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Financial Market Infrastructures: Critical Centers of Innovation
Michael Bodson, DTCC President and CEO

Mike Bodson tells FOCUS that FMIs remain well placed to lead financial market innovation but collaboration will be essential if new silos are to be avoided.

After years working behind the scenes, financial market infrastructures (FMI) are playing a more prominent role creating innovative solutions to help the industry navigate a challenging economic and regulatory environment.

Today, financial firms face an intensified regulatory landscape of increasing compliance challenges and higher costs, along with constrained returns on equity. Implementation of Basel III is already morphing into discussion of Basel IV, and mandates such as Dodd-Frank, EMIR and FATCA are reducing revenue opportunities for firms and straining liquidity through heightened capital requirements. Although banks will have to continue cutting back, the reality is that the typical approach to cost-cutting alone won’t solve these problems. With this in mind, DTCC commissioned a study in 2014 on the post-trade ecosystem in the U.S. and Europe. It found that industry utilities accounted for only 5% of the approximately $100 billion spent annually on back office costs.

The findings revealed that the real opportunity for savings is in creating greater efficiencies in the middle and back offices. Achieving this goal would require the industry to more effectively leverage its utilities, and for the utilities to collaborate to a greater degree than they have in the past, to centralize and standardize certain non-differentiating, noncompetitive processes in order to drive down costs and risks through economies of scale. As interest among firms has grown, we are seeing an unprecedented degree of innovation from FMIs. Standardization and utilization of common processes may often be a difficult task to undertake, but the opportunity to significantly lower costs for the industry over the medium and long term are significant.

While FMIs are collaborating with each other and clients on utilization, they are also working on innovative ways to create more efficient processes and lower their cost structures. Blockchain and cloud computing are two examples. Blockchain, almost by its nature, can only be successful through collaboration. We believe distributed ledger technology potentially offers a once-in-a-generation opportunity to re-imagine and modernize the industry’s infrastructure to address long-standing operational challenges. However, to date, industry efforts to incorporate blockchain use have initially been uncoordinated which could lead to siloed applications that do not integrate, resulting in similar reconciliation challenges to what the industry faces today.

As we discussed in a white paper that we issued on this topic in January, we intend to be at the forefront of this issue by helping to spearhead industry use cases, serving as a leader in the governance of open source, fostering collaboration and by making investments in partners that can help advance the technology. A key benefit to blockchain is to generate a single version of the truth which should eliminate the multiple reconciliations which are currently needed, many o f which are manual. While that will simplify the process question, perhaps the greater question is how to take legacy infrastructure and create lighter weight and more agile capabilities.

"Blockchain, almost by its nature, can only be successful through collaboration."

Cloud computing may provide the answer as it has reached the scale availability that allows firms like DTCC to innovate and experiment quickly without the need for heavy infrastructure investment. In the short to medium term, it may well have a much greater positive impact on our business than blockchain.

The cloud enhances our agility, enables us to get to market quicker or change direction faster and scale up and down in real-time. We can duplicate an environment in the cloud with minimal investment, which saves the industry money and frees up resources for investment in other priorities.

These are a few simple examples of opportunities we are pursuing. As the industry looks to FMIs for greater support, we have an opportunity to broaden our role by using our creativity and ingenuity to develop new solutions that further reduce costs and risks. This is an exciting time of innovation at FMIs, and DTCC is well positioned to make a more significant impact across markets, asset classes and regions.

FMIs have moved out from the shadows in the post-crisis period. They are more visible than ever before, but they are also under greater pressure to bring innovative solutions to market to support the industry. As utilities and incumbents, are FMIs best equipped to spearhead this innovation? Is there a danger that they may lose out to smaller and more agile start-ups?

Since the financial crisis, FMIs have been leaders in bringing innovation to the market. The definition of innovation is not solely about the introduction of new technology, but also includes new ideas or methods. As the industry looks to navigate a challenging economic and regulatory environment, FMIs like DTCC have extended their role and are driving innovation to help firms better manage costs and risks. As a result, FMIs are partnering and collaborating to a greater degree than in the past to address industry challenges.

While DTCC always keeps an eye on potential competitors and operates our business with a commercial mind-set, we believe our unique value proposition as an industry-owned and -governed utility differentiates us in the marketplace. Because our Board of Directors and our shareholders are also our clients, our interests and objectives are completely aligned. In addition, our network of relationships across the financial industry globally is an incredible asset, as is our capability to create value through massive economies of scale. Lastly, it is the integration of our wide range of products and services that smaller providers cannot come close to matching. Therefore, our primary focus is on addressing industry needs, mitigating risk and protecting market stability, which are all critical to the safety and soundness of the financial system.

The figure you provided of market utilities accounting for only 5% of the $100 billion spent every year on back-office costs was certainly striking. How do you explain that incredibly low level?

