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Reconciliation Utility: An Idea Whose Time Has Come

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To bolster their long-term competitive advantage, securities firms are rewiring their basic reconciliation function by employing a service utility model.

To bolster their long-term competitive advantage, securities firms are rewiring their basic reconciliation function by employing a service utility model.

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  • 1. • Cognizant ReportsReconciliation Utility:An Idea Whose Time Has ComeThe pressure is on for securities services firms to do more with less.This has reconciliation department heads grappling with questionsthat could fundamentally redraw the contours of this function andre-architect the post-trade lifecycle. Executive Summary • The mandate for the reconciliation function Reconciliation departments across securities will materially change. With numerous trad- firms are at a crossroads. For a function long ing scandals and rogue elements infiltrating buffeted by increasing volumes, complexity of trade, the scope, scale and character of recon- traded products and suboptimal IT infrastructure, ciliation as a control function is fast changing. recent high-profile trading scandals1 were the From a post-settlement internal audit func- proverbial last straw. These scandals served as tion, reconciliation will move upstream as a a painful reminder to the securities industry of proactive controller of risk. the fragility of their vaunted risk management systems. With regulators swooping in, securities • A changed reconciliation mandate will firms are re-examining the role of reconciliation, necessitate rewiring of this function. These an internal control function long considered to be changes in the reconciliation function will the last bastion of the trade lifecycle. impose material demands on an already stressed post-trade reconciliation infrastruc- As pressure mounts for reconciliation ture. Standardizing and farming out the departments across firms to do more with less, material portion of traditional reconcilia- department heads are grappling with questions tion activities to trusted partners — including that could fundamentally redraw the contours intersystem, intercompany, nostro and depot of the reconciliation function and eventually and customer/prime broker reconciliation — re-architect the post-trade lifecycle. We believe will amplify the reconciliation team’s band- that the time is ripe to rewire and industrialize width to focus on the new role of proactive risk the basic reconciliation function, through a viable controller. service utility model. There are several forces driving the need for this change: • A stressed post-trade reconciliation infra- structure will give impetus to rewiring and cognizant reports | april 2012
  • 2. industrializing efforts. The securities indus- Specifically, securities firms must leverage their try’s rapid growth in the first decade of the heft to take a leadership role in creating a vibrant 21st century led to an asymmetric evolution supplier market by doing the following: of front-office, middle-office and back-office capabilities. While the revenue-centric front • Playing the incubator role. Given the care office was primed with the best of systems innovative models need and the unique and platforms to play the volume game, slick nature of utilities industry-like models, capital reconciliation platforms that were asset class market firms would do well to join hands to let agnostic bypassed the middle and back offices, the approach take root (through their roles as as firms adopted an attitude of benign neglect market makers) and sustain by taking a cue toward these cost centers. from other industries. • Standardizing processes to ensure seam- Custom-built IT reconciliation solutions, which less transition, obviating or minimizing have rippled across securities firms, catering the cost and disruption in terms of time and to specific reconciliation needs, have com- service resulting from switching providers. pounded the problem of inter-system recon- • Partnering with service providers through ciliation within firms. The pain is felt across joint ventures to build reconciliation utilities, the industry, in the form of low auto-match an asset-heavy, capital-intensive business. rates and heightened operational risk from unmatched items, long expectations in turn- Service providers, for their part, must do the around time, communications breakdowns and following: errors that cripple portfolio managers’ trading agility, thanks to an inaccurate picture of the • Shed the traditional “lift and deliver as-is cash and securities position. at low cost” mindset