Wednesday, January 30, 2008

Fragmentation is not a dirty word

In the run up to the implementation of MiFID there was considerable 'umming' and 'aahing' about the impact the relaxation of the 'concentration rule' would have on the proliferation of trading venues and what that would mean in terms of fragmenting liquidity in Europe.

Those that were keen to see the status quo preserved in terms of liquidity residing largely with the national exchanges, painted a confusing picture of multiple trading venues springing up and the challenges of having to connect to all of these venues in order to demonstrate best execution.

Well it seems that debate has been quashed and smart order routing systems are helping "re-aggregate" liquidity.

"Fragmentation is good," said George Andreadis, head of AES, liquidity strategy, Europe, Credit Suisse at Finexpo in London. He then went on to cite a long list of reasons as to why it was good; less cost, lower latency trading, and attracting more liquidity into this space.

While Chi-X Europe may have been the only game in town, with its smarter, faster, cheaper model, Andreadis highlighted a whole host of planned MTFs looming on the horizon, including SmartPool, scheduled to launch in Q2 2008, Project Turquoise, and US "dark liquidity pools" such as BATS Trading and Pipeline, which are contemplating whether to launch this side of the pond.

It appears to be a very crowded and fragmented trading landscape emerging in Europe, mirroring what has already occurred in the US. Yet, Andreadis said that smart order routing technologies made it easier to determine where liquidity resided in 'dark pools'.

His mantra seemed to be that dark liquidity pools and MTFs were here to stay and that traders looking to demonstrate best execution ignored them at their peril. But the key to success in a market where liquidity is fragmented is the smartness of your order routing systems. "There is dumb order routing, smart order routing and very smart order routing," joked Andreadis.

Project Turquoise gives it the hard sell

There was standing room only in the auditorium at the annual Finexpo event in London for the session on Project Turquoise presented by the MTF's CEO Eli Lederman.

After much fanfare and very little substance since the group of seven investment banks announced Project Turquoise back in 2006, Lederman seemed eager to dispel the notion that Turquoise was the mythical concoction of a bunch of investment bankers, rattling their sabres in the hope that the London Stock Exchange and others would reduce trading prices.

Well Project Turquoise has still not gone live, although Lederman was adamant that preparations for the launch date in September 2008 were well underway and that he was confident Turquoise would attract liquidity from day one. "We will have a lot of members, it is going to attract liquidity," Lederman kept repeating over and over.

And if that is not enough to convince those sceptics who are still doubtful as to whether Turquoise will get off the ground, Lederman was eager to stress that it had secured office premises. "We don't have marble steps or vaulted ceilings, but this is a modern exchange," he said.

Project Turquoise has chosen Swedish technology provider Cinnober (they also built Project Boat)to build its trading platform and Progress Apama is providing the CEP engine for the MTF's market surveillance system. But Lederman was short on the details regarding the trading platform. All he would say is that it will be an "integrated transparent order book with a dark pool."

It seems that the launch date for Project Turquoise may also be a moving target, as Lederman said that it was not focused on the date alone and that it was keen to implement a trading platform that was not a "monolithic purpose built system."

Yet, despite Lederman's efforts to reassure the market that Project Turquoise is "moving full steam ahead," anyone who has observed the Project Turquoise "showboat" for the past couple of years will probably be inclined to say, the proof is in the pudding. And after talking it up so much, almost to the point of evangelizing, Lederman better hope the pudding is worth eating.

Friday, January 25, 2008

Real-time volatility

Those of you who read my "Crisis of Confidence" post will know that I have been questioning to what extent advanced risk measurement approaches and real-time data management technologies could have prevented the current crisis of confidence in the banking sector.

Could it for example have enabled SocGen to detect and even prevent its €5 billion of losses caused by a rogue trader dealing in European stock futures? Maybe not. But it appears that in a new post-MiFID world, with multiple MTFs springing up and all of them looking to compete with one another on speed of trading and cost, that market surveillance and risk management is becoming more of an issue.

Project Turquoise, the MTF set up by a consortium of investment banks, has announced that it will incorporate a "real-time" market surveillance system combining Progress Apama's Complex Event Processing (CEP) engine and Detica's market surveillance expertise.

