Cost Containment, Shifts in Trading Reshape Buy-Side Operating Models and IT Initiatives
Originally published April 27, 2009
NEW YORK — Investment managers seeking to optimize their operations and IT support are more frequently turning to outsourcing back-office functions, even as they try to balance cost-savings and the risk management necessity of high-touch services, according to consultants and industry observers.
Risk management technology and client-facing technology are attracting spending, observes Dayle Scher, Research Director, Investment Management, TowerGroup. “A lot of investment managers are focusing on data management, especially those that already had data management projects in place and had been focusing on security master data,” she says. “They are now shifting to focus on counterparty or entity data management, but leveraging the applications they already have in-house. A lot of the data management vendors substantiate that.”
Back offices are taking more cuts than front offices, according to Scher. “Projects around order management systems and risk analytics take precedence over new back-office projects, so back-office projects really need to leverage development that’s already been done,” she cautions.
The projects most likely to go forward this year are those concerning counterparty risk management, collateral management efficiencies, and improving post-trade automation, according to research by Scher. For buy-side back-office projects, collateral management is likely to be outsourced, while data management, electronic trade confirmation and internal and external reporting are all likely to stay in-house, she adds.
“Having a nimble reporting infrastructure and internal benchmarking for reporting internally to chief operating officers on the key performance indicators will be a big focus, and having that infrastructure as flexible as it can be,” says Scher.
These developments are occurring in a context where industry retrenchment to attain cost containment is determining what projects proceed and which projects are modified, postponed or terminated, she adds. Legacy system replacements and large-scale implementations are most vulnerable, according to Scher.
For firms looking to transform business operations, back offices can be restructured through transactions, while portfolio management can only be changed by cutting manager salaries, which does not bring as much cost savings, according to Adam Schneider, Principal at Deloitte Consulting. “It’s an interesting time to be a custody vendor,” he says. “In the back office, it’s very difficult to get rid of fixed costs. The second round of changes [after staff reductions] is typically something more structural. They save the most by eliminating fixed-cost infrastructure in exchange for someone else’s existing infrastructure. We see extraordinary interest in relatively large-scale transformation activities focused on consolidation, outsourcing and offshoring.”
An extraordinary percentage of trading is now technology-based, where a system follows the tick, executes before it, pushes orders through stat-arb programs or executes a program, explains Schneider. “But a lot of that is program-based, not buy-and-hold-based,” he says. “So it’s effectively different segments of the equity community and they are driving in different directions. A number of equity shops are busy investing both on the buy side and the TARP money capital markets side, because market sophistication, market speed, market access and delay times all have to go in the right direction year over year.”
For some firms, portfolio management and administration costs have become the top concern, over trade automation, according to Schneider. “First and foremost is controlling these costs through consolidation,” he says. “Multiple firms are looking to do various types of cost improvements, outsourcings, offshorings and eliminating duplicate capability. All of that is happening. There’s a lot of emphasis on that on a near-term cost savings basis, which typically means outsourcing, offshoring or a combination of the two.”
Both the outsourcing and internal restructuring options, for both front and back office changes, offer differing advantages, especially for hedge funds, according to Josh Goldstein, Chief Operating Officer and Senior Managing Director at Verition, a Greenwich, Conn.-based hedge fund that began a multistrategy fund in October 2008 with about $200 million in assets. “When thinking about infrastructure, the decision is always whether to buy or build,” he says. “It’s a balancing act. You have to ask yourself, what are you trying to accomplish? What strategies need attention? What’s your budget? And, how quickly do you need it? When making infrastructure decisions, I conduct thorough due diligence — like any investor should when considering a new investment opportunity.
“In our case, we’re in a particularly advantageous position. We’re a relatively small fund, but have the infrastructure and operational depth of a much larger firm,” he adds. “As COO, my job is to put the best tools in the hands of our professionals, in order to keep their focus on investing, not operational issues.”
In addition to the back offices facing cuts and restructurings, COOs also must take their cues from the front office on how the new environment changes operations due to risk management needs or any other reason, explains Kevin McPartland, Senior Analyst at The Tabb Group. Risk monitoring in particular, has to evolve so firms need not wait for batch processing to get the status of their portfolio or know their exposure accurately, he adds. To accomplish this, technology has to be updated from front to back. “They have to update how the trades are captured — including an error check when they’re done in the front office and how the middle office systems can manage the volume of trades in efficient enough time,” says McPartland. “They [trading data] need to be touched by people as little as possible, to then have the resulting reports or information turned around quickly.”
Data comes from the front office, but the underlying reporting technology is an operational function residing in the middle office, particularly systems examining exposure and profit-and-loss, according to McPartland. “The underlying technology must do the same things considerably quicker than before,” he says. “It comes down to the trader and the firm as a whole understanding where they fit in the market at any given moment. Obviously, we know counterparties can go away overnight, so waiting for an overnight batch to see what your real counterparty exposure is isn’t going to work anymore.”
Still, automation of certain back-office processes can yield savings and optimize operations, according to Scher. “One example is any kind of trade notification that a firm had not automated by using SWIFT,” she says. “That doesn’t require a big investment — such as a fund manager that had not previously automated fixed-income trade notification but had equity notifications automated.”
Another example of a small development in leveraging existing infrastructure would be, if a firm trades OTC derivatives, to use DTCC Deriv/SERV. “That is relatively inexpensive for the buy side if they already have FPML development in-house,” adds Scher. On applying technology and managing portfolios and trading, the balance between high-touch service and automation [see Global Investment Technology, February 16, 2009 cover feature] appears to be tipping more toward automation, a change from two months ago, as McPartland and Schneider see it.
“Thousands and thousands of jobs have been eliminated at all these major firms,” says McPartland. “Not only is automation about doing things quicker, it’s also about doing the same or more with considerably fewer people. From the front-office perspective, with the market as volatile as it’s been, people have been leaning more on sales traders to help them navigate. So for the front office, there is a push to high-touch services. The technology and the old-fashioned relationship model really need to work together. Technology is an enabler but the people behind it and the service that people can provide when there’s a problem, question or when things get hard, that will really make or break which firm people stay with, over years.”
So far, however, most actual trading is technology-based, according to Schneider. “It’s follow-the-tick, execute before, push them through statistical arbitrage programs or execute a program,” he says. “It’s an extraordinary percentage of the total volumes. But a lot of that is program-based, not buy and hold-based. Market sophistication, market speed and market access all have to go in the right direction year-over-year and that’s continuing.”
Although buy-side firms may have changed course regarding their use of automation for portfolio management, risk management and data management, what course they will choose still appears to be undecided, however, as front offices sort out what functions will remain high-touch and middle and back offices try to figure out how to manage their operations.
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