THE INDUSTRIALIZATION OF CAPITAL MARKETS: where are we now? The notion of centralized infrastructure and services is not new. It has been used successfully in other industries for years. There is, however, a renewed interest in industrialization within the capital and commodity markets. Many firms are once again considering how utilities could help increase efficiencies, reduce costs and, ultimately, improve their return on equity (RoE). In this article, Ryan Baccus discusses the ways in which today’s industrialization efforts are putting market utilities back in the spotlight, when they make the most sense and what firms can expect in terms of benefits. Introduction Definition of Industrialization

The process in which a society or country (or world) transforms itself from a primarily agricultural society into one based on the manufacturing of goods and services. Individual manual labor is often replaced by mechanized mass production and craftsmen are replaced by assembly lines. Characteristics of industrialization include the use of technological innovation to solve problems as opposed to superstition or dependency upon conditions outside human control such as the weather, as well as more efficient division of labor and economic growth. Source: Investopedia (filed under labor unions)

Figure 1: The Evolution of SABRE—An Example of a Successful Market Utility

The concept of industrialization and the potential of leveraging economies of scale to reduce costs and increase profits is not a new one. Outside of financial markets, there are numerous examples within manufacturing, telecom and even the airline industry (See the Sabre example in Figure 1) where organizations have been able to work together to standardize elements of the supply chain. There is also a rich history of events where firms have also co-invested in technical solutions that provided an enhanced service at a fraction of the cost compared to a scenario where each organization would have individually built solutions. There have been a number of successful initiatives within the financial markets community to develop new concepts collaboratively that have resulted in the creation of market utilities and other central market infrastructure. These have typically occurred with a limited process scope where a business function was not already being performed and there was an appropriate regulatory incentive acting as a catalyst. The industrialization proposition, by its very nature, has a more commercial focus, which means that the conditions for success are more complicated. As such, it has traditionally been more challenging to mobilize market participants to collaborate and co-invest.

Paper-based ticket system for air tickets American Airlines (AA) and IBM jointly announce plans for semi-automatic business research environment (SABRE)

EasySabre introduced to allow customers to make reservations directly

Saved 30% on its investments

(1988) 36 million fares

1960s

Expand service to hotels and cars

1970s

1980s

Acquisitions and partnerships to expand services and integration 1990s

System is expanded to broad travel agent user base, not just AA agents

Addition of integrated frequent flyer program

Online terminals are added

Joint venture with ABACUS to access Asian market

2000s

(1978) 1 million fares

CROSSINGS: The Sapient Journal of Trading & Risk Management

22

One of the more high-profile examples of the industrialization proposition within the capital markets is the JP Morgan Arcordia service. Created to drive greater industry standardization, Arcordia, which was spun out of the JPMorgan back office in March 2000, was a provider of ASPbased post-trade processing services for over-the-counter (OTC) derivative trading for use by other organizations. Widely recognized as a leading platform with rich functionality, the commercial operations of Arcordia were, however, wound down in November 2001 with a JPMorgan spokesperson confirming at the time, “Recent events and the continued economic slow-down have caused the firm to re-evaluate its external Arcordia business plan.”1 The Arcordia offering preceded years of rapid growth in the OTC derivative market and the general sentiment was that the market practices and dynamics were not mature enough at the time for the offering to succeed.

Market Conditions and the Case for Industrialization The current market environment is characterized by shrinking margins, increasing cost pressures and more exacting regulatory standards. This has created an environment where there is a significant focus upon opportunities for cost reduction and return on investment and where substantial funding has been channeled towards meeting global regulatory requirements. In parallel and through a number of successful internal and external initiatives, there is also a greater awareness and willingness to collaborate on common challenges faced by the marketplace. Together, these two factors have created an environment that has the potential to drive efforts for marketwide industrialization to a successful conclusion.

As one would expect, the financial markets have undergone a major transformation in the years since the Arcordia offering. But are market conditions any more stable now and, if so, what does the capital markets’ industrialization roadmap look like?