and move toward building cutting-edge technology and delivery• Securities firms and service providers platforms. must jointly work to create a vibrant recon- • Deliver reconciliation as a service and price ciliation utilities market. As reconciliation it per transaction, like any other utility, thus departments across securities firms prepare helping to lower and variabilize clients’ overall to take a more proactive risk controller role, it reconciliation spend. is imperative to create scalable capacities with • Set return expectations at a low but steady service providers, which can carry out “tick rate, like any other utility business. the box” reconciliation at scale, effectively and efficiently.The Case for CushionsRogue-trading losses as percent of common equity. 0 10 20 30 40Barings Bank*Feb. 1995 241 $1.4BSumitomoJune 1996 $2.6BSociété GénéraleJan. 2008 $7.2BAllied Irish BanksFeb. 2002 $0.7BDaiwa Bank $1.1BJuly 1995 EstimatedUBS† $2.3B trading lossSept. 2011Source: The Economist * As % of shareholders’ fundsFigure 1 † Alleged cognizant reports 2
  • 3. Forces Exposing the Fault Lines in Trade Reconciliation Forces Description Implications Large securities Many players; disparate processes and market systems within each firm. • Communications breakdown both within the firm and among counterparties. Exponential trade growth Rapid volume growth across prod- ucts (cash and derivatives) and asset • Low auto-match rates; heightened opera- tional risk from unmatched items. classes. • Decrease in trading agility, thanks to an Growing product Rapid growth of over-the-counter inaccurate picture of the securities and complexity derivatives trades — equities, rates, cash position. currency and fixed income. • Trades based on dated data, due to a IT application silos Implementation of different reconcilia- month-end reconciliation cycle. tion solutions for different needs • Errors due to multiple hand-off points, (e.g., systems for reconciling front- thanks to multiple reconciliation solutions. and back-office trade records). • Valuable staff time spent on reconciliation.Source: Cognizant Research Center analysisFigure 2The Reconciliation Function Makeover non-standard processes, requires firms to over-Trading scandals over the last 20 years support come the challenge of dealing with a range ofthe same fundamental truth with which counter- products, across asset classes. Not only are thereterrorism experts grapple: The terrorist needs multiple types of reconciliations (see sidebar,to get lucky once, while the counter-terrorism below), but when reconciliation processes aremachinery must be lucky every time. These underpinned by multiple IT applications — tailor-high-profile, repeated trading scandals have made to handle distinct products — the challengebared the fault lines in firms’ vaunted risk is elevated to a Sisyphean task.management practices. With rogue elementsinfiltrating the trade (see Figure 1, previous Rewire and Industrializepage), the scope, scale and character of recon- The forces that amplify the reconciliationciliation as a control function must rightfully challenges include exponential volume growthchange. From a post-settlement internal audit in traded products, suboptimal reconciliationfunction, then, reconciliation will move upstream infrastructure, IT application silos that dot theas a proactive controller of risk. landscape of securities firms and the growing complexity of products (see Figure 2).Reconciling trades in the complex securitiesmarket, with its multiple participants and The Anatomy of Trade Reconciliation Typically, securities firms conduct the following four common types of reconciliation to grease the wheels of trade: • Intersystem reconciliation, to resolve breaks that arise due to feed issues between the front-office and back-office systems. • Intercompany reconciliation, to resolve breaks due to feed issues/incorrect bookings between the different legal entities of the firm. • Customer and prime broker reconciliation, to resolve post-settlement breaks on all customer and prime accounts. • Broker dealer controls, to resolve all depot and nostro post-settlement breaks. Today, reconciliation managers are asked to provide reports of breaks in pre-settlement date positions, AVI, cancel and re-book, etc. In essence, they are expected to assume the role of risk mitigator in the firm. This expectation is compounded by the recent fraud events at several large broker-dealers. cognizant reports 3
