THE FUTURE OF THE MIDDLE OFFICE

The Middle Office evolved as a result of various issues facing Sell-side firms. Two issues, in common, to these firms were:

1.     a need for additional controls to improve the accuracy of the trade details at the beginning of the trade lifecycle

2.     the need to identify and resolve issues causing trade settlement delays

The response was to establish a function that would be closer to the front office, where client facing activities tak place, than the traditional back office. That’s how the name Middle Office came to be and has stuck.

Eventually buy-side firms, as well as other industry service organizations, also established a middle office function as well. This allowed each to functionally match-up to broker/dealers, custodians and prime brokers. Over time the focus of the Middle Office grew to include accounting, reporting and other control activities. The role of the Middle Office has improved operational efficiencies, reduced the cost of resolving delayed and failed trade settlements.

As the time between trade and settlement date shrinks, the Middle office may again prove to be an essential function in maintaining operational efficiency.  The reduction of time between trade and settlement date results in less time to resolve problem trades. This loss of time will require firms to rethink existing internal practices to ensure that there is sufficient time to identity, analyze the cause and resolve the issues that may delay timely and accurate settlement.

Today resolution of problem trades often requires interaction across various front, middle and back office areas. This can take a considerable time and may result in settlement delays. A shortened trade-settlement schedule may result in an increase in unresolved trades. This will have a negative impact on settlement and post settlement activities plus increase operating costs.  One approach might be to reduce the number of departments or staff involved in trade and settlement processing.

Restructuring operational responsibilities is one alternative to consider. Perhaps moving the activities associated with pre-settlement and settlement, now performed by the Back Office, to the Middle Office may be worth a review.

A new infrastructure might include reassigning functions between the Middle ad Back Office areas as follows:

1.     Middle Office – all post order(trade) execution through settlement functions

2.     Back Office – all post settlement through to asset servicing functions

This change is a huge leap from the structure that has been in-place for years. It is similar it to the introduction to technology in the 1960’s which resulted in new work flows, new departments and procedures. Technology continues to support the business and the impact is the same, with slight variations and the evolving changes are accepted as (business as usual.  

This is one approach. There is sufficient time for the industry to ponder the impact of reducing the trade-settlement and explore appropriate responses.

         Do you agree that this is a situation we will face?
 

                Is splitting functions between Middle and Back Offices viable? 
      
                     Can you offer alternative responses?

MULTIPLE SYSTEMS = MAINTENANCE CHALLENGES

The approach broker / dealers adopted early on in the development of application technology was to develop product-centric systems. For example a, equity system fro equities, a government systems for Treasury and a MBS system for mortgage backed securities. As a result, today firm have multiple processing platforms, each supporting specific products. The driver behind this approach was to create a template system that could be cloned to support other product systems. For example if the base fixed income system was the Treasury bond system, it could be used as the foundation for corporate and municipal bonds. Extraneous or unneeded functionality would be stripped while new functionality unique to corporate and municipal bonds would be added. This allowed firms to avoid "reinventing the wheel" each time they introduced a new product and sped up the process as well.

The outcomes were many similar, but different processing systems, each requiring expertise, maintenance and support. For example some products settled one day after trade date, others five days after trade date while mortgage backed securities can settle up to six month after trade date. Differences were pervasive throughout the trade life-cycle as well as in reference data, trade entry, and asset servicing and reporting. This required systems developers and maintenance staff to have current and relevant expertise and knowledge of each product and the related processing functions. The bottom line is that this resulted in increased information technology costs and often delayed new functionality and updates to be applied, even today.

Firms are still struggling to find an approach to address this challenge.  In the past 30+ years have seen many innovations in database design, programming languages and other advances that can provide benefits to financial services firms processing systems. But first they must reduce the number of product-centric systems to facilitate an efficient future environment. There are various alternatives; one is to build a new multi-product system to replace the product-centric systems. But the alternatives require a major effort in cost and resources. And have to be done in the current environment of keeping costs down.

 

         What is your opinion about this?

          Does this cause firms to less competitive?

                                Are there other viable approaches available?

CONSOLIDATED AUDIT TRAIL (CAT) – A REAL OPPORTUNITY

The Securities Exchange Commission (SEC) Rule 613 requires the timely collection of securities transaction executed in US markets.  In addition to the SEC, CAT is being created with the active collaboration of the registered exchanges and FINRA which are commonly known as Self Regulatory Organizations (SRO). The first step focuses on the reporting of US National Market Securities (NMS), which includes listed equities and options.

Though a driver of this effort is the “Flash Crash of 2010” I believe that it reflects the regulators realization that they need to be more proactive in gathering timely data on all transactions flowing through the US infrastructure. Logically they are starting with trade data, which are currently dispersed across multiple markets. There are a still number of open issues that remain to be addressed by the regulators but I am confident that the other participant’s interests and concerns will be addressed to the benefit of the industry.