Figure 2: Industrialization Drivers and Enablers

Industrialization Drivers Volumes: While the Bank for International Settlements (BIS) statistics show a steady increase in OTC volumes (notional outstanding) since the financial crisis, the revenue at many major investment banks has declined. 2014 represented a particular challenging time with FICC markets, in particular, providing disappointing returns (Tricumen estimates that the top 13 banks’ FY 2013 capital markets revenue for FICC was down approximately 9.5% from FY 2012 levels).2 Profits: At the same time, organizations’ efforts to reduce headcount and take operational costs out of the business continued to slow down in 4Q13. Cost reduction programs are expected to accelerate in the first half of 2014 with a number of organizations looking at ways in which to transform the business including reviewing the scope and/ or the business mix of their FICC divisions, extending well beyond the disposals of physical commodities units.

Industrialization Enablers Standardization: OTC derivatives regulations have enforced greater standardization in trade execution, clearing and posttrade services across the industry. The adoption of these standards across areas like reporting, confirmations and portfolio reconciliations has also increased the number of active participants on these platforms from what was once a largely major investment bank user base. Data Quality Demand: There has been wide support for new industry initiatives, such as Know Your Customer (KYC) and client data, underlining a shift in ambitions as organizations consider moving critical business functions to an external provider. Rationalization: Internally, application rationalization efforts as part of cost-cutting initiatives have reduced the diversity and levels of customization within major investment banks toward global standards. This is paving the way for true service-oriented architecture and business “functionalization” benefits.

Costs: A number of institutions also recorded significant costs in 2013 due to litigation or as a result of the investment required to keep pace with global regulations.

23

Given these conditions, there is a greater willingness throughout the market to consider industrialization initiatives. However, the scale of ambition across organizations varies depending on experiences and circumstance, with the challenge of balancing initiatives focusing on optimizing sourcing and location strategy, internal group-level functionalization and market-wide industrialization. Based on perceived delivery risk, there is often a portfolio of initiatives working toward different levels of standardization at the same time. As such, there seems to be greater demand for functionspecific industrialization efforts rather than attempts at replacing entire post-trade services.

The Focus for Capital Markets Industrialization What makes a function more suitable for standardization? The following characteristics of a function should be evaluated before determining whether to standardize it or not: • Competitive advantage—The level of competitive advantage associated to the function by clients • Market breadth—The number and profile of market participants that perform the function • Efficiency—The level of effort (cost) and inefficiencies associated to the function • Stability—The likelihood of major change affecting the function in the short to medium term

Figure 3: Industrialization Value Chain—Standardization can act as a key enabler or a primary limiting factor for industrialization efforts. The value chain below highlights gradients of standardization that can be used to evaluate industrialization opportunities and understand the prospective impact and, ultimately, adoption.

Regional Standards (i.e., FICC EU)

Global Product Standards (i.e., FICC Global)

Global Division Standards (i.e., OTC Global)

Business Global Group Standards Standards (i.e., IB Global) (i.e., Parent level)

Industry Standards

Figure 4: Trade Documentation Industrialization Stability Assessment Matrix

Industrialization Suitability Assessment Competitive Advantage

Market Breadth

There is no perceived advantage in the trade documentation process. Regulation has narrowed the performance range significantly given T+1 documentation standards.

The application of T+1 trade documentation regulations impacts a significant portion of the market. Without a more collaborative process, the industry as a whole will not be able to meet regulatory requirements.

Benchmarks will collectively drive improvements in performance across the industry. Efficiency­—The documentation exchange processes that exist today are seen as archaic and are typically managed on duplicative infrastructure for confirmations, legal documentation and term sheets.

Stability—Regulators are expected to remain in an observing status for some time but have communicated standards and are currently receiving metrics and reports so are able to identify outliers.

Market participants maintain their own populations of templates and terms that are exchanged with a common client base.

Electronic volumes processed over electronic trading venues and electronic affirmation platforms are expected to grow.

CROSSINGS: The Sapient Journal of Trading & Risk Management

ISDA is increasing levels of standardization through updated equity and credit derivative definitions.

