THE INDUSTRIALIZATION OF CAPITAL MARKETS: where are we now?
The notion of centralized infrastructure and services is not new. It has been used successfully in other industries for years. There is, however, a renewed interest in industrialization within the capital and commodity markets. Many firms are once again considering how utilities could help increase efficiencies, reduce costs and, ultimately, improve their return on equity (RoE). In this article, Ryan Baccus discusses the ways in which todayís industrialization efforts are putting market utilities back in the spotlight, when they make the most sense and what firms can expect in terms of benefits.
Definition of Industrialization
The process in which a society or country (or world) transforms itself from a primarily agricultural society into one based on the manufacturing of goods and services. Individual manual labor is often replaced by mechanized mass production and craftsmen are replaced by assembly lines. Characteristics of industrialization include the use of technological innovation to solve problems as opposed to superstition or dependency upon conditions outside human control such as the weather, as well as more efficient division of labor and economic growth.
Source: Investopedia (filed under labor unions)
The concept of industrialization and the potential of leveraging economies of scale to reduce costs and increase profits is not a new one. Outside of financial markets, there are numerous examples within manufacturing, telecom and even the airline industry (See the Sabre example in Figure 1) where organizations have been able to work together to standardize elements of the supply chain. There is also a rich history of events where firms have also co-invested in technical solutions that provided an enhanced service at a fraction of the cost compared to a scenario where each organization would have individually built solutions.
There have been a number of successful initiatives within the financial markets community to develop new concepts collaboratively that have resulted in the creation of market utilities and other central market infrastructure. These have typically occurred with a limited process scope where a business function was not already being performed and there was an appropriate regulatory incentive acting as a catalyst. The industrialization proposition, by its very nature, has a more commercial focus, which means that the conditions for success are more complicated. As such, it has traditionally been more challenging to mobilize market participants to collaborate and co-invest.
One of the more high-profile examples of the industrialization proposition within the capital markets is the JP Morgan Arcordia service. Created to drive greater industry standardization, Arcordia, which was spun out of the JPMorgan back office in March 2000, was a provider of ASP-based post-trade processing services for over-the-counter (OTC) derivative trading for use by other organizations. Widely recognized as a leading platform with rich functionality, the commercial operations of Arcordia were, however, wound down in November 2001 with a JPMorgan spokesperson confirming at the time, “Recent events and the continued economic slow-down have caused the firm to re-evaluate its external Arcordia business plan.”1 The Arcordia offering preceded years of rapid growth in the OTC derivative market and the general sentiment was that the market practices and dynamics were not mature enough at the time for the offering to succeed.
As one would expect, the financial markets have undergone a major transformation in the years since the Arcordia offering. But are market conditions any more stable now and, if so, what does the capital marketsí industrialization roadmap look like?
Market Conditions and the Case for Industrialization
The current market environment is characterized by shrinking margins, increasing cost pressures and more exacting regulatory standards. This has created an environment where there is a significant focus upon opportunities for cost reduction and return on investment and where substantial funding has been channeled towards meeting global regulatory requirements.
In parallel and through a number of successful internal and external initiatives, there is also a greater awareness and willingness to collaborate on common challenges faced by the marketplace. Together, these two factors have created an environment that has the potential to drive efforts for market-wide industrialization to a successful conclusion.
Given these conditions, there is a greater willingness throughout the market to consider industrialization initiatives. However, the scale of ambition across organizations varies depending on experiences and circumstance, with the challenge of balancing initiatives focusing on optimizing sourcing and location strategy, internal group-level functionalization and market-wide industrialization. Based on perceived delivery risk, there is often a portfolio of initiatives working toward different levels of standardization at the same time. As such, there seems to be greater demand for function-specific industrialization efforts rather than attempts at replacing entire post-trade services.
