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Back Office Silos Remain for Japanese Financial Institutions, Says Celent and SmartStream

The back and middle offices of Japanese financial institutions remain very siloed and there has been little progress towards automating areas such as corporate actions, according to a recent report by analyst firm Celent. The report, “Post-Trade Processing in Japan: Back and Middle Office STP at Brokerages, Banks and Asset Managers”, which was commissioned by solution vendor SmartStream Technologies, indicates that asset classes in the country remain siloed across multiple business lines.

The report examines the state of STP in Japan across asset classes and was conducted through a survey of domestic Japanese brokerages, commercial banks and asset managers. The vendor decided to sponsor the research because it has ambitions to expand its service offering in the country, explains Richard Cummings, regional director for Asia Pacific at SmartStream. “We’ve been active in Japan for a few years and have both regional and megabanks as clients. However, to date, we’ve concentrated on providing our reconciliations solutions in Japan. We believe there are opportunities for us to expand that with other solutions, including TLM Cash Management, TLM Corporate Actions and TLM Trade Process Management,” he elaborates.

Given the conclusions of the report, it would seem Cummings has some basis for these conclusions. Japanese financial institutions are characterised by fragmented systems and while the demands placed on post-trade processing infrastructure have evolved, the tools needed to support this change have not, says the report. There is also a significant distinction between the different players in the domestic market in terms of focus. Of the three financial sectors surveyed, asset managers in Japan are placing the most emphasis on improving levels of STP, while banks are placing the least emphasis on this area.

Neil Katkov, senior vice president of Celent’s Asia Research group and author of the report, explains why the sell side may be ahead of the buy side already in some areas: “The buy side are typically much more cost conscious when it comes to IT investments than the sell side, in any market (except for some high flying hedge funds, if any are left). Also, for a sell side firm, STP reduces their internal costs for all trading, including proprietary trading and execution only brokerage, giving them a stronger incentive.”

However, there are some further barriers particular to Japan that mean the sell side is not being compelled to invest in STP, says Katkov. “One is slow uptake of electronic trading. Another one is a regulatory framework that effectively hands much of the asset management market to just a few custodians; as a result custodians have no competitive pressures to upgrade their services to an electronic/STP infrastructure. This means that the benefits of buy side firms would be limited to mostly internal efficiencies, not external ones (for example, interoperability with the custodian).”

Much like the rest of the world, recent market events have not been kind to Japanese financial institutions but this may provide an opportunity for investment in IT, claims Katkov. “The market in Japan has tanked, causing a drop in equities trading that affects the sell side and a devaluation of equities assets on the buy side. This is a driver for firms to put more emphasis on derivatives, as well as more active equities trading, which can be effective in volatile markets like the current one. So while the financial crisis is causing cutbacks in technology infrastructure spending in general, it may also spur more derivatives trading, active trading of equities, and cross border trading, all trends that act as drivers for STP in the back office,” he explains.

This focus on asset classes other than equities and FX would be a welcome change for the market in which less attention has been paid to improving derivatives, fixed income and cash processes. Take up of OTC derivatives, cross border trading and the adoption of advanced execution technologies may well cause firms in the country to revisit their processes, claims the report.

Cummings reckons the report highlights a few interesting Japanese market trends. “The first was the continued use of highly siloed operations by asset class that for many years have been viewed as a significant barrier to lowering risk and cost and improving STP rates. The knock on effect is that middle and back office costs, unsurprisingly, remain high and firms in Japan are missing opportunities to increase efficiency through automation,” he explains.

“The second, related issue is that STP in Japan has tended to focus on the flow between internal systems. Less progress has been made in the automation or assisted workflow for exceptions handling or corporate actions. For example, the asset managers surveyed all processed exception manually, while the majority of firms in Japan process exceptions in batches,” he continues.

This lack of accounting for exceptions handling and workflow issues therefore means that firms are overestimating the level of STP they have achieved, the report indicates. Cummings elaborates: “The underlying reason for this lack of progress is that exception management is treated separately and is not considered part of the STP process, unlike the US or Europe. To overcome the problem, firms have tended to throw more people into the back office but this simply isn’t sustainable or cost effective in the medium to long term.” A total of 34% of respondents have been increasing their headcounts to cope with these issues, the report highlights.

The remaining barriers to automation include a lack of standardisation and low electronic trading levels due to: lower usage of FIX standards; regulations making it difficult for asset managers to use average pricing (without which the efficiencies of electronic trading are lowered substantially); and high market concentration (Tokyo Stock Exchange has 90% of equities trading) and the fact that electronic trading tends to take off more in fragmented markets.

There is also a degree of resistance to reducing head count in the back office due to Japanese corporate commitment to employment security, which negates one of the main drivers for STP: lowering costs by automating manual processes, explains Katkov. However, the financial crisis has succeeded in pressuring manufacturing industries to lay off tens of thousands of people, eroding the resistance to downsizing, he adds.

“In the area of corporate actions, Japan is simply a few years behind developments in the US. We can expect STP to improve here over the next few years. Exceptions handling may resist change longer, due to the resistance to downsizing,” he continues.

There are plenty of other drivers for change in the market, according to the report. “Market infrastructure is also being upgraded, for example equities were dematerialised in January 2009 and clearing may eventually move to T+0, quickening the trade cycle,” explains Katkov. “These are changes that tend to create an infrastructure conducive to STP and increase the need for STP. Competition from foreign firms (both buy side and sell side) is also a driver for domestic firms to increase efficiencies, cost and performance.”

Moreover, globalisation of the brokerage industry and capital markets will eventually bring the same drivers for STP found in, say, the US to bear on the Japanese market, continues Katkov.

These may spell positive changes for the vendors in the country in the future, but for now the market remains a challenge. “So far, the situation could be better characterised as a relative lack of appetite for automation,” says Katkov. “Even so, international vendors have had some success in selling STP enhancing technology to Japanese firms, particularly in high volume areas such as FX. As Japanese firms come to adopt more STP, international vendors will find opportunities. But they will also find themselves in competition with domestic vendors, who will respond to the same market changes and develop new products offering more STP.”

SmartStream is certainly hopeful that the market will provide a new revenue stream, as its more traditional markets in the US and Europe feel the squeeze. Cummings explains that the vendor will be working with local partners to introduce a broader range of its Transaction Lifecycle Management (TLM) solutions for Japanese firms.

“There are clear benefits to using real-time exception management within the transaction processing framework. Integrated, workflow-based exception management alerts users to potential issues and provides the most appropriate path to resolution to ensure the item can be returned to the transaction flow as efficiently as possible,” he says. “That approach removes manual processing and duplication of effort. As a result, the back office is more efficient and the cost per transaction reduces, and fewer transactions are left outstanding so operational risk is reduced.”

Cummings is confident that the vendor will be able to get the message across to the Japanese market in the long run. But given the current challenges remaining, this may take some time.

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