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Wall Street Seeks Edge From Operational Alpha

Alpha was a front-office term, but now banks and brokers are looking to the middle and back office for profitability.

As regulatory demands push costs higher, and while automated trading decreases fees,  banks and brokers are looking at the middle and back office to gain operational alpha -- a new trend in capital markets. “The concept of operational alpha is gaining momentum and taking on renewed importance based on the premise that an integrated front-to-back-office infrastructure can deliver greater cost efficiencies and controls,” said Anthony Perrotta, Jr., principal and head of fixed income research for Tabb Group. Perotta moderated a panel at Tabb Forum’s MarketTech 2014 event last Wednesday.

Alpha used to measure the incremental value that a portfolio manager brings to a fund’s investment performance relative to a benchmark or index, said Perrotta, but more generally the term is being used to define profitability. Until recently it could not apply to the middle and back office, but the industry is undergoing change.

“While the front-office gets all the sizzle, there is another game at play here,” said Michael Hoskins, CTO of Actian, where he evangelizes trends in big data analytics, Hadoop, and cloud. According to Hoskins, people are rethinking how the processes are constructed. “It’s all about the data,” he says. As firms build electronic trading systems, they can put probes into their electronic networks. “Advanced thinkers are tapping their operational systems, ingesting and inhaling that data into one place.” Customers are trying to bring the exhaust from their trading systems and figure out how to radically drive down costs., he said. Analytics are  secret weapon, said Hoskins.

Steven Silberstein, chief technology officer at SunGard, said the demands for operational alpha or operational efficiency are greater than ever before. In the post-Knight Capital environment, there is more focus on operational risk and operational alpha, said Silberstein, calling this an “inflection point that reminded people that things move really fast and bad things can happen. So there is a refocus on operations, the network, and the service. That stuff has value in the front office.” What firms are getting wrong in looking at the middle and back office is that they’re not looking at the people.

Everyone agreed that moving alpha from the front to middle and back office was inevitable, but one challenge is that the middle office has been subject to less investment over the years. “Many firms are not prepared to implement operational alpha from a defensive standpoint in their middle and back office for that reason,” said Hoskins. For example, “When there are market fluctuations, you need to have collateral calculations at your fingertips.” He added that firms are not prepared.

Legacy systems that are holdovers and are not integrated create a problem around operational alpha, said Perrotta. Andy Brown, CEO of Sand Hill East Ventures, singled out the cost structure of running a capital markets business as an obstacle. “Any complex system never gets retired,” said Brown, a former group technology officer of UBS who has worked for banks in architecture and infrastructure during his career. Citing the multiple dimensions of cost structure, he explained that region and country make up one dimension, asset class is another, and trade lifecycle is another. “If you are in almost every asset class in 72 countries and you have to be in every trade lifecycle stage, that can be very complex stuff.”

Smaller firms are also under revenue, margin, and regulatory pressure, said Silberstein. What SunGard is hearing more and more “is a willingness and openness to ask someone else with a lower cost structure to take this stuff over from us,” he said, citing the interest in managed services. It’s not only to gain alpha, which is a positive but in some cases, “keeping your head above water is efficiency.”

While capital markets firms are warming up to outsourcing in certain parts of the business, they still need to keep certain operational processes inside, which is a contradiction, said Perotta.

The role of technology
How can technology play a role in operational alpha? “Nimbleness is definitely a large component for operational alpha,” said Joseph Squeri, chief information officer at Citadel. Agile development is the latest buzzword that exists across tech teams right now. “That is great for building the offensive side of operational alpha. But there is a huge defensive side needed for regulatory controls and operational controls and making sure you optimize on both. That is critical for a financial industry changing as much as it is,” he said, citing changes in market structure and firms changing to serve their clients.

Managed services also pose a raft of challenges, such as how firms connect internal data services with external sources and how they handle security and privacy, said Hoskins. Despite these challenges, he maintained that firms have no choice but to move to managed services. “The competitive challenges are driving you.”

Focusing on operational efficiency involves a total behavioral change, said Brown. He traces the change to 2012, when banks were not profitable in equities. The back office outweighed the revenues of the front office. This was true of Merrill, Goldman, and every other firm on the street due to cost structure. This changed the point of view toward flows in general, and equities in particular. In firms that are tackling operational efficiency, the front-office executives are accountable for front-to-back for the P&L, whereas in the past they only cared about profits and not the L for liabilities, he said.

Just as Wall Street had a race to zero in electronic market making, Brown said, there is an industry race to zero in operational alpha. People want to get frictionless trading processes that don’t break trades. “As soon as one person does it everyone else will be compelled to do so because of price.”

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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