Turquoise's post-trade market surveillance system will capture breaches of trading rules, detect market irregularities and develop enhanced trading execution analytics. But given the risk failings that have been highlighted at individual banks recently, one has to ask how effective these technologies are.

The UK's Financial Services Authority (FSA) also worked with Progress Apama and Detica on its "next-generation market surveillance platform", called Sabre II, which also uses CEP to process and analyse real-time event streams. According to reports, the FSA's old market surveillance system only had "end-of-week" capabilities as opposed to the ability to detect market irregularities in real time.

If MTFs and the FSA are relying on CEP for market-compliance issues, is this likely to filter down to the individual bank level where risk management and detection systems are found to be wanting?

Giles Nelson, director of technology, Progress Software, says it is seeing an increasing number of organisations using technology to provide an integrated real-time view of their position and risk analytic systems, which he anticipates will only increase as electronic trading volumes increase.

"With the increasing pace of electronic trading it's vital that a real-time view is available. The volatility in markets over this last week demonstrates the need for this."

BIC and IBAN confusion persists

With all the turmoil going on in the markets, the first official day of SEPA, 28 January 2008 when SEPA Credit Transfers became commercially available, may pass without much fanfare.

However, just to add to banks' woes, Compass Management Consulting estimates that despite there being a low number of non-STP cross-border payments in the eurozone, the 2% to 5% of non-STP payments that require manual intervention, are steadily eroding banks' trading profits.

Based on its analysis of European banks, Compass estimates that non-STP payments can reduce overall trading profits by up to 25%. To back up its claim, it cites its observation of a banking operation handling 300,000 transactions a day that generated 7,000 exceptions. "Despite the relatively low 2.3% exceptions rate, 270 full-time equivalent staff (FTEs) were required for manual processing of these payments, each of which costs between £25 to £40 to handle," said Richard Bissett, head of banking services at Compass.

Compass found that an average of 20% of all transactions fail requiring manual intervention. These 20% of transactions account for 80% of total back office costs. Bissett says 60% of exceptions could be fully automated. Yet, according to Compass' analysis, banks are only managing to automate 4% of exceptions.

Shedding some light on the results, Bissett said that the real question is why are there still non-STP payments when BICs and IBANs were introduced to try and increase the automated handling of cross-border payments in euro? He says corporates are still "totally confused" by BICs and IBANs and that of the 62,000 BICs, only 20,000 are connected (SWIFT network participants).

With SEPA placing further pressure on banks' payments processing margins, Compass anticipates that this will bring the challenge of exceptions processing into greater focus. It still doesn't resolve the rather confusing issue of BICs and IBANs though, and with cross-border payment volumes tipped to rise post-SEPA, one can only expect the number of exceptions to increase unless something is done to remedy this.

Thursday, January 24, 2008

A crisis of confidence

There is nothing like a whiff of a financial crisis, to inspire technology vendors to espouse such pearls of wisdom, which go something along the lines of, 'Well if they had implemented such and such a piece of software, that does so many millions of risk calculations per second, then they would have been able to calculate their real risk exposure much earlier on and perhaps prevented such a crisis.'

Some grid computing and data management vendors have been having a field day with the current crisis sweeping through the global credit markets. I for one remain sceptical as to whether technology can really overcome the financial markets' overwhelming desire to not only make money, but to behave like a pack of herd animals converging on a tasty corpse.

Although risk management and Basel II may be at the top of the agenda (well at least it is at the top of regulators' agenda), does any amount of technology and advanced risk measurement approaches really make a difference, or have recent events merely provided the stimulus that tipped over an already precarious house of cards? The apple was already rotten and recent events have only served to demonstrate how rotten it actually is.

Confidence in banks, particularly those that were considered to be financial heavyweights that could survive almost anything, including a nuclear holocaust, is at an all time low, and one has to ask have we only seen the beginning of the unsightly chinks in the banks' armour?

Then there was today's announcement by Société Générale that it had uncovered €5 billion of losses caused by a rogue trader dealing in European stock futures. Sound familiar? Nick Leeson of Barings Bank lost approximately £800 million in 1995 in rogue trades.

