market volatility & trade fails drive a new fixed income standard: does your operating model...

Does your operating model measure up?

Market volatility &trade fails drive a new fixed income standard

THE NEW FIXED INCOME STANDARD

Increased Market Volatility and Settlement Failures Drive the Need For a New Fixed Income Standard

Broker-dealers must enhance their operational models to effectively navigate and manage fixed income market risks, which have increased exponentially as a result of the financial crisis. “The New Fixed Income Standard” provides the fundamental end-to-end operating model that a world-class brokerage firm requires in today’s dynamic market.In just ten years, the amount of global debt outstanding has more than tripled and is at an all-time high, approaching USD 100 trillion. The amount of global debt outstanding, segmented by domestic and international debt, is displayed in Exhibit 1.

The global market meltdown as a result of the financial crisis sent investors scurrying for protection, liquidity, and more stable returns in the form of bonds. Trading volumes and market interdependencies across asset classes continue to climb with investors’ increased demands for fixed income products and liquidity. These market

factors have significantly raised the bar on how prepared broker-dealer operations are to meet their obligations in this market environment.

These forces, combined with the continuation of the European debt crisis and emerging regulatory requirements, have led many firms to question their existing fixed income business model and opportunities for growth.

As they seek to adapt and transform, many are beginning to ask critical questions, including:

• How can we quickly capitalize on rapid global market changes?

• Can we drive down costs and keep abreast of new regulations without compromising service?

• How can we minimize the investment of resources and talent while accelerating the time required to reach The New Fixed Income Standard?

Based upon market insights, leading client practices and industry data, considerations are suggested to help evaluate the shortcomings of existing business models to more effectively address regulatory and customer demands and increasing market forces.

From Capital Requirements to Trade Fails, Risks AboundDaily market fluctuations in reaction to high market volatility (for instance Greece, Spain, and Portugal), and the desire to capitalize on instantaneous market shifts, are spurring the steep growth of electronic trading. A recent survey conducted by the Association for Financial Markets in Europe shows that one-third of asset managers execute at least 60% of fixed income trades electronically, and over half plan to increase the percentage of volume traded electronically. And 90% of sell-side respondents plan to increase their electronic trading in fixed income securities.

The continued transition to electronic trading platforms is being done to meet the increased demand for fixed income products and enable

EXHIBIT 1 Global Debt Securities Outstanding (1996-2011)

Source: Bank of International Settlements, CEB TowerGroup

(In Billions USD)

100,000

80,000

60,000

40,000

20,000

0

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

1996

1997

1998

1999

2000

28,730

99,688

Domestic Debt International Debt

2


portfolio diversification while improving margins and transparency. US Treasury securities, one of the world’s most widely-traded securities classes, has witnessed a substantial increase in average daily trading volume coinciding with the move to electronic trading in fixed income.

The size and volatility of the market has the attention of regulators. Globally, regulators are seeing increased capital adequacy and improved risk management as tools to increase stability. From Dodd-Frank to Basel III, proposed regulations seek to impose more requirements on providing financing operations transparency, improved market participant conduct, and enhanced enterprise-level reporting.

Increased capital requirements have forced firms to further evaluate their operational practices and concentrate on optimizing the use of their capital. The substantial increase in trading volumes, combined with the vast number of bond issues globally, has put further pressure on firms from a data management perspective, which is critical to achieving high levels of straight-through processing (STP). Although a low interest rate environment has contributed to the increased settlement fails outstanding, data management issues are the most common reason for trade exceptions.

Reducing operational exceptions, including settlement fails, drives the need for a holistic world-class operations solution.

The increase of marketplace complexity and high-profile institutional failures have heightened global leaders’ and regulators’ focus on risk management, where increasing capital requirements and transparency into balance sheets will intensify in the future.

Following a substantial increase in failed US Treasury trades after the onset of the 2008 financial crisis, the Treasury Markets Practice Group (TMPG), comprised of industry participants, proposed to levy a failed trade charge to parties for not delivering securities in a timely fashion. As a result, fails declined dramatically. More recently, TMPG recommended a charge for fails in mortgage-backed securities (MBS), indicating many firms are still struggling with fail control. Exhibit 2 shows the aggregate amount of settlement fails outstanding in the US bond market has been on the rise over the last two years. Settlement fails carry a number of negative results, including: costs of borrowing securities, increased counterparty credit risk, lost interest on the proceeds for the seller, and staffing costs related to addressing the fails.

EXHIBIT 2 US Bond Market Settlement Fails Outstanding (1999-2011)

Source: Federal Reserve Bank of New York, SIFMA, CEB TowerGroup

Receive Deliver

(In Millions USD)6,000,000

5,000,000

4,000,000

3,000,000

2,000,000

1,000,000

0

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

99

Jan-

00

6,000,000

5,000,000

4,000,000

3,000,000

2,000,000

1,000,000

Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

3


Financial crisis repercussions have also put the US brokerage industry under considerable revenue pressure. As global investor confidence has been shaken, equity market volumes have continued to decline from their pre-crisis levels, resulting in reduced firm revenue. Consequently, leading brokers have been forced to slash expenses, cutting costs by over 61% from their all-time high in 2007. Exhibit 3 highlights the stark decline in US securities industry revenues and expenses since the financial crisis unfolded in 2008.

