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Switching a Back-Office Relationship Is Very Hard

While the front office is eminently more glamorous and lucrative, switching front-office providers is easy. Switching a clearing, custody or depository relationship, however, is very hard.

The back office is like Rodney Dangerfield -- it gets no respect. While it processes all transactions, a day without hearing from the back office is like a day without problems.

That said, things are changing. Commissions and spreads are declining, and trading technology is creating a level of abstraction between the buy and sell sides that is making it more difficult to differentiate broker offerings and maintain margins. As this occurs, the "nominal" back-office charges don't look so nominal anymore.

Prime brokers are learning this as they cater to hedge funds. And exchanges are learning this as they see the Deutsche Bourse's, Euronext's and the CME's enhanced valuation predicated upon their vertical clearing models. So what does this mean?

It means that back-office services are stickier than the front. While the front office is eminently more glamorous and lucrative, switching front-office providers is easy. Switching a clearing, custody or depository relationship, however, is very hard. First, there are fewer back-office service providers. Second, the tight integration among firms' technology infrastructures, books and records, and processing facilities with their back-end providers makes it not only complicated, but also costly to switch back-end relationships. Third, because of this difficulty, switching is risky. What if the conversion is botched? Saving a few bucks on transactions but losing a billion dollars in the technology conversion won't fly.

But while there is not much firms can do about changing their depository, there are significant things they can do to reduce back-office costs. Certainly, better technology integration, enhanced messaging, interindustry standards, reference data utilities, and the vision of STP in which everyone is connected and everything is exception-based would improve back-office efficiency.

While enhanced operational efficiency is wonderful, the real challenge, though, is interfirm cooperation. How can firms better communicate? There are a few interesting models developing that allow firms to process more efficiently. One of these models is buy-side consolidated clearing, in which an institutional investor uses an intermediary to consolidate orders that are executed through a number of brokers. This process, developed by Electronic Specialists and FireFly, allows buy-side firms to aggregate executions across brokers and provide an additional level of anonymity, all with a single custodial ticket charge. It also streamlines the broker execution, as a broker-consolidator execution can be netted.

While currently not much can be done to reduce depository fees, this likely will change as brokers apply more pressure to the current central clearing model. As the NYSE and Nasdaq look to make overseas acquisitions, and the industry looks to the tight linkage between the CME/CBOT and the CME Clearing, there are questions about how the equity side of the business can both profit and reduce costs by changing the current way securities are cleared, settled and held. While this won't happen tomorrow, we expect that the DTCC will be under greater pressure than ever to become more efficient and reduce costs, or risk the creation of a new entrant in this space.

Fortunately, Rodney got his respect before his passing. But it may take a while for the back office to gain the respect that it rightly deserves. Still, the trend is obvious: The back office is important and will be where the game is won. While many can build a great front end, not everyone will have the economies of scale to make the back work. And at the end of the day, if it isn't cleared or settled properly, then the investment in the front is meaningless. <<<

Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio

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