Five Reasons why Interoperability is Key to Success in Post-Trade Services
By Angie Walker, Global Head of Business Development, Capital Markets, R3
The pandemic has illustrated that digital transformation of entire industries, almost overnight, is possible. But the world of post-trade services appears to be lagging behind other parts of capital markets infrastructure when it comes to digitisation and the representation of the lifecycle through a single common infrastructure. Market participants no longer need to compromise through disparate, siloed systems at significant cost to their franchise in terms of resources, efficiency and avoidable failure. The technology already exists in production today to allow a wide variety of market participants and associated service providers/vendors to interoperate through the use of these common infrastructures and shared services.
During the last 18 months, many businesses have had to completely rethink their ways of working – often through transformation of legacy infrastructures – in order to adapt to the ‘new normal’. This unprecedented chapter in time presents a real opportunity for market participants to embrace these new technologies to affect material change. Arguably nowhere is the need to capitalise on this opportunity more pressing than in post-trade space.
In recent decades, advances in electronic trading technology have slashed operating costs related to brokerage and execution. With digitisation long established in the front-office, it is now time for the industry to turn its attention to tackling middle- and back-office inefficiency. This is the critical next step for the digital transformation of capital markets, helping firms move the profit dial further in their favour.
By running post-trade processes on a single common ledger-based infrastructure, market participants will be able to work more efficiently across a greater variety of interoperable post-trade services. This allows for vendor agility, optimising collateral requirements and minimising – in some instances eliminating – reconciliation and risk. The technology already exists to make this a reality, but an industry-wide shift is required to tackle this market-wide challenge. Therefore, the onus is on both financial market infrastructures and market participants to drive this change and to position themselves in the driving seat of a new, more agile and fiercely competitive future.
Single Version of the Transaction
Today each trade creates multiple records for all parties — sometimes being replicated over 30 times within a single post-trade lifecycle — and must be reported, surveilled, matched, valued, margined, subject to risk calculations, optimised, aggregated, netted, reconciled and more — often all day, every day, throughout the transaction’s entire lifecycle.
Staggeringly, there can be over 50 vendors involved in processing each trade, adding significant complexity, cost and risk during its journey. It has been estimated that 50–80% of back-office time is spent purely on reconciliation alone.
Distributed ledger technology (DLT) allows for a single version of the transaction (“what you see is what I see”) alongside the associated trade data set available on the ledger… in short, reconciliations would be a thing of the past. This approach results in a significant reduction in breaks, transforming operational risk, time and costs overall. It also moves the role of middle- and back-office staff to one of exceptions handling, a transformation from where they are today. Consequently, early adopters using this technology differentiate themselves from their competitors through enhanced key performance indicators (KPIs) in client services and offer a more competitive service fee to the end customer.
Future-Proofing the Post-Trade Environment
Banks spend billions of dollars each year on outdated legacy post-trade systems, and still must dedicate hundreds of personnel to processing, reporting and reconciling trades. During the first COVID wave, the number of broken/failed trades during March and April 2020 became so large that the Fed mandated a return to work of over 270 key trading staff across a number of financial institutions. The staff were summoned for an emergency weekend to clear a massive backlog of failed trades in March and April, highlighting the stress that built up in the financial system when the Coronavirus tore into markets. The pandemic emphasised the fragility of current infrastructures, but also the need for transformation of post-trade infrastructures.
Regulators are taking note — for example, the Bank of England has established a task force aimed at tackling outdated post-trade infrastructures, with day one focus on FX. This was swiftly followed by a proposed new regulation by the PRA, FCA and Bank of England in the form of rules around Operational Risk Resilience. The rules mandate that board executives have implemented appropriate strategies for Operational Risk Resilience by 2022 and that they must have implemented those plans by 2025. This is not an obligation that any single market participant will solve alone. It will require market-wide collaboration in order to build out common infrastructures that will allow them to meet these new and more robust wide-sweeping obligations.