  • 4. The pain is felt across the industry, in the form of buy side (see Figure 3), the composition of tradedlow auto-match rates and heightened operational funds underlines the industry’s complexity.risk from unmatched items, long expectations inturnaround time, communications breakdowns, While traditional equity assets doubled in thea month-end reconciliation cycle that forces first decade of the 21st century, alternative assetday-to-day investment decisions to be made classes like exchange traded funds, hedge fundswith dated data, inaccurate breaks numbers and OTC derivative trades grew exponentially.that amplify compliance risks and valuable staff Millions of daily trades executed by these markettime spent reconciling that could be spent on risk participants — across asset classes and oncontrol work. exchanges like NYSE and over the counter (OTC) — amplify the scale and complexity of the modernFast Growth, Complexity-Induced Stress securities trade and the intermediation process.While explosive volume growth continuesto strain the post-trade processing infrastruc- Application Silos Amplify Challengesture across the securities industry, the increasing As most securities firms already had a basic bankcomplexity of traded products has exposed the account reconciliation solution, their instincts ledfault lines in these systems, most of which are them to build custom solutions to address grow-tailored to handle cash equities and fixed income ing reconciliation needs — from internal account,securities. treasury and securities, through portfolio and cash management (see Figure 4, next page).The securities trade is underpinned andintermediated by a large number of players — This has created a portfolio of reconciliationmarket facilitators, buy-side firms, trade service system silos within each firm, thereby creatingproviders and issuers such as sovereigns, govern- a “reconcile-the-reconciliation” scenario. Justment agencies and corporate institutions. While as dikes, bunds and culverts are added to servethe $130 trillion of total assets under manage- as ad hoc substitutes to a dam to aid in floodment at the end of 2011 highlights the scale of the control efforts, securities firms keep applyingSizing the Securities Trade Assets under management, 2011, $ trillion Private wealth, $42.7 Pension funds, $29.9 ETFs, $1.3 Hedge funds, $1.8 Private equity, $2.6 Mutual funds, $24.7 SWFs, $4.2 Insurance funds, $24.6 Assets $ billion Notional amounts outstanding, $ trillion2,400 700 6002,000 Hedge funds 5001,600 Exchange 4001,200 traded funds OTC derivatives 300 OTC derivatives 800 Exchange 200 Exchange traded 400 traded derivatives derivatives 100 0 0 2000 02 04 06 08 10 2000 02 04 06 08 10Source: TheCityUK estimates; BlackRock; Bank for International SettlementsFigure 3 cognizant reports 4
  • 5. band-aid remedies in the absence of a dam-like Asset classes such as derivatives introduceenterprise-wide reconciliation solution. complicated trade structures involving more than two counterparties — for example, a primeThis silo approach has resulted in multiple broker, an executing broker and a buy-side firm.systems to build, operate and maintain, resulting All these firms, with their disparate systems,in disparate exception management processes. internal workflows and variations in terminol-Meanwhile, the absence of an integrated cash ogy, pose formidable challenges to the existingmanagement solution severed the link between systems and the processes they manage.transaction matching and account reconciliation Reconciling these trades requires numerousprocesses and caused a spike in reconciliation sequential, nonstandard communications acrossmanagement overhead. multiple parties. In the absence of a flexible post-trade reconciliation infrastructure, one thatWith today’s heightened regulatory scrutiny, rec- is asset-class and message agnostic, firms haveonciliation and exception matching is no longer resorted to temporary solutions such as Micro-just a business issue but has a material compliance soft Excel-based manual workarounds in mostangle to it. Securities firms have strong incentives cases and shoehorned amendments to legacyto rationalize the number of separate reconcilia- applications in others — leading to suboptimaltion systems in house and replace them with an efficiency and effectiveness outcomes.automated enterprise-wide system. The upshotof doing that is to realize material benefits in the According to the International Swaps and Deriva-form of increased productivity, greater scalability, tives Association’s (ISDA) 2011 operations bench-streamlined reconciliation processes, enhanced marking survey, roughly 10% of trade recordscompliance and improved client service. contain errors across interest rate, credit, equity, currency and commodity derivatives. The surveyProduct Complexity Bares Fault Lines also attributes 50% of trade capture errors toReconciliation issues are symptomatic of a larger the front office. The sources of error range frommalaise — a suboptimal post-trade infrastruc- counterparty