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Innovation Beats Regulation

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By Penny Davenport, managing director, and Lansing Gatrell, director, Markit Document Exchange, Markit Group

2010 has carried on where 2009 left off with the spectre of regulation hanging over the financial markets. At the same time, government continues to get bigger, in education and healthcare as well as financial markets, in both the United States and Europe. President Obama is trying to go on the offensive by pushing for the banks to be broken up, separating investment banking from the consumer business. Britain’s chancellor, Alistair Darling, is considering the same recommendation. However, as the state encroaches and the threat of regulation builds, Markit expects to see a significant creativity push to fend off the potential bottleneck of bigger government and increased regulation.

This creativity will be evident on both the buy side and the sell side and will be driven, in particular, through technological efficiency and operational excellence. A report from Aite Group recently found that business agility was financial firms’ top objective for 2010. This was a major change from 2009 when cost reduction in the face of the credit crunch was cited by most businesses as their top priority. Markit believes there are three key areas where we will see innovation in 2010, in particular on the buy side.

The first area where we expect to see innovation and advance on the buy side is in the area of data aggregation for both market and reference data. 51% of buy side firms surveyed by Tabb Group in December 2009 cited data aggregation as their biggest challenge in the area of risk management. In cases where data comes in from multiple sources, including data vendors, exchanges and sell side firms, this leads to inefficiencies in terms of both cost and data management, not to mention sub-optimal use of the data for portfolio and risk management.

In small to mid-size buy side firms, resources are typically very stretched and this has been heightened following the drive to cut costs in 2008/2009. Single traders and risk management officers, for example, are expected to manage functions that are much broader in terms of responsibility than their peers at sell side firms or the larger asset management institutions. Therefore, any ways in which processes can be streamlined, or in which data can be delivered more efficiently, bring considerable productivity benefits.

There has been a proliferation of market data available, for example in the younger asset classes such as credit. This data can encompass end-of-day mark-to-market data, intraday pricing, liquidity indicators and trader quotes. The increase in the types, and quantity of data, on offer has had a significant benefit in terms of transparency and improved risk management by providing more information to market participants. It has levelled the playing field between buy side and sell side, reduced spreads and addressed concerns at the regulators.

However, it is hard to extract the potential value from the data unless the delivery, and aggregation, mechanisms are organised. Both buy side and sell side are able to take advantage of data aggregation feeds such as Bloomberg’s PhatPipe, Thomson Reuters Data Feed Direct and Markit Solutions. This means that they only have to implement one file with one set of download tools, typically automated, bringing considerable efficiency benefits.

In the field of reference data, a report issued by Patni found that 91 out of 100 asset managers do not currently have a single supplier of reference data, although this is an aspiration. Respondents said that an average of 6% of trades fail as a result of poor reference data. The report identified that buy side firms are becoming increasingly aware of the time and resources they devote to purchasing, cleansing and distributing reference data. Further, it cited the acknowledgement of risks arising when this is not done well, including failed trades. This heightens the need for a centralised, scrubbed data feed.

Once the data has been delivered, the next topic is how it is accessed and displayed. Buy side firms are able to utilise increasingly effective data aggregation tools such as portfolio management tools and data desktops to provide clear and concise access to their data sources. The data will typically be mapped using standard entity identifiers to provide a true, cross asset class view of a securities instrument or a reference credit. Having this data professionally organised and at their fingertips enables the buy side to make more effective decisions in a more timely manner.

The second area where we predict we will see change is with the combination of risk and compliance functions on the buy side. Aite Group also recently reviewed the challenges faced by compliance officers on the buy side as they work to keep pace with pending change in the regulatory environment, as well as new financial products. The rate of change in the industry is quite phenomenal and both regulators and investors wholly expect that buy side firms have to stay ahead of this change.

This poses a significant issue for the compliance officer who has to cover a wide range of day-to-day activities including know your customer management (KYC) and trading and liquidity compliance. There is no off-the-shelf technology solution, or data package, to support this range of activities, heightening the challenge for the compliance officer. Although compliance teams would like to add headcount to their staff, ideally, the combination of the risk and compliance functions on the buy side will actually lead, conversely, to more efficiency.

There is a lot of overlap between the functions and a compliance officer can be in possession of relevant knowledge applicable to the risk management function. This actually creates economies of scale or capacity in the functions, which brings benefits for both the firms and for the individuals themselves. This is already being borne out by some smaller buy side firms, which have presciently made the move to combine the functions.

Overall, across multiple functions including portfolio reconciliations, corporate actions management or straight-through processing, buy side firms will spend significant effort in 2010 to review their processes and move to adopt best practices. The combination of reduced spending and the tide of regulation will, in fact, bring efficiency and transparency through re-invented processes, workflows and organisational change.

The final area where we see significant innovation through both technology and operational excellence is in the area of US Withholding Tax forms, a little-known part of the US tax code, which could have major implications for dealers and investors both foreign and domestic.

