The Digital Future of Securities Finance

In 2023, reverberations from bank failures and liquidity shifts due to rising interest rates shook up the balance sheets of many financial institutions. The shrinking prime brokerage industry, coupled with the regional banking crisis, the meme stock saga, and the collapse of Archegos Capital, has posed a challenge for hedge funds in formulating their prime brokerage strategy. Market turbulence and heightened volatility are pushing managers to review prime brokers’ core services and value propositions to find a partner that can give them a competitive edge.

Securities finance is essential to a healthy market, but much of the market is burdened with heavy cost structures, outdated technology, and inefficient organizational designs. Over the past 20 years, financial institutions have begun to progress beyond aging legacy infrastructure, applying new technology on top of outdated systems or turning to providers for support. The result is that many firms operate on a patchwork of solutions underpinned by decades-old mainframes.

Over the last decade, the securities lending industry has successfully responded to both regulatory and market challenges, including Basel III, Dodd-Frank, and the Capital Requirement Regulation. This year, the industry will continue to be challenged by the Fed’s interest rate decisions and the SEC’s rules and proposals, particularly those around transparency.

As the securities finance industry continues to respond to these substantial changes, participants will demand more straightforward access to data and real-time information, and the reliance on highly manual processes will pose a challenge. The solution is to reimagine the legacy workflows and silos in the financial markets to improve access for all participants.

Drivers of innovation

Regulation in industries like technology and medicine often follows innovation, and governing bodies must keep up with the latest developments. In finance, the opposite can be true - new regulations sometimes drive innovation, challenging the industry to develop solutions that meet rising standards in reporting and processing.

For example, mandated Central Clearing of U.S. Treasury and Repo through the Fixed Income Clearing Corporation will place a greater emphasis on optimizing the cash equity and fixed income inventory across the firm (i). Firms must centralize inventory from different desks through an integrated, centralized platform. An SEC study of the impact of this rule on markets and market participants found that technology will be the most considerable cost to market participants adopting the rule and that outdated systems would be a significant constraint (ii). One firm noted, “It would be very difficult to incorporate this change at scale, and we could choose not to participate.”

Also at the end of last year, the SEC approved the new Rule 10c-1a, which will require certain entities to report information about securities loans to a registered national securities association (RNSA) and require RNSAs to make publicly available certain information that they receive regarding these lending transactions (iii).

By mandating more transparent and efficient reporting, regulators hope to better understand systemic risk and prepare to make decisions during future market events. Around the world, regulators are tightening their rules and guidelines to better oversee the market, particularly in traditionally opaque businesses like securities lending.

Rule 10c-1 doesn’t go into effect until 2025, but the industry must begin preparing for the sheer volume of data and reporting requirements. Firms investing in modern and cloud-native technology will be better positioned to deliver new products and services quickly. Tech-forward firms can offer clients game-changing services and more reliable, real-time access to locates and often have more flexibility to take on clients left behind by legacy banks burdened by capital constraints.

Finally, the May 2024 shift to T+1 settlement will challenge legacy and fragmented technology, entrenched manual processes, and siloed data across capital markets. Firms must build certainty into their payments and settlements to effectively prepare for the change.

This deadline puts increasing pressure on in-house operations teams. Shorter timeframes mean more work for teams, particularly for those funds trading overseas and at high volumes. Fund managers must thoroughly review their systems and counterparties to ensure a smooth transition.

The stability of a counterparty during market and regulatory changes, along with considerations such as product offerings, securities lending supply, and financing capabilities, are key differentiators. Specifically, as Common Equity Tier 1 (CET1) ratios face pressure under Basel III regulations, banks may need to scale down their balance sheets, potentially reducing hedge fund lending. A provider's regulatory oversight and strengths play a crucial role in determining the potential impact on a relationship when there are changes in business strategies or commitments to a business line.

A roadmap for modernization

The entrenched nature of traditional legacy systems has continued to pose a significant challenge to the securities finance industry’s digital transformation efforts. Starting with their traditional architecture, firms operate on fragmented platforms based on deep and inflexible technology. In many cases, large amounts of custom code have built up over time to manage tasks that legacy systems were never designed to support.

This means that near-obsolete technology may still be in use because data cannot be changed, application programs cannot be upgraded, or it is heavily integrated into a firm’s functions. Over time, some firms have acquired technology from newer vendors to live on top of legacy systems. Still, these pseudo-modern solutions are awkward and difficult to update, often with poor visibility.

Other firms might combine multiple vendor solutions to meet the needs of today’s markets, but that often leads to lengthy integration processes, high ownership costs, and fragmented data stored across multiple systems. Others may have installed a single-source vendor solution capable of supporting numerous activities. However, installations and custom modifications can be expensive and are at the vendor's mercy.

The long-term solution is a cloud-native, horizontally scalable capital markets ecosystem that adds considerable efficiencies to a business and can be continuously developed to meet changing market demands.

Despite its importance, securities finance is an area of the financial services industry that has only seen limited innovation. Like much of today’s capital markets infrastructure, it depends on antiquated technology, such as mainframes, which can create data challenges for clients. Modernizing the trading tech stack can reduce costs in critical areas like reference data management, reconciliations, clearing and settlement, middle office, regulatory reporting, and overall application footprint. A nimbler, more agile firm can grow through innovation and deliver higher-quality returns for asset owners and stakeholders through easy-to-use APIs, access, automation, and insights.

One central solution

Progress does not occur in a vacuum. Vendors in the trade space have launched developments and enhancements in an effort to increase automated trading functionality by systematically integrating trading platforms. However, efficiencies will be hindered without similar developments in the pre-and post-trade space, like in onboarding, trade settlement, or loan allocation.

These challenges are met by varying solutions for workflow efficiency, regtech, analytics, and more, all developed by different market vendors. As discussed, this piecemeal approach can result in fragmented data and heavy operational burdens. It also means that development happens at different paces as each participant adopts enhancements suited to their own existing infrastructure.

The solution is a central platform that de-silos key inputs and leverages advanced analytics and machine learning to optimize the balance of inventory, collateral, and margin against customer demand–with the goal of more liquidity, better economics, and reduced systemic risk.

Investing today for tomorrow’s success

To operate at peak efficiency, banks and brokers must reduce the manual processes that increase risk of error and operate in silos in favor of technology that empowers users to make smarter decisions and to identify potential risks throughout the trading process.

A prime example of this is locating. Traditionally, allocating locates has been manual and inefficient, requiring traders to navigate multiple pages of information and negatively impacting efficiency. New, high-tech developments in locates allocation systems allow customers to submit orders directly through their order management system, reducing manual labor and providing a more reliable customer experience.

Simplifying the technology behind trading and post-trade functions can transform it from a cost center to a competitive advantage. But for many firms, upgrading would require rewriting many systems with significant technical debt, massive resourcing, and high planning costs—a daunting project with low chances of success.

Modern, high-performance computing coexists with mainframes. But as the value of data continues to rise, those who invest in the technology and capabilities to keep up with fast-paced, intraday market changes will come out on top.

It’s time to update the infrastructure powering capital markets. A single-source platform can potentially optimize operations across teams, asset classes, and geographies, reducing cost, complexity, and risk. In turn, this makes it easier for emerging managers, professional traders, and institutions to access capital markets.

To keep up with the accelerating pace of modernization, firms will need to invest in technology to meet the needs of investors and regulators. Those who do will be part of building the modern, scalable future of capital markets—improving access, speed, and service for all participants.

This article originally appeared in the Securities Finance Times.