The GameStop saga was back in the news recently, with the SEC releasing a 45-page blow-by-blow report, stating “this event put the markets infrastructure under serious strain and undermined the principles of a stock market based on a ‘system of mutual trust and participation.’” But how can the industry prevent such an event from happening again? One solution lies in synchronizing the back-office operations of trading counterparties.
The SEC’s position on Gamestop is not overstated. Settlement is the backbone of financial market infrastructure. This critically important function – like many post-trade processes – until recently has been hidden in the background, but staggeringly the stock market’s settlement infrastructure still operates on largely the same system as over fifty years ago.
The emergence of new digital technologies in recent years has presented an opportunity to transform both the stock market and the entire financial sector’s post-trade infrastructure for the better, finally achieving the trust and participation the SEC is calling for – simply by sharing data confidentially, across the system, on an immutable ledger.
Legacy infrastructure – no longer fit for purpose
The delay between execution and settlement has been a bugbear of financial market participants for years. In some asset classes, the process has changed very little in generations, while other elements of markets infrastructure have modernized beyond recognition in the meantime.
The settlement of an equities trade happens two days after the transaction takes place, which means there are risks that need to be managed: most notably, the risk that the buyer won’t actually have the funds or that the seller can’t deliver the shares. These risks can increase at times of high volatility, such as occurred during the GameStop incident.
If the broker doesn’t have the funds, the clearinghouse has to step in. If there still isn’t enough collateral and the broker has collapsed, the clearing house’s member firms have to provide the cash. The central clearinghouse also plays a critical role in bolstering market certainty by ensuring quick, clean resolutions when a financial institution defaults.
Not only is such post-trade infrastructure inefficient and slow, it is also very expensive for participants. Middle- and back-office operational costs dwarf front-office and execution costs. Banks spend billions of dollars each year on outdated legacy post-trade systems and still have to dedicate hundreds of staff to processing, reporting and reconciling trades. Despite this expenditure, failures such as the GameStop debacle still happen.
Regulators are taking note – for example the Bank of England has established a task force aimed at tackling outdated post-trade technologies – but the onus is on market participants to drive real change. Currently less than a third of fintech investment is spent on the middle and back-office. Given firms are spending upwards of $20 billion a year on post-trade processing systems alone, this situation has to change.
Electronic order management and trading, for example, has transformed the way trades are executed in virtually every single asset class since it was introduced in the late 1980s – yet middle- and back-office infrastructure has failed to keep pace. The key difference is that middle and back-office functions have little – if any – shared infrastructure outside of central market infrastructures such as CCPs, despite being one of the largest sources of costs to a financial institution.
A single trade today creates multiple records for all parties, sometimes being replicated over 30 times within the post-trade lifecycle, and has to be reported, surveilled, matched, valued, margined, subject to risk calculations, optimized, aggregated, netted, reconciled and more – often all day, every day, for the whole of the transaction’s lifecycle.
Staggeringly, there can be over 50 vendors involved in processing each trade, adding significant complexity and risk of errors. It has been estimated that 50-80 percent of back-office time is spent purely on reconciling systems.
Complex and opaque cost structures for post-trade services have also become the norm, with trading institutions facing multiple license fees, messaging charges, IT overheads and staff costs. Coupled with diminishing spreads and the reduction of risk appetite combined with increased regulatory costs, in some areas post-trade costs even exceed the potential profit from the execution of the trade.
Part of the reason for this is that, to date, there has been very little competition for post-trade services, in particular for payments, SSIs and regulatory reporting. As a result, the space has failed to modernize and mutualize costs – even as the industry has become predominantly electronic.
Capital markets play a vital role in the real economy, and therefore it’s critical they function fairly and effectively. To do this they must be supported by resilient and cost-efficient post-trade processes.
The GameStop incident is further proof that post-trade reform is no longer a ‘nice to have’ – firms must make this their top strategic priority today. Their current infrastructure is a significant and expensive problem. It is costly, risky and materially restricts their agility to take on new markets and clients, to grow and to innovate.
Sharing the middle and back office
Moving away from duplicated and inconsistent isolated systems of record held at each firm – and instead enabling shared data, business logic and processing –can mutualize middle and back-office systems and assure that one firm's view is identical to their counterparts.
This would allow firms to start decommissioning expensive elements of their bespoke infrastructure, break down silos and significantly reduce costs while positioning the banks to better compete in today’s very competitive landscape.
The seemingly simple premise of bringing multiple parties into consensus about common facts provides the foundation upon which a whole new ecosystem of post-trade services can be built and deployed, driving competition amongst vendors and greater choice for end-users.
This holds the key to releasing banks and other financial institutions from the technological binds in which they find themselves after years of unstructured investment in multiple generations of expensive legacy post-trade technology.
In the last few weeks alone, we have witnessed a quiet revolution in this space. The Swiss stock exchange, SIX, launched the SIX Digital Exchange, a fully integrated trading, settlement and custody infrastructure based on blockchain technology. This is a major turning point in the transformation of financial markets, setting the standard for digital asset exchanges and central security depositories in the future.
With initiatives like this, it is clear that banks are standing on the brink of a brighter future that promises radically reduced costs and massive increases in efficiency and profitability. The most advanced enterprise blockchain platforms are ready to support the post-trade infrastructure of tomorrow—at whatever speed is necessary to prevent events such as GameStop. The real task now is for regulators, the technology community and participants to work together to drive the evolution of the market forward in a rapid but responsible manner.
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Richard Gendal Brown, R3