name to legal agreement date, andture. While firms continue to make material these errors plague all the commonly tradedinvestments in their electronic trading platforms, derivatives. No doubt, portfolio reconciliation is aprice feeds, advanced analytics and specialist challenge, and 10% of trades fail to settle, leadingstaff to bolster their front, middle and back to material losses for securities firms.offices, the post-trade processing guts of anyfirm suffer benign neglect. The biggest casualtyof this neglect is the reconciliation function.A Plethora of Reconciliation Requirements Number of processes Cash management Portfolios Securities Treasury Internal account Bank accounts reconciliation Tactical fragmented silos matching processes Growing needsSource: SterciFigure 4 cognizant reports 5
  • 6. Industrialize Reconciliations via • Homegrown Microsoft Excel- or Access-basedService Utilities solutions.The securities industry is reconciled to ever- • On-site vendor applications.increasing transaction volumes across multiple • Hosted solutions that provide remote accessasset classes and the complexity of traded to specialist reconciliation systems.products and regulations, which relentlessly • Quasi-enterprise-wide reconciliation solutions.alter the rules of engagement. Firms are seizedby increasing operating costs wrought by these An Aite Group study estimates securitiesforces and the need to rein them in. Today, nearly firms’ IT spending on reconciliation systems to beevery firm is exploring a utility-like solution to USD $520 million by 2014.2reconcile all trades and resolve all exceptions in acost-efficient manner, a non-negotiable need that What is missing, however, is the securitieshas not changed, if RFP activity in the space is industry’s equivalent of a foundry model forany indication. the reconciliation utility, similar to that found in the semiconductor industry. This model led toBy reconciliation utility, we mean a platform the separation of a semiconductor fabricationdesigned for scale to handle reconciliation and plant operation (foundry) from an integratedexceptions management. This should take the circuit design operation, into separateform of a centralized, enterprise-wide system companies or business units (see sidebar, below).with the ability to handle different products In our assessment, while all the necessaryacross asset classes, including reconciliation and conditions to fuel demand for a reconciliationexception handling of trades in a timely, accurate utility exist, a robust supply-side ecosystem is stilland cost-effective manner. This utility model will taking shape.be technically and commercially feasible if andonly if securities firms and service providers Partnering to Create a Vibrantpartner to shape a vibrant utility market. Reconciliation Utilities Market Specifically, we believe securities firms shouldWhat has changed is the rapidly evolv- leverage their scale and take a leadership role ining base of service providers with maturing creating a vibrant supplier market. They can doreconciliation platforms and business services this by:offered through multiple delivery models.Today, four types of solutions are commonly • Playing market maker. As the market forimplemented, depending on the size and com- a reconciliation utility takes shape, securitiesplexity of traded assets (see Figure 5, next page): firms must demonstrate commitment to a Formulating a Foundry Model A fabless (fabrication-less) semiconductor company specializes in the design and sale of hardware devices and semiconductor chips, while outsourcing the fabrication or "fab" of the devices to a specialized manufacturer called a semiconductor foundry. Prior to the 1980s, the semiconductor industry was vertically integrated; owning a captive semiconductor fabrication facility was a must for chip manufacturers. Semiconductor companies owned and operated their own silicon wafer fabrication facilities and developed their own process technology for manufacturing their chips. They also carried out the assembly and testing of their chips and fabrication. But this asset-heavy business model came at a price. Today, it costs over USD $3 billion to own a captive fabrication facility, which is affordable for only a few manufacturers like Intel and Samsung.3 Players such as Taiwan Semiconductor Manufacturing Company (TSMC) were, there- fore, incented to turn economic disadvantage into an opportunity. TSMC and others today build semiconductor foundries and manufacture chips for players like NVIDIA, whose value proposition lays in innovative chip design but lack the capital to own and maintain a captive fabrication facility. cognizant reports 6
