March 10, 2011

The middle and back offices inside Wall Street firms are enjoying new status and increased budgets as new regulations put a renewed focus on risk management and compliance.

Until the financial crisis hit in 2008, banks were highly focused on the front office where they invested large portions of their discretionary dollars into the latest new ways to source liquidity. Firms pumped large sums of money into their proprietary trading desks, algorithmic trading engines and low latency infrastructures, while the less sexy middle and back office divisions were left to manage with limited resources and older, less sophisticated systems.

There are those in the industry who argue that the outdated technology available to risk management and compliance functions led to a worsening of the financial crisis as many firms struggled to understand their exposures to troubled counterparties. Since the financial crisis, however, there has been a significant shift in spending patterns in financial services firms, and compliance and risk functions in particular have enjoyed an increased status in terms of influence and budget. Many firms are beefing up their risk departments, which are gaining new visibility and clout. Chief risk officers and chief compliance officers now report directly to CEOs and sit on executive committees, and many firms are investing heavily in compliance technology, in particular trading surveillance systems.

We expect to see a surge in regulatory technology spending, with an emphasis on reporting, as legislation passed in 2010 -- the Dodd-Frank Wall Street Reform and Consumer Protection Act in the US and the European Market Infrastructure Regulation (EMIR) in Europe -- is turned from laws into rules in 2011 and 2012. Just which portions of these bills get turned into regulation is very much up for debate, as support for the full Dodd-Frank bill is waning in Congress these days.

In the past, most compliance technology was built or bought for internal purposes and controls, but now as regulators are placing greater pressure on firms, more and more dollars are being spent to address growing external reporting requirements as well. These regulatory rollouts will be driving a lot of technology investment decisions in the next couple of years.

Risk and compliance technology innovation

The industry is currently seeing a lot of innovation in terms of governance, risk and compliance technology. Complex event processing (CEP) technology in particular, which was originally used to stream real-time market data and power algorithmic trading, has been adapted to build real-time surveillance and filtering tools. Some of the quants and mathematical geniuses that once built trading algorithms are now working on trade surveillance systems, in particular to monitor high-frequency trading, where the market moves so fast it is impossible for a human auditor to keep track. CEP vendors have made market surveillance a big part of their sales pitch.

Increasingly complex compliance requirements are also forcing firms to update the way they manage regulatory reporting on trades. This can be a nightmare for large, globally dispersed firms with many trading accounts and that grade with dozens of counterparties. A lot of people are currently trying to work out the best way to aggregate the relevant data, filter it, and extract what they need.

What's Next

By now the industry, the investing public and the regulators have recognized that there needs to be more transparency and better reporting facilities at the majority of financial firms. Without the impetus provided by specific legislation, however, it is doubtful many firms would give up focusing on revenue generating applications to focus on reporting, transparency and risk management.

New legislation also presents new opportunities. As new laws are passed and the compliance landscape becomes ever more complex, there is a very real possibility of firms being able to perform regulatory arbitrage between asset classes and countries. Capital markets supervisory authority is split in the US between the SEC, the CFTC and the Fed and this presents firms with opportunities for arbitrage, while those countries that roll out restrictive regulation risk losing business to less aggressive countries. This lends a profit generation angle to regulatory compliance and reporting, which will help focus attention on this area.

While sourcing liquidity will always remain a priority -- and technology dollars will always find their way there -- over the coming year we can expect to see a steady increase in the amount of money firms are willing to invest in governance, risk and compliance technology. Driven partly by a need for a better understanding of exposures, and partly by new opportunities for regulatory arbitrage -- but in particular by the coming into force of new legislation -- firms across Wall Street can be expected to invest heavily in beefing up their middle and back office systems in 2011 and 2012. The front office is not the hot spot any longer.

Rob Hegarty is global head of market structure for Thomson Reuters.