Our latest Executive Summary, sponsored by Thomson Reuters, is the white paper “Determining Best Execution: What Role Does Transaction Cost Analysis Play?”.

The Markets in Financial Instruments Directive (MiFID) came into effect on 1^st November 2007 and brought with it a requirement for all European firms to achieve best execution for clients. Not only do firms have to achieve best execution, they must also show they have obtained best execution – or the “best possible result” for clients, which may be determined by price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of an order. 

This Executive Summary looks at the business, market and regulatory drivers for evaluating best execution at global firms and examines whether TCA is appropriate for the institutional buy-side and brokers to ensure orders receive the optimal mix of price improvement, speed and likelihood of execution.

Key Findings

• Environment – Brokers and institutional clients alike recognise the MiFID obligations on best execution are applicable to them, and are a high priority. All those who were interviewed for this paper have put together best execution policies that are reviewed annually. All firms interviewed for this paper were performing their own best execution analysis before the MiFID requirements came into force and continued to do so. Brokers also report clients are increasingly asking to view their best execution policy.

• Concerns – There are some concerns that the MiFID best execution requirements are not currently being met.  

• Establishment – TCA is more established in the US than in Europe and this is likely to lead development in the latter region in two key ways: firstly some firms expect regulators to institute a consolidated market data tape for equities trades in Europe, as already exists in the US. Individual customers of TCA services are also likely to adopt the vendor already used in their US office to ensure commonality of systems.

• Differences across the Atlantic – However key differences between use of TCA in Europe and the US are also likely to continue: MiFID covers a wider range of products than the equivalent regulation, Reg NMS, in the US, and uses broader terms to define best execution, rather than just price.

• Current use of TCA to prove best execution – TCA is viewed as playing a crucial role in meeting the MiFID best execution requirements. However it is not solely used to meet regulatory requirements.

• Desired providers/methodologies – Commonality of systems is important, so European users are likely to use the system that is used in their US offices, TCA being more established in the US.

• Return on Investment and time to market – Cost of TCA services is viewed as expensive but necessary. Despite well-documented cuts to buy-side technology budgets recently, TCA has not suffered widely, perhaps because as a risk-reducing tool it is appealing in the current risk-averse investment climate.

• Benefits of TCA – Clients do not just use TCA in order to meet regulatory requirements. It is also seen as offering commercial advantage with significant return on investment as a result of a refined trading process.

Conclusion

TCA is seen as a vital tool for brokers and investment firms alike to meet their requirements to show best execution under MiFID, and is considered to offer sufficient ROI. However it is in early stages of use and adoption and further development is hindered by a number of issues. Chiefly, the data used to analyse transaction costs is perceived as flawed. The lack of a consolidated market data tape for equities trades in Europe and the exclusion of some trading venues and dark pool data from some TCA benchmarks are seen as major limitations to the usefulness of most existing TCA services.

However TCA providers have taken steps in the right direction to correct this problem and at least two vendors now provide benchmarks calculated from the full universe of equities venues. Real-time TCA is also in very limited use in Europe currently, but its advantages are known to clients and they say they would use it when they see improvements in the data used for TCA and in their own trading technology. 

It is clear there is a sizeable appetite and enthusiasm for useful and accurate TCA, and users would not be put off paying more, or going through the disruption of switching services, to get the right service. As such there is a real opportunity for a vendor who is able and willing to respond to investment firms’ demands in this fast-growing sector. 

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Introduction

The events of the past 18 months highlighted the need for banks to be more aware of the systemic risks to which they are exposed. In the wake of the credit crisis, stress testing has emerged as the tool of choice when assessing the impact of low probability, high impact events. There has been a substantial increase in regulatory demands for firm-wide stress testing as supervisory bodies worldwide decide how best to prevent future liquidity and credit crises from occurring. 