Commenting on the SocGen announcement, David Dearman a partner at accountants and business advisers, PKF had this to say:

"This fraud highlights the continuing lack of controls at some major financial institutions. The lessons of the Nick Leeson and Barings case in 1995 appear to have been forgotten by some. The scale of this clearly surpasses that fraud and is truly shocking."

According to Dearman, there was much "soul-searching" and review of procedures at financial institutions in the City of London following the Barings' incident, and procedures were tightened in a number of instances.

"I can only trust that the procedures adopted in the City a decade ago are working and being regularly reviewed, but there will undoubtedly be some very nervous senior people in the industry today," Dearman continues.

Interestingly, perhaps what both incidences highlight is the ability for someone with detailed knowledge of a bank's control systems to override those very systems put in place to prevent such an incident from occurring.

It reminds me of a comment one compliance consultant made not so long ago, that banks tend to focus more on external threats as opposed to internal threats. One has to ask though, would any amount of sophisticated risk management techniques and real-time data management technologies have uncovered or even been able to prevent someone using their knowledge of a company’s security systems to conceal fraudulent positions?

Tuesday, January 22, 2008

The 'superbanks' of tomorrow

In recent months with bank stocks plummeting and the aftershocks of the US credit crunch continuing to resound in global markets, no one would be surprised if the outlook for the banking sector going forward was dire.

Yet, while our faith and confidence in banks may be at an all-time low, McKinsey believes banks will double their profits and revenues by 2016.

It predicts that global banking revenues will grow, on average, by a not too unhealthy 7.5% a year from 2006 to 2016, compared with an average of 8% a year from 2000 to 2006 (and 12.6% from 2002 to 2006). Although revenues are expected to slow somewhat, McKinsey says they will still exceed current forecasts for GDP growth by more than one-half of a percentage point a year over the 10 years from 2006 to 2016.

"Consequently, we expect the industry to generate $5.7 trillion in revenues and $1.8 trillion in after-tax profits by 2016 —more than twice the levels at the end of 2006."

How can this be, you may ask with household names such as Citi having to grovel to Middle Eastern sovereign wealth funds to help balance their balance sheets after significant write-downs in the current sub-prime debacle.

Well it seems part of the reason for McKinsey's rather bullish predictions for the banking sector is the growth in demand for banking and financial services in emerging markets, which it says will contribute roughly half of the absolute growth in new banking revenues from 2006 to 2016, while North America and Western Europe will account for 25% and 20%, respectively.

Russia, says McKinsey will be one of the fastest-growing large markets in the next few years, alongside China. More importantly perhaps, India is predicted to overtake Central and Eastern Europe. Those segments that are likely to be profitable include retail banking and investment banking, trading and securities services, which McKinsey says will provide a larger relative share of bank revenues.

But perhaps the biggest driver that may support McKinsey's predictions is the prospect of more consolidation in the banking sector to create "superbanks".

"Over the next five years, we expect a new wave of consolidation to speed the emergence of 'superbanks,' with more than $500 billion in market capitalization," says McKinsey.

Today, global banking is the least concentrated industry says McKinsey with the top 20 banks accounting for less than 40% of its global market cap, compared with an average of 67% in other key industries. Interestingly, those banks that are in the Top 20 today, are not guaranteed to be the 'superbanks' of tomorrow. "Even the current top European and US banks aren’t guaranteed to achieve 'superbank' status with their existing portfolios," says McKinsey.

Outsourcing crunch time

Regular readers of this blog will know that I have regularly commented on the hype surrounding outsourcing. Outsourcing is definitely here to stay, but as firms' experiences of outsourcing have matured and some of the gloss has gone off outsourcing as being a cost-effective panacea for companies' woes, outsourcing entered the 'trough of disillusionment' for some firms.

Having said that, the latest quarterly stats from sourcing advisers, TPI, suggests that outsourcing is on the rise, particularly in Europe, which has now surpassed the US in terms of total number of contracts signed (220 valued at €32.7 billion) compared to 194 contracts signed in the US valued at €21.3 billion.

While in the past a significant portion of contracts signed were renewals of existing outsourcing business, according to TPI, in 2007, the annualised value of new contracts awarded in Europe was up almost 31% on 2006 levels, compared with an increase of 13% globally.

