Forces of Nature

The Impact of Investment Technology in the Current Regulatory Landscape

October 2013

Across the financial industry, the regulatory environment is rapidly changing. With a heightened focus on risk management and transparency, insurance companies and many other global financial institutions are facing a dramatic increase in regulations. Politicians, investors and regulators are demanding more oversight in a global attempt to lessen systemic risk through the Dodd-Frank Act, European Markets Infrastructure Regulation (EMIR), International Financial Reporting Standards (IFRS), and imminent changes in countries such as Singapore and Australia — to name a few.

These new requirements are pushing managers to re-evaluate their current platforms and IT infrastructure. Using siloed legacy systems that only allow for interaction via spreadsheets is no longer a viable option. Flexible and multi-functional automated platforms with greater transparency into the investment lifecycle are now needed to meet evolving investor needs, regulatory requirements and front-office demands, as well as stay competitive. 

Key development areas are primarily related to the deluge of global compliance rules, particularly accounting requirements for providers of accounting services. IFRS is a prime example. Today, more than 112 countries require or allow the use of IFRS in the preparation of financial statements by publicly held companies. In the US, the Securities and Exchange Commission (SEC) is planning to set a date to allow US public companies to use IFRS, and perhaps make its adoption mandatory.

Proposed and implemented changes place a significant burden on maintaining and updating technology supporting the investment lifecycle. In addition to those already mentioned, they include the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) financial instrument accounting revisions; the SEC's recommendations that the riskiest money market mutual funds adopt a floating share price, and the US Congress-initiated Foreign Account Tax Compliance Act (FATCA) requiring improved tax compliance.

The Complexity of the Search for Alpha

Financial institutions, and more specifically insurance companies, are finding themselves in a place where they need to invest in more complex strategies, as the traditional fixed income environment hasn't been generating the returns that they need. In their quest for yield, they are looking into more alternative strategies, including derivatives and more exotic options, such as hedge funds and private equity.

A good example of the regulatory implications is how the Dodd-Frank Act affects clearing and reporting over-the-counter (OTC) derivative trades. With an overhaul of the swaps market, as well as concerns for counterparty risk, insurance firms now have to be focused on daily reconciliation of their collateralized portfolios with all counterparties to mitigate risk exposure.

This increased focus on real-time reporting promotes transparency in "who holds what" exposure, daily automated reconciliations of collateral and derivative positions, and an overall shift from an opaque bespoke market structure to a central clearing model. The new environment and rules demand an IT infrastructure that provides an automated, scalable integrated middle- and back-office OTC derivative operation.

Build vs. Buy Remains Relevant

The regulatory demands and pressures to produce yield for investors put technology at the forefront of the evolution. The decision to build technology internally or buy from external providers has more relevancy than ever before. It is increasingly difficult for all but the largest companies to do development in-house. Firms must decide to either develop and operate the technology in-house or purchase an external solution. It is becoming significantly complicated for financial institutions to develop internally, because the pace of change is so high and the complexity is increasing so rapidly. Because companies have so much pressure to hold their organizational costs down, it's difficult for them to develop industry-leading technologies and to invest in the talent required to manage and evolve the technology.

While there are perceived advantages to build or buy approaches, much of the decision comes down to cost and control. Building and supporting an internal system requires a best-in-class pool of resources that can provide cross-functional expertise for front-to-back office technologies. This can be extremely cost prohibitive and detract from a firm's focus on core competencies, such as gathering and managing assets. As a general theme, we see clients trying to concentrate their internal efforts on areas that they think are going to be real differentiators for them. Increasingly, that tends to be around investment decision making and the investment management process.

Financial institutions often want the complete control that is achieved through an in-house system. Realistically, the cost can be an obstacle and many firms take a hybrid approach in which they can control priority data, modelling and inputs. Fortunately, there are solutions providers with the flexibility to serve clients operating under both models. Flexible software solutions allow clients a choice over the level of control that works for their specific business. Gone are the days of "one-size-fits-all" solutions for financial institutions. Collaborative partnerships between clients and providers are paramount to being successful.

Some of the advantages of purchasing an external software solution are scale, total cost of ownership and speed to market. For example, when entering a new geography, it is very efficient to work with a provider with established requirements for those markets. To manage the software in-house would take time and expertise to build up the required capabilities. Regardless of whether you're developing the software yourself or licensing the software, it is important to have people internally who understand the application and can respond to the front office when there are critical decisions to be made.

Choosing the Right Partner

All of these factors have significant implications for technology providers who must stay close to their clients to anticipate needs and develop solutions that can be rapidly deployed. As a result, there has been significant increased involvement from external stakeholders in the evolution of investment technology. In tackling these challenges, financial institutions need to be comfortable that they are working with partners who are proactively investing in technology to keep up with evolving regulation and investment strategies. Ultimately, the clients should play an important role in determining the priorities of their technology provider and where they should be allocating their technology investment dollars.

Flexible and multi-functional automated platforms with greater transparency into the investment lifecycle are now needed to meet evolving investor needs, regulatory requirements and front-office demands, as well as stay competitive.

Head of Software Solutions, State Street Global Exchange