The key factor driving the use of stress testing is pressure from regulators. Supervisory authorities such as the FSA, SEC and BIS all cite stress testing as a fundamental part of the risk management framework. Most notably, the FSA has published a number of consultative papers under the title ‘Strengthening Liquidity Standards’ that focus on the use of stress testing and scenario analysis.

Key Findings and Recommendations

In a Lepus conducted research study where financial institution executives were interviewed to determine what actions are being taken to prevent future liquidity and credit crisis, it was recommended that:

• A Stress Testing Regime Be Defined – Research indicates that many banks feel that traditional historical scenarios used in stress testing have been somewhat discredited as a result of the crisis. Banks should now try to use more forward-looking hypothetical scenarios that simulate a possible future event. There has also been an increased use of ad hoc stress tests to assess the impact of certain risk factors.

• Stress Testing Should Be Implemented Organization Wide – One of the positives to emerge from the credit crisis is the increased profile of risk management. While the results of stress tests would once have been largely discarded by financial institutions, they now command far greater attention. To make the most of the stress testing process, results should be used widely across the bank. There is an increasing trend for senior management to use results as an influence on strategic business decisions. 

• A Firm-Wide, Cross Asset Class Risk Management Solution Should Be Implemented – The benefits of a firm-wide and cross asset class approach to risk management are substantial. Further to giving banks the ability to manage risk across all global entities, it can also greatly reduce the burden of regulatory reporting.

Conclusion

Regulatory pressures look certain to drive banks toward a more comprehensive, firm-wide approach to risk management. Over the coming months banks will make significant investment in their stress testing platforms to bring them in line with regulatory demand. Although historical scenarios are now deemed less credible due to the events of the past 18 months, hypothetical economic disasters and ad hoc stress tests are being used with increasing frequency. The renewed interest in stress testing from senior management will ensure that it receives the necessary support and investment to produce an accurate and useful assessment of exposure across the organisation.

Used effectively, firm-wide stress testing will become an essential tool that banks use not only to manage risk, but also as a driver of future strategic business decisions.

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Regulatory requirements are essential, and are amongst the most substantial and fundamental factors driving the banking business. Any change in regulation may potentially increase the cost of conducting conventional business activity, reduce the appeal of an investment, or change the competitive landscape. Dialogue around compliance is something that has been accentuated of late, as the regulators are proactively seeking to address the recent mishaps in the global financial markets.

Key findings

• Need for a global regulator – A global regulator, or at least increased alignment between global regulatory bodies, would help to eradicate some jurisdictional nuances that make regulatory compliance such a tricky and time consuming task.
• Impact on risk management – The sub-prime contagion and subsequent credit crisis have certainly put emphasis on the way banks undertake and consider their risk management policies, processes and procedures.
• Stress testing – One fundamental theme that has come from all the literature surrounding regulation of the financial services industry is the increased need for stress testing as an effective tool for risk management.
• Cost of regulation – Testimonies from various industry sources indicate that rigorous regulatory requirements are on the horizon and it is of no surprise therefore, that many banks are expecting to see an increase in associated costs and expenditure in this area.
• Remuneration - Various figures deem the FSA to have backed down over remuneration after pressures from the City. Many feel that imposing restrictions on potential earnings would surely be a step too far, causing a mass exodus of the City’s top talent to other regions and countries.
• Transitioning to the new regulatory environment – Banks will face a number of challenges in the transition to the new regulatory environment. Steps banks can take to ease the transition include improving communication, hiring the right people and investing in new systems.

Conclusion

The current wave of regulatory reform facing the financial services industry today is unlike any in the past. Market practitioners are expecting extensive regulatory reform and are preparing to address the different requirements and directives. Regulators look set to enforce their new polices harshly and will use substantial fines to act as a deterrent. Ultimately, while the cost of these regulatory reforms may be high, as the credit crisis demonstrated, they will be insignificant when compared to the cost of another financial meltdown.

