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November 1, 2002

Connectivity Cost Control

By Nick Davidge

Today's Wall Street technology woes may remind you of the 1960s backoffice crisis. This latest problem results from the need to contain costs while demand for electronic processing services snowballs.

Forget the expected $7 billion price tag for T+1. The industry faces unprecedented demands from customers and regulators to ramp up service levels. Much of it falls under the general category of connectivity.

That's the real-time integration of diverse computer systems effected by implementing messaging strategies. But the combination of huge IT spending in the late 1990s, combined with a bear market, mean the industry is tapped out at the worst possible time.

IT Salaries

In fact, in retrospect, it is hard to account for even modest results from the spending spree. I can think of several major initiatives with price tags in excess of $100 million at major brokerage firms that today are unable to sustain business cases for even the cost of the maintenance. After he went on to found an Enterprise Application Integration (EAI) company, one former CIO remarked cynically to me that his greatest accomplishment had been to pay the largest IT salaries ever seen!

In those heady days the world did appear to believe that, with sufficient investment in technology infrastructure centered around J2EE application servers and message busses, all subsequent business demands would be met. But since they took away the proverbial punch bowl, business managers have largely turned out the lights and we are back to the same legacy: a batch application environment that is as resistant to change as ever.

Consolidation on the vendor side has created such financial pressures on maintaining profits in a declining revenue environment. Every time an online discounter lays off 10 percent of its labor force or merges, that's 10 percent fewer market data terminals. There is simply no willingness to spend on anything other than regulatory mandates. Some hitherto significant profit sources, such as principal trading or market making, have effectively disappeared. The latter as a result of decimalization.

As is typical of a declining revenue marketplace in this case in the area of transaction volume the customer pressure and competition on prices are extreme. I used to think brokers who outsourced backoffice processing at $2-$5 per ticket were the lucky ones. They were able to align costs with revenues. That is, until I realized that certain clearing firms with great control over their technology costs were able to offer clearance at under 30 cents per ticket on volume. This is similar to Rockefeller showing his competitors that his selling price was lower than their production cost.

The inevitable impact will be a massive consolidation of transaction processing capabilities. This will probably come as a desperation attempt to collectivize via industry utilities such as the DTCC. First, though, I suspect we are in for several more years of the vicious cycle of downsizing and price-cutting.

In this environment, there are strategies for success. Consolidation a la Standard Oil and nimble operators like a Getty. The consolidation is well under way in certain segments like global custody, where I doubt there will be more than five viable players by 2004. For retail and clearing we are early in the cycle. There is still a great deal of excess capacity that will fuel the cycle of price competition and cost cutting.

The scale players expect to gain advantage by being able to amortize the costs over larger transaction volumes while the smaller players will turn to outsourcers. The difficulty is that the service providers are largely unable to cut costs and will probably end up killing their hosts. That's the ultimate Darwinian failure. On the scale side it turns into a staring match over who sells and who loses money to stay in the game. One thing that is certain is that the days of massive architecture driven infrastructure build out are over.

Hail the return of business control to IT spending!

Nick Davidge is the founder and CEO of Davidge Data Systems, a wholly-owned subsidiary of S1 Corp.