Though obscure, withholding taxes are levied on all US sourced investment income. Determining the correct amount of withholding tax is a complex and operationally intensive process. The burden of collecting withholding taxes falls on the party responsible for distributing US sourced income, typically banks referred to as ‘withholding agents’. The withholding rate for a particular client or counterparty is driven by income type and tax status, the latter being a function of tax residency and client type. If the proper amount is not withheld, withholding agents are liable for any shortfall. Tax status is determined by collecting tax forms from clients – W-9s for domestic entities and W-8s for foreign vehicles.

The W-8 forms are the most burdensome because withholding agents are required to have signed paper originals, which must be physically renewed every three years. These forms need to be completed by institutional or end investors in hard copy for all dealer or custodian counterparties, often multiple times in order to prove their withholding tax status. The paper burden for all sides is substantial, creating a major operational headache, and has significant cost implications for both buy side and sell side institutions. This is heightened in cases when sell side firms lose the forms, during a relocation for example, and they need to be supplied again!

In a recent survey conducted by Markit Group, nearly 25% of sell side respondents cited that their firm processes more than 10,000 buy side withholding tax forms per annum. For 50% of the total number of respondents, between 10 and 20 full time headcount are involved in this activity globally. A third of respondents believed that they would reap significant efficiency benefits if they could receive these tax forms electronically and pre-validated from the buy side instead of having to collect and process these manually.

Though the paperwork for withholding agents is already onerous, the US government seems determined to compel these banks to go even further. For example, the IRS may require withholding agents to determine a client’s birthplace, despite its irrelevance for tax status.

The IRS has been trying to ‘crack down’ on US persons who have not declared their assets overseas. Further scrutiny has been placed on qualified intermediaries (QI), foreign institutions that agree to adhere to US regulations, in the belief that QIs may directly or indirectly be helping US persons facilitate tax evasion. And perhaps most controversially, the proposed Foreign Account Tax Compliance Act of 2009 could have far reaching implications for US withholding agents, QIs, and even non-qualified intermediaries (NQIs).

Ironically, these stricter requirements may actually spur industry-wide change required to effectively apply the new regulations from both an operational and a technology perspective. The IRS certainly appears to recognise that the desire for stricter regulations must be coupled with increased flexibility for meeting those requirements and has recently encouraged withholding agents to use online questionnaires with clients to produce ‘original’ tax forms as PDFs.

Since the most significant burden is the current requirement to collect and validate the original version of the W-8s – a process that often includes back-and-forth mailing of paper forms between withholding agents and clients – an electronic format significantly increases the speed and accuracy with which forms are processed. Equally revolutionary will be the IRS’s hoped for authorisation for withholding agents to ‘share’ original tax forms. Although this has technically been allowed for years, the industry has never managed to muster a critical mass of withholding agents to take advantage of it. This appears to be changing and we hope will be placed at the heart of an IRS Memorandum of Understanding.

Online document repositories can be combined with third party electronic validation tools to realise the full potential of sharing tax forms. Institutional clients make efficiency gains by doing a tax form once rather than one for each withholding agent. Withholding agents gain by automating the validation process and accessing various tax data electronically rather than the current manual exercise. Such a combination of tax form sharing and electronic validation has long been desired throughout the industry and users expect to gain significant efficiencies even with the possibility of tighter regulations.

Markit’s eTax engine, in partnership with Compliance Technologies International (CTI) centralises the processing of W8 and W9 tax forms onto Markit Document Exchange platform (MDE). It provides the ability for buy side firms to complete a single form, instead of multiple forms, and to have this one form run through the MDE eTax engine. That single form is then distributed electronically to all relevant sell side counterparties. This is a significant operational saving and also provides improved control, making it much harder to lose those forms!

The online form satisfies audit requirements by both the US Internal Revenue Service (IRS) and external auditors, and also provides the ability to reconcile the statement against a withholding statement. This change, or development, in withholding tax processing is Markit’s eTax engine is a primary example of the use of both innovation in technology and operational improvement to generate efficiency in the face of increasing regulation. The available Withholding Tax statement, which is available to users, doesn’t quite constitute real-time reporting but it comes much closer to it, helping to promote confidence in investors

The financial markets have been on a path of continuous change since their inception. Along this path, there have been many times when we have faced significant change. For example, 1986 saw the ‘big bang’ in the City when there were three major sea-changes including to allow foreign groups to buy UK stock-market firms, and the ending of the discount house monopoly on issuing government securities. The prospective change we face today, following the credit crunch, is probably the most daunting since big bang. Should all the regulation that has been touted actually become reality, the financial markets will become very different places indeed. However, as before, we do not expect financial firms to retreat. Rather, we predict that we will see a trend of continued innovation on the buy side, using both technology and operational excellence, with no expected reduction in productivity. It goes without saying that the sell side will be innovating at a similar pace and the partnership between the buy side and the sell side will be synergistic in terms of change.

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