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Banks need to start being more aware when it comes to the matter of rogue trading. This needs to be for the long term rather than just trying to appease staff, investors and the media in the short term. The preventative methods should be ongoing and a consistent process. It is no longer sufficient to just merely comply with regulation as this has clearly not worked in the past, as this report will outline. Instead, the financial industry needs to wake up to the fact that rogue trading events have occurred and will occur if the organisation’s approach does not change. It is a sad indictment on people’s character but for many people, if they can get away with fraudulent activity they may be sorely tempted. That attitude needs to be quashed and the way to do this is for banks’ attitudes to start changing.

Key findings

• Crime is Indiscriminate – There is no discrimination on bank sizes, wealth, investment tier or where it is globally situated. Instead what it shows is that greed and some traders’ arrogance is in indiscriminate and demonstrates that many banks have fallen prey. However, this does not abscond banks from any responsibility regarding this topic.
• Time for change – There is a real need for information to give managers a holistitic view of all relevant operations, with sufficient IT systems that enable communications between departments, while highlighting risks and controls.
• Change is a’happenin’ – In the wake of rogue trading events last year, banks went to revisit and confirm other control framework. If there is one positive thing to come out of rogue trading scandals it is that firms have stepped up control methods against these events. However, this is not enough.
• Focus of attention – While rogue trading was still very much on the agenda, there was a distinct feeling that it was disappearing once more off the radar. This is known as Disaster Myopia.

Conclusion

Rogue trading scandals are a popular media topic designed to rile the investment banking industry and consumers. Incidences of financial crime are a sad indictment on the financial services industry due to the huge amount of losses, both in monetary terms and also reputation. Such examples of financial crime have shaken the industry but gradually the passing of time quells any sense of urgency when it comes to preventing rogue trading as other more recent events take precedence. The question still lingers as to how big a rogue trading scandal does there need to be before the industry seriously takes note and alters its monitoring and controlling methods for the long haul. It is all very well, the sector altering its practices in the wake of the scandal but realistically there needs to be a more continual conscious awareness of this act.

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Adopting a comprehensive approach to managing technology assets and resources has never been more important. However, using disparate IT related information that spans across the enterprise and converting it into useful and meaningful information may not be an easy task by any means. Furthermore, in order to align the technology with business needs, IT departments need to have more commercial awareness in addition to their core technological skill set.

Key findings

• Current practice – According to research conducted by Lepus the dashboard is also used to escalate issues up the hierarchical chain, and is used by various stakeholders, i.e. departmental heads, senior management as well as the IT risk group.
• Technology – Banks have to continuously consider the buy versus build paradigm across their many business lines and functions, however, as far as the CIO Dashboard and toolset is concerned the latter seems to be the trend at the five banks that Lepus consulted for the purposes of this study.
• Organisation – Research has also found that in addition to a more consistent view, the reporting framework has been enhanced. The dashboard makes it easier to report to senior management and allows decisions to be made on the basis of more robust and readily available information.
• Future outlook – As far as future plans and initiatives for the CIO Dashboard are concerned, there was a split between the banks spoken to. Three of the banks are not looking to do anything drastic with their dashboard in the imminent future. However, one top tier European bank mentioned their aspiration towards a more integrated and holistic approach.

Conclusion

The majority of banks spoken to, do not have one specific tool in place that they call their CIO Dashboard. As far as the build versus buy model is concerned, all of the banks spoken to have taken matters into their own hands, relying on internal resources to develop and implement their tools and processes. Some of the main reasons for this were identified to be cost savings as well as flexibility. The CIO Dashboard leads to greater visibility, transparency, assisting and facilitating engagement with the key stakeholders in the organisation.

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FX markets around the world have withstood the events of the past eighteen months surprisingly well. Prior to the fall of Lehman Brothers in September 2008, the total daily volume of FX trades had been steadily growing.

