Modern banks operate booking processes and structures that are staggeringly complicated and often antiquated. Some banks even use systems that use imperial pounds and shillings, which seems odd given many staff would not have been alive when they were in use.

Modern banks operate booking processes and structures that are staggeringly complicated and often antiquated. Some banks even use systems that use imperial pounds and shillings, which seems odd given many staff would not have been alive when they were in use.

Booking structures span multiple technologies, locations and jurisdictions, and regulators are increasingly concerned about the problems that these complex structures cause when it comes to resolving collapsing banks. Consequently, there is an increasing drive for banks to focus on bringing about centralisation and coherence to their booking structures.

The challenge

Though the majority of trading occurs in the major financial centres like London, New York and Singapore, trades can be “remotely booked” to an entity overseas, making them indistinguishable from trades carried out in that location. Remote booking allows management of market risk and utilisation of discrepancies between regulatory conditions in different locations (regulatory arbitrage). The result is a booking system that rapidly loses coherence as different entities book to one another in an institution that often lacks any form of central trade repository.

The scale and complexity of bank booking systems, combined with their lack of technological coherence and reliance on out-dated systems, will represent an ever-increasing impediment to banks in future years. Overhauling these systems is never easy or cheap, but there are several reasons for banks to consider doing so:

Costs to support

More complex internal accounting drives up running costs and makes operational errors more likely. Though front-end systems operate at light-speed (often literally), post-trade processing is far slower and this represents a cost to banks. One inherent problem is that bank systems grow organically over many years. Legacy technologies remain in place, as it is cheaper to add to an old system than to migrate to a new one. This produces an evolutionary chain that often stretches many years into a bank’s past, resulting in an increasingly old, disjointed failure-prone systems architecture.

Market Risk

Particularly when more complex products are traded, opaque booking structures open up the possibility of systemic information loss. One of the often cited factors that led to the 2008 crash was the fact that banks’ estimations of market risk were skewed due to poor record keeping of the complex derivatives traded. This resulted in risk exposures far beyond established safe levels, most notably in the case of Lehman Brothers.

The unwinding of Lehman’s has turned out to be one of the most complicated financial undertakings in history, and as such increasing amounts of regulatory pressure is aimed at mitigating this type of problem in future. In light of the Lehman Brothers’ collapse, the regulators now argue that complex booking structures are needlessly opaque. The unwinding of the bank has provided direct evidence that the existing market complexity represents a huge potential cost in the event of a bank failing.

Regulatory Pressure

All trends point to an increasingly transparent marketplace, complete with simpler booking structures. Banks are receiving ever increasing fines for errors in their often obsolete booking systems, and as front office technology improves, these back-end systems will only fall further behind the curve. Regulations like Dodd-Frank and MiFID have introduced an increased focus on transparency and, coupled with this, regulators have made numerous demands to banks to improve resolvability. The Bank of England‘s Megan Butler and Andy Murfin made calls this year to banks to either simplify booking structures or face regulatory orders to do so. This is unlikely to be the last such call.

What needs to change?

Banks will need to focus on bringing about centralisation and coherence to their booking structures, which will begin with a reform of the core technology. One proposed medium for this eventual change is “Blockchain” technology, described recently as “as impactful on the back office as electronic trading was on open outcry” by Nasdaq CEO Bob Greifeld¹. The concept of a Blockchain is that every participant in the market holds a record of all the transactions in that market which is updated in real time. Whenever a transaction is made, the specific detail of that trade are broadcast onto the market and updated into the myriad of separate ledgers held by each participant. In effect, market participants will operate their own transparent, self-updating central trade repository.

Indeed, Blythe Masters, widely held to be the originator of the credit default swap, suggests that “Blockchain” technology will supplant traditional booking systems by distributing all trading information across the network of market participants, thus removing the need for swathes of back office activity. This would result in a simple, transparent and universal trading system that would allow regulators easy access to market records while simultaneously saving banks huge sums in administration costs.

Though this system would not prevent activities like regulatory arbitrage, it would certainly serve to ease regulatory pressure because of the transparency it would bring. The blueprint for banks is changing, and an opaque system reliant on complex and archaic technology will not be able to survive in the next phase of the financial system.

References:

1 http://www.bloomberg.com/news/features/2015-09-01/blythe-masters-tells-banks-the-blockchain-changes-everything

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