Outsourcing in Capital Markets

Outsourcing in Capital Markets
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. Regulators’ attitude 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.

Back Office Outsourcing by Buy Side Firms

Back Office Outsourcing by Buy Side Firms
In the last few years buy side firms have had to make lot of changes in their mid and back offices. There are primarily two drivers that have forced firms to make these changes. Leading up to 2007, the economic climate was favorable, and profits were rising, which meant technology budgets were also on the rise. Many firms made technology investments on an ad-hoc, or as per need, basis. Since the front office trading departments are primary revenue generators in trading firms, the technology decisions were largely determined by front office staff based on their immediate needs for certain asset class or execution methods. The mid and back office activities were largely ignored and continued to be run by legacy systems. The crisis of 2008 changed firms’ priorities dramatically. Revenues dwindled and margins were hit. In tumultuous economic climate managing costs became an utmost priority. While downsizing enabled cost cutting in the short run, firms had to consider long term cost savings opportunities by improving operational efficiency and making strategic technology decisions. Against this backdrop the mid-back office was ripe for attention. Many institutions still use legacy systems. Most of them are based on simple excels, offline communication, and handled manually without much automation. There is little integration in the mid-back office of the disparate platforms used in the front office. These create huge operational inefficiencies, and if not addressed adequately, can diminish or even nullify the efficiency gains achieved in the execution of trades. In the aftermath of the financial crisis, the regulatory environment has undergone rapid changes and is still evolving. This has created additional obligations for mid-back office processes in the areas of risk management, reporting and regulatory compliance. It has become essential that firms address the complete trade cycle in a much more holistic way, and are on top of their processes almost on a real time basis to be able to adequately address regulatory and business needs. These two drivers are often conflicting with each other. In the short term, firms have to prioritize technology investments to address regulatory and compliance related issues. Large numbers of impending regulations and a finite technology budget have meant most of the spending is being made to meet regulatory issues, which leaves little room to invest in projects on efficiency and process improvement. Some firms have mentioned to us as much as 60% to 80% of their change management budget is being spent on regulatory and compliance related issues. In this backdrop, outsourcing of mid-back office processes by buy-side institutions is becoming popular. Since almost all of them have to make same, or similar, arrangements to adhere to regulators’ demands, there is good potential for the development of shared utility services whereby firms can outsource some or all of their back office functions to a third party service provider. While the trend of outsourcing in back office function is not new to the industry, this practice is gaining greater traction as buy-side firms realize the complexities of reconciling higher volumes of more complex trades – this is increasing the strain on staff and IT. At the same time, service providers have improved their capabilities and now offer a wide variety of choice for their buy-side clients. Custodian banks are seeing a surge of interest in their outsourcing services from buy-side firms. Increasingly custodians are finding that clients are asking for solutions specifically to deal with the new derivatives regulations. The concentration of flow driven by outsourcing is likely to accelerate within derivatives operations. However, we expect the trend will eventually affect cash securities operations as buy-side look to rationalize their back office functions. Through outsourcing services, investment manager will move fixed cost into variable ones and decrease the complexity of their back office operations. This evolution will be particularly acute in derivatives operations due to the complexity of dealing with the new regulatory regime, DFA and EMIR. Prime brokers will be able to leverage their back office capabilities to insource additional flow, especially around derivatives operations. While there are similarities in the mid-back office functions and processes at global institutions, large banks also need significant customization to manage firm specific needs. The challenge in developing a utility based service model is to design a common platform that will still have room for addressing custom needs. Many providers are considering of coming up with such an offering. There is a race to accomplish this at the earliest as they understand that the first one to offer it would have a big advantage over others.

Outsourcing in Wealth Management: A Growing Trend

Outsourcing in Wealth Management: A Growing Trend
Outsourcing has been in use in the financial services industry for quite some time, at least for a couple of decades. However, wealth management firms have lagged the financial services industry in adopting outsourcing, primarily due to issues relating to privacy, data security, and loss of control. Many of them did not invest in technology from a strategic point of view for a long time, instead taking a siloed approach depending on specific business needs. The global financial crisis has contributed to a major paradigm shift in this regard. The crisis has significantly impacted both revenue and costs. Lacklustre market conditions have prevented them from generating superior returns impacting top line; this has been exacerbated by loss of clients, who, driven by disappointing returns and loss of trust, have looked away from their advisors or looked to diversify wealth management relationships. At the same time increasing regulatory pressures and newer regulations have compelled wealth managers to grapple with newer challenges in terms of control, compliance, risk management and streamlining operations. In this evolving environment wealth managers have slowly started to wake up and embrace technology and operations outsourcing as one of the solutions to meet the challenges. Cost cutting remains the primary driver behind adoption of outsourcing, which typically can save 20% to 30% of costs over a 3 to 5 year period. Secondly, outsourcing also offers easy scalability options; this is more relevant now as firms are either cutting down or closing operations in certain markets, while looking to expand in others – all in a short period of time. Time to market has therefore become critical. Data management, especially in large organizations offering multiple services, is another aspect that firms are looking to outsource. Along with benefits, there are a number of areas for concern with outsourcing. The most important of them is loss of control and security, both of great importance to wealth managers. Data privacy and data hosting constraints continue to be key concerns; violations in this area can be harmful for wealth managers’ brand image, which somewhat limits the universe of functionalities that wealth managers are comfortable to outsource. Another concern is around fiduciary responsibility and compliance and operational risk. Since the firm is responsible for regulatory compliance for all operations, including the ones outsourced, there is an increased need for easily accessing data and information for enhanced control and client and enterprise reporting. Firms will need to demonstrate their ability to provide the information requested by both clients and the regulatory authorities on-demand and in formats for consumption tailored to the individual’s preferences. Over time the industry has evolved a set of norms to overcome the concerns related to outsourcing. Extent of outsourcing adoption varies by region, the US being far ahead of Europe, while Asia lags the other two regions by some distance. Adoption also depends on the size and nature of wealth management firms. While Tier I and Tier II retail banks, insurance companies and brokerages have outsourced significantly, adoption of outsourcing remains moderate in smaller sized firms, especially in trust companies and family offices. In terms of functionalities, the further a wealth management function is from a client “touch point,” the more likely it is to be outsourced. Therefore, mid and back office functionalities are more likely to be outsourced. Outsourcing in the areas of global custody, securities lending, client servicing, and accounting and settlement of trades in is relatively widespread. Front office functionalities have been outsourced less; while some firms are slowly outsourcing their client on boarding or financial planning functions, outsourcing in the areas of product development, marketing, and fraud management is still limited. Outsourcing in the wealth management industry is likely to see further adoption in the near future. This will be mainly driven by firms in the US and Europe. Outsourcing practices in wealth management is still not as mature as those in other parts of the financial services industry and wealth management firms are starting to realize its benefits. In addition, existing market conditions as well as external factors like regulation will drive the growth in outsourcing business. IT budgets are expected to remain flat or decline in most markets. This will restrict firms’ ability to spend on technology. However, this also means firms will now have to do more with less and channel investments efficiently. Outsourcing provides one option for increasing efficiency without needing significant investments in infrastructure. Tier II and tier III firms will embrace outsourcing following the lead of tier I firms. While IT outsourcing has been the dominant part of outsourcing practices till now, process outsourcing is likely to gain more traction in future.