  • 7. utility model by running material portions time and service disruption for clients. Over of inter-system, inter-company, nostro and time, as the market matures, securities firms depot reconciliations in a third-party utility must standardize their products and processes platform. This will send positive signals to and demand the same from service utilities to service providers and other firms that want make switching between utilities as seamless to test the utility waters. as possible. This will help shape a competitive reconciliation utilities market and make it an This critical confidence-building measure will operating reality. materially allay the fears of service providers and skepticism of new firms looking at a utility In the case of OTC derivatives, the securities model. The nascent utility market urgently industry is fully committed to increasing the needs market makers — leaders that can look levels of product and process standardiza- beyond the conventional, which is a role that tion across asset classes, which will reduce securities firms alone can adopt to build scal- operational risk and promote efficiency. able and a commercially viable reconciliation Also, the large broker-dealers have com- service delivery models. A demonstrable, mitted to partner CCPs, trade reposi- credible story will go a long way toward tories and infrastructure providers to creating a robust utility market. This will help redesign and automate processes and service providers attract new clients and electronic platforms for key business ratchet up scale, upon which the commercial functions like matching and confirmation, viability of utility model is predicated. affirmation, managing lifecycle events and the calculation and effecting of settlements.• Standardizing processes to minimize The results of these commitments will largely switching costs. The hallmark of any utility determine the feasibility and success of the model is reduced switching costs in terms of utility model.Reconciliation Solution Variants Reconciliation Solutions Description Advantages Disadvantages In-house A Microsoft Excel- • 100% control. • Ongoing maintenance. reconciliation solution or Access-based application. • No license costs. • Lack of scalability. • Customization. • Limited functionality. Vendor A specialist recon- • Robust functionality. • License fee. application ciliation application installed on-site. • Access to periodic • Reliance on vendor. functional updates. • Time-consuming • Automatic system maintenance. implementation. Hosted solution Remote access to • Rapid implementation. • One-size-fits-all solution. specialist software developed and main- • All connectivity managed • Control and accountability by the vendor. concerns. tained by a vendor at an off-site location. • Automatic system • Hosting fee. maintenance and upgrades. Enterprise Integrated solution • All reconciliation covered, • Generic solutions. solution incorporated in internal and external. • High-volume. dependency. the core banking application. • Single investigation and exception management solution across the entire organization. • Greater automation and straight-through processing.Source: AdventFigure 5 cognizant reports 7
  • 8. • Partnering with service providers through to move away from the full-time equivalent joint ventures to build reconciliation utili- (FTE)-based pricing model and toward transac- ties. Building and running a scalable, polished tion-based pricing like any other utility service. and updated reconciliation platform is capital For the clients to benefit from a service utility, intensive. Today, most capable and proven transaction-based pricing that variabilizes service providers may either not have the bal- and reduces overall reconciliation spend is ance sheet strength or the risk appetite to go non-negotiable. it alone and build these platforms. Securities firms can address this by picking up material • Reset return expectations. Low but steady stakes in the service utility. This move will returns characterize most of the utilities also create a positive sensibility about service business, and reconciliation utilities are no utilities and help deepen the market. exception. This is a capital-intensive business, and service providers have grown reliant onService providers, for their part, must do the high margins by playing the cost arbitragefollowing: game and need to reset their return expectations. Winners in this business will be• Rewire service models. Service providers long-term players that continuously invest in must shed the conventional “lift and deliver platform updates and domain excellence to as-is at a low cost” mindset and move to offer reconciliation as a service — cheaper, deliver reconciliation as a platform-based faster and better. service. It is imperative for service providers