Key findings

• FX Business overview – The FX market experienced something of a boom throughout 2008 with trading volumes reaching previously unforeseen levels, largely due to increased interest from buy-side firms. FX businesses typically trade plain vanilla products such as spots, forwards, and swaps, as well as more exotic options, though research suggested that there would be something of a flight to simplicity in the current environment.
• Technology – With the inherently global nature of the FX market it is favourable for banks to have global systems. This point was demonstrated most clearly by one tier-1 European bank who said that the global nature of their systems enables them to quote the same price for a currency pair anywhere in the world. All of the banks that Lepus spoke to stated that they have global FX systems, though inevitably there are areas with certain discrepancies.
• Risk – As the landscape of risk management has changed as a result of the credit crisis, it is becoming increasingly important for all the stakeholders to be aware of the risks associated with trading certain products, including technologists. Promoting an all round risk aware culture is something that many organisations are keen to do. As such, while technologists would pay particular focus to operational risk, it is important to look at some of the other risks facing the FX business at present.
• Future trends – Research has shown that there is huge potential for growth in the FX market over the next few years. Has buy-side firms continue to show interest in this area, the nature of the market and the underlying technology will be forced to adapt.  Investment in building out the capabilities and stability of e-trading platforms is likely continue, but also, banks are likely to invest in their Back Office FX processing systems, to ensure they are able to keep up with the expected increase in traffic.

Conclusion

As the FX market evolves, it will cease to be the playground of the major investment banks. As volumes continue to grow, more and more players will be attracted to this highly liquid market and those failing to invest in the infrastructure required to process this high volume of electronic trades will be left by the wayside.

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There has been a surge of interest over the past year in finding ways to decrease the power, cooling and space requirements of the data centre. Hardware accelerators are billed as one of the technologies that may be able to assist this. Typically hardware accelerators are far more power efficient than CPUs and due to the fact that they exploit multiple levels of parallelism, they offer vastly increased processing power.

Key findings

• Most viable hardware accelerators – It seems at present that the most viable hardware accelerations technologies are GPUs. However there seems to be a lot of interest in Larrabee from Intel and this may turn out to be the most successful on it’s release.
• Window of opportunity – Some have suggested that there will only be a limited window of opportunity for hardware acceleration technologies. However, only one of the interviewed banks firmly believes this.
• Lack of skill in the market place – In line with previous research in this area, this report found that there is a shortage of people in the financial services industry with knowledge of programming for hardware accelerators.
• The role of the quantitative analyst – The role of the quantitative analyst will very likely have to change going forward. Quants will have to become more aware of the infrastructure they are programming to.
• Investing in optimisations – At present banks are not very quantitative in their approach to optimisations. As the cost of new hardware is so cheap, it is very easy to put forward a business case to simply buy new hardware.
• Outsourcing – Only one of the interviewed banks is actively looking at outsourcing more of their IT. The most popular model seems to be a compute on demand type arrangement.

Conclusion

Ultimately the credit crisis has made it incredibly difficult to predict what may happen in this area. Hardware acceleration technology has been on the radar of the leading banks for a number of years now, but the inevitable cuts in IT spend have forced these projects to remain on the back burner.

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The proliferation of low latency data feeds supporting the growing algorithmic trading market is one of the main drivers for what many people are calling CEP. The extent to which CEP platforms are actually being used and installed within the financial industry is fiercely debated between various reports, press releases, conferences and blogs.

Ultimately, CEP is the process of collecting related and unrelated real-time and historical data and events. Business logic is then applied to those events to detect patterns and conduct analysis.

In algorithmic trading, banks can use CEP, to monitor trades and calculate risk on a real-time basis supposedly allowing for real-time hedging. However, there is some evidence that CEP is being used for risk monitoring, fraud detection and surveillance as well. Last year the US Financial Services Authority (FSA) installed the Progress Apama event processing platform to power its SABRA II transaction monitoring and market abuse detection system, for example.

Despite this, there are some who argue that the promise of CEP does not translate into a good enough business case for the installation of CEP.

Parallel to the activity around promoting CEP, there is a reality within banks dealing with requirements to analyse real-time information and to feed the incessant demands of algo trading engines.

