Seizing opportunities in the evolving prime brokerage landscape
13 June 2023
It is time to update the infrastructure powering capital markets, argues Clear Street’s head of prime financing Robert Sackett. Firms that answer the call to modernise will see fewer bumps as the May 2024 deadline approaches for T+1 implementation in the US and Canada
Image: stock.adobe.com/Mary
“To meet the accelerated settlement timeframe, it is critical that market participants eliminate manual processes and maximise automation in the post-trade pre-settlement space,” stated Valentino Wotton, head of institutional trade processing at the Depository Trust & Clearing Corporation (DTCC), reflecting on the launch of a joint initiative that DTCC has established with Nomura Research Institute to provide automated central matching facilities for cash securities transactions in Japan.
Wotton was cautioning that market participants should be well into preparation for the shift to T+1 in the US and Canada, which is rapidly approaching in just under one year. He is far from the first to warn about the stress that outdated infrastructure will put on capital markets.
Various estimates put the size of global capital markets at US$118 trillion to US$125 trillion a year and counting, but much of the industry has not taken advantage of technological advancements and still operates in the past. While the front office of trading organisations is typically lean and therefore less impacted by volume spikes, the middle and back office feel mounting pressure from increased processing speed and volume requirements.
At the same time, asset managers, banks and insurers have been under increasing regulatory pressure to enhance trade-related accountability and are demanding more from the sell-side. This means that market participants not only need to keep pace with fast-growing trading volume and increasing complexity, but they are expected by their clients to enhance reporting services.
In addition to the approaching deadline for T+1, US bank regulators are preparing to issue a notice updating US capital rules, known as Basel III Endgame, with the implementation date expected to be 1 January 2025. As the deadline approaches, measures to reduce counterparty and trading risks will be an important focus for large banks, which may look to further cut prime brokerage clients and services in anticipation of the new regulations.
These changes are coming to a head. The shrinking prime industry and evolving regulatory system, coupled with a lack of innovation over the past 20 years, has created great opportunities for those invested in developing the technology to support prime brokerage.
Looking under the hood
The multi-trillion dollar capital markets industry is the backbone of the global economy, but it still relies on mainframe technology from the 1980s. The result is fragmented systems and interfaces that leave market participants struggling to react to market changes and meet the needs of data-hungry investors and regulators.
How is this possible? The mainframes that have supported global capital markets for decades were built to answer specific questions at a specific point in time. Over the years, modern technology has been layered on top of the antiquated infrastructure, only providing a temporary solution. Similar to building a new house on top of an old foundation, sooner or later the base will give way and the whole structure will crumble.
Put simply, the silos have calcified over time to the point where it is easier for humans to talk to each other rather than find a way for the technologies to communicate. This tech debt creates broken processes that form the operational inefficiency that plague firms today.
Investors, like all consumers, have become accustomed to on-demand service. They expect to be able to react quickly to market events and are looking to expand into alternative asset classes like crypto. Prime brokerages are challenged to keep up with these demands and provide the granularity, data visualisation and user experience that investors and regulators need.
Global settlement changes
While global regions — including the US, Canada and India — announce their intention to shorten the settlement cycle, the Association for Financial Markets in Europe has also launched a task force to explore whether Europe is right to follow the move to T+1.
The antiquated technology that dominates the industry today will bring mainframe batch cycle times in the compressed settlement cycle into question. Decreasing the number of days between execution and settlement will reduce counterparty, market and credit risk across the settlement cycle, but the bulk of the cost introduced by the move to T+1 will be borne by broker-dealers, clearing firms and prime brokers.
Moreover, workflows will need to be reconsidered to reduce settlement failures and allow the move to T+1. In Europe, settlement failures have remained particularly high since the pandemic, fuelled by market volatility and ongoing pressure on a smaller number of operations staff. Though the latest data shows a promising improvement in equities fail rates, fails remain a significant concern for both regulators and institutions.
Adding to the pressure is the new Settlement Discipline Regime (SDR), which enforces penalties for failed trades in an effort to improve settlement discipline. Penalties range from 0.5 to 1 bps and apply to securities that are traded on an European Economic Area (EEA) exchange or cleared in an EEA central counterparty. Under these rules, central securities depositories impose the penalties on the counterparty responsible for the failed trade.
In his communication on trade affirmation, DTCC’s Wotton continued: “To meet the accelerated settlement timeframe, it is critical that market participants eliminate manual processes and maximise automation in the post-trade pre-settlement space. Specifically, the SEC highlighted that institutional trades must be allocated, confirmed and affirmed as soon as technologically possible and no later than trade-date, referred to as same day affirmation.”
A DTCC report found that brokers will see significant challenges and costs in realising T+1 and they will need to address legacy technology and external messaging challenges immediately. The throughput and integration demands for modern clearing platforms are not easily navigated in large organisations, especially when replacing a legacy solution in-flight.
That pressure is reinforced because many investors are not engaged on T+1 and risk overestimating the ability of their service providers to help them to be ready. Overall, the DTCC report found that only 46 per cent of the market expects to be ready for T+1.
