The funds industry could realise huge savings, improve the client experience and boost its profits by mutualising back-office processes. Distributed ledger technology makes co-operation possible like never before, says Vince Lucey, Head of Product, Calastone.
There is a stereotype of the civil service sustained by the media in which corridors of functionaries push around pieces of paper. One person puts a stamp on a form and passes it to a colleague, who adds a second stamp, and then the papers travel to another department where several more functionaries apply several more stamps. The purpose of these activities is not often very clear.
This kind of hopeless, overmanned bureaucracy is, quite rightly, a source of amusement. But, if you work in the back office of a fund company, your laughter might be a little hollow. The fact is that fund distribution in Europe, rather like the fictional bureaucracy, is less efficient than it should be.
Repetition of manual tasks and the duplication of records, not to mention the need for constant reconciliations, combine to burden fund companies and, ultimately, the end investor with needless cost and complexity, which push down investment returns and weigh on corporate profitability.
A lack of commonality in the industry underlies most of these problems. Fund companies would benefit from collaboration but often lack the opportunity to talk to one another effectively. Without consensus on these matters, inefficiency is all too widespread.
The good news is that there is a solution to this malaise. If all of these processes were to be placed within a single environment, where all funds participants could easily and simply share information in a common infrastructure, there would be a solution to this lack of collaboration.
This full mutualisation of fund processes would allow industry participants to save money when sharing information, while removing the need for each participant to sustain their own, parallel operations. It is time to make Europe's fund industry work together for the common good.
Money to be saved
The amount of money the funds industry could save by process mutualisation is likely to be significant. An influential study by Deloitte, 'Europe's fund expenses at a crossroads', predicted that if mutual processes were employed across a range of back-office functions, then the annual processing cost of fund distribution in Luxembourg would fall by 70%.
The study estimated Luxembourg's annual costs to be about €1.3 billion, so a decline of this size would be a significant saving (the estimate was based on data supplied by transfer agents relating to 2014).
"Fund companies would benefit from collaboration but often lack the opportunity to talk to one another effectively."
The authors of the Deloitte report admitted that their forecasts for possible savings were “aggressive”. To realise the full 70% saving, mutualised, automated and streamlined processes would need to be implemented across all of the following functions: orders; cash processing; know-your-client and due diligence; data and document dissemination; errors and reconciliations; and transfers, corporate actions and dividends.
Such a transition might fairly be called a revolution in fund distribution and would require an unprecedented level of industry co-operation.
But the incentive is there. And, with the advent of distributed ledger technology (DLT), we have the tool to move forward. With DLT, fund companies have an unparalleled opportunity to mutualise many of their processes using technology that is secure, efficient and transparent.
What does DLT do exactly?
DLT is exciting because it promises to dramatically simplify the process of record-keeping on which fund administration ultimately relies. DLT employs cryptography to create tamper-proof digital ledgers that can be accessed by a range of authorised participants.
Any changes to a ledger are immediately reflected across the entirety of the blockchain, which means the permitted participants always have access to an accurate record, or in other words, to a single version of the truth, all within a shared environment.
The transformative potential of DLT has already been demonstrated by cryptocurrencies such as Bitcoin, which was the first digital currency to benefit from the robustness and security generated from a distributed infrastructure.
"An influential study by Deloitte, 'Europe's fund expenses at a crossroads', predicted that if mutual processes were employed across a range of back-office functions, then the annual processing cost of fund distribution in Luxembourg would fall by 70%."
Industries such as fund management are now beginning to take advantage of the commercial opportunities available. For regulated industries such as financial services, permission-based DLT networks can support critical KYC and AML obligations, while delivering the higher level of security and robustness required for mainstream financial organisations.
There are several ways in which DLT could help to achieve the cost savings forecast by Deloitte.
These include the reduction in re-keying and manual errors. Risk is minimised by the removal of the need for manual reconciliations and the mutualisation of core infrastructure, by utilising the benefits of a secure and robust shared ledger.
Errors and reconciliations accounted for a staggering €355 million of the €1.3 billion annual processing cost in Luxembourg, according to Deloitte, making this function the second most costly after fund orders. A blockchain-based infrastructure could do away with most of this wasted effort. Reconciliations are not required within this environment because the state of a transaction is instantly visible to all parties once they have unanimously agreed the validity of the transaction.
Indeed, DLT offers a range of benefits for participants in the blockchain, across fund managers, distributors or transfer agents. For the fund manager, the cost and efficiency savings would allow them to focus on the performance of their funds. For distributors, the technology could allow a decreased spend on administration and market access.
With a move to a more client-centric approach, placing more emphasis on stronger model portfolios, personalised solutions and greater accessibility. Transfer agents, meanwhile, have the chance to upgrade their service provision and offer a wider breadth of solutions to their fund manager clients.
There are many obvious benefits associated with mutualisation of the funds industry. There are challenges, though. One potential barrier is regulation.
Since the global financial crisis, fund companies have been grappling with a quantity of incoming regulation so daunting that it has frequently been described as a tsunami. Growing businesses and focusing on technological efficiency can be made more difficult when so much of organisations' resources are being spent on complying with new legislation and guidelines.
However, mutualisation projects need not be seen as competing for resources with regulatory needs. In fact, mutualisation can itself be part of the solution. DLT-based systems have the potential to make compliance operations far more efficient and therefore less costly. Mutualisation could actually reduce the cost of meeting regulatory burdens.
Another hurdle that is often mentioned is standardisation. Different fund managers have different ways of categorising items such as share classes. There is no doubt that coordinating a large and diverse industry is a complex affair, but again, the opportunity for mutualisation to reduce costs and increase efficiency is evident. DLT-based systems based on consensus are the antidote to business siloes and competing standards.
At Calastone, we are developing technology that will realise our vision of a friction-free funds world. Our recently launched Distributed Market Infrastructure is a blockchain-enabled market infrastructure that fully digitalises global distribution for mutual funds. This will enable investors and fund providers to migrate to an efficient and effective distribution market that will reduce total cost and open up significant new business opportunities.
We know that incompatible standards are a problem, so we have ensured that the DMI prioritises interoperability and a simplicity of migration. The system is designed to allow fund industry participants with a variety of different standards to connect with it. Because the industry cannot shift to common standards overnight, we need systems to bridge the gaps and allow the industry to realise the benefits of distributed ledgers while full standardisation remains elusive.
Other possibilities are revealed by the implementation of DLT and the DMI. Services that would not be economical in the traditional fund distribution environment such as micro-investing.
When customers invest very small sums in a fund, it would be practical in a blockchain-enabled network because the cost of each transaction would be significantly reduced, and manual intervention and errors are removed entirely. Innovations such as these could help the funds industry reach a larger, more diverse group of customers than before.
In summary, the potential benefits of mutualisation to the funds industry are evident. Blockchain-based services such as the DMI are the right tools to achieve this goal. By enabling the sharing processes and procedures, thereby allowing participants to interact more efficiently and at a lower cost, technology can declutter an inefficient environment and ensure the industry is fit for purpose in the years ahead.