 Lee Cutrone
Managing Director, Industry Relations
To many people, outsourcing conjures up the image of high-wage domestic jobs lost to lower-wage countries offshore. In fact, terms such as “outsourcing” and “offshoring” are often used interchangeably in many circles. But to banks with large global custody businesses, outsourcing means something else entirely: providing services to large asset management clients that typically revolve around trade processing and settlement. Aside from keeping jobs onshore, this flavor of outsourcing has the benefit of allowing banks to earn predictable, fee-based income streams to hedge against riskier banking activities that depend on capturing net interest margin. It also allows investment managers to focus their resources on servicing their clients on the front-end rather than the back-office.
But while custodian bank outsourcing is a growth area, competition for new business is fierce, and margins have already been squeezed to help banks expand their client base by offering low prices over competitors. Indeed, custodians may be trying to compete on the basis of cost when it may not be the deciding factor for an investment manager. In so doing, these outsourcing providers might be putting unnecessary margin pressure on their business models in order to win new clients.
Even more worrisome is that outsourcing providers and their investment manager clients appear to disagree on the value for price of those outsourcing services and on what matters most to outsourcing clients. If outsourcing is to achieve long-term viability, banks need to address issues surrounding the business model of their outsourcing services to ensure alignment with client needs.Such are the findings of a recent survey of investment managers and global custodians conducted on behalf of Omgeo.
The Cost of Miscommunication
There is currently significant disconnect between global custodians and fund managers, according to the survey findings.For instance, 44 percent of fund managers say they choose providers based on flexibility—banks’ ability to accommodate the manager’s systems and behaviors. 39 percent of the same look for banks’ specialization in securities services. More often than not, investment managers seem to want to leverage their existing infrastructures rather than alter their systems to fit within outsourcers’ solutions. What’s more, investment managers expect their outsourcers to have strong knowledge of the space in which they operate to help mitigate headaches that might arise when handing the reins over to another entity.
However, custodians erroneously believe that investment managers are mainly interested in cost. While cost is certainly a topic of consideration, clearly, investment managers are more concerned that they can relinquish the responsibility of clearing and settlement and know that the tasks fall into knowledgeable, capable hands. Moreover, despite the aggressive pricing by banks to attract this business, some 33 percent of the investment managers surveyed still believe the value for price of outsourcing services is unattractive. Less surprisingly, only eight percent of banks felt the same way. Banks can be forgiven, though, for mistakenly assuming cost drives the decision-making process, because at the end of the day, if it isn’t cost-efficient for an investment manager to outsource, they are likely to forgo the process to save money.
Investment managers’ interest in flexibility does pose a threat to the profitability of the outsourcing services provider business model, as it prevents custodians from achieving economies of scale by absorbing additional processing into existing systems. These issues—investment managers’ dissatisfaction with banks’ pricing and value model and pressure on costs—could well mean a shakeout in the outsourcing business among participating bank outsourcers and, ultimately, higher prices for investment managers, who may be forced to suffer through another transition process to their new outsourcer, who is less likely to offer their services on terms similar to their predecessor outsourcer bank. The discrepancy in perception between client needs and values must be eliminated if outsourcing is to sustain itself as a viable business model.
What Investment Managers Want
Although this form of outsourcing may be poised for some dramatic changes, for the reasons noted above, make no mistake that investment management outsourcing is here to stay. This is due largely to the fact that fund managers continue to see the benefits of allowing an external source to manage their trade processing and settlement so they can stay focused on servicing their own clients. Our survey found that in addition to traditionally outsourced tasks, fund managers are interested in outsourcing an array of other functions.
Nearly two-thirds of fund managers polled would consider outsourcing standing settlement instruction database management, followed by 59 percent who would be interested in sending trade confirmations to a third-party vendor. More than half would consider outsourcing transition management; 47 percent would outsource performance measurement and attribution, and 44 percent are interested in outsourcing both reconciliations and fails management.
However, though investment managers are willing to outsource multiple functions, the survey found that custodians may well be over-providing in some other areas. Investment managers most often leverage custody, transfer agency, fund accounting and proxy voting services through outsourcing, but the large majority said that they would never consider outsourcing allocations and regulatory compliance—two services that most custodians consistently offer.
Also apparent is the problem of relationship. It isn’t news that investment managers look to outsourcers to save on technology costs and that they also want to free up resources to focus on investment performance. What is surprising is the level of apprehension involved in sharing or relinquishing the responsibility. 55 percent of those surveyed said that they lack confidence in provider capabilities and are concerned about losing control of business processes.
This lack of understanding adversely affects relationship. While 83 percent of custodian banks see their investment management clients as valuable partners, only 40 percent of the managers share this view. The other 60 percent see their providers as nothing more than “typical vendors.” That doesn’t mean the investment managers don’t want to evolve the relationship beyond vendor/client status – clearly, a partnership model is likely to benefit both sides of the arrangement. The findings merely indicate there is still much road to be paved.
If banks want to keep relationships long term, they must align themselves more closely with their clients’ business drivers. Clearly, bank outsourcing services providers have their work cut out for them. Outsourcing is not a panacea, and the business model may in fact go through some significant change before it settles as a consistently viable alternative for investment managers.
There is little doubt, however, that it is worth the effort. Outsourcing is advantageous for the industry. It promotes efficiency and encourages the use of standards, which help encourage a more streamlined marketplace. Custodians and their clients must agree on goals and areas of focus in order to avoid a shakeout and to foster relationships that meet everyone’s needs for the long term.
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