participants. Standardisation could eliminate this issue altogether. It could also enable sharing the costs associated with some elements of back-office functions. Common standards would drive interoperability that would support digital transformation across markets, as it would make it easier and cheaper for the sector to connect.
Recommendations for capital markets technology firms:
- The market is witnessing a rise in the digital transformation of post-trade operations; this may pick up further due to initiatives such as plans to shorten the US settlement cycle from T+2 to T+1 and the Australian Securities Exchange’s plan to replace its Chess equities clearing and settlement system with a DLT platform. This is the right time to invest in building DLT platforms and preparing sales, marketing and implementation teams for the growing demand, to compete effectively and gain more market share
- Capital markets firms should collaborate and discuss with regulators the need to create global standards that could make post-trade processing easier and risk-free across regions and asset classes. If this happens, the resulting interoperability would drive digital transformation across markets, increasing demand for technology providers
How Acuity Knowledge Partners can help
The technology research practice within our Corporates and Consulting Group offers a range of strategy support services to technology providers. We work with Fortune 500 fintech firms and capital markets solution providers, offering insight on areas such as the technology landscape, competitors’ moves, growth opportunities, M&A and deal insights, and the regulatory landscape. Our subject-matter experts provide customised, time-bound solutions to help you swiftly map your strategic objectives and execution plans.
About the Author
Ghanshyam has over 9 years of experience in the corporate strategy and consulting domain. Currently, he works with senior strategy staffers of the technology firms and helps them meet their strategic goals such as market entry strategy, product portfolio revamping, competitive intelligence, white space identification and many more. Ghanshyam previously worked at Bain, where he assisted clients across industries in strategic projects. He holds a Master’s degree in Business Administration and Bachelor’s degree in Computers
Originally published at https://www.acuitykp.com.