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10:38 AM
Irfan Khan
Irfan Khan
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Going Back to Front Office

Buy-side firms must address the new post-Dodd-Frank ecosystem. The first step: Stop focusing on the front office and pay more attention to the back office.

Marc Quintyn, an economist and division chief of the International Monetary Fund Institute, wrote recently in QFinance that there are two certainties in supervising capital markets: One is dramatic change, and the other is extreme complexity with no end.

Similarly, the two major drivers of structural change in capital markets today are dramatic regulatory shifts and exploding rates and volumes of market data.

One of our customers, the CIO of a major Wall Street bank with more than 50,000 employees worldwide, was too overwhelmed to tell us how much his job has changed since the subprime mortgage crisis in 2007. But he did say that five years ago he worked from front to back, and now his focus is on back to front.

To say the tip of this iceberg indicates a considerable change is surely an understatement. And there is more than one iceberg.

Capital markets are taking icy hits on all sides: The U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act with all its 2,300 pages; a raft of European Union financial regulations; and the Group of 20 (G20) leading economies endorsing the Basel III rules. While the G20 is a good year away from announcing tighter rules for the biggest global banks, an image is taking shape of how the new Wall Street might appear.

That image is not yet clearly in focus. We've yet to learn exactly which bank and non-bank institutions will be on the list of those that U.S. Treasury Secretary Tim Geithner wants to "run with a much more conservative and prudent leverage and funding mix." But a new watchdog group created by Dodd-Frank would monitor them.

Capital markets firms must analyze how they can meet the reshaped financial ecosystem by establishing governance models, which align resources and address the IT and data changes. This is especially challenging given how long these changes usually take to implement.

The core of this work is deciding what, when and how to install the next generation of sophisticated IT systems. These should allow capital markets companies to deliver more efficient risk management, as well as more frequent data disclosure. This in turn helps them meet the tightest official scrutiny, since the FDR administration.

Firms across the globe are facing issues such as how to respond to pervasive future regulatory and legislative changes that will impact operations, as well as what the new rules will mean. The Dodd-Frank law and new regulations coming from the European Commission suggest a closer alignment with the U.S. in some areas. This would require a complete reshaping of market structures.

Among the new changes are rules intended to raise market integrity following the "flash crash," when an algorithm launched a tidal wave of buying and selling. It precipitated a 6 percent plunge in the market, which quickly recovered.

"While some blame circuit breaker alignment, others data volume and latency, and still others point at high frequency traders pulling liquidity, the macro question remains: How do we create a market that doesn't fold under duress?" wrote Larry Tabb, head of the TABB Group consultancy, in his column. Impacts of the 2001 and 2008 crashes were minor compared to the May 2010 flash crash's damage, he added.

To create a more robust market and minimize the damage from future crashes, the European Union imposed new rules for asset-backed securities (ABS) last September. Also in 2010, the U.S. Securities and Exchange Commission proposed changes to sharply increase the disclosure requirements for ABS. Dodd-Frank financial reform law also focused on disclosure, as well as skin-in-the-game issues.

All of this hits U.S. issuers of ABS from several directions.

For perspective, Dodd-Frank takes only six pages to mandate that the Commodity Futures Trading Commission implement conflict of interest rules, specific duties for swaps dealers, and establish a chief compliance officer. It looks simple until more than 130 pages of subsequent rulemaking further complicate matters.

Some industry leaders say this will shift the CFTC's traditional role from a principles-based operation to a prescriptive rules-based organization. Banks, brokers, exchanges and others, in turn, find it hard to know when -- and where -- to commit investments.

Ensuring that the capital markets industry is able to bring more resilience to the system will require a lot of work and a lot of rules. And if regulatory change is the first of two major drivers of structural change, soaring volumes and rates of market data is the second.

Back In Power

Power is shifting from traders in the front office to risk and back office managers. With this comes the search for a single, consolidated platform.

Organizations are looking for one integrated real-time view of all transactions coupled with straight-through processing (STP), from front-office trading desks all the way to the valuation. They also want compliance; other middle and back office order management; execution quality analytical tools; and risk control functions that occur when trades are done. Many of these functions used to be afterthoughts.

Driving this change is the added complexity coming from growth in smart order routers and trading algorithms. Asset managers are increasingly interested in companies' efforts to rationalize their workflows and drive efficiencies at every point in the trade life cycle. It is clear to them that seamless order management from back-to-front and front-to-back produces better performance, time-savings, fewer errors, increased control and improved client service.

As volumes and data requirements continue climbing, the need to remain efficient has put the back office in the frontline of the IT focus. This is a special concern for companies who have grown by inheriting disparate systems and applications. Few of these companies -- or any other companies -- have managed to standardize their platform and provide true STP across their back-office services.

Yet a standardized platform greatly facilitates the manager's job of effectively controlling dispersed trading desks; conducting meaningful surveillance of overall trading activity; evaluating real-time position at risk; and streamlining transparent and accurate risk calculations.

In the light of the two major drivers of structural change, regulatory shifts and exploding market data volumes and rates, it is possible to draw out the key attributes of the next generation of infrastructure for capital markets firms. Design attributes are:

  • Continuous flow of data from active sources (internal and external) to the application environment where it is used for analysis and reporting
  • Capability to operate on data as it is transmitted for purposes of filtering, validating and transforming
  • Reduced batch-based processing of data
  • Capacity to instantiate application environments with required data sets for an application cycle
  • Shared data repository with services around it
  • Greater system reliability to ensure minimal impact on business continuity and recovery

Capital market firms lacking these attributes will be unprepared for the trading environment of tomorrow. They will not survive without better quality data that is linked together for decision-making.

Meeting the challenges will involve rewriting many applications and changing the architecture of some key systems. Significant improvements to the front and middle office will be required to accurately compute profit and loss (P&L) estimates, as current systems may not be able to capture all of the data for trades and estimates.

In addition, handling front office risk demands intraday risk management solutions. Real-time solutions require new designs for application and data architecture.

Effective back office management may not always require real-time solutions, but near real-time, scalable solutions are a must.

Consequently, the capacity to harvest related information from internal and external systems will be critical for the next generation of IT infrastructure. It will streamline, aggregate and present the information to decision makers in a contextual framework. The emphasis will be on risk assessment and valuation at the portfolio and balance sheet level -- and on a much more frequent basis than the current norm, which now may span weekly and even monthly cycles.

Expect to see a great compliance chase over the next two years, as new regulations and expanding data impact almost all of the capital markets institutions and their customers worldwide, consuming an ever-increasing volume of resources, both human and capital.

Irfan Khan is vice president, chief technology officer for Sybase, Inc.

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