3 Back-Office Strategies Broker-Dealers Need to Use Right Now

NEW YORK (TheStreet) -- If you're a broker-dealer, technology has shaken up your business, but it can also help you compete better. You can use technology to strengthen your back-office processes.

The CME Group (CME) plans to close most of its futures trading pits in Chicago and New York next month, making it clear how quickly electronic trading has overtaken the open outcry system.

Although the roots of electronic trading were planted in 1992 with the birth of the CME Group's electronic communication network Globex, many organizations were able to continue business as usual until the Securities and Exchange Commission authorized electronic exchanges in 1998. As recently as 1997, the Chicago Board of Trade (now owned by CME) was betting on traditional trading with an expansion that at the time made it the world's largest trading floor.

Since then, however, advances in electronic trading have allowed traders to almost instantaneously capitalize on price fluctuations, rendering traditional trading nearly obsolete.

Firms today must work faster and be smarter to match rising industry standards. By automating any part of their day-to-day operations, from regulatory compliance to customer relationship and execution-fee management, broker-dealers can protect their competitive edge.

Especially for older firms struggling to adapt to market fragmentation (and its residual costs), now is the time to address and renovate critical business practices. Here are a few back-office guidelines broker-dealers should follow to remain successful amid a changing industry landscape:

  1. Make trade surveillance a preventive process: Broker-dealers must comply with regulatory standards or face fines, damage to their reputations and other penalties. With the right automated tools in place, firms' monitoring of daily trading activity can help catch the most egregious abuses before they occur, including spoofing, layering, wash sales and limit or market-on-close orders. Each of these behaviors carries significant risks for broker-dealers who fail to preemptively detect illegal trading activity. Spoofing and layering contribute to market distortions like the infamous 2010 Flash Crash, and some traders use wash sales to avoid taxes. Similarly, limit and market-on-close orders can inaccurately inflate a trader's portfolio. Rogue actors often "test the waters" before committing full-blown trading fraud; a comprehensive market surveillance strategy can help your firm identify malicious patterns before it's too late.

  2. Get a grip on trade-execution costs: Few broker-dealers consider trade-execution fees to be a major source of spending, but too many firms have gone out of businesses over a failure to adapt to the evolving exchange landscape. As recently as a decade or two ago, broker-dealers only dealt with a small selection of prominent exchanges and could afford to pass execution fees on to clients at a flat rate. Today, the exchange market is heavily fragmented, and broker-dealers need a dozen or more variables (trade details) in order to determine precise trade-execution fees.

    It can be extraordinarily difficult to calculate the exact execution cost per trade, especially when managing immense trade volumes over a short period of time. Unsurprisingly, spreadsheet-based calculations are unlikely to reflect the true cost of a trade. Broker-dealers without a solid grasp on their margins per trade and per client are unlikely to remain profitable. Large firms like Goldman Sachs (GS) and Morgan Stanley (MS) can afford to devote entire teams to fee analysis, but smaller organizations would be wise to invest in fee-management software to avoid a slow death from accumulated, obscure execution costs.

  3. Invest in soft-dollar programs and commission-sharing agreements: Most broker-dealers understand the value of customer loyalty, and commission sharing agreements and other soft-dollar programs provide an excellent way to reward clients. Simply having these programs in place, however, isn't enough. Broker-dealers must move beyond manual, opaque calculations and boost the firm's bottom line while meeting the demand for streamlined, real-time trade information.

    Traditional CSA outsourcing can be prohibitively expensive, but advances in back-office technology give broker-dealers the best of both worlds, balancing cost effectiveness with program excellence. At their best, CSA and soft-dollar programs provide increased visibility to clients and vendors, reduce the burden of maintaining comprehensive audit trails, and ensure standardization and accuracy. Especially as CSAs come under scrutiny in the EU, U.S. broker-dealers should prepare their systems to handle a potential spike in demand from European portfolio managers.

As the financial and capital markets sectors become more reliant on sophisticated technology, many broker-dealers still lag behind and hold on to outdated processes. To ensure stability and future growth, firms must place the back office on equal footing with the front, and invest in new monitoring and reporting capabilities accordingly.

Previously marginal concerns like exchange fees and CSA transparency now have the power to sink or generate revenue, depending on a firm's technological competence. Broker-dealers squeezed by ongoing consolidation and aggressive competition must thoroughly embrace IT -- and the efficiency it offers -- in order to survive and thrive.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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