Cost reduction was the clarion call at NeMa Vienna. This is particularly relevant for the besieged investment banking community with returns on equity far below the acceptable norms. But it resonates as well with the custody world, attuned to regular cost reductions, albeit more on the back of the endowment value of rising markets than alchemy across the securities transaction lifecycle.
The paradox is that post-trade costs are likely to rise. First, the regulators will undoubtedly take action to eliminate the risk of the ever growing intraday exposures that are offered by banks for minimal cost. This is mainly due to a flawed perception by those suppliers that they are really at bank option exposures. They are not, as is well understood by the regulators, for they are the very life blood of the brokerage industry, among others. As one who has lived through two major crises in markets, I can assure everyone that the incredibly difficult credit judgement at the crisis point is a systemic one across each bank’s portfolio of exposures rather than a counterparty specific one. What will regulators do? They are likely to look for committed offerings from banks for at least a component of the total exposure or ring-fenced liquidity pools from those capable of generating them.
And second, the market is becoming more complex in geographical, instrument and infrastructure terms. There are more moving parts and, even if the unit cost of each part reduces, the likelihood is the sum total of the costs will increase as the average portfolio becomes less OECD and more global, less cash instrument based and more derivative biased, and a mandatory user of more, rather than fewer, infrastructures.
So how do we reduce cost? Standing back and looking at the world of investment from a distance, some things become apparent. The main one is that cost reductions are an imperative and not a nice-to-have! Investment management is severely overpriced. Fees range from the odd basis points for dumb beta through to the outrageous 2+20% for some alpha seeking alternatives. Those fees will reduce, especially as investment managers become ever more aligned to the politically charged world of supporting post-work lifestyles of the greying population through pensions and other saving vehicles. Second, trading spreads are ridiculously high especially for liquid counters. Foreign exchange is moving to a computer based transaction matching process. The same will happen with investment counters, at least in marketable instruments, which account for over 70% of all transactions. Third, the post-trade market infrastructures will rationalize. The traditional exchanges will not be able to continue in their current form; they are people-intensive and costly, with the MTF world showing the way they will need to develop. In that world, cost allocation and logical business process is critical; the subsidy of the liquid for the illiquid counters does not work in a free market. CSDs will consolidate; T2S will start with transaction flows and, although it may take a decade or more, asset servicing will follow suit.
But this will not reduce costs dramatically. It will, though, reduce revenues for the two key custody drivers, the investment manager and the broker dealer. So, how is the industry going to help them?
The first issue will be to reduce demand for credit. There are multiple ways to do this including adapting the algorithms used in settlement, standardizing settlement timeframes globally and seeking legal changes to enable custodians to clear across clients as well as market side.
The second would be to reduce the number of infrastructures. The most costly parts of the settlement life cycle are the CCP and the trade/settlement match. The CSD is relatively low cost. Trade repositories are also quite simple infrastructures from a technology and operational perspective. All of them need standards and standardized processes. The CCP environment needs to look for co-management of collateral in shared centralized pools and also agree on uniform global standards for haircuts. That would reduce operational cost and collateral usage. We need to extend the trade matching service into the settlement space. And we need to accept that simple infrastructures, whose prime value added is their local presence or local language, can survive, if their domestic users so wish, but they need to enable true interoperability with cross-border investors’ CSDs of choice.
And I have touched on parts of the third issue already. We need three sets of standards: We need messaging standards, we need performance standards, and we need harmonization. Again, many will have their favored vehicles for market harmonization, but critical, duplicative and high-risk costs are incurred in the complex and nation-state specific world of KYC. A similar problem arises in the world of tax, exacerbated by FATCA, the attraction of FATCA style regulation for many across the world and hence the risk of proliferation of that intrusive and high-risk process. And we can add to the list harmonization in the mundane world of corporate actions. That is a problem on which working groups throughout the world have spent many man years of effort; the solution is there, but the will to implement appears to be lacking.
And it is the lack of will to implement that is the biggest challenge of them all. ISO 20015 and 20022 give us a rich messaging environment and, again, the subject matter experts have labored hard to ensure that appropriate messages exist. But the standards are shunned by the practitioners. To some extent, this is understandable. New messages are costly to adopt. And there are always other priorities. It is the same with harmonized practices. It is the same with infrastructure consolidation. Changing things that work take a lower priority than product and service extension related changes. But it is the things that allegedly work that are behind our industry’s cost problem.
In my mind, the key need is to improve automation, but for that the market needs to harmonize, adopt new messaging standards and penalize more heavily performance failures. The drive for harmonization must be in conjunction with multinational authorities, especially in areas of tax or KYC. We need to stop using credit, especially intraday, as a free gift. And we need to adapt the two most expensive pieces of our infrastructure, the trade matching and CCP spaces. The irony is that all this is doable. The problem is finding the catalysts to ensure it is done.