24

Client reference data is an area that meets the criteria previously outlined due to its non-proprietary nature and the significant cost for market participants. This has been reflected in recent market offerings from the DTCC, Markit, Thomson Reuters and SWIFT. Another area that fits the suitability criteria is the potential for a central utility that could provide for netting efficiencies across margin and settlement movements, given the upcoming enforcement of margin for uncleared trades for OTC derivatives and the market-wide demand. An area that was less straightforward was trade documentation. While it is largely considered to be a nonproprietary function, the changing landscape and uncertainty around trade volumes make this an interesting function to explore. Can the trade documentation function be moved into a shared service that can ultimately drive reduced costs, increased controls and more effective compliance by creating greater levels of standardization and enhanced transparency? While largely perceived as a non-proprietary function, trade documentation is still managed bilaterally in most instances. The analysis in Figure 4 suggests that trade documentation is, in fact, a good candidate for standardization. However, the uncertainty around volumes and processes could see the

industrialization take place gradually (potentially focusing on the issues of document exchange initially) to ensure that the perceived long-term benefits can be realized. Outside of core business functions there are other opportunities for “utilitization” and where innovative solutions could help in terms of economies of scale. As an example, Goldman Sachs and Fidelity Investments have recently given their backing to the Open Compute Project, an initiative to open source hardware and datacenter designs. It is expected to transform the way in which infrastructure is designed and manufactured in the IT industry. Jay Parikh, vice president of infrastructure at Facebook, which founded the Open Compute Project three and a half years ago, said that in the past three years Facebook has saved an estimated $1.2 billion on IT infrastructure costs by doing its own designs and managing its own supply chain. CEO Mark Zuckerberg later added that on top of this savings, Facebook has saved enough energy to power 40,000 homes for a year and reduced carbon dioxide emissions at a level that is equivalent to removing 50,000 cars from the road for a year.3 Grant Richard, managing director of technology infrastructure at Goldman Sachs, gave a presentation at the Open Compute Summit where he outlined the potential impact of the Open Compute Project for his organization, summarized in Figure 5.

Figure 5: Goldman Sachs Technology at a Glance

68

Firm and public designed data centers

8,000+

Engineers and technologists

1.2 BN

Lines of code

34

Megawatts available

10,000

Network devices

118,000+

500,000 Computer cores

4,000

Servers in the “GS Cloud”

Applications

16 MM+

45,000

Software charges per month

Servers

28 PB Storage

59,000 Databases

50,000

Remote desktop sessions

25

Ryan Baccus

“ The majority of IT, processing and support behind banking services is delivered in-house with platforms that are highly duplicative across players and offer very little by way of competitive advantage.

is a Vice President based in London driving Sapient Global Markets’ Regulatory Response offering. With more than eleven years of experience in the OTC derivative market, Ryan has led a number of high-profile engagements for major global investment banks, industry associations and central market infrastructure providers with a specific focus on execution and posttrade services. [email protected]

“ We estimate up to $7-9 billion of industry costs could be pushed out into an external supply chain (net savings of $3-5 billion) that can deliver scale economies as well as enhanced flexibility and potentially more innovation. We expect only a part of this to be achievable within a 2-3 year time-frame and estimate $1-3 billion of annual cost savings at stake by 2016.” Source: Morgan Stanley - Wholesale & Investment Banking (March 20, 2014)

Mobilizing for Capital Markets Industrialization

References:

The business case for any industrialization effort can be complex. At the heart of these types of initiatives is an intuitive benefit model. However, due to the long-term payback and a range of commercial models, there are a number of subjective scenarios, such as trade volumes, levels of STP and delivery confidence, etc., that must get factored into the numbers. But for those organizations that make the commitment to industrialization, the benefits can be significant. While the initial design will likely be complex given the inherent challenges around security and commercial models, the key to success is establishing the right governance model—one that is empowered and able to commit to long-term initiatives where there is the potential of materially impacting the organization’s ROE. For organizations looking to meet ambitious cost-reduction targets, industrialization stands out as a viable option that can enable genuine business transformation.

1. Finextra, “JPMorgan Chase winds down Arcordia,” http:// www.finextra.com/news/fullstory.aspx?newsreview=com ment&newsitemid=3714 (November 7, 2001).

CROSSINGS: The Sapient Journal of Trading & Risk Management

2. Tricumen, “Capital Markets Results Review 4Q13/FY13,” http://www.slideshare.net/DarkoKapor/tricumen-4-q13capmkts-resultsopen. 3. Enterprise Tech Systems Edition, “Goldman Sachs and Fidelity Bank on Open Compute,” http://www. enterprisetech.com/2014/01/29/goldman-sachs-fidelitybank-open-compute/ (January 29, 2004).

26