Exploring the Global Financial Information Superhighway

Vol. 1: Investment Banks as a Global Financial Information Superhighway

Consulting Fellow, RIETI

In the mid-1990s, the concept of the information superhighway was introduced in the United States under the leadership of then Vice President Al Gore, who played a significant role behind the scenes of the Clinton administration. Gore's interests and concerns have since shifted from information to the environment, and he is currently involved in a worldwide campaign designed to educate people on global warming through means such as his documentary movie An Inconvenient Truth, which was a major box office hit last year and which helped earn him the 2007 Nobel Peace Prize. In the meantime, the information superhighway vision espoused by Mr. Gore about a decade ago is now having an enormous impact on international financial systems.

Investment banks have a prominent role in international finance today, constantly transferring enormous sums of funds across national borders, making full use of their global information systems. Until about 20 years ago, offices of investment banks, which were located in Tokyo, Hong Kong, Singapore, Sydney, London, New York, Chicago, and other financial centers, operated independently. Over the last 15 years, however, investment banks have constructed a global management structure that enables them to adapt to waves of advanced information, and in the process have transformed themselves into global financial information superhighways.

Hidden perspective: understanding international finance from an information infrastructure standpoint

This early summer, as I was approaching the offices of the Bank of England on the way home from the office in London where I am currently working, I bumped into an English friend I had not seen in about 10 years. I had worked with this gentleman in Tokyo and Singapore, developing global information systems. A few weeks later, we met at a pub in the city, where we had an interesting conversation. He told me that he currently worked at the London branch of a Portuguese investment bank, managing its global information system. This followed a stint at a German investment bank in Frankfurt, where he had been developing global information systems since 1997.

Not surprisingly, the development of global information systems dominated our conversation. We discussed which applications were good or bad, what lay behind failures when implementing even a good application, and what points were important when carrying out a project. After a vigorous exchange of opinions, we both found we agreed on one thing: the key to success in the investment banking business in an increasingly competitive multinational industry is to construct an efficient global information system.

Although the political, business, and academic circles in Japan have not yet paid attention to the concept of "investment banks as a global financial information superhighway" from the title of this report, this seems to be a hidden perspective, one that enables us to identify elements that could have a major impact not only on the financial industry, but also on the broader economy.

The main artery of international finance: investment banks

The term investment bank seems to have two meanings today. The first refers to an investment bank as a business, and the second to an investment bank as an organization. An investment bank as a business refers to arranging financing from the market by issuing securities and advising on corporate strategies such as mergers and acquisitions (M&A). An investment bank as an organization includes not only the investment banking division (IBD), which encompasses the first definition, but also the trading division that aims to earn profits using the proprietary account and the sales division that generates fee income by handling sell and buy orders from customers as an agent.

Although the IBD is often seen as the key source of profits for an investment bank as an organization, at a number of European and American investment banks the income generated by the IBD in fact accounts for less than 20% of total income. At these investment banks, the trading and marketing divisions play the central role in generating income. An investment bank as an organization with these various income sources is called a full-service investment bank.

Financial institutions take many different forms, such as commercial bank, securities broker, general insurance company, and life insurance company. Among them, in contrast to those financial institutions that serve as a kind of capillary vessel for local finance by providing a retail business that deals with large numbers of small transactions, investment banks are more like a main artery of international finance, operating a wholesale business that deals primarily with large transactions for institutional investors. Since management techniques for retail and wholesale businesses differ, many large financial groups run commercial banks and investment banks as separate organizations.

The organizational structure and information systems of investment banks

The profit center and cost center of an investment bank can be explored at a deeper level than was discussed previously in "Japanese Financial Market's Strategy in the Globalization Era."

At the top of the organizational structure of an investment bank sits the front office. The front office is classified as a profit center of the investment bank as it is the part that earns profits. The investment bank is obligated to completely split the front office into sections that deal in the primary market and those that handle financial instruments in the secondary market. The M&A division, which deals with the issuing of securities and corporate strategies with respect to M&As, belongs to the primary market sections.

Those sections that deal with financial instruments in the secondary market are again divided into subsections by product type such as stocks, bonds, and derivatives. It is common to establish divisions among these sections, such as the trading division, which handles proprietary trading, the marketing division, which deals with orders from customers, and another division that creates new business models. The secondary market sections aim to earn profits through different types of financial transactions, such as futures, options, swaps, forwards, and lending and borrowing, employing an array of financial instruments, including currencies, funds, stocks, bonds, and investment trusts.

In the front office, information systems and technologies are used in a number of areas, such as obtaining market prices from the financial markets in real time using the Internet, a market price database and computational software that enable complex quantitative analyses; the delivery of research reports on the financial markets and the economy; and an online system that executes financial instrument transactions with counterparties. In addition, a new business model for the front office called direct market access (DMA) is beginning to emerge. DMA uses cutting-edge information technology to expand the computer network of the investment bank not only inside the bank but also to customers' desks.

A cost center, called the middle office, is located in the middle of the investment bank's organizational structure. The central function of the middle office is to manage risks related to financial transactions. Although the generation of revenue is not a function of the middle office, it serves as an important support function that enables the front office to earn profits. The middle office uses information systems primarily to manage market risk and credit risk. It is also common to use these information systems to acquire market prices in real time, as in the front office.

