Dodd-Frank Act: how will the Act affect IT?

New US regulations as embodied in the Dodd-Frank Act will have a far-reaching and profound impact on the investment management industry, not only in the USA but elsewhere, affecting competitive positioning of firms, market structure, revenue growth, profitability, and IT budgets. The industry will have to overhaul five Iinvestment management system areas: risk management, compliance, reporting, analytics, and data management.

By Dushyant Shahrawat, Senior Research Director, TowerGroup

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The passage of the Wall Street Reform and Consumer Protection Act (also known as the Dodd-Frank Act) signifies the biggest US regulatory change since the 1930s and will have an enormous impact on the securities and investments business. I n our belief, the reforms will have a substantial influence on over 4,000 brokerage firms, an estimated 8,500 investment managers, and all the 10–12 US exchanges and alternative execution networks.

The Dodd-Frank Act became law in July 2010. I t is the most sweeping piece of financial regulation passed in the USA in decades. All types of financial firms will feel its impact, from banks to investment firms, from brokers to insurance companies.

The legislation has special significance for the securities and investments industry, with brokerage firms being affected the most among all financial firms and traditional investment managers being affected the least. The impact on brokers will include lower revenues, higher costs, and a change in the competitive environment and market structure.

The law seeks to correct structural weaknesses in the US financial industry like the risk posed by activity that falls outside direct regulatory supervision i.e. trading in over-the-counter (OTC) derivatives, the systemic risk posed by very large financial entities failing, and the dangers of not requiring underwriters and securitisation firms to maintain some exposure to the assets they securitise.

Sweeping as it may be, many crucial details of the Dodd-Frank Act remain unclear – the legislation is still a work in progress and securities firms will have to await details of the rules with which they must comply. Changes in areas like derivatives and new capital requirements will be phased in gradually, the first phase being expected in 12–16 months and the second phase over the next two to three years.

IMPLICATIONS FOR IT

The Dodd-Frank Act and other regulation related to securities and investments will collectively have a major impact on the technology and operational decisions of financial institutions. Old priorities will be sidelined (i.e. the need to amend instment management systems to support new financial products will be dampened as financial innovation slows), while new priorities will emerge (i.e. supporting transparency and disclosure). Below are five implications of new regulation on the industry's technology and operations.

Key areas for consideration
Not surprisingly, the passage of the Dodd-Frank Act and other regulations will mean greater investment management system requirements in certain areas: risk management, compliance, reporting, and analytics. It is our belief that IT spending in the risk and compliance business will grow 8–9% between 2010 and 2011, led by the largest institutional brokerage firms. Hedge funds must initiate IT projects to comply with registration requirements and enhance overall transparency and disclosure of operations (albeit quite hesitantly). And data management will also necessitate great improvements in risk management, compliance, reporting, and analytics.

Renewed focus on cost savings and efficiency
As regulation impacts the industry's economics, pressing down revenue (from proprietary trading, OTC derivatives) and pushing up costs (of risk management, compliance, reporting), pressure on cost savings and efficiency will revive. There will be overall cost pressure on the entire IT budget, particularly in areas like agency brokerage and OTC derivatives. Even if economies improve dramatically in 2011 and beyond, chief financial officers will continue to pressure heads of IT and operations to seek ways to trim costs in response to continued market uncertainty and reduced profitability.

Supplier ties
A re-assessment of suppliers will be driven by the shift in business and IT needs due to changed regulations, the drive to trim costs, and the need to become more technologically nimble and enhance business flexibility and agility to respond to new regulations. Over time, the re-assessment of supplier relationships could cause a dislocation in the provider market with suppliers with strong functional knowledge and competitive pricing winning out over competitors that have generic solutions not customised to the industry’s needs.

Greater pressure to outsource
New regulations will also push some firms to re-examine their attitude toward outsourcing. Renewed cost pressures and the need to bolster capabilities in certain areas may cause investment managers to seek more relationships in both business process outsourcing (BPO) and information technology outsourcing (ITO). Brokers will also further expand outsourcing relationships in securities processing, causing the few remaining firms that self-clear to consider using correspondent clearing providers.

Organisations will further outsource functions such as custody, trade settlement, cash management, and investor services, which are already largely outsourced; that is, a higher proportion of activities will be outsourced. Areas such as valuation of illiquid instruments, administration of OTC derivatives, and collateral management, which are currently outsourced in a limited way, will be offered up for outsourcing bids. However, some functional areas – including supplier management, risk management, compliance, and order management – will remain off the outsourcing agenda for the most part.

Changes in service delivery
Regulatory pressure will also have an impact on investment management firms' attitude toward the way they consume software, influencing their perception of concepts such as application service provider (ASP)-based delivery, software-asa-service (SaaS), and cloud computing. For the last five to seven years, there has been a clear trend in the industry toward thin-client computing and accessing software through a web-based interface.

The new regulations will push this trend further as companies grapple with three demands: the need to reduce costs, enhance flexibility, and report in real time. The need to cut costs and enhance flexibility will drive up demand for cloud computing, with the initial focus being on pushing generic services like storage and computing power into the cloud soon followed by more business functions like data management.

OPPORTUNITIES

In response to these changes in the IT and operational priorities of investment management companies, what should they be doing and what opportunities do they have in this changing environment?

It is our belief that the collective weight of US regulatory reforms will greatly affect the technology-related and operational decisions of securities and investments firms in particular. Pressure will be greater on chief technology officers to cut costs, drive greater efficiency, better articulate return on investment on new projects, be more accountable to business users, and be more flexible in responding to business needs and regulatory requirements.

In addition to demands for investment management technology improvements, there will be opportunities for institutions that service asset managers and broker-dealers. These include custodian banks, sub-custodians, prime brokers and hedge-fund administrators. Major financial institutions such as State Street and Bank of New York are already rapidly bolstering their capability in areas such as collateral management, derivatives processing and securities valuation.

Figure 1 illustrates six issues that will become major priorities for the institutional securities business due to US regulatory reform and presents examples of focus areas driven by regulatory challenges.

Figure 1. Invetsment management system focus areas driven by regulatory reforms of the securities industry.
Source: TowerGroup.

POINTS TO CONSIDER

In response to the new regulatory powers, greater resources, and a stricter mandate granted to regulatory agencies by the new laws, securities firms will need to enhance their compliance departments, add staff to deal with more regulatory examinations, and implement compliance software (for surveillance of employees for insider trading, data security, and privacy). This means that investment management organisations will have to overhaul their systems to support needs in five application areas: risk management, compliance, reporting, analytics, and data management.

It is clear then that the Dodd-Frank Act will have a profound impact on the technology departments of securities and investment firms, requiring them to make changes to processing, accounting, risk management, and compliance software applications. Lower revenue in areas such as OTC derivatives and agency trading will put pressure on IT budgets, but green shoots will emerge in areas such as risk management, reporting, and data management.

Dushyant Shahrawat is a Senior Research Director at TowerGroup in the Securities and Investments practice, Boston, USA. With over 15 years of experience in financial services, he is a Chartered Financial Analyst (CFA) and a member of the Boston Security Analysts Society. Dushyant Shahrawat researches strategic issues facing asset managers, hedge funds and brokerage firms globally, and advises clients about strategy, marketing, regulation, technology and product development. He has shared his opinions on financial industry trends at over 100 events across the USA, Europe and Asia and has appeared on various television and radio channels. He has also been widely quoted in printed publications such as the Wall Street Journal, New York Times, Fortune, and the Financial Times.