With increasing expense pressures, many firms are limited in their ability to adjust to the changing demands and increased volumes of the current market. Simultaneously, many broker-dealers are unable to integrate foreign fixed income into their business model, adding to operational complexities and costs while limiting the ability to expand. Attaining a world-class fixed income operations model across asset classes while minimizing risks and costs, requires industry-leading technology and operations, expertise, and resource differentiation.

Achieving the New Standard in Four Steps: Technology & Operations, Expertise, Risk Management, and CostThe rapid pace of regulatory change forces broker-dealers to wring more than cost reduction from their operating model and evolve more quickly than in the past. The complexity of supporting fixed income trading increases exponentially when expanding into international markets. Core processing technology must incorporate global trading, regulations, and clearing/settlement requirements across markets while providing transparency for operational risk management. Plus, firms must have a well-defined data management strategy to not only reduce the cost of data, but more importantly, to support a high level of STP across the trade lifecycle in order to mitigate risk and provide a seamless client experience.

Step 1: Build an Industry-Leading Fixed Income Operating ModelTechnology and operations provide the infrastructure and scale for supporting increased fixed income volumes, new products, and continuous improvements. Firms should also assess their current or planned capabilities to identify processing gaps that may limit business growth or introduce greater risk to the firm.

Core technology and operations must be able to support the specific requirements of processing a range of fixed income instruments and financing transactions across the globe while handling volume spikes. In addition to providing multi-currency and multi-region support, the core processing technology and operations must handle the nuances of each product, including accrual methods, financing options, while pooling allocations among hundreds of other specific calculations. The core processing system should provide for automated processing of key functions, complemented by knowledgeable operational staff that define and deliver best practices.

Leading US fixed income firms have been able to reduce expenses by over 60% from their high water mark of 2007. Has your firm?

EXHIBIT 3 US Securities Industry Domestic Gross Revenues and Expenses (1999–2011)

Source: SIFMA, NYSE Euronext, CEB TowerGroup

Revenues Expenses

(USD in Billions)

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

1999

2000

$400

$350

$300

$300

$250

$0

$200

$150

$100

$50

4


• Will our operational expertise allow us to expand into new business areas, such as prime brokerage?

• Does our fixed income technology and operations support multi-currency clearance and settlement?

• Can we provide operational support in multiple local time zones, or do our global offices operate in silos?

Step 2: Test Your Global Fixed Income ExpertiseFixed income global expertise extends beyond strong operational knowledge, such as trading practices. Clearing and settlement in multiple countries involves a vast network of depositories and custodians, requiring extensive knowledge of local market practices. Regulatory expertise is critical, not only to ensure local compliance, but to help mitigate operational and financial risk. Exhibit 4 provides an overview of the global interdependencies of brokerage processes.

Self-assessment: Technology & Operations (i.e. Process Reengineering) Key questions firms should ask themselves to evaluate their fixed income technology and operations are:

• Does our fixed income operating model enable our firm to achieve a competitive advantage in the marketplace, and do we have the agility to support new regulations and products in a timely manner?

• Can we handle the specific processing requirements of all global fixed income products with a high STP level and efficient data management?

• Does our current operating model enable scalability, flexibility, and the ability to offer a differentiated client experience compared to competitors?

• Does or will our fixed income technology integrate easily into other critical systems and fit into our future architecture?

Source: CEB TowerGroup

EXHIBIT 4 Interdependencies of the New Fixed Income Operating Model

ACCOUNT STATEMENTS

Trading

Order Routing

Order Execution

Block Orders

Post Trade

Books & Records

• Client positions & transactions

• Stock record

• Multicurrency accounting

• Margin processing

• P&L

Clearing & Settlement

Trade Support

Purchase & Sales

Security Master

Collateral Management

Fail Control

Cash Processing

Asset Servicing

Regulatory Compliance

Operational Risk Management

Client Experience Technology/Operations Infrastructure

CUSTOMER & REGULATORY REPORTING

ANALYTIC & DECISION MAKERS

WEB PORTAL RECORD KEEPING

BROKER-DEALERS CLEARING HOUSES/CENTRAL COUNTER PARTIES

CUSTODIANS DEPOSITORIES

REAL-TIME TRADE

CONFIRMATIONS

BANKS

5


Self-assessment: Fixed Income Expertise Key questions firms should ask themselves in evaluating their fixed income expertise are:

• Does our operations staff have the specialized knowledge and experience to support all of the instruments currently traded and those we plan to expand into?

• How can you leverage your supply chain for expertise?

• Is our team aware of global standards and best practices?