Though this effort requires substantial efforts to develop and implement, it is a real opportunity to bring the industry into the 21^st century. In addition it should provide an opportunity to sunset or eliminate various trade reporting systems that provide similar data to specific regulators. Also, I believe that this data collected by a central source may, in the future, provide other benefits to the industry as well.

            Do you believe that there is real value in this new rule?

                        If so, what are the benefits? If not, why not?

                                    If not, what the alternatives to meeting the regulatory needs?

COLLATERAL MANAGEMENT OR MIS-MANAGEMENT……

Depending on the level of preparation, it could be either of the above. Traditionally collateral management was a back office function with little or no impact on the front office. But the Dodd-Frank Act (DFA), European Market Infrastructure Regulation (EMIR) and Basel III require participants to collateralize trades and other transactions.

Broker-dealers have been collateralizing clearing and guarantee funds for many years. But buy-side firms, such as hedge funds and other fund managers, have not had the same experience. They will now be required pledge collateral to support their transactions. If they don’t have appropriate or sufficient collateral they will need their custodians or clearing brokers to locate the needed collateral.

This requires custodians, clearing brokers and industry service organizations to enhance their services. As such it is a new source of revenue to industry service organizations and a new cost for their clients.

Electronic interfaces among the industry service organizations as well as investor will be critical to ensure that transactions are collateralized at minimal costs.

            What are the critical issues facing your firm?

                        How will you optimize the collateral you have?

                                    What are the available alternatives to improve collateral?

WHAT'S UP WITH THE LEGAL ENTITY IDENTIFIER?

It’s been a while since the need for recognizing legal organizations and their related entities has been identified. There have been a number of announcements on initiatives but little definitive movement on a coordinated global response to LEI.

Remember that it was difficult to determine their exposure of derivative trades especially for firms, like Lehman, that were facing a credit crisis. The initial drive for LEI was the Dodd Frank Act (DFA) and European Market Infrastructure Regulation (EMIR). Their focus was to reduce counter-party and systemic risk related to derivatives trading and settlement.

February 12^th was the date for SWAP trades to be processed with LEI. Problems were expected but the news about this event has been sparse.

What are your thoughts, good, bad or neutral, concerning global legal entity identifiers?

                        Are the regulators ready to respond to reported anomalies?

                                 Should a global identifier be extended to other assets?

SUPERVISORY COLLEGES FOR INTERNATIONAL CREDIT RATING AGENCIES

These organizations were established as a result of recommendations that the International Organization of Securities Commissions (IOSCO) made in their final report published in July 2013.  Supervisory Colleges for International Credit Rating Agencies creates a mechanism for sharing and discussing information regarding:

• Compliance with local or regional laws and regulations
• Implementation of, and adherence to, the IOSCO Code of Conduct for CRA
• Establishment and operation of rating models

•  Methodologies, internal controls, procedures to manage conflicts of interest
• Procedures for handling material non-public information
• With the goal of promoting better understanding of the risks faced or posed by international CRA and how relevant supervisors are addressing these risks

One lesson learned, was that credit rating agencies face conflicts. The Supervisory Colleges are a creative approach to avoiding similar missteps.

The colleges for S&P and Moody’s will be chaired by the Securities and Exchange Commission (SEC) and the college for Fitch will be chaired by the European Securities Markets Authority (ESMA. The SEC

              What’s your opinion about the need for supervision of credit rating agencies?

     Is this an appropriate response?

What are the critical best practices for the CRA?

CENTRAL SECURITIES DEPOSITORIES (CSD) - THE FUTURE OF LOCAL CSD

How will the announcement by the London Stock Exchange (LSE) to create a Central Securities Depository in Luxembourg impact local CSD? 

Today, most CSD are country-based service centers supporting local market participants via immobilization or elimination of physical certificates, providing book entry trade settlement, collecting interest and dividend payments and processing corporate action. Currently little or no interface to other local CSD is available.

The current local CSD infrastructure requires global participants to join multiple CSD to establish a first-hand presence in local marketplaces. This is expensive beyond multiple membership fees. It requires additional record-keeping, compliance with local regulations, increased risks if regulations don’t offer sufficient protection and additional interface applications.

There are two International Central Securities Depositories (ICSD), Clearstream and Euroclear that address some of inefficiencies of local CSD. They offer services across multiple marketplaces and offer centralized reporting. The LSE announcement adds another ICSD entity for global participants.

                What is the ideal CSD? (Local, International or a combination)

                            Should it be member or privately owned?

                                          How should they be regulated?