Financial reform carries a price tag – or penalties for past transgressions, if you want to look at it that way. Various fees and assessments, whether for capital requirements, examinations, deposit insurance or resolution funds, will be increased or newly introduced. Moving more over-the-counter instruments into clearing systems or exchanges means more capital and collateral charges, though presumably with risk-reducing benefits.
But those are just bills from outside authorities. What will the post-crisis environment force on organizations in the way of internal operations and technology expenditures? The trend is, obviously, up, for both compliance and competitive reasons. An industry whose profitability is on the mend should find these incremental needs, for the most part, affordable. But as they assess the relative costs and benefits, it is just as likely that not all financial services companies will approach their spending on technology, trading and risk systems the same way that they did going into the crisis.
A study released last week by Boston-based research firm Celent, an Oliver Wyman Group affiliate working with support from derivatives and risk technology vendor FINCAD, offers a revealing glimpse into the costs that firms have to consider in the increasingly critical area of pricing and valuation services. This is, overall, a $2.5 billion industry, on its way to $2.9 billion in annual revenues in 2012, according to projections last year by another Boston research firm, Aite Group.
In “Optimizing the OTC Pricing and Valuation Infrastructure,” Celent breaks down the costs of derivatives analytics for an in-house operation: an up-front investment of at least $9 million, and, depending on the institution’s aggressiveness, annual costs ranging “between 25 percent and 50 percent of initial investment to keep pricing and risk analytics relevant.” In other words, over a five-year software lifecycle, it will take “investments between $25 million and $36 million alone to build, maintain and enhance a complete derivatives library.”
A major implication of Celent’s finding is that firms face decisions on whether they want to bear these costs, scale back, buy more “commoditized” programs off the shelf or even outsource. It should be a familiar thought exercise by now: “build versus buy.” However, change may not be easy to bring about: Especially in areas relating to sophisticated, complex or bespoke products, building has long been considered necessary to maintain a competitive edge.
Simon Garland, chief strategist of Kx Systems, a Palo Alto, California-based supplier of high-performance databases that support the analytics of many top buy- and sell-side firms, marveled in a recent interview at how the industry elite – the Goldman Sachses, Morgan Stanleys, JPMorgans et al. – continue to invest in the “arms race” year after year, seemingly undeterred by market downturns. But Garland also wonders if more than a handful of firms can realistically expect to be always ahead of the game and profit from having, for example, “real-time everything.” Others, he implied, will have an increasingly hard time continuing to pay the price of being wannabes.
The Celent report, authored by research director Cubillas Ding, concludes: “Unless there is scale in deal volumes and analytics development, we believe that most firms, in one way or another, need to adopt a hybrid approach to the provision of analytics and models. For mid-size firms especially, it is not likely to be cost-effective to pursue a total in-house strategy. Firms need to find clarity on how internal development enhances their value proposition, weigh it against continuing costs and control overheads, and reconsider whether to build or buy models in the longer term.”
Jeffrey Kutler is editor-in-chief of Risk Professional magazine, published by the Global Association of Risk Professionals.