The Focus for Capital Markets Industrialization
What makes a function more suitable for standardization? The following characteristics of a function should be evaluated before determining whether to standardize it or not:
- Competitive advantage—The level of competitive advantage associated to the function by clients
- Market breadth—The number and profile of market participants that perform the function
- Efficiency—The level of effort (cost) and inefficiencies associated to the function
- Stability—The likelihood of major change affecting the function in the short to medium term
Client reference data is an area that meets the criteria previously outlined due to its non-proprietary nature and the significant cost for market participants. This has been reflected in recent market offerings from the DTCC, Markit, Thomson Reuters and SWIFT. Another area that fits the suitability criteria is the potential for a central utility that could provide for netting efficiencies across margin and settlement movements, given the upcoming enforcement of margin for uncleared trades for OTC derivatives and the market-wide demand.
An area that was less straightforward was trade documentation. While it is largely considered to be a non-proprietary function, the changing landscape and uncertainty around trade volumes make this an interesting function to explore. Can the trade documentation function be moved into a shared service that can ultimately drive reduced costs, increased controls and more effective compliance by creating greater levels of standardization and enhanced transparency?
While largely perceived as a non-proprietary function, trade documentation is still managed bilaterally in most instances. The analysis in Figure 4 suggests that trade documentation is, in fact, a good candidate for standardization. However, the uncertainty around volumes and processes could see the industrialization take place gradually (potentially focusing on the issues of document exchange initially) to ensure that the perceived long-term benefits can be realized.
Outside of core business functions there are other opportunities for ìutilitizationî and where innovative solutions could help in terms of economies of scale. As an example, Goldman Sachs and Fidelity Investments have recently given their backing to the Open Compute Project, an initiative to open source hardware and datacenter designs. It is expected to transform the way in which infrastructure is designed and manufactured in the IT industry. Jay Parikh, vice president of infrastructure at Facebook, which founded the Open Compute Project three and a half years ago, said that in the past three years Facebook has saved an estimated $1.2 billion on IT infrastructure costs by doing its own designs and managing its own supply chain. CEO Mark Zuckerberg later added that on top of this savings, Facebook has saved enough energy to power 40,000 homes for a year and reduced carbon dioxide emissions at a level that is equivalent to removing 50,000 cars from the road for a year.3
Grant Richard, managing director of technology infrastructure at Goldman Sachs, gave a presentation at the Open Compute Summit where he outlined the potential impact of the Open Compute Project for his organization, summarized in Figure 5.
“The majority of IT, processing and support behind banking services is delivered in-house with platforms that are highly duplicative across players and offer very little by way of competitive advantage.
“We estimate up to $7-9 billion of industry costs could be pushed out into an external supply chain (net savings of $3-5 billion) that can deliver scale economies as well as enhanced flexibility and potentially more innovation. We expect only a part of this to be achievable within a 2-3 year time-frame and estimate $1-3 billion of annual cost savings at stake by 2016.”
Source: Morgan Stanley – Wholesale & Investment Banking (March 20, 2014)
Mobilizing for Capital Markets Industrialization
The business case for any industrialization effort can be complex. At the heart of these types of initiatives is an intuitive benefit model. However, due to the long-term payback and a range of commercial models, there are a number of subjective scenarios, such as trade volumes, levels of STP and delivery confidence, etc., that must get factored into the numbers. But for those organizations that make the commitment to industrialization, the benefits can be significant. While the initial design will likely be complex given the inherent challenges around security and commercial models, the key to success is establishing the right governance model—one that is empowered and able to commit to long-term initiatives where there is the potential of materially impacting the organization’s ROE. For organizations looking to meet ambitious cost-reduction targets, industrialization stands out as a viable option that can enable genuine business transformation.
- Finextra, “JPMorgan Chase winds down Arcordia,” http://www.finextra.com/news/fullstory.aspx?newsreview=comment&newsitemid=3714 (November 7, 2001).
- Tricumen, “Capital Markets Results Review 4Q13/FY13,” http://www.slideshare.net/DarkoKapor/tricumen-4-q13-capmkts-resultsopen.
- Enterprise Tech Systems Edition, “Goldman Sachs and Fidelity Bank on Open Compute,” http://www.enterprisetech.com/2014/01/29/goldman-sachs-fidelity-bank-open-compute/ (January 29, 2004).