Trading middle offices are not a new phenomenon, they have been in existence for a number of years. Originating from the amalgamation of trading assistant roles with operational functions, which were either directly connected to traders or directly related to the initial trade lifecycle, the purpose was to provide greater control over the business by moving safeguards further upstream.
In early middle office models, a variety of functions, from initial and flash PnL predictions through to trade checkout and affirmation, were managed centrally. At that time, banks chose the functions to include in the middle office based upon the bank’s existing structure, as there was no industry precedent to follow. Those functions that were too difficult to move into the middle office were left in their original positions. There was not a predefined operating model for the middle office and, in addition, the work carried out by the functions transferred was generally manual in nature and therefore heavy in operational risk.
What was consistent in all middle offices, was the need for contact with front-end trading and sales personnel and there was therefore a requirement, on the part of a middle office professional, to have appropriate trade support and trade lifecycle experience and expertise. Even today with increased automation in the industry, the need for this experience and expertise has not reduced. The issue facing banks today is, how to develop this expertise? Full trade automation has eliminated the need for manual processes. Unfortunately, it is by understanding those manual processes that we learn how functions operate and get to know the nuances of particular processes. Has automation eliminated this educational path?
Why create a middle office?
There have been many “Rogue Traders” over the years. The most infamous, probably being Nick Leeson who brought down Barings Bank in 1995, by losing approximately Â£827m. More recently in 2008, Jerome Kerviel, a Societe Generale trader lost the bank ~£3.7bn. There is an argument that greater controls further up the trade lifecycle would have either prevented these frauds, or at the very least caught them earlier.
By creating a more disciplined control framework around trading businesses, with effective and visible controls over trading and the trade lifecycle, there is less opportunity or incentive to break the rules. This was one of the principal reasons for the creation of the early middle office functions.
In addition to tighter controls, other benefits for maintaining the middle office function have emerged. For example, cost efficiency. By creating better, tighter controls and fixing mistakes earlier in the process, trades can flow through bank’s support systems more neatly and efficiently. This leads to cost efficiencies over the longer term.
So what has changed?
As trading margins have decreased and banks have placed greater emphasis on efficiencies, many operational processes have been consolidated into group wide processing factories to save cost. For example, individual product trading groups would previously have had their own settlement functions, with their settlement staff having specific knowledge of the products that they were settling. The individual settlement functions created subject matter experts (SMEs) in the mechanics of the underlying products. As these functions consolidated into processing factories that education diminished. Settlement professionals became SMEs in the processing of moving money and less so in the essentials of the underlying products.
Similarly, and more acutely within derivatives documentation (due to cost pressures, regulatory scrutiny and the need to report trades in a timely manner), the trade lifecycle has been automated. Automation included the production of trade transactions, which had previously been manually documented by derivatives specialists. Unfortunately, automation has not yet been developed for very complex or exotic trades. The resulting scenario is that there is still a requirement for product specialists who can document these complicated products. However, the learning path has effectively disappeared.
One final issue facing middle offices is that of career progression. The middle office was once a pre-cursor to a career in the front office. The occurrence of fraudulent traders who had previously worked in operations, and therefore built a deep knowledge of the operational processes (and flaws within them), has resulted in banks restricting this career path. The opportunities for career progression from the middle office have therefore reduced. This has manifested itself as a reduction of suitable professionals who choose the middle office as a career.
What does the future hold for the middle office function?
The principal function of a middle office is control. As a result, the middle office role is evolving from that of a support function to becoming one of the primary controls over trading businesses. To provide the necessary level of control requires a high level of domain knowledge and product expertise. Unfortunately, the learning paths required to meet this standard are disappearing. Middle offices are being challenged to build and maintain their knowledge base and educate their staff in the underlying products whilst also ensuring that staff are aware of the changing and ever expanding regulatory environment.
Despite the challenges, the middle office function is increasingly becoming a prominent reason for clients to transact with specific organisations. Traded products are becoming commoditised, trade attributes are normalising across market participants, with less price differentiation between market participants. In the absence of other reasons, clients are therefore looking at those organisations who process their trades quickly and efficiently and, most importantly, error free. Consequently, they are looking for an improved client experience. Client experience is improved by the quality of data used in processes and a functioning middle office is a key driver of good data quality.
The future is therefore bright for the middle office function, but the role is becoming increasingly technical as products innovate, without automation keeping pace. The challenge is to ensure staff development keeps pace with innovation, without the traditional education in trade processing.