The low percentage of spending on utilities for back office needs was really about legacy structures at the firms that had been built to handle necessary operational processes, combined with a view that controlling as much of the pre- and post-trade processing chain would create a competitive advantage. The key takeaway from the study was that the current operating model is not sustainable due to increasing costs and ongoing regulatory and compliance pressures on the banks. Whereas in the past many firms wanted to own and operate the processing stack themselves, they have realized that it no longer provides them with a competitive edge in the new market environment. Rather, there is greater recognition among banks that they can reduce their costs and risks by utilizing certain non-differentiating, noncompetitive back and middle office functions and processes, such as KYC and management of client entity data. As a result, market infrastructures are partnering and collaborating to develop large-scale solutions for these shared services.

Can you share with us some examples of how this greater leverage of post-trade utilities, as well as extensive collaboration between utilities, is playing out?

I think three joint ventures DTCC has today are good examples of collaboration and being able to leverage the expertise, technology and capabilities of both DTCC and our partners to address crucial challenges First I would mention DTCC-Euroclear Global Collateral Ltd. A white paper just published suggests industry-wide unsupported exposure due to collateral settlement failure for sell-side firms alone is estimated to be $27 billion. Our joint venture will streamline collateral processing on a global basis and deliver transparency, mobility, efficiency and security to the marketplace, and has the potential to offer unprecedented operating efficiencies to the industry while protecting the stability and integrity of the financial system. It will also enable the industry to align with the primary goals of regulators to enhance transparency and strengthen systemic risk monitoring. This is a great example of how two utilities can jointly develop solutions, avoiding duplicative investments and create a much more powerful global solution.

Clarient Global is another example of an industry utility for client data and documentation founded by DTCC and six global banks. The Clarient Entity Hub is a comprehensive entity data solution providing control, standardization and transparency during the client onboarding process and ongoing client lifecycle events. Clarient brings together integrated client entity data solutions that have the power to help firms to lower costs, improve data quality, support regulatory reporting requirements and enhance risk analysis. In this instance, it is the partnership between a utility and a group of industry participants that brought an innovative value proposition with scale to the industry.

Thirdly, I would mention Soltra as an important example of collaboration and leveraging expertise. DTCC worked with the Financial Services Information Sharing and Analysis Center (FS-ISAC) on this joint venture created to help secure companies from cyber threats. The result is Soltra Edge; the first industry-driven, threat intelligence sharing platform designed to facilitate the collection of cyber threat intelligence from various sources, convert it into an industry standard language and provide timely, actionable information to users. The software has had more than 2,000 downloads, including extensive downloads from many sectors outside of financial services.

You have described the impact of new financial regulations as ‘revenue reducing’ and liquidity straining.’ Are some of these effects already factors in the current market turmoil?

There have been a number of positive impacts stemming from the new financial regulations. Banks are stronger than they were in 2008 because they have increased capital, reduced their balance sheet leverage and enhanced their liquidity to strengthen their overall financial picture. In addition, there is greater transparency in the markets, particularly the OTC derivatives market, and there is diminished risk taking across the industry. However, new regulations have also created unintended consequences, such as the potential fragmentation of liquidity and capital, which could make the financial system weaker and less resilient during times of stress. Unfortunately, the extent of this potential impact will only be understood during those stressful periods.

How transformational are the changes we are already seeing in the post-trade sector going to prove? Do you think a major consolidation of post-trade incumbents likely or is a proliferation of new and competing solutions the more likely outcome?

When looking at the major incumbent FMIs, I believe we are more likely to see greater levels of collaboration between them than consolidation. However, the same dynamics driving FMI innovation are also spurring new competitors that are looking to provide variations of those solutions. My expectation is that we are likely to see greater levels of competition in the post-trade space in the years ahead than we experienced in the past.

Blockchain has become the hot topic of conversation over the past year. Do you think there are dangers that companies will go their own separate ways and that we will end up with fragmented solutions that limit the industry’s ability to fully leverage this technology?

Collaboration is essential. Otherwise, there is the risk of creating countless new siloed solutions based on different standards with significant reconciliation challenges – essentially the very same issues that many of us believe distributed ledgers can help solve.

"Since the financial crisis, FMIs have been leaders in bringing innovation to the market."

In our recent white paper on this topic, DTCC explains that the most logical way forward is for the existing, regulated and trusted central authorities to help play a leading role in introducing the standards, governance and technology to support distributed ledger implementations.

Furthermore, we believe these organizations, working in partnership with a wide range of the industry, can help ensure that new opportunities are in the best interests of post-trade processing and consistent with long-standing goals of mitigating risk, enhancing efficiencies and driving cost efficiencies for market participants.

Tell me why you think Cloud applications could be more transformational than blockchain?

I think it is too early to tell which will be more transformational. I do think blockchain provides a rare opportunity to examine some of the operational challenges we have been dealing with for long time and take a fresh approach, particularly in automating inefficient processes. As for cloud computing, I believe it will have the largest positive impact on our applications and cost base over the next five years. Cloud technology has reached the scale and availability that allows us to build environments without having to invest millions of dollars to buy, build and maintain internal servers, storage and security structures. All of this should allow us to drive down our costs and increase our ability to innovate on behalf of the industry.

This article first appeared in WFE FOCUS March 2016.