With urgency comes an opportunity in the capital markets. Firms that answer the call to modernise and spend 2023 coordinating with compliance, working with regulators, and upgrading and testing their end-to-end systems will see fewer bumps as May 2024 approaches.
A shrinking industry
Adding fuel to the fire is the changing nature of the prime brokerage business and the regulatory and reporting demands that confront the prime broker community. This pressure comes as services diminish and innovation and investment disappear, with several major primes leaving the business altogether and other independent primes being acquired.
Industry participants are preparing for Basel III Endgame, which is anticipated to be the most significant change to US banking regulations since Dodd-Frank and the Consumer Protection Act. The expected notice of proposed rulemaking (NPR) will have extensive implications for economic growth, credit availability, liquidity and market stability.
Basel III Endgame will change how much capital firms need to hold against credit, market and operational risk exposures and is designed to make capital requirements more risk-sensitive while reducing variability of risk-weighted assets (RWA). This brings liquidity coverage ratio (LCR) requirements to top of mind and is expected to substantially increase aggregate capital requirements.
Whether the drivers are changing trading conditions, new capital requirements, or shifting macroeconomics, ejecting smaller clients seems to be the preferred path for firms that have not made the necessary investments to upgrade their legacy technology estates. Dependency on highly manual processes means that these firms cannot operate profitably with smaller clients, or with clients that have more sophisticated risk profiles or demanding trading strategies. Rather than service these clients properly, the dominant philosophy seems to be that the needs of the prime broker outweigh the needs of their clients.
This cycle of cutting services has been an ongoing feature of prime brokerage for the past decade. This pattern is destined to continue without a real move to invest in modern technology to manage risk in today’s markets. Modern technology allows for automation, data insight and scale in a variety of market conditions, driving efficiency and reducing operational frictions.
Building market structure for the future
To operate at peak efficiency, banks and brokers must reduce the manual processes that increase risk of error and operate in silos in favour of technology that empowers users to make smarter decisions and to identify potential risks throughout the trading process.
Simplifying the technology behind trading and post-trade functions can transform this from a cost centre to a competitive advantage. But, for many firms, this upgrade would require rewriting many systems, with significant technical debt, massive resourcing and planning costs — a daunting project with low chances of success.
Modern, high-performance computing coexists with COBOL, and microservices with mainframes. But as the value of data continues to rise, those that invest in the technology and capabilities to keep up with fast-paced, intraday market changes will come out on top.
It is time to update the infrastructure powering capital markets. A single-source of truth platform has the potential to optimise operations across teams, asset classes and geographies, reducing cost, complexity and risk. In turn, this makes it easier for emerging managers, professional traders and institutions to access capital markets.
To keep up with the accelerating pace of modernisation, firms will need to invest in technology to meet the needs of investors and regulators. Those who do so will be part of building the modern, scalable future of capital markets — improving access, speed, and service for all participants.
Wotton was cautioning that market participants should be well into preparation for the shift to T+1 in the US and Canada, which is rapidly approaching in just under one year. He is far from the first to warn about the stress that outdated infrastructure will put on capital markets.
Various estimates put the size of global capital markets at US$118 trillion to US$125 trillion a year and counting, but much of the industry has not taken advantage of technological advancements and still operates in the past. While the front office of trading organisations is typically lean and therefore less impacted by volume spikes, the middle and back office feel mounting pressure from increased processing speed and volume requirements.
At the same time, asset managers, banks and insurers have been under increasing regulatory pressure to enhance trade-related accountability and are demanding more from the sell-side. This means that market participants not only need to keep pace with fast-growing trading volume and increasing complexity, but they are expected by their clients to enhance reporting services.
In addition to the approaching deadline for T+1, US bank regulators are preparing to issue a notice updating US capital rules, known as Basel III Endgame, with the implementation date expected to be 1 January 2025. As the deadline approaches, measures to reduce counterparty and trading risks will be an important focus for large banks, which may look to further cut prime brokerage clients and services in anticipation of the new regulations.
These changes are coming to a head. The shrinking prime industry and evolving regulatory system, coupled with a lack of innovation over the past 20 years, has created great opportunities for those invested in developing the technology to support prime brokerage.
Looking under the hood
The multi-trillion dollar capital markets industry is the backbone of the global economy, but it still relies on mainframe technology from the 1980s. The result is fragmented systems and interfaces that leave market participants struggling to react to market changes and meet the needs of data-hungry investors and regulators.
How is this possible? The mainframes that have supported global capital markets for decades were built to answer specific questions at a specific point in time. Over the years, modern technology has been layered on top of the antiquated infrastructure, only providing a temporary solution. Similar to building a new house on top of an old foundation, sooner or later the base will give way and the whole structure will crumble.
Put simply, the silos have calcified over time to the point where it is easier for humans to talk to each other rather than find a way for the technologies to communicate. This tech debt creates broken processes that form the operational inefficiency that plague firms today.