Another cost center, called the back office, is located in the lower part of the investment bank's organizational structure. The functions of the back office can be divided into two types: one focuses on management inside the organization, such as accounting, tax, personnel management, internal compliance management related to company policy, external compliance management related to financial laws, information security management, and internal audits. The second type emphasizes communication with external parties, for example in the opening, maintenance, and closing of customer accounts, the delivery and trade confirmation, the reconciliation of funds transfers and securities settlements, the management of customer master data and product master data, and regular reporting to authorities. Most operations conducted in these back office functions involve daily routine work.

The back office uses information systems principally for clerical processing activities after the front office executes financial instrument transactions. Given that some of the settlement and regulatory reporting operations are directly linked to the central bank and stock exchanges, the accuracy of data is considered to be the most important factor for back office operations. As the demands for T+1 - meaning to make settlement a day after the trade date - grow stronger around the world, a review of the information systems structure is beginning to be emphasized with the aim of improving the business process. A new business model called offshore outsourcing has meanwhile emerged, slashing the cost of clerical processing by expanding the in-house information network into places like Singapore, Bangalore, and Glasgow, where labor costs are lower.

Initiatives at the construction sites: from a vertical to a horizontal connection, and then to a global connection

Historically, the banking business has a strong affiliation with information networks. The Rothschild family is renowned for having constructed an information network that spanned Europe in the 18th and 19th centuries, and then accumulating vast wealth by capitalizing on their information network for financial transactions. This history encourages the assumption that there is a strong causal link between the information network and profits in the banking model.

In today's world, owning an advanced information and communication network is essential for generating profits from the investment banking business. This requirement in fact constitutes a formidable barrier to entry into the investment banking industry.

Over the last few years, in order to study the global information system strategies, data on presently running computer systems were collected from more than 10 multinational investment banks. Three major points were discovered.

1) Vertical connection of information systems: straight through processing
The first finding is that there are a number of instances in which so-called straight through processing (STP) has been achieved. STP connects the three layers of the front, middle, and back offices from upstream to downstream. Before information systems evolved to the levels of today, much of the clerical processing in an investment bank was done manually, using paper. The work would normally be done independently in each of the front, middle, and back offices, and financial transactions executed in the front office were recorded manually in trade tickets, which were sent to the middle office and the back office, where the date was entered separately.

However, when the clerical processing is done under a structure in which the front, middle, and back offices are disconnected, two major problems arise. The first is that a mismatch of data will occur. The second is that the clerical processing will be more time consuming. But if financial transactions data entered at the front office flows to the middle office and the back office via a computer network, no mismatch of data among divisions will occur, and the time required for clerical processing will be substantially reduced. Using information systems, STP has solved these two problems simultaneously.

2) Horizontal connection of information systems: integrating diverse financial instrument transactions
Whereas STP improves efficiency vertically, from upstream to downstream, investment banks are also taking steps to horizontally improve efficiency, by processing diverse financial instrument transactions on the same information system platform. For stock transactions for example, this enables them to not only monitor numbers encompassing all types of transactions, such as ordinary transactions, margin transactions, and loan transactions by issue, but also to manage the earnings from stocks, convertible bonds, fixed income, investment trusts by customer account, and by proprietary account.

3) Global connection of information systems: establishment of the global booking system
Along with the vertical integration of systems through STP and the horizontal integration of financial instrument transactions, investment banks employ an internal system in which data associated with financial transactions conducted in one place are sent to a series of other locations in an order that follows the rotation of the Earth - from Tokyo, to London, and on to New York - by employing global information networks. The front office organizes groups by financial instrument transaction and assigns traders in Tokyo, London, and New York. Traders in each office generate income using the accounts shared by the group. This scheme is called the global booking system, and it enables investment banks to manage risks and earn income in international financial markets around the clock.

International financial information superhighways of investment banks and challenges of Japanese financial groups

This three-dimensional connection of the vertical (STP), horizontal (integration of various financial instrument transactions) and cross-border global connections (establishment of the global booking system) is made possible by the rapid technological innovation of information systems. An increase in hardware capability has bolstered the scale and speed of processing, while advances in software have led to knowledge accumulation and innovation. The expansion of networks has meanwhile facilitated globalization.

Over the last 15 years or so, financial groups in Europe and the United States have been establishing investment banks that serve as a global financial information superhighway. This process has been led by American banks, followed by Swiss and German banks, then by their British and French counterparts. This is literally a large-scale, ultrahigh-speed financial information network that collects, accumulates, and transports financial information at the global level, along with architecture that can return high quality international financial information to their home countries.

MIT Professor Lester Thurow says that the rules of the game in the international economy have changed dramatically. The financial markets in Japan have just emerged from the very long tunnel that was the aftermath of the economic bubble, and some large Japanese financial groups appear to be aggressively building the global financial information superhighway of an investment bank to catch up with their European and American competitors, based on an awareness that the mechanisms of international finance have changed dramatically.

The next report will investigate offshoring and outsourcing, using cross-border information networks. The focus will remain on investment banks.

October 10, 2007

October 10, 2007

Article(s) by this author