to partner with securities firms to structure Road Ahead commercially viable business models in a way In our view, winning securities firms should that makes reconciliation delivered as a utility partner with service providers and help build workable. Anecdotal evidence points to deep commercially viable utilities to bolster their long- IT budget cuts across securities firms. Firms term competitive advantage. We see an oppor- are increasingly looking to monetize their tunity to rewire the reconciliation function in a current platforms — in short, they are look- way that enables industry players to focus on ing for partners with strong balance sheets what they do best and rely on trusted partners and risk appetites to overhaul their current to perform non-core tasks, as we’ve seen in the systems, deploy reengineered solutions and/ semiconductor industry. Not only will this lighten or offer reconciliation as a service. the current asset-heavy model, but it will prepare these companies’ business models for the future.• Offer transaction-based pricing for recon- ciliation services. Service providers needFootnotes1 Trading scandals include UBS (September 2011); Société Générale (January 2008); Allied Irish Banks (February 2002); Sumitomo (June 1996); Daiwa Bank (July 1995); Barings Bank (February 1995).2 “Reconciliation Solutions Market Overview 2011: Supply and Demand Evolves,” Aite Group, July 19, 2011, http://www.aitegroup.com/Reports/ReportDetail.aspx?recordItemID=816.3 “Above the Clouds: A Berkeley View of Cloud Computing,” Electrical Engineering and Computer Sciences, University of California at Berkeley, Feb. 10, 2009. cognizant reports 8
  • 9. ReferencesEtienne Savatier, “Moving from Silo Matching to Enterprise-wide Reconciliation,” Sterci SA, January2012, http://www.sterci.com/downloads/wp/Sterci-WhitePaper-Reconciliation-2012-22-12.pdf.“Collateralised Portfolio Reconciliation Best Operational Practices,” ISDA, June 30, 2010.“2011 ISDA Operations Benchmarking Survey,” ISDA, November 2011.Letter to William Dudley, president of the Federal Reserve Bank of New York, from the G14 members,March 31, 2011, http://www.newyorkfed.org/newsevents/news/markets/2011/SCL0331.pdf.“Building the Business Case for a Reconciliation Utility,” SmartStream, September 2008,http://www.ithound.com/abstract/building-business-reconciliation-utility-2513.Fred Cohen, “Reconciliation Services: Building Efficiency, Transparency and Control,” BankTech India,Sept. 6, 2011, http://banktechindia.com/news/11-09-06/Reconciliation_Services_Building_efficiency_transparency_and_control.aspx.“Putting a Recon Factory to Work for Your Company,” Syntel, http://www.syntelinc.com/uploadedFiles/Syntel/Industries/Financial_Services/Capital_Markets/SYNT_FS_CapMkts_ReconFactory.pdf.AuthorAnand Chandramouli, Director, Cognizant Research CenterSubject Matter ExpertJ N Venkateswarulu, Senior Director, Cognizant Business Process ServicesBanking and Financial ServicesDesignHarleen Bhatia, Design Team LeadSuresh Sambandhan, DesignerAbout CognizantCognizant (NASDAQ: CTSH) is a leading provider of information technology, consulting, and business processoutsourcing services, dedicated to helping the world’s leading companies build stronger businesses. Headquarteredin Teaneck, New Jersey (U.S.), Cognizant combines a passion for client satisfaction, technology innovation, deepindustry and business process expertise, and a global, collaborative workforce that embodies the future of work.With over 50 delivery centers worldwide and approximately 137,700 employees as of December 31, 2011, Cognizant isa member of the NASDAQ-100, the S&P 500, the Forbes Global 2000, and the Fortune 500 and is ranked among thetop performing and fastest growing companies in the world.Visit us online at www.cognizant.com for more information. World Headquarters European Headquarters India Operations Headquarters 500 Frank W. Burr Blvd. 1 Kingdom Street #5/535, Old Mahabalipuram Road Teaneck, NJ 07666 USA Paddington Central Okkiyam Pettai, Thoraipakkam Phone: +1 201 801 0233 London W2 6BD Chennai, 600 096 India Fax: +1 201 801 0243 Phone: +44 (0) 207 297 7600 Phone: +91 (0) 44 4209 6000 Toll Free: +1 888 937 3277 Fax: +44 (0) 207 121 0102 Fax: +91 (0) 44 4209 6060 Email: inquiry@cognizant.com Email: infouk@cognizant.com Email: inquiryindia@cognizant.com©­­ Copyright 2012, Cognizant. All rights reserved. No part of this document may be reproduced, stored in a retrieval system, transmitted in any form or by anymeans, electronic, mechanical, photocopying, recording, or otherwise, without the express written permission from Cognizant. The information contained herein issubject to change without notice. All other trademarks mentioned herein are the property of their respective owners.