 Tony Freeman
Director of Industry Relations, EMEA
There are very few firms in the financial services sector for whom outsourcing is not on the agenda. More recently, the investment management sector which has traditionally seen specific back office functions lifted, removed and in-sourced to third parties has borne witness to a swathe of deals where custodians have begun inching ever deeper into asset management. Most attribute this trend to the last few years and some significant developments, namely; Scottish Widows outsourcing to State Street or Schroders outsourcing to JPMorgan for example. Where custody originally provided just the essential securities services to an investment manager, it has now sprung further ahead and now encompasses the entire asset management back office.
Today, such deals commonly include many of the traditional middle office functions; asset servicing, client reporting, fund accounting position keeping and performance measurement. Therefore, where does the trend towards outsourcing end, or has it really just begun? Some would say it is just the beginning and performance measurement is a good example why this is the case.
Global custody providers could be heard last year stating performance measurement was appearing more frequently in requests for proposals. This proved to be the case as it became clear that investment managers� own internal performance to risk studies were identifying individual centers where costs and efficiencies could be improved. Investment managers indicated that by outsourcing performance measurement and other related functions the investment manager could ideally focus on his core responsibility and allocate tasks such as data management to a service provider. This is even more significant if one considers that performance measurement is traditionally seen as one of the more complex functions within IM operations. Although this is a very quantitative task, it is ultimately skilled, dependent on the skills of individuals who will actually calculate, reconcile and report on performance. They need the FTSE and MSCI index construction information which may not be needed for the more simplistic tasks they have traditionally undertaken.
Hedge funds are another example; an increasingly mature market with more middle aged hedge fund managers looking to upgrade obsolete systems or outsource various functions. As the hedge fund market enters its second generation of existence then systems and operational support must develop beyond the start-up infrastructure so common with this market. In addition, recent trends indicate more traditional long only investment managers are taking on alternative investments only to discover a wide operational and support gap between running traditional and alternative products along side each other; in-effect, an immediate need for a combined prime brokerage and custodial offering.
Both these examples suggest that the overriding theme in procuring third party support and outsourcing of specific functions is for two primary reasons.
Firstly, to maintain operational and cost effective infrastructures that support the firms competitiveness, particularly given increasing requirements around compliance and regulation. Another point here of course is transparency and the example regarding outsourcing performance measurement serves this well. Recent market turmoil has pervaded a vision and regulatory environment that necessitates greater transparency. As a result, there�s been a surge in demand for such services as the subject of increasing client and regulatory scrutiny hits investment managers. Third party service providers stand to do well should they provide a superior service.
The second point, and perhaps more importantly for some, is that such deals create an environment and structure whereby resources concentrate on what the investment manager does best; investment management itself, growing the business strategically and focusing on the core business.
To industry observers Mellon is one of a number of examples of this recent cross-over by outsource suppliers into the front office. Through lifting out the entire back and middle office functions of institutional fund manager TIA last year, the deal reportedly enabled a greater number of strategies to be developed over one quarter as the fund manager could apply a singular focus on managing clients� assets. However, as a caveat to this trend, it should also be noted that large-scale asset managers will often consider entire control of their own infrastructure a source of competitive advantage. Therefore, there are limits. Outsourcing will not appeal to all.
Arguably, markets are still emerging from the events of recent years and are yet to achieve a desired level of equilibrium. In recent times, the drive to access third party scale has been the need to reduce costs, as per economic conditions. However, in tandem with gradual market recovery, this market driver is switching from one of costs to one of mitigating operational risk. Evidence in the market suggests strong opportunities ahead for the wider lift-out model by custody providers. However, as the point above regarding large-scale asset managers notes, limits exist. The drive to outsource specific middle and front office functions stands to gain more ground, as evidenced by the growth in outsourcing performance measurement and the changing drivers to mitigate operational risk. This component-based approach can deliver very specific benefits and looks to be where the immediate future of outsourcing will procure significant gains.
Regulatory pressures of course come into play and Basel II, whereby banks must hold capital against operational risk, will affect many outsourcing mandates. There are lots of different areas and �sweet spots� where a component-based approach delivers greater value and the level of complexity involved is in itself indicative of the growth opportunities for outsourcing. All deals will require systems to unlock this value between a component approach and reduction of risk. Here, technology will be the key and moving to a straight-through-processing environment which reduces error handling and improves exception processing will maximize operational performance. The future of outsourcing is safe. In many regards it is in fact just beginning. Its future will correspond with that of technology and greater integration, but overwhelmingly it will develop in complexity, satisfying various sub-sectors and a sophisticated investment management community.
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