23 June 2017
Zohar Hod

Post-trade derivatives

Zohar Hod - truePTS

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The Cost Conundrum

19 April 2017  |  3363 views  |  0

Cost cutting, price slashing, and organizational reductions are all major pillars in recent years of attempts to adjust performance to the new business environment. However, not all costs are the same and not all cost cutting measures are the right ones to make if you want your business to thrive for years to come. In order to decide how and where to reduce costs, we need to look at the factors that create different costs within the industry.

 

Economy of scale – The larger your firm is, the lower the perceived incremental or marginal costs should be. However, this scale can also work in the opposite direction as some large organizations have a hard time reducing their cost below a set level of expenditures. An agile organization should be able to utilize a sizable share they save by economy of scale. Nonetheless, today’s agile access to purchasing power and the continued creativity and flexibility in cloud based usage charges allows smaller organizations to capture a larger share of the cost savings allowed by moving into the cloud.

 

Capacity and how you utilize it – This is an interesting factor as the other satellite factors that affect this cost are constantly changing. First, there was the age of creating capacity within your own facility which was expensive and a hard to disable or get away from. Costs were not limited to only infrastructure, but also to maintaining that capacity globally. This materialized in the form of installing and maintaining multiple data centers in many locations. This cost is hard to change. Then, technologies such as VMware allowed the user to create additional partitioned capacity on the same server, basically allowing top utilization of the server that’s being maintained and is a good step towards reducing cost. Finally, the cloud has reached the mainstream. With the cloud, there are two ways to build your capacity- a private cloud or a public cloud. There are many differences between the two but it’s important to say that the public cloud, which is perceived to be less safe, can provide more flexibility but is less likely to be implemented in the fintech area. The latter provides full flexibility of capacity but comes with a catch. Cost effectiveness favors this option if you CAN predict your capacity utilization, but spikes in utilization might cost you a lot of $$$.

 

Integration and efficiencies of vertical integration – Integration is a great way to reduce costs in the long run, however, it is also a sure way to create dependencies and inflexibility of costs. Making sure that multiple systems use the same data set is very helpful when trying to keep costs down, but migrating to an integrated approach might actually be cost prohibitive, although this depends on the existing architecture. One type is vertical silos, which was used by banks in the past mainly because of the notion that each bank knew its own customer demands and needed to react to them independently of other businesses within the bank. The vertical integration around databases used, risk systems, and treasury functions have been cost effective for the banks that implemented this integration, but full vertical integration is not popular on the street these days. Many hope that the advent of distributed ledger will solve their woes, but I am afraid it might be a false hope.

 

Hidden dependencies - These dependencies can materialize in both business dependencies and technical dependencies. In a recent meeting with a senior bank executive, the discussion revolved around the amount of cost I could save the bank with my service. The discussion revealed many hidden dependencies which were preventing the reduction of real costs using one service or another. In this specific case, the dependencies were on a network provider that the bank relies on for trade communication which revealed a known issue in the industry. As much as the industry wants to reduce costs, these hidden dependencies are preventing it from happening. The radical approach would be to build some of the systems the market infrastructure depends on from scratch, but let's be real, these opportunities don't happen often. Even new technologies that offer greater increased capacity or greater flexibility come with hidden cost dependencies. One more example would be the use of large database stacks such as Hadoop or the programming of micro-services which is the latest craze in the market. Both technologies come with hidden dependencies and hidden costs to maintain because of the extra flexibility they provide users. 

 

Sell side and buy side costs are fixed – Now we come to the obvious conclusion and the conundrum. The bottom line is, that no matter how you cut it, there is a baseline of costs that are not flexible. The buy side fee structure is under pressure from both the hedge fund perspective (which has not shown a great performance in recent years) and from the asset manager’s perspective (who have been under pressure and seen a big migration into ETFs and Index funds). Sell side business models are crumbling under regulatory pressures and are currently not considered growth models. So what would an institution do when faced with this conundrum? Innovation is necessary for growth, innovation requires capital investment growth, and should therefore replace older costs.

 

So, what other options (good, bad or ugly) could be implemented:

 

Pay freeze - Bad for moral, period.

 

Cut in management - Some of this might be helpful, but in the general sense of things, businesses need leaders and this is one area where costs should not be removed..  

 

Consolidation - Consolidating services is a great way to reduce redundant costs. As mentioned above, consolidation has its own issues around hidden dependencies and therefore is also limited in its ability to dramatically reduce the baseline costs.

 

Be specific about cost saving - This part is as important as generally cutting across the board but has a double whammy negative effect. It demoralizes the team, makes successful teams feel like they are being wrongfully targeted, and thus may possibly be a crucial mistake in the area of savings. Being specific about cost cutting is the key in making the process a success.

 

New tech -  Investments in new technologies such as Blockchain or a full migration into the cloud is the way to go. It does not immediately appear in the bottom line, but without a massive investment in innovation, growth will NOT happen. We are facing an era of innovation with the interaction of humans and technology, financial institution need to stay invested in this innovation.

 

Outsource - Duh… financial institutions have been at the forefront of outsourcing but they never gave up real control until recently. For example, banks have moved development or operations resources to places such as India and present them  as their own facilities. The next level of outsourcing is facing the industry. Recently, some companies have decided to outsource their middle/back office operations to vendors such as Accenture. Great start but are there true cost savings that materialize from this level of outsourcing? I would argue that there aren’t. Furthermore, non-core functions should and would be outsourced. The secret to solving this conundrum is to boldly choose which functions are not core, and my answer to that is…..

 

Good luck!

 

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truePTS delivers an innovative, independent platform, focused on revolutionizing all post-trade workflows in derivatives and related financial products. I'm eager to help continue building and scaling...

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