What impact will volatility have on brokerage and trade expense operations

By Daniel Carpenter, Head of Regulation at Meritsoft (a Cognizant company) 

From the CME surpassing 25 million contracts for 15 continuous trading days, to Euronext share trading transactions being up 92%, March was an unprecedented month for trade volumes.

While unpredictable daily levels of volatility presents opportunity, increased volumes coupled with the challenges of working from home means the operational headaches created to process and settle trades is much greater than it was a few months ago.

But as revenues continue to surge, are profits as high as they could be? Margins have been squeezed over the last decade and banks have been struggling to make money on certain asset classes, as demonstrated by the withdrawal of some major investment banks from equities. The problem is many financial institutions cannot fully articulate why these desks are not profitable and are struggling to make the required improvements to provide this transparency. Additionally, internal teams need to have visibility of what they are reconciling, allocating or paying across the different units.

Trading risk

Generally, firms are at risk because their operations departments work in asset class silos. From a trade expense perspective, the separate arms of investment banks have hundreds if not thousands of trading counterparties across different jurisdictions, for which contracts have been sporadically and inconsistently agreed over decades. As such, they have multiple rate cards, in multiple currencies and asset classes, for the same clients in different regions.

At the moment a lot of houses processes are far too manual. Rate cards can often be circulated via email in a pdf format and not controlled or digital. Financial houses cannot possibly keep track of their contracts as they have historically, particularly for the larger ones who have a bigger web of relationships. If they have not done so already, houses need to digitise their rate cards as a first step.

Once digitised, they should also be centralised. Without a centralised, digital repository, it is next to impossible to know which rate cards are up to date or transactions being calculated accurately. For example, most broker relationships have a foundation built on global rate discounts. However, if there is no central calculator, there is no way to know if the discount has been applied to transactions. As it is, it would take financial houses a lot of time to gather that data and manually apply it. This is straightforward analysis which should be taking place on a daily basis.

Similarly, centralisation and daily automation reduces risks relating to incorrectly billed transactions. Unless financial houses can create and match bills to executed trades on a central system, there will be cases where they pay thousands in trade related fees which may have subsequently been cancelled or failed for a variety of reasons. An intelligent system which matches, manages and pays all fees automatically removes this risk and leakage.

Once digitised and centralised, contracts can then be reviewed across the business. Some firms do not regularly amend their agreements, and some do not change contracts for years, meaning their rates might not be competitive or the volumes promised to obtain rates did not materialise. This lack of review occurs for a variety of reasons including responsibility being fractured, lack of easy access to data, inability to normalise and analyse data. Historically a front office agrees to a fee which looks roughly right without taking other costs into consideration. The trouble is that all this can take place without the operations team that processes fees knowing the intricacies of the rate card structures. Therefore, the price is never really questioned. Financial houses must ensure they have renewal dates, daily reconciled fee accruals and automated month to month processing.

Even if a house decided to review their contracts, there can be problems with counterparty identification. Recent years has seen a global consolidation of brokerage and many relationships are logged on legacy systems with out of date account identifiers. System 1 might identify a client as 123 when another identifies it as ABC despite them being the same client.

All in all, the complexity of broking relationships means these functions now require automation to be done effectively or investment banks leave themselves exposed to over-engineered fee structures. If they are to provide a frame for analysis to make informed decisions, these firms must implement a process to digitise, centralise and standardise their brokerage operations across all asset classes, in all regions.

Revenues to profit

The ultimate aim is better return on equity for all. The use of one system for trade expense management as opposed to many will empower operations to establish accurate rates and avoid any overpayments of fees. A global platform will provide the levels of transparency needed to examine the total cost of ownership of all their relationships in ways not previously possible, allowing financial houses to measure real counterparty profitability, as opposed to perceived profitability.

In most cases, trade expenses are the second largest cost for banks behind people, but it is clearly one which many do not have a firm grasp on. And not just because of the fragmented fee structures. All of the associated costs of each client, such as KYC and compliance are often not accounted for. Ideally, the buy side should fully understand the impact of scalability on its costs to the extent that it can predict exactly how much costs would change should volumes jump say 10 per cent on a specific desk, in scenarios similar to what we have seen in March.

With volumes as high as they are currently, analytics has become more important: every transaction has a cost, so higher volume means higher costs. The different desks are processing more trades with a broader range of prices without an understanding on how these affect margins. Historically, firms would possibly perform retrospective monthly profitability analysis, but today you cannot wait till the end of the month in the current climate; fees and revenue may shoot up or down each day. You cannot analyse data across disjointed spreadsheets, certainly not quickly, so more daily insight is needed.

Understanding where profits are being generated will also empower executives to make decisions on whether to entrench on certain assets classes or identify areas for expansion. For example, and as has been seen in the market, some big investment banks are moving back towards their core historically strong asset classes to focus on what will make them the most money.

There are of course data challenges to expense and fee consolidation, but the benefits could be truly significant. For example, imagine if financial houses had this technology in place over the last few months. Not only would the operational headache be significantly reduced, but the analytics would be invaluable. They would be able to determine where they are making the most money, or not, and whether you were being given the best prices, or not. Why would you not want to know if you could have made $100,000 more by using a different counterparty?

Strategic global deployment

This is clearly a busy time for operations teams and houses may feel that they have too much to settle and cannot step back and strategically plan. However, such drastic changes as has been seen in the market over the past month will force firms to try to do things differently. Now is the time to review how they operate their trade expense processing and deliver a way that will allow them to maximise financial performance and replace an old problem which has been exposed and hugely exacerbated by current trends.

One of the main factors holding firms back is the upfront and ongoing investment needed to employ people with the right skills to overhaul their existing infrastructure. Any trade expense project is a major task, one which requires the team to know the nuances of the data as well as the businesses needs and challenges. Operating on outdated platforms, which have old processes and no real-time management, is no longer an option. It will become increasingly difficult to turn a profit with systems like this and the industry requires greater accuracy.

A sea change is necessary, but it must be strategic. Financial firms should consider how to phase in changes which deliver immediate benefits and future proof the business. By reviewing processes in stages, firms can use technology to quickly make brokerage cost-efficient and scalable and make tangible savings.