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Building the Back Office Superhighway

Market participants and regulators have focused on modernizing front-office trading systems, but nowhere is the need for increased automation more apparent than in the middle and back offices.

The love-hate relationship between technology and trading has been one of the most rapidly evolving stories of the past year. Against a backdrop of algorithmic coding errors and botched IPOs, regulators are taking steps to improve market structure; in the U.S. they have requested a consolidated audit trail system to provide transparency to trades across all types of execution venues. Regulators have also discussed the implementation of a “kill switch” that would instantly disconnect a troubled trading firm from exchanges, though who should flick the switch remains up for debate.

For decades much of the industry focus has been on the need for greater automation in the front office, which has sometimes been described as a superhighway. Most front-office systems at market participant firms worldwide have become “electronified,” and the front office has become a very efficient, risk-averse part of operations, executing trades in milliseconds. However, it is urgently important that we as an industry remain focused on the middle and back offices. It is there, after a trade is made, where basic processes continue to be conducted manually or with outdated systems, adding time — and risk — to trade settlement.

The middle office is more like a dirt road than a superhighway. Many outside the financial industry would be surprised to learn that in the U.S. it currently takes three days to settle a trade. That’s an eternity compared with the amount of time it takes to complete front-office duties such as trade execution.

Consider how easy it is to make most online purchases. The buyer receives confirmation immediately upon clicking “purchase.” In the financial markets this doesn’t happen for days. Today the confirmation process, which takes place in firms’ middle offices, often still uses a combination of spreadsheets, e-mails and faxes.

Settlement failure rates remain 2 percent or higher in many of the world’s major financial markets. Although the technology required to clear and settle securities transactions instantaneously exists, the financial industry’s long-established behavioral habits, along with firms’ resistance to allocating capital to these processes in a still-constricted market, remain obstacles to implementing it.

With the regulatory environment putting increased pressure on firms’ trading operations and profitability being squeezed, market participants must increasingly focus on gaining operational efficiencies across the entire life cycle of their trades to capitalize on cost reduction and lower the risk of trade failure. Recent events are proof that Wall Street must focus on its internal systems and processes to support the bottom line.

Today the equity markets are clearly the furthest along when it comes to technology and automation. Fixed income, however, has recently seen widespread adoption of electronic trading, with some large market participants rolling out electronic trading systems for the asset class. This has resulted in increased volumes in the fixed-income markets, just as it did in the equity markets a decade ago. To ensure that the increasingly fast-paced fixed-income markets run smoothly, the middle office also needs to keep pace. An Omgeo study found that fixed-income markets see settlement failure rates as high as 7 percent, which translates into compromised trading strategies and lost revenue for investors. Automation reduces the risk of human error that is responsible for a large number of failures, while ensuring that trades clear both quickly and correctly.

Listed derivatives are even further behind. According to research firm TABB Group, global exchange-traded derivatives volumes are growing rapidly, with trading of futures and options contracts rising at a compound annual growth rate of 21 percent since 2003. The combination of increasing volumes and complex processes highlights the need to automate the posttrade allocation and settlement processes.

Electronic trading is here to stay, but as an industry we urgently need to embrace robust technological tools from front to back office. We should look to leverage the same powerful systems that got us here to bolster the risk management processes required to handle the challenges those new systems have created. By investing in middle- and back-office automation, we can work to ensure that we are using our technology wisely, to restore confidence.

The future of our markets will depend on how effectively we pave our dirt roads by getting rid of manual processes that are no longer suited to today’s trading and only serve to introduce risks and decrease transparency. Only with effective automated processes will firms ensure that they can meet the demands of clients, boardrooms and regulators, both today and tomorrow.

Marianne Brown is president and CEO of Omgeo, a provider of posttrade processing and trading life cycle management solutions.

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