The new post-trade order

Many processes in financial markets are inefficient and out of date. Tony Freeman takes a look at how we can change industry behaviour.

A recent headline in the FT – Oil traders face Yahoo messaging blow – is a stark reminder of how hard it is to change behaviour. It may be surprising to outsiders but many operational practices in the financial markets are actually highly inefficient and out of date. The FT says “Yahoo Messenger has long been oil traders’ favourite tool for blasting out orders and gossip”. Yahoo will soon start to encrypt the messages and allow users to “un-send” a message. Both are anathema to modern compliance standards. If asked today, I doubt a compliance team would have approved the use of Yahoo as a means of trading. The origins of how a no-cost public email system became the standard mechanism for oil trading is unclear – but it almost certainly happened by accident.

The story highlights two often under-appreciated trends – first-mover advantage is huge and it isn’t much affected by product suitability. Secondly, changing behaviour is widely acknowledged to be very difficult. However, this credo is worth testing. We’re all surrounded by constantly evolving technology – which we buy even though we didn’t ever anticipate it in advance. I didn’t know I wanted an iPhone until I played with one in-store.

So maybe the question is – why is change so hard in the post-trade industry? I don’t believe the people who work in this industry are resistant to innovation. I’m sure they probably drive home in a hybrid-electric car with sat-nav, MP3 music streaming over Bluetooth etc. The car is also likely to be quite young – not many people have a car which is more than 10 years old. A further 10 years into the future will likely see the same commute being done in a hydrogen powered self-driving vehicle. But when they get into the office will they still be receiving faxes? At the current rate of progress in the post-trade space, it is a distinct possibility!

Recent feedback from clients supports this theory – it shows that large segments of the buy-side and corporate sectors haven’t updated their post-trade operational technology for a very long time. To continue with the car analogy – they are driving a 1983 Ford Cortina listening to music on a cassette tape. One banking client in Australia recently highlighted their issues in processing margin calls for OTC derivatives. Their trade volume is more than 40,000 per month, resulting in more than 100 margin calls per day all processed by email. A significant proportion of their counterparties are in the Americas and Europe meaning that the working day overlap is minimal. On top of this, emails are unstructured and lack sufficient security and there’s no process efficiency – a rise in trade volumes results in an equal rise in operational workload. All of this inefficiency is exacerbated by time-zone differences.

Another example of inefficient post-trade practices is a very large European energy company client with extensive global operations and a substantial portfolio of interest rate swaps, bespoke FX and commodity derivatives. Their process model is to trade by telephone, receive a trade confirm from the bank by fax, manage collateral with a spreadsheet and instruct margin payments by email.

Unsurprisingly they have problems reconciling trades and positions with their counterparties. Many of the reconciliation breaks are months old – and show no sign of being resolved. Furthermore, inefficient operational processes could cause a significant reputational problem if they do not reach the standards set by regulators. But lack of standards and definitions is exacerbating the issue – for example a synthetic forward FX trade can be reported as a single trade or as two connected trades. Some trade repositories operate one mechanism, others do the opposite. Reconciliation between trade repositories then becomes a lot more difficult.

So what explains the dichotomy? Why are sophisticated firms prepared to tolerate the extra risk and cost of using outdated operational processes? For buy-side firms the “who pays” issue is the most likely explanation – the costs of inefficiency are levied against the fund, rather than the fund manager. A buy-side firm in France told us they were happy to pay €10 per fax instruction to the global custodian because the cost was allocated to the fund therefore it was treated as a custody cost. A much smaller fee for using a trade confirmation system would be paid by the fund manager because it is not a custody cost.

A corporate client doesn’t have the same choice; whatever it pays it cannot charge the cost to another entity. The answer therefore may be that investment in modern technology and scalable risk-averse processes simply isn’t a priority. The technology works – so why change it? In the absence of a crisis or a regulatory mandate, any expenditure is regarded as a cost, rather than an investment. In another business segment this probably wouldn’t be a concern but wholesale financial markets are different. We are in a community and therefore are uniquely inter-connected. A financial institution that operates inefficiently is imposing a cost on its counterparties and sometimes on its clients as well. The inefficiency and excess cost ripples out – we all pay in the end.

What can be done to address this issue? Maybe the automotive industry provides a template. Environmental legislation in this sector – primarily detailed and tough emission standards – is constantly driving innovation. The torrent of legislation since the financial crisis has focused on risk from a financial perspective. There has been very little focus on structural efficiency. It may not be a welcome message – but perhaps some intrusive legislation which includes detailed operational standards would be a good idea. Or perhaps we have to wait until Japanese electronics firms stop selling fax machines?