Since our last blog on the issue of back office outsourcing by capital market firms, we have received quite a few questions and comments on the issue of outsourcing/ shared services in the capital markets. Here is a quick summary of the key themes that run across most of the queries we receive.
Drivers for adoption of Outsourcing
There are broadly three or four forces that are forcing capital market firms to outsource more:
Over capacity – till 2007-08 buoyed by favourable economic climate capital market firms had built up significant capacities (many divisions, larger teams, multiple platforms for several asset classes). Often capacity was built on an ad-hoc basis from a technology point of view without a holistic firm wide strategy. In the aftermath of the crisis profitability has been hurt and firms have taken recourse to short term measures like shutting down divisions and headcount reduction. Now it is time to take longer term approach to reduce costs on a longer term basis by focusing on core business and getting rid of non-core parts by outsourcing.
Weak volumes – due to the weak macro-economic climate trading volume has suffered drastically resulting in lower commission revenue for capital market firms. At a time when top line has been hurt and unlikely to recover quickly firms need to manage costs better to stay competitive.
Electronification of markets – Electronification in the areas of trading and execution in recent years and intense competition among providers of electronic trading tools have put further pressure on profitability as fee per trade is continuously declining.
Regulations – While firms grapple with the above challenges, they have also had to adhere to a plethora of regulations, which not only increase the cost of doing business, but also impact how, or if, they can carry out certain businesses.
Many of these regulations require firms to make changes in operations (e.g., reporting, compliance etc) under a shrinking technology budget. Outsourcing is being seen as a viable route to manage all these challenges. Since many firms in the ecosystem are having to adhere to same regulations and therefore make similar changes in their technology and processes there is a case for shared services to gain traction. Moreover, many firms are deciding to limit building in-house technology capabilities; rather than becoming technology behemoths they are deciding to focus on their core businesses. Sensing this opportunity some outsourcing service providers are considering developing a common platform that firms can use on a pay per use basis. Service providers are unlikely to do this all by themselves, rather they are partnering with product-platform providers to come up with a complete solution. While the ultimate goal is to develop an end to end shared platform, it is unlikely to happen in the short term. The instances that have emerged so far are more on provision of shared services for particular functions/modules (e.g., regulatory reporting, client on-boarding etc).
Outsourcing at the industry level
Target2-Securities (T2S) in Europe is a good example where the settlement of trades is being outsourced to a common platform developed and run by industry and the Eurosystem. Beyond that, most initiatives in this regard are being carried out by individual firms. Typically it takes the form of partnership – either between a financial institution and a technology vendor, or between technology service and platform providers. Any initiative at an industry level will be a long drawn process (T2S has been in development since 2006-07) and therefore in the short-medium term we are likely to see more partnership type of offerings.
Emerging areas in Outsourcing
Wealth management is definitely an area that has traditionally not been outsourced, but is being outsourced now.
Functions that are still unlikely to be Outsourced
For outsourcing, almost everything in the mid/back office can be, and is being, outsourced. This includes: order management, risk management, risk analytics, regulatory reporting, reconciliation, fund accounting, fund administration, corporate actions, clearing and settlement. However, extent of outsourcing in the front-office is less as that is sensitive to end clients and therefore firms want to maintain more control over those functions. Even then, we see functions like client on-boarding, certain aspects of customer relationship management (e.g., reporting, portfolio viewing, portfolio aggregation etc) are being outsourced. Research, marketing and product development are areas that have gained limited traction in outsourcing.
Shared services is still a nascent phenomenon and what can and cannot be outsourced to a shared platform still remains to be seen.
Furthermore, in the aftermath of the crisis, some financial institutions themselves are offering their proprietary technology and platforms to other firms. We have seen brokerages offering their electronic trading execution tools, technologies, and even white labelled algorithms to smaller firms that do not have the necessary resources to build it themselves. Many prime brokers are doing the same by offering their trading and clearing platforms to new start-up hedge funds. This offers the provider firms with fee income which is more stable and less volatile compared to trading commission.
Risks involved with Outsourcing
Outsourcing in capital market firms, particularly in mid and back office area, is not a new phenomenon and has been in place for well over a decade now. Over this period of time, firms – both financial institutions and their service providers – have developed set of best practices that alleviate concerns about risks on outsourcing. Regulators have also come up with broad guidelines to address management of risk for outsourced functions and accountability issues.
Outsourcing in wealth management is a recent phenomenon. Because of privacy and confidentiality issues involved in the wealth management business, wealth managers have traditionally been reluctant to outsource. The situation is changing now and some have started outsourcing their mid-back office functions. Safeguarding client confidentiality and potential for reputational damage due to lack thereof are perceived as areas of concern.
As discussed above, regulators are not particularly concerned about outsourcing at the moment as they have already addressed them over a period of time and also because they are having to deal with several other issues (e.g., market reforms, oversight etc). Outsourcing is not a top priority at the moment. Shared service is an emerging area and has not gained sufficient traction in the market to come under regulators’ purview. Therefore some concrete guideline is unlikely to come by in the near term.