Buy-Side Clearing: Driving Efficiency Through Aggregation

The dynamics of virtually all industry relationships and operations now follows a new paradigm. Access to the state-of-the-art trading tools, algorithmic capabilities, connectivity to dark pools and technology to manage the market in real-time has become critical. The emergence of algorithms as a vehicle to execute as much as 30% of all shares traded has improved the traders’ ability to fill their orders at best price, but at the same time has led to an explosion in the number of executions.

With so much attention on the front office (both historically and today), the back office has always had the misfortune of being somewhat neglected. Except for the early part of the decade—when STP and T+1 held the industry’s attention—every significant program over the past five years seems to have been instigated by, and for, the front office. Because of this, the affects of the dramatic changes in trading have been estimated, measured, discussed, analyzed, evaluated and debated from the front office perspective, but rarely recognized from the back office view. That however, is changing, as the cost of processing so many trades grows large enough to impact overall trading cost.

In spite of the well publicized paring of broker lists among the top asset managers, the bulge bracket brokers and some notable new entrants continue to add new strategies and destinations. As a result, buy-side firms use an even broader set of execution venues than ever before. While one obvious result of this is increased diversification of order flow across more brokers and execution venues, a less visible result is the multiplication of the number of settlements which asset managers and their custodians need to process, without commensurate growth in budget—or even attention. The effect of this change is having a clear impact on both their ability to maintain low clearance costs and an efficient back office.

If present trends continue, the back offices of many buy-side firms will continue to experience more stress in keeping up with the rising number of trades coming from their broker counterparties. Despite all of the efforts to date to implement STP procedures and systems, buy-side firms are having a hard time keeping back office costs under control. Some of the largest asset managers are now spending hundreds of millions of dollars per year on trade processing costs alone, much of which is a direct drag on fund performance. Clearly, this is a cost element that these firms can no longer continue to simply ignore, so some firms are looking at ways to aggregate and reduce the increasing number of trade allocations.

The drive to achieve best execution has uncovered ways to minimize costs from explicit commissions to more transparent opportunity cost. To date, the back office costs associated with a trader’s choice of execution venues has had little to do with evaluating best execution, in part because the direct relationship has been elusive. However, as trade processing costs continue to rise, identifying effective solutions to reduce these costs has taken on new importance.

To date, ‘doing nothing’ has been the easiest and most common approach, but buy-side firms are growing more sensitive to reducing their costs, or at least offsetting their increased clearing fees. However, institutions are increasingly looking to reduce the volume of tickets associated with low-touch trading. While it is certain that advanced trading flow will continue to increase for buy-side institutions, aggregating or compressing multiple tickets from different algorithms, dark pools, executing brokers, and venues has become a more viable option for many buy-side institutions. While central clearing aggregation enables investment managers to benefit operationally from processing fewer tickets—minimizing its back-end costs—its ultimate success remains uncertain.

The TABB Group Report on Buy-Side Clearing: Driving Efficiency Through Aggregation

This report is based on conversations with professionals representing several different, but related segments of the buy-side clearing firms trading European equities. Buy-side traders and operations managers, custodians and vendors all presented unique views of the changing clearing paradigm addressed in this report. It itemizes the growth of buy-side settlement costs, breaks down the clearance process, presents a case for potential aggregation and central counterparty solutions, and assesses the challenges faced by providers of such solutions.