Equity And Debt 2000

Growth of outsourcing in Investment Banks supported by cost study of Equity & Debt markets

Financial products, particularly Derivatives, are costly for banks to process in-house, reports a new survey by Z/Yen, the City-based Risk/Reward Management firm. Shrinking margins are forcing banks to reduce costs per trade, which range from $10 for a Cash Equity to $2,000 for processing of a 5-year Swap. Outsourcing and insourcing are thus becoming accepted ways of staying competitive on costs per trade.

The study shows that smaller investment banks with lower volumes cannot compete on costs and should be keenest to outsource.

Larger investment banks, which should already benefit from economies of scale, can continue to reduce their costs per trade by insourcing additional volume. This study provides evidence to justify the trend for larger investment banks to set up processing utilities, e.g., JP Morgan’s Arcordia and Deutsche Bank’s European Transaction Bank.

Jeremy Smith, Director of Financial Services at Z/Yen, said, "It is clear than the market for commercialising processing services is primed for growth. Banks will have to decide whether they want to insource or outsource".

The study was carried out by Z/Yen and a consortium of 10 major US and European Banks. The scope of the study was to compare and contrast Operations, Middle Office, Finance and IT costs for 21 individual financial products within 9 nine major product areas (see below):

Each bank provided detailed cost, volume and headcount data for a full-year. Over 18,000 data points were gathered, analysed and consolidated into a set of comparative benchmarks. The product scope included both primary and secondary trading in the European Market.

Cash Equities are the cheapest Cash Product to process - followed by Exchange Traded Futures and Options. Bonds and Repos are the most expensive.

1. The cost per trade for OTC Derivatives is far higher than for Cash Products. The cost of processing an OTC Derivative is 10 to 15 times higher than its corresponding Cash Product, even though banks have spent huge amounts on automation.
2. Even Vanilla OTC Derivatives are expensive to process. For a vanilla interest-rate swap, it costs an average of $260 to process a new deal and $350 per year to maintain the trade (risk, P&L, rate sets and payments). This means that the average cost of a 5-year swap is approximately $2000.
3. Emerging Markets costs are higher than the major markets. The processing cost of an Emerging Markets bond is twice that of a Government or High Grade bond.
4. Costs per Trade vary widely between banks, therefore, there is plenty of room to reduce costs further across the market. While many of the participants had broadly similar product profiles, costs ranged widely. In some (but not all cases), smaller banks had the highest cost per trade, while those that had centralised their operations tended to benefit from economies of scale (see point 9 below).
5. Costs per Trade ranges were wider for OTC Derivatives than Cash Products showing that these products are still "settling in". Future savings could be large. For example, for OTC Equity Options, the costs per trade reported were from $40 to $900 whereas all the high-volume banks could process a new Cash Equity for less than $30.
6. The technical expertise required for new products pushes up costs. The fully-loaded cost per head (including accommodation and office technology as well as staff costs) ranged from $120,000 to $140,000 for most products. However for Credit Derivatives, the average cost for the Middle-Office was $175,000.
7. Banks with the largest volumes tend to have the lowest costs per trade. For all products, there was a correlation between high volume and low cost, i.e., economies of scale. A bank with an annual trade volume of 1 million trades a year is likely to be 65% more expensive than one with a volume of 4,000,000 per year. Thus, low volume banks are unlikely to be competitive.