And it seems financial services firms are once again leading the way in the demand for outsourcing, representing more than 38% of the total value of outsourcing contracts signed. According to TPI, the worldwide market for Financial Service Operations (FSO) outsourcing has grown by 22.5% since 2003.

I think we have only seen the tip of the iceberg when it comes to outsourcing by financial service providers. A number of regulatory imperatives (Basel II, MiFID, SEPA) is placing significant demands on banks' back offices, and not all banks are well positioned to meet those demands in terms of their systems and investment capability.

Some difficult decisions have yet to be made by financial institutions regarding their back office processing, whether it is in the securities or payments business. Crunch time is rapidly approaching for them to decide what is strategic to their business and what they can outsource or white label.

Wednesday, January 16, 2008

Lunches, trains and automobiles

Are we on the brink of a recession? Well even if we aren't, it seems like the markets are talking themselves into one, and it seems I am not alone in thinking that the market is panicking itself into a recession. Christmas sales haven't been what they used to be for retailers (although I think far too much weight is put on analysts' expectations especially when supermarket giants like Tesco still manage to record a 3.1% rise in Christmas trading, even though it was below analysts' expectations of 4%), and based on December figures the UK housing market is at its worst since the recession of 1992.

But retail earnings and housing slumps aside, some say a true sign that we are in a recession has to be the demise or otherwise of the business lunch and the number of people taking taxis.

I was just discussing this over a business lunch today, which lasted for a couple of hours - always a good sign that the days of the two-hour business junket are far from over. And judging by the busy lunchtime crowd that was in the restaurant, businesses are not battening down the hatches quite yet.

So it is official, while consumer confidence may be ebbing, all important business confidence is hanging on by the skin of its teeth, and those that work in the markets say, despite the credit crunch, trading volumes have not declined.

I feel another round of outsourcing coming on. The credit crunch may not mark the end of the business lunch, not yet anyway, but will it prompt banks to more seriously consider what is core to their business and what it is not and outsource the non- value-added menial tasks to high volume processors that benefit from economies of scale?

Tuesday, January 15, 2008

Compliance tops the agenda

For those of you wanting to get a heads up on the post-MiFID environment, Basel II, the third Anti-Money Laundering Directive, what regulators may have in store for the hedge fund community or the next installment of 'MiFID-like' directives, Complinet is hosting its fifth annual Compliance Conference in London on the 6-7 February.

The conference program features some of the European Commission's and the FSA's leading lights who can fill banks in on the latest developments surrounding the MiFID Directive Level 3 (not so good news for those that thought MiFID had come and gone). The FSA's head of risk will happily share its vision of principles-based regulation and what it means in a post-MiFID environment, and why it is imposing so many fines for lack of compliance with Treating Customer Fairly breaches.

And if that wasn't enough to make any risk manager's head spin, there will also be sessions on how data protection laws and other regulatory requirements often result in competing and conflicting requirements (something I am particularly interested in). Do KYC requirements, for example, often conflict with firms' data protection obligations?

There will also be sessions on Basel II, the latest anti-money laundering edict handed down from on high, and leaping into the uncharted territory of principles-based regulation, which we know a number of financial service providers developed a distaste for in the run-up to MiFID's implementation.

Monday, January 14, 2008

Prudential - less than prudent with customer details

Prior to Christmas the UK's HM Revenue & Customs lost the personal details of millions of child benefit recipients, and the latest data management debacle by institutions that consumers entrust with their data is Prudential, which has been less than prudent with their wealthiest customers' personal records.

According to the latest reports, a box containing premium customer details, including cheques and other sensitive information, was found on a roadside near Reading Berskhire by a vehicle recovery driver.

Apparently the box fell to the side of the road when it was being transported from Prudential's offices in Reading to a "secure" facility in Essex. In this day and age with electronic data storage facilities, image scanning and remote backup of data available, it seems astonishing that personal customer information is still being transported in paper format in boxes.

Even if the box had not been lost on the side of the road, anyone transporting the information could have easily photocopied some of the sensitive documents and used them for fraudulent purposes.

It begs the question, why are government departments and financial service providers opting for the least expensive and less safe option when it comes to protecting customers' personal data? There are really no excuses for these organisations who we entrust with our personal information to be reliant on such antiquated systems when it comes to data storage and protection. What is it going to take for these organisations to take data protection more seriously?