Model delivery communications and standards; or, Déjà vu all over again

This issue’s Nuts & Bolts column is a departure from our usual tutorial format. In keeping with this newsletter’s focus on model delivery, we discuss the landscape and conditions under which the managed account industry is working to develop best practices and communication standards for sharing portfolio models among model providers and recipients. Given the transition of assets from traditional SMA to models-only platforms, and the increased operational risk in communicating model instructions being discussed by industry participants, we believe this topic is timely, particularly because the road to standardization may be longer than many participants anticipate, and firms will need to adjust expectations and strategies accordingly.

Where we’ve been

The managed account industry’s first experience with creating standards for participant communication involved new account opening and lifecycle maintenance (distributions, tax harvests, restriction changes, terminations and the like). This initiative sprang from the recommendations of a study by Deloitte, commissioned by the trade organization The Money Management Institute (MMI) in 2002.

There were two major challenges in developing a standard protocol for managed account origination and maintenance. First, although a large committee convened by the MMI and composed of subject matter experts from many participant firms worked diligently on the development of a standardized communication protocol through which sponsors could communicate account-level instructions to managers, few if any firms had systems in place that would be able to process the standard messages that were specified. The result was a set of standards that were developed without knowledge as to how they would be handled by automated systems. Firms therefore found it difficult to estimate the cost of adopting the standards, and even more difficult to quantify the ROI (notwithstanding efforts by some, including this author, to make the case publicly). After initial enthusiasm among participants, without implementation projects to create a sense of urgency and bring focus to the committee’s efforts, work on the standards slowed.

The second challenge arose as committee members, and industry participants outside the committee, debated as to whether the purpose of the MMI effort was to create an open industry standard, or to launch an industry utility. The MMI Board of Governors ultimately decided the question by commissioning a second study (this time by Accenture), which in 2006 recommended the MMI focus on developing standard protocols, to be made freely available to all participants.

The decision by the Board resulted in the creation of a formal charter for the committee, including a defined process for review and approval of industry standards. However, by the time the first release of protocol standards was approved by the Board in 2009, the financial crisis hit bottom, and models-only programs were seen as likely to replace traditional SMA programs. As assets in traditional programs shrank, so did interest in communication standards that targeted traditional operations.

Defining and redefining the role of applications, communication standards and hubs

Historically, the development of communication protocols has been driven by the opportunity for applications that provide business functionality to deliver greater value through integration with other systems further down the supply chain. A prominent example in the financial services industry is the FIX protocol, which began in 1992 as a way to link order management systems of equity trading desks at Fidelity and Salomon Brothers. From there, use expanded to other broker-dealers. By the late 1990s, value-added networks (or hubs) such as TNS, Autex, FIXNet and Radianz were helping to link buy side and sell side firms, execution venues, and exchanges.

By basing FIX on the requirements of existing order management systems, integrating the protocol entailed only limited changes to application functionality (and hence, low cost and favorable ROI). In the same way, after the use of FIX in point-to-point communications was well established, the value proposition of centralized networks connecting protocol users was readily understood and accepted.

There is a not-so-subtle point that is also important to mention: the very existence of automated order management systems meant that the problem of buying and selling equities was already well understood and documented years before FIX was developed. The parameters of an equity order, as well as the expected responses from a liquidity provider, had been generally agreed among all participants for decades. In fact, order routing networks using the earlier CMS protocol had been in use since the late 1970s. All of these factors formed a body of knowledge that helped speed the process, as well as reduce implementation cost and risk.

The current state of the managed account industry is very different. The "business contract" of a model change instruction from provider to recipient—what information is sent and what information is received in response—is far from universal among industry participants. Solutions to manage the process of proposing and approving model changes, and controlling their release to distribution partners, are only now beginning to appear.

Developing business applications most often originates with the automation of existing business practices. Through an understanding of business processes, application processing logic is developed. Functional gaps are typically discovered and resolved in preproduction testing. Therefore, communication standards that define only events and data structure without being exposed to application logic are largely untested, often incomplete, difficult to evaluate in terms of cost savings and may enounter resistance with respect to industry-wide acceptance. Because they are dependent on standards, networks and hubs are often the last evolutionary stage of an industry-wide communications solution.

Managing industry-wide adoption of model communications standards

Even if it were feasible to develop communication standards in advance of applications, it’s unlikely that centralizing the implementation of those standards in a single network or hub would be desirable. The requirement of having all participants integrate with a single communication hub would potentially create a bottleneck in terms of resource availability for development and testing. The time required for general industry acceptance could be extended even longer due to the need to incorporate into the communication hub new business requirements from the universe of adopting firms. Again, in a centralized model, the queue for such development would be experienced by all participants.

Alternatively, when participants integrate with each other directly in a distributed paradigm, the pace of development and innovation is driven by business need of the parties. With more participants involved in the integration of linking to each other, the industry knowledge base necessary for the development of standards can only grow more quickly. Approaches that are proprietary will give way over time to those based on agreed upon standards. Standards that emerge from the integration experience of many participants’ projects can in turn be expected to be more robust than a protocol defined for any single network.

The path forward

Former Yankees great and Hall of Famer Yogi Berra might characterize discussions among operations professionals about challenges in supporting models-only programs as “déjà vu all over again.” With its enormous variations in communication channels and business rules among participants, the current state of model delivery operations bears great resemblance to the traditional SMA operations they are intended to replace. It is only natural that industry practitioners long for a solution in the form of a common utility connecting all participant firms. In fact, this is the same thought process that initiated the first industry standards effort around account servicing, where in hindsight, progress was slower than most participants expected.

Communication standards and hubs should form an important part of the industry infrastructure connecting model providers and model recipients in the future. However, experience in other segments of financial services indicates that hubs and networks will gain traction only after the communication of portfolio models and updates has reached a mature state, both in terms of industry agreement on the business contract for model delivery and of available processing solutions.

We have seen that the development of a standard communication protocol can be a time-consuming process, where competing functional requirements and even business interests must be resolved among participants. This is not to say that the managed accounts industry should abandon the goal of developing open standards for participant communications. It simply means that firms should not view such standards as a precondition to implementing cost-saving and risk-reducing solutions now.

In fact, managed account firms may be better served to focus on documenting their business requirements for model maintenance, review, release and implementation. There will continue to be an important role for industry trade organizations as forums for sharing the knowledge gained from these activities and for collaborative work to define best practices and business-level standards while looking for opportunities similar to the one Fidelity and Salomon found years ago to link internal applications. Not only will firms who begin partnering with solution providers with offerings supporting these processes will benefit from cost savings and risk reduction, development of industry-wide standards will happen with greater confidence when there are "success stories" that validate process flows among participants with automated solutions.

The path to industry-wide adoption of a FIX-like standard for model communications will likely be longer than the industry would prefer, but the rapid growth of assets on models platforms argues against firms waiting for unlikely "silver bullets" to appear. A distributed approach among participants linking to each other for model delivery will not only spread out development risk and reduce implementation bottlenecks, but will also be more likely to result in the body of knowledge necessary to drive the industry forward.