Exploring the Global Financial Information Superhighway

Vol. 3: Dawn Period of Offshoring and Outsourcing in the Investment Banking Industry (part one)

Consulting Fellow, RIETI

In Volume 2 of this series, I focused on the pre-dawn period of offshoring and outsourcing from 1970 to 1989 and identified that European and U.S. investment banks faced the question of how to operate back-office processing in their organizations in an environment of expanding international financial transactions. In this section, I discuss the dawn of offshoring and outsourcing from 1990 to 1994. The discussion takes three perspectives: movements in international politics and the global economy, investment banking business, and back-office processing system.

International politics and global economy: The pound sterling crisis in September 1992 and the inauguration of the Clinton administration in January 1993

For many years following the end of World War II, the United Kingdom had adopted a cradle to grave welfare policy that was based on the theories of John Maynard Keynes, the British economist who emphasized the importance of creating effective demand through public investment. Contrary to the discovery of William Phillips, another UK economist and a professor at the London School of Economics (LSE), who identified the correlation between inflation and unemployment, as a result of the welfare policies, the UK economy went on to experience a period of stagflation, in which both prices and unemployment rose.

Aiming to defeat the stagflation, Prime Minister Margaret Thatcher conducted "small government" structural reforms during her approximately 12 years in office, from 1979 to 1990. As a part of the reform programs, she encouraged the so-called financial Big Bang, deregulation of the financial sector symbolized by the liberalization of securities brokerage fees and the allowance of foreign capital participating in the City of London. The reforms failed to demonstrate the desired results during either the Thatcher administration or the subsequent government under Prime Minister John Major, which took over the reforms, and in September 1992 the UK faced a currency crisis triggered by the sell-off of British pounds by George Soros.

Since the end of the currency crisis in 1992, however, the British economy has been recovering over the long term, driven by the development and expansion of the City of London as an international financial center. One of the factors driving this growth has been the expansion of the over-the-counter (OTC) derivatives business involving foreign players that have established a presence in the City of London. Today, various types of derivatives products are created and traded on the OTC derivatives market by combining different types of transaction methods, such as swaps and options with underlying instruments such as interest rates, currencies, bonds, equities, commodities, and credit.

In the United States, meanwhile, the Clinton administration was inaugurated in January 1993. Taking over the task of addressing the enormous fiscal deficits accumulated during the Reagan administration from 1981 to 1989 and the first Bush administration from 1989 to 1993, President Clinton embarked on fiscal consolidation immediately after establishing his office. To do this, he appointed Al Gore, who advocated the "information superhighway" vision, as Vice President, and Lloyd Bentsen, a financial industry expert, as Secretary of the Treasury. Mr. Clinton also appointed Robert Rubin, who used to be a highly competent trader on Wall Street for many years and was co-chairman of a leading U.S. investment bank, as Assistant to the President for Economic Policy. In 1995, Mr. Rubin took over for Mr. Bentsen as Secretary of the Treasury. Thus, the Clinton administration maintained a cabinet lineup geared at bolstering the U.S. economy with finance and information technology as the core engines. As a result, earnings of U.S. companies recovered, and share prices climbed. After many years in deficit, the U.S. government was able to achieve a budget surplus in 1998.

Financial architecture in Japan: Changes to the stock and bond markets

In 1990, share prices began to fall steeply in Japan. From about ¥38,900 in January 1990, the Nikkei Stock Average (Nikkei 225) had fallen below ¥20,000 by October the same year. After staging a temporary recovery to near ¥27,200 in 1991, the index remained range-bound between ¥14,200 and ¥23,900 from 1992 to 1995. Meanwhile, the balance of Japanese government bonds climbed, from approximately ¥166 trillion in 1990 to ¥225 trillion in 1995. In particular, outstanding issues ballooned over the several years after 1996. The balance of ordinary government bonds alone, excluding fiscal investment-and-loan bonds, reached approximately ¥367 trillion in 2000 and ¥526 trillion in 2005 (extract from published data of the Ministry of Finance [Note 1]).

For several years before 1990, the stock and bond markets in Japan underwent significant change. In the stock market, the Japan Securities Dealers Association (JSDA) introduced the "Regulations Concerning Foreign Securities Futures Transactions, etc" in 1988, following the listing of the Nikkei 225 Futures on the Singapore International Monetary Exchange (SIMEX) in 1986. This enabled Japanese securities firms to invest in futures listed on SIMEX. Also in 1988, the Tokyo Stock Price Index (TOPIX) Futures and the Nikkei 225 Futures were listed on the Tokyo Stock Exchange (TSE) and the Osaka Securities Exchange (OSE), respectively, while in 1989 the TOPIX Option was introduced to the TSE and the Nikkei 225 Option opened on the OSE (Note 2, Note 3). This creation of new futures and option markets has meant that arbitrage transactions, which generate profit using price differences between cash securities transactions and futures transactions, have been active on the TSE, OSE, and SIMEX since 1990. Accompanying this development, stock exchanges have been disclosing information on arbitrage transactions everyday since May 1991.

Like the stock market, the Japanese bond market has been introducing new schemes. In October 1985, the TSE opened the long-term Japanese government bond (JGB) futures market using the 10-year Japanese government bond as an intrinsic product. In July 1987, the same long-term JGB futures market was opened on the London International Financial Futures and Options Exchange (LIFFE). In July 1988, another JGB futures market involving the 20-year super long-term Japanese government bond opened (Note 4). In April 1989, bonds transactions with options, so-called bond OTC options, were lifted. This was made possible by defining this transaction as one of the forms of bond trading, rather than defining it within the scope of securities OTC options under the Securities and Exchange Law. With the establishment of the bond-borrow-loan market in May 1989, the structure of the Japanese bond market, equipped with cash, futures, options, and lending, was complete.