Key findings

• Banks are starting to use CEP for feeding data into algorithmics trading systems as well as for finding dealing opportunities and trading pairs across asset class.
• Risk monitoring, fraud detection and surveillance are also growth areas for CEP.
• CEP installations at banks tend to be localised and seen as experimental rather than main stream technology.
• The costs and infrastructure issues surrounding CEP development may not be fully understood by bank staff interested in ‘cool’ technology.
• Streaming SQL, although well-used, may not be the best language to develop CEP engines.

Conclusion

Ultimately, CEP is not an off-the-shelf application; its benefits rely on being tied into a firm’s internal business model. The technology of CEP enables business rules and logic to be realised for use in functions such as algorithmic trading and surveillance. It is no wonder that the financial industry is interested in using this technology to find dealing pairs, monitor risks and detect fraud.

However, as with any ‘cool’ technology there is a tendency for its hype to overpower the realities of developing, installing and maintaining a relatively young IT environment.

The emergence of third party vendors, Apama, Aleri and Streambase among others, it is evident that there is a market for CEP in the financial services. However, most agree, while the talk around CEP will continue for some time, any real, mature market penetration will probably not happen any time soon.

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Data management and data cleansing is one of the most challenging and most ignored problems within the financial markets industry. The issue caused by the quality of data is no more pronounced that with the risk modelling and management departments.

In addition to the wide variety of data sources providing data in slightly different formats, there are a number of industry drivers that are adding to the data cleansing conundrum. Those include additional regulations, increasingly complex instruments, new market participants, IT goals related to straight through processing and increased use of data aggregators.

Attitudes around fixing the data cleansing and quality problem are wide ranging. Some are compliant feeling that data management within investment banks will always be fraught with inconsistencies and incomplete information. Some throw responsibility back to the vendors, asking the data providers to work to standardise delivery formats. While others remain perplexed that the financial industry as a whole has so far failed to develop a common identifier scheme for financial data.

Key findings

• Two ways – Most banks split the data cleansing process between external and internal data.
• Most problems – It is the internal data that causes the greatest data cleansing challenge. But data quality among vendors is an industry wide issue.
• Clean enough – Data quality and cleaning is a relative concept within bank, and ‘clean enough’ is the workable option.

Conclusion

With the current economic crisis improving the methods and use of proper risk management techniques is now a headline concern. One of the main ways to improve a risk model is to improve the quality of the data that goes into it.

Investment banks employ teams of staff just to authorise and map a wide variety of data to the appropriate systems and applications. 100 percent clean data is never going to be an achievable goal, not within the modern, global investment bank.

There are many ideas around how to fix the data quality problems. However, the overwhelming attitude to data quality is one of complacency. It is an issue that has to be dealt with, but can never be fixed. Clean and consistent data is a relevant concept, not just between banks, but between models and even instruments. For the time being the financial industry is resigned to inputting data that is merely ‘clean enough’.

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In addition to personnel, the expenditure on technology will be one of the most substantial costs that a bank has to allocate for. Similarly it is one of the most important as well, therefore it needs to be researched and selected accordingly to suit the client, product offering as well as the business model. 

Key findings

• Current practice – In a recent study that Lepus conducted on vendor technologies and trends, one leading vendor servicing the banking industry told Lepus that clients have a dedicated risk customer advisory boards where they share best practice methodologies and feed this information back to them.
• In response to client requirements the vendor told Lepus that they are working on a selection of projects. This is of no surprise given the recent changes that have occurred across the capital markets.
• Technology – The technology tools and solutions need to reflect and account for the changing dynamics of the business. Flexible, more comprehensive and robust solutions are fundamental, and the ability to scale up or down will be very important during these volatile times.

Conclusion

Given the complex nature of the business at today’s banks, with a myriad of trades occurring in a blink of an eye, there is a growing need to implement more robust technologies across the front, middle, and back offices. Leveraging such solutions across the enterprise should attract and reassure clients and help to manoeuvre in these increasingly fast paced markets.

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