With the advent of execution-only pricing and direct market access, the economics of institutional sales and trading must change. Currently, the cost structure of a sales and trading operation is made up of four items:

• The cost of providing liquidity
• The cost of position management (hedging),
• The cost of trade processing, and
• The cost of technology

Depending on the product (OTC derivatives versus cash securities) and market liquidity, costs for a typical sales and trading operation break out approximately as 60% for liquidity provision, 15% for position management, 10% for trade processing, 10% for technology and 5% for other expenses.

As institutional clients move to direct market access and demand pricing that unbundles research and advisory services from execution, the value of marketers and traders decrease substantially. In this low-margin world, directly accessible markets provide liquidity, sharply reducing the need for the market making functions provided by marketers. Further, the institutional clients do their own financial engineering, obviating the need to maintain and hedge sell-side positions. This, in turn, reduces the need for traders and the cost of their positioning and hedging activities. Research, if paid for at all, is conducted by the buy-side which formulates its own trade ideas. In the end, the buy-side will pay the cost of marketers, traders and position management only when the trade idea is new, the product is proprietary or its risk is complex.

The cost of a sales and trading operation in a world of execution-only pricing and direct market access is significantly different than it is today. The cost and efficiency of trade processing and technology have become much more important to profitability. PA has developed tools and techniques to improve performance in each of these two areas. This brief describes the tools and techniques we use to help clients improve capacity and efficiency in trade processing and operations.

The Tools and Techniques

Traditional reengineering techniques are heavily dependent on techniques developed for the manufacturing sector. The efficiency challenges of the financial markets are different from manufacturing: automation creates large blocks of capacity; the units being assembled are units of information not physical parts; processes and resources are marshaled as-required to solve a client's financing problem rather than to produce a standard output at the least cost. We have chosen four techniques that yield insight into the efficiency problems present in the financial markets. These techniques have been developed and refined over ten years in a broad range of businesses. These businesses include: cash equity sales and trading, OTC derivatives (equity, fixed income and FX), private placements, central counterparty-clearing house and corporate lending.

Post mortem analysis of failed trades.

This technique is aimed at identifying the root cause of failures in information integrity, matching and valuation. We draw a sample of failed trades; develop a profile of each, plotting events in its lifecycle and the sources of associated trade processing information. We then apply a root cause diagnostic tree to establish the fundamental cause of trade processing failures. We have trees that apply to corporate bonds, project finance loans, commercial loans, equities, exchange traded derivatives and OTC derivatives. The output of this analysis is a profile of the causes of trade failure which points directly to interventions that will reduce or eliminate these fails. See figure 1.

Information dependency analysis.

Financial products, particularly OTC derivatives, are manufactured by assembling sub-assemblies of information. The assembly process is complex, with multiple sources cascading information into the trade process at many different points and on a variable schedule. When that information is made available, its quality and its completeness determine the length of the overall trade processing cycle. The information dependency analysis (IDA) plots the sources and sinks of units of information and the schedule on which the information is exchanged. Using a quantitative technique that identifies optimal schedules, the IDA suggests changes in process structure and timing that reduce the total cycle time. At the same time it identifies sources of rework and how these sources can be eliminated.

Trade lifecyle analysis.

This technique extracts information from trade capture, order management, transaction management and settlement systems and creates a complete trace of the events in each trades life. Using these traces we can calculate the paths taken by trades that do not process straight-through and how much time and resource these non-STP trades consume. The technique allows clients to benchmark processing times and error rates against other institutions using standard, apples-to-apples categories.

Reflective time study (RTS) analysis and process costing.

Establishing a cost baseline and measuring improvement off that baseline is fundamental to any reengineering initiative. The reflective time study technique is used to identify the quantity, the cost of rework, error correction and capacity limitations. It provides nearly the same accuracy as traditional time-and-motion techniques at 40% of the elapsed time and 20% of the effort. We have RTS templates that cover most financial markets activities.

Sales and trading has enjoyed high margins for decades. Operations and technology costs have not been important drivers of profitability. With the advent of direct market access and execution-only pricing, processing and technology costs become much more important. The tools and techniques described here provide a means of managing these costs, producing profits in what will be a much more difficult business environment.

Peter Stockman is a member of PA Consulting Group's management team and leads the firm's capital markets group in New York. He works with investment banks, re-insurance companies and clearinghouses on issues relating to strategy, operations improvement and risk management. Peter can be reached at 212-973-5913; email: peter.stockman@paconsulting.com; web: www.paconsulting.com.