Ultimately, the buck stops with market participants to drive these changes. Yet today, less than a third of fintech investment is spent in the middle- and/or back-office. Given that firms are spending upwards of $20bn per year on post-trade processing systems alone, this stark imbalance between the level of investment, versus the cost of operation of such infrastructures is simply unsustainable.
For those daunted by the prospect of wholesale technology change, DLT enables firms to create seamless interfaces between the ledger and legacy infrastructures. The technology that underpins the ledger means that firms can ensure interoperability between the current systems and the new world of ledger-based services. This enables low or no risk interactions between the two worlds. Existing technology remains accessible whilst allowing new services to evolve organically over time, enhancing market interactions and in doing so, future-proofing participants post-trade environments.
A Single Common Post-Trade Infrastructure
If this all seems a little far-fetched, by comparison, the front-office has been collaborating for over two decades, facilitated by the evolution of FIX. In the front-office, market participants across a wide spectrum of institutions collaborate using a broad range of order and execution-based services on common infrastructures. This has transformed front-office processes across a broad spectrum of asset classes. Yet, post-trade processes have remained fundamentally unchanged for decades.
This is largely because in today’s world market participants’ middle- and back-office functions have little, if any, shared infrastructure outside of the central market infrastructures. This is despite post-trade services being one of the largest sources of costs to most financial institutions.
A single common post-trade infrastructure would empower market participants, their customers and their service providers to collaborate by sharing the costs associated with such an environment. Participants would benefit from market-wide consolidation whilst enjoying the benefits of a competitive landscape in which vendors deliver a broad range of services, allowing for interoperability both “on ledger” and “off ledger”.
Diminishing Dependency on “Off Ledger” Services
Post-trade services have fundamentally failed to modernise and mutualise costs — even as the industry has become predominantly electronic. The current post-trade disparate “off ledger” infrastructure is costly, risky and often materially restricts banks in their agility to grow, innovate and take on new asset classes, markets and/ or clients.
By maximising efficiency and interplay between legacy and new processes in post-trade lifecycles “on ledger”, banks are able to reduce and ultimately phase out their long-term dependencies on “off ledger” services, minimising reliance on remote netting, aggregation, clearing and reporting through the migration of many, if not all, of these services to the ledger over time.
Interoperability and the impact on Settlement Finality
For many, the biggest prize of all would be having settlement atomically, seamlessly executed “on ledger” and with definitive legal certainty – this would be better still if the execution involved the use of central bank cash, ensuring an irreversible transfer of value. Whilst that may be some way away – although potentially not as far as we think – the interoperability between the ledger and other established “off ledger” settlement rails, combined with the introduction of services such as the Bank of England’s new omnibus account model for digital currencies, means that synthetic wholesale CBDC is soon to become mainstream.
The ability to move value instantly and with definitive legal certainty is, without doubt, one of the most powerful and transformational aspects of the use of the ledger. It demonstrates the vital importance of having interoperability between obligations “on ledger” and the movement of value onto the ledger, in order to defuse those obligations atomically and potentially instantaneously. Thus, empowering market participants to significantly reduce settlement time and cost whilst eliminating failed settlement & Herstatt risk.
Capital markets play a crucial role in the real economy, and it is therefore vital to the health of the industry as a whole that they function fairly, robustly and effectively. To do this, market participants need resilient and cost-efficient post-trade processes.
Post-trade services are ripe for innovation and transformational change over the coming 5-10 years. Interoperability between the ledger and today’s platforms holds the key to releasing financial institutions market-wide from the technological binds in which they find themselves after years of unstructured investment in multiple generations of expensive legacy post-trade technology.
The last 18 months have been a significant catalyst in the broader acceptance of representing assets in a digital form across central banks and regulators the world over. Whether through the use of a token or simply a record that points back to the underlying asset, combined with the use of the ledger in immutably recording origination, provenance and the transfer of ownership, the representation of assets in a digital form has seen a marked increase in adoption within some of the most highly regulated and mission-critical parts of the post-trade life cycle today. The writing is on the wall, post-trade modernisation is no longer just a nice to have but a vital part of preparing the industry for the future world of institutional-grade digital asset trading.
