Undervaluing your middle office is a mistake
An underpowered or outsourced middle office can limit performance for clients just as the value of operational alpha is peaking.
The middle office is too often perceived as a cost centre. In fact, the flexibility and efficiency of the middle office is at the core of processing trades for many client service functions, making it a key element of a bank’s relationship with buy-side clients. As the asset management community evolves through consolidation, changing investment patterns, the continued low interest rate environment and technological innovation, banks must adapt their operations to effectively connect with and support their clients. In this article we challenge the traditional assessment of the middle and back office functions as cost centres, and suggest them as differentiators.
The middle office in today’s environment
Firstly, the very purpose of the middle office, providing transparency and certainty, is increasingly important to demonstrate to clients how asset managers use investment capital and indicate performance. Specifically, initiatives such as the CFA Institute’s Global Investment Performance Standards (GIPS) and the European Union’s packaged retail investment and insurance-based products (PRIIPs) rules establish benchmarks for buy-side firms around data and disclosure which are becoming the baseline expectations of end investors. This level of transparency requires the capture and support of an increasing amount of static data against which trade confirmations need to be checked.
Client complexity is also growing. The continued low-interest rate environment is rendering the model of holding cash fixed income instruments for their full tenor less rewarding and potentially higher risk as credit exposures increase under COVID-19. Building portfolios which offer a decent return now often involves a more complex set of instruments to generate alpha and hedge against default risk. Liquidity is decreasing across asset classes – most notably in fixed income – which reduces the data available to support intraday pricing and portfolio reconciliation.
The pressure and expectation on the middle office is increasing as the need for accurate and timely tracking and reporting of positions and valuations rises. The middle office manages significant communication and record keeping for the end customers and retaining control of that function and the service levels for confirming, affirming and allocating trades is incredibly valuable.
A common, standardised set of data with interfaces that allow the seamless flow of information between front and back offices optimises performance and service levels, resulting in operational alpha. Taking this view reverses the traditional assessment of the middle and back office functions as cost centres, and reclassifies them as differentiators.
For instance, different buy-side firms might have multiple formats for trade allocations. This creates a challenge for a bank expanding its business into new regions, or when clients are merging, and may require that bank to switch to a new way of working. When working to meet those challenges, firms with an established middle office platform that can conform to a variety of standards is a differentiator and will better position a sell-side broker to engage with new clients. Thinking of the middle office as valuable ensures the client has positive engagement with a bank at every level.
For firms to benefit from this differentiator, there are two challenges that must be overcome: operational workflow and outsourcing.
If operational workflow has been configured to be compatible with legacy technology, for example, by being hardwired with front office systems, its capacity to change will be inherently limited. Front office technology is largely built within asset class or instrument siloes and that severely reduces its ability to support operational alpha generation. As clients require more data in an efficient manner, these structural siloes risk service pauses and increased error rates. A multi asset broker running three order management systems to handle different assets, each with their own middle-office suite, must process trades in three different places.
The second challenge is outsourcing of the middle office. Breaking a fundamental component of service quality out of the bank and entrusting it with another provider introduces operational risk, cedes control of service levels to a third party, and risks passing a problem from one firm to another without solving it. The logical place for middle office functionality is within the bank itself, integrated with the back-office system, where it can keep pace for confirmation and allocations for multiple clients, across multiple jurisdictions. This liberates the middle office from restrictive front-office siloes and creates an opportunity for banks to deliver better service across the board.
Seize this opportunity
As banks review their middle office operations over the next twelve months, they should embrace the opportunity to deliver a better service to clients by optimising those operations to suit their buy-side partners.
This can be achieved by integrating the middle and back office more effectively and building workflows that are client focused, to drive value in the reliability and transparency of the service.
Competition between banks in 2021 is likely to be intense as investors continue to ramp up demands for service quality and clarity, which will lead to greater focus on the entire value chain for clients.
October 21, 2020