Investors, like all consumers, have become accustomed to on-demand service. They expect to be able to react quickly to market events and are looking to expand into alternative asset classes like crypto. Prime brokerages are challenged to keep up with these demands and provide the granularity, data visualisation and user experience that investors and regulators need.
Global settlement changes
While global regions — including the US, Canada and India — announce their intention to shorten the settlement cycle, the Association for Financial Markets in Europe has also launched a task force to explore whether Europe is right to follow the move to T+1.
The antiquated technology that dominates the industry today will bring mainframe batch cycle times in the compressed settlement cycle into question. Decreasing the number of days between execution and settlement will reduce counterparty, market and credit risk across the settlement cycle, but the bulk of the cost introduced by the move to T+1 will be borne by broker-dealers, clearing firms and prime brokers.
Moreover, workflows will need to be reconsidered to reduce settlement failures and allow the move to T+1. In Europe, settlement failures have remained particularly high since the pandemic, fuelled by market volatility and ongoing pressure on a smaller number of operations staff. Though the latest data shows a promising improvement in equities fail rates, fails remain a significant concern for both regulators and institutions.
Adding to the pressure is the new Settlement Discipline Regime (SDR), which enforces penalties for failed trades in an effort to improve settlement discipline. Penalties range from 0.5 to 1 bps and apply to securities that are traded on an European Economic Area (EEA) exchange or cleared in an EEA central counterparty. Under these rules, central securities depositories impose the penalties on the counterparty responsible for the failed trade.
In his communication on trade affirmation, DTCC’s Wotton continued: “To meet the accelerated settlement timeframe, it is critical that market participants eliminate manual processes and maximise automation in the post-trade pre-settlement space. Specifically, the SEC highlighted that institutional trades must be allocated, confirmed and affirmed as soon as technologically possible and no later than trade-date, referred to as same day affirmation.”
A DTCC report found that brokers will see significant challenges and costs in realising T+1 and they will need to address legacy technology and external messaging challenges immediately. The throughput and integration demands for modern clearing platforms are not easily navigated in large organisations, especially when replacing a legacy solution in-flight.
That pressure is reinforced because many investors are not engaged on T+1 and risk overestimating the ability of their service providers to help them to be ready. Overall, the DTCC report found that only 46 per cent of the market expects to be ready for T+1.
With urgency comes an opportunity in the capital markets. Firms that answer the call to modernise and spend 2023 coordinating with compliance, working with regulators, and upgrading and testing their end-to-end systems will see fewer bumps as May 2024 approaches.
A shrinking industry
Adding fuel to the fire is the changing nature of the prime brokerage business and the regulatory and reporting demands that confront the prime broker community. This pressure comes as services diminish and innovation and investment disappear, with several major primes leaving the business altogether and other independent primes being acquired.
Industry participants are preparing for Basel III Endgame, which is anticipated to be the most significant change to US banking regulations since Dodd-Frank and the Consumer Protection Act. The expected notice of proposed rulemaking (NPR) will have extensive implications for economic growth, credit availability, liquidity and market stability.
Basel III Endgame will change how much capital firms need to hold against credit, market and operational risk exposures and is designed to make capital requirements more risk-sensitive while reducing variability of risk-weighted assets (RWA). This brings liquidity coverage ratio (LCR) requirements to top of mind and is expected to substantially increase aggregate capital requirements.
Whether the drivers are changing trading conditions, new capital requirements, or shifting macroeconomics, ejecting smaller clients seems to be the preferred path for firms that have not made the necessary investments to upgrade their legacy technology estates. Dependency on highly manual processes means that these firms cannot operate profitably with smaller clients, or with clients that have more sophisticated risk profiles or demanding trading strategies. Rather than service these clients properly, the dominant philosophy seems to be that the needs of the prime broker outweigh the needs of their clients.
This cycle of cutting services has been an ongoing feature of prime brokerage for the past decade. This pattern is destined to continue without a real move to invest in modern technology to manage risk in today’s markets. Modern technology allows for automation, data insight and scale in a variety of market conditions, driving efficiency and reducing operational frictions.
Building market structure for the future
To operate at peak efficiency, banks and brokers must reduce the manual processes that increase risk of error and operate in silos in favour of technology that empowers users to make smarter decisions and to identify potential risks throughout the trading process.
Simplifying the technology behind trading and post-trade functions can transform this from a cost centre to a competitive advantage. But, for many firms, this upgrade would require rewriting many systems, with significant technical debt, massive resourcing and planning costs — a daunting project with low chances of success.
Modern, high-performance computing coexists with COBOL, and microservices with mainframes. But as the value of data continues to rise, those that invest in the technology and capabilities to keep up with fast-paced, intraday market changes will come out on top.
It is time to update the infrastructure powering capital markets. A single-source of truth platform has the potential to optimise operations across teams, asset classes and geographies, reducing cost, complexity and risk. In turn, this makes it easier for emerging managers, professional traders and institutions to access capital markets.
To keep up with the accelerating pace of modernisation, firms will need to invest in technology to meet the needs of investors and regulators. Those who do so will be part of building the modern, scalable future of capital markets — improving access, speed, and service for all participants.
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