Back-office processing system: Existence of a wide variety of information systems

In the previous report, I identified the pre-dawn period before 1989 as an era when the major topic for the investment banking industry was "who handled large volumes of international financial transactions in what way." After 1990, investment banks increased cross-border financial transactions in various types of products. At the same time, segregation was established and implemented within their organizations, in which Japanese equities and bonds were handled by the Tokyo branch, while UK equities and bonds were handled by the London branch. This led to a need to conduct both back-office processing between branches, such as New York, London, Tokyo, and Hong Kong, and back-office processing in local markets, which in turn encouraged a rapid increase in the number of systems handling back-office processing at work sites.

Generally speaking, the back-office processing system of an investment bank consists of multiple modules in three layers. In the first layer lies a product master that manages attributes, such as the security names and security codes, units of face values, currencies, listed securities markets of stocks, fiscal year-end or mid-year date of companies issuing stocks, interest rates of bonds, and the method of calculating accrued interest, for financial products such as equities, bonds, and futures; a customer master that manages attributes of counterparties or customers of transactions, such as the names of customers and brokers, account numbers, addresses, occupations, and differences between residents and non-residents; and a module that prepares and records contract data by adding information such as trade date, settlement date, currencies, price, quantity, face values, brokerage fees, accrued interest, and the names of the markets related to individual financial transactions by retrieving data from the product master and the customer master.

The second layer includes a function that manages the position at an investment bank's own account based on the trade data of financial transactions prepared in the first layer and a module that handles the settlements of cash money and physical securities. The module to manage the position in the proprietary account identifies positions in various layers, such as the entire company, division, group, and trader, as well as the difference between the contract price at the time of conducting a financial transaction and the market price, and calculates the unrealized profit and loss by multiplying the position by the price difference. The cash remittance and securities settlement module conducts reconciliation of bank accounts, settlement of cash money and physical securities with the central bank, securities exchanges, a securities depository center, securities finance companies, customers, and brokers.

The third layer has a module that integrates data of cash and securities settlements in order to manages corporate actions that deal with the receipt and payment of interests and dividends, stock split, merger, and the change of corporate name; a module that conducts accounting in accordance with the Generally Accepted Accounting Principles (GAAP) of each country; and a module that prepares regulatory reports and legal documents that investment banks are obligated to submit by the ministry of finance, the central bank, securities or financial exchanges, and financial industry associations in each country. Regardless of whether the financial market is in New York, London, or Tokyo, the back-office processing system of an investment bank basically consists of these three layers.

In those days, multiple systems were operating under different system environments, including an online type directly connected to a host computer of an external organization, a global network type connecting overseas branches across borders, and an independent local area network (LAN) type that was introduced by individual branches. As a result, the system structure in most investment banks became a subject of derision, and was dubbed a "spaghetti" structure, instead of a makunouchibento (referring to a Japanese lunch box with rice and neatly organized side dishes) structure.

Struggling with entry barriers: Investment banks arrive in Japan then leave

As explained in the five force model theory (Note 5) developed by Harvard University professor Michael Porter, barriers to entry will always emerge. From the mid- to late-1980s, European and U.S. investment banks that acquired a securities business license in Japan by establishing a Tokyo branch began to apply and operate in the Japanese financial markets the transaction methods they had established in New York and London. In the Japanese bond market, it was already established practice for institutional investors to conduct transactions in ¥100 million units on a bilateral basis. Since this was done using almost the same architecture as that employed in the financial markets in Europe and the U.S., European and U.S. investment banks managed to expand their revenues in the Japanese bond market, thanks to the creation of a new market and the revision of rules relating to the futures, option, and borrow-loan transactions of the bonds described above.

In the meantime, as the Japanese stock market had yet to introduce the fee structure liberalization known as the Japanese-style Big Bang, old practices peculiar to Japan were still very much in evidence. These practices were alien to many European and U.S. investment banks, and they struggled to effectively manage their Japan operations. Some withdrew from the equities business in Japan only a few years after acquiring a securities business license. The major reason was higher-than-expected back-office processing costs, including system operation and development costs, which could not be justified by the earnings generated.

In conclusion, it can be said that the dawn of offshoring and outsourcing in investment banks, the main focus of this report, was the time when European and U.S. investment banks were troubled by the question of how to operate an investment banking business and generate profit in the Japanese stock market, where the architecture is different; a question they were motivated to answer by their awareness of the attractiveness of the Japanese financial markets based on the profitability they enjoyed in the bond market. The next section will look at the reasons why European and U.S. investment banks faced such high costs entering the Japanese financial markets from 1990 to 1995.

November 22, 2007
  1. "Debt Management Report 2006 – The Government Debt Management and the State of Puclic Debts: Changes in outstanding amount of government bonds," The Ministry of Finance (2006)
  2. "History of TOPIX Futures," Tokyo Stock Exchange (2007)
  3. "History," Osaka Securities Exchange (2007)
  4. "History of JGB Futures," Tokyo Stock Exchange (2007)
  5. "New Edition: Kyoso no senryaku (Competitive Strategy: Techniques for Analyzing Industries and Competitors)" DIAMOND, Inc., Michael E. Porter (1995), ISBN 978-4478371527

November 22, 2007

Article(s) by this author