• Does our operating model support continued fixed income expertise development to meet changing regulations?

• Does our operational support utilize industry best practices?

• Does our fixed income operational expertise provide us with a competitive advantage?

Step 3: Evaluate Your Operational Risk ManagementA key consideration for firms evaluating their fixed income capabilities involves their ability to manage risk. Due to regulatory changes, growing volumes, increasingly complex products across multiple markets, and the need to operate more efficiently, risk management has become a focal point for the industry. Actionable risk management is dependent on accurate, timely, and relevant data. Firms need to have operational processes, expertise, and technology that facilitate the ability to aggregate and analyze data to proactively identify potential exposures before they occur, as opposed to reacting to problems as they arise.

Self-assessment: Operational Risk Management Key questions firms should ask themselves in evaluating their ability to effectively manage risk are:

• Do our fixed income capabilities adequately allow us to monitor operational and counterparty risk in real time?

• Do we have the scalability required to meet compliance and regulatory commands?

• Are current gaps in operational processes hindering our ability to maximize the use of our capital and exposing us to unnecessary operational risk?

• Do we have the key measurements in place to manage operational risk?

• Will our firm be exposed to increased operational risk should key staff members unexpectedly leave the firm? Do we have a contingency plan in place?

• Can our fixed income capabilities handle the specific processing requirements of all products traded in the front-office with a high level of STP?

• Could we reduce our exposure to risk by re-evaluating our operational model? Are there alternative operating models that would allow us to reduce our exposure to risk?

Step 4: Measure Your CostsA final consideration for firms evaluating their fixed income capabilities involves costs. Amid an environment characterized by declining margins in the brokerage industry, the ability to support firm operations and manage risk while facing constant cost reduction pressures is the industry norm. Firms must carefully balance the cost of supporting their fixed income business with the requirements for expansion, operational excellence, regulatory compliance, and sound risk management practices.

Self-assessment: Cost Key questions firms should ask themselves in evaluating the cost of supporting their fixed income capabilities are:

• Can we reduce financing costs by re-evaluating our operating model?

• How quickly can we drive down costs while enhancing service levels and reducing risk?

• How much flexibility in personnel do we have to respond to volume peaks and troughs across products and markets?

• Do we have a front-to-back office technology and operations strategy that optimizes cost?

6


• Do we have the resources to support new products and new regulatory reporting requirements in a cost effective manner?

• Are there ways we can reduce our fixed costs associated with supporting our fixed income capabilities and move to a variable cost model that allows expenses to fluctuate with our volumes?

• Are technology maintenance and development costs undermining our ability to expand our fixed income footprint?

Conclusion

Attaining The New Fixed Income Standard in a rapidly changing economy requires a solid and flexible operating model. Engaging a partner can enable your firm to take advantage of market opportunities while reducing costs.

Supporting fixed income instruments across the globe and asset classes in a volatile market requires a thorough assessment of four areas: technology & operations, expertise, risk management, and cost. On the technology side, the core processing system must handle the unique requirements of products across currencies with a high level of STP. Operationally, firms need to support trading, clearing, and settlement practices across jurisdictions. Expertise is indispensable in expanding into new products and markets, and in complying with ever-changing regulations. And firms must be able to support their capabilities under continued downward cost pressures.

With increased regulatory requirements, client demands, and the ongoing challenge to manage headcount, many firms find that outsourcing a piece or their entire solution allows for greater agility in changing markets, speed to market for new products, ability to meet client demands, and improved risk management while attaining a significant cost savings over an in-house solution.

Finding the right partner to attain The New Fixed Income Standard is critical to providing end-to-end operational transparency in order to expand into new products, reduce operational risk, and realize cost savings. You should look for a partner with proven functional expertise and an unparalleled understanding of building infrastructures to support all aspects of fixed income operations globally, plus the ability to help your firm get to market quickly.

There are alternatives for addressing these issues. That’s where Broadridge comes in.

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permission of Broadridge Financial Solutions Inc. © 2013 Broadridge Financial Solutions, Inc.

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Contact UsFor further information please email [email protected]

Michael Alexander, President Broadridge Business Process Outsourcing Solutions [email protected]

J. Michael Hopkins, President – Fixed Income & Risk Management Broadridge Financial Solutions [email protected]

About BroadridgeBroadridge Financial Solutions, Inc. (NYSE:BR) is the leading provider of investor communications and technology-driven solutions for broker- dealers, banks, mutual funds and corporate issuers globally. Broadridge’s investor communications, securities processing and business process outsourcing solutions help clients reduce their capital investments in operations infrastructure, allowing them to increase their focus on core business activities. With 50 years of experience, Broadridge’s infrastructure underpins proxy voting services for over 90% of public companies and mutual funds in North America, and processes more than $5 trillion in fixed income and equity trades per day. Broadridge employs approximately 6,400 full-time associates in 13 countries. For more information about Broadridge, please visit broadridge.com.