Motivations behind Outsourcing in Wealth Management

This year Celent surveyed technology providers that service wealth management firms. The goal of the survey was to learn the motivations and strategies of wealth management firms that outsource components of their business to third party vendors.  The last time we did this survey was five years ago.

From the survey, we learned that one of the main drivers of outsourcing today is so wealth managers can experiment with the latest technology before committing vast resources to a technology that may only be a fad.  Similarly, wealth management firms are eager to outsource because it allows them to scale up or down their operation, or enter new regions, quickly and efficiently.  Wealth managers prefer to work with a technology provider to test ideas, tools and regions, before building a permanent team and spending on fixed costs.

Several motivations to outsource have become more important today than they were five years ago. These motivations include: to improve efficiency, to enrich the customer experience, and to respond to regulation.  Over the last five years, across the world we have seen a push for more stringent regulation.  Therefore, it is not surprising that regulation is top of mind for most wealth managers.

As products and services are increasingly commoditized, it is important for wealth managers to distinguish themselves via the customer experience. It is likely that over the next 12 to 18 months, wealth managers will spend relatively more time on outsourcing front office operations. For example, firms may look to vendors for improvements in: the onboarding experience, components of the advice and planning process, and help desk services.

For more information on the global outsourcing landscape in wealth management, please see my report, Outsourcing in Wealth Management: The Drivers and Strategies.

Utility-Managed Services in Capital Market

Need to cut cost to boost sub-optimal levels of RoE is becoming essential for capital market firms in the backdrop of tepid revenue growth and increasing compliance burden. Firms have tried short term measures to cut cost, but should now consider long term strategic review of business and operations.

Moving beyond traditional outsourcing arrangements, mutualization of costs at a group or industry level through adoption of shared service and industry utilities would enable long term cost reduction.

Celent has been tracking the utility landscape for the last two years starting initially its coverage of the utility solutions in the Know Your Customer space, as that area saw a number of solutions emerge in a quick period of time. However, the industry has seen development and launch of newer solutions under the managed service/utility model that span across the value chain of capital market ecosystem – such as post-trade operations, reference data management, collateral management, regulatory reporting etc.

The utilities in capital markets are a new phenomenon with the potential to significantly transform how operations are carried out at financial institutions. Understandably, this has created a lot of interest and curiosity among several participants as they look to redesign their operations and solutions around the utilities to adapt to the changing situation. Uptake of the utility and shared services will be driven by a growing realization of value and can take a while.

Many large banks have already realized the valuable proposition that a utility can bring and have therefore taken an active role in adopting, and even in the development of, some of the utility solutions. Such large institutions are best suited for utility adoption in the near term. Some of the utility providers are large industry players with significant industry penetration in their respective markets; they can hand hold and provide a level of comfort to clients who are now considering adopting utility solutions. This would pave the way for next wave of adoption of the utility model and will likely take place over the short-to-medium term. As the firms in the above two categories adopt utility solutions in the short-to-medium term and demonstrate successful use cases, others who are currently on the wait and watch mode are likely to adopt this new model in the medium-to-long term.

A recent Celent analyzes salient features of the emerging utility-managed service in capital markets including detailed discussion on thirteen such solutions; the report is available for download here.

Operations challenges for APAC asset managers

The global capital markets have been going through a turbulent recovery phase in the last few years. Asia-Pacific is no exception to this rule and the region’s asset managers will come up against a set of operational issues and constraints to be addressed in a difficult market environment. Addressing regulatory pressures, be they from within their own jurisdiction, or from without, will be paramount in the mind of asset managers. It is important for managers to consider the various KYC and AML requirements internationally and how they affect their respective jurisdictions. This is not an isolated enterprise, and must be undertaken along with the task of upgrading the operational capabilities, and if required, acquiring the necessary platforms or systems to address these concerns. As much as possible, asset managers must try and use a comprehensive solution, underlining a desirable holistic approach to the issue. Most asset managers will meet their various operational requirements by using a mix of in-house and third party services. Outsourcing is nothing new to the industry, but can still be challenging. It has its own set of risks which need to be considered and mitigated for successful operations. Firms have to ensure a strong integration of the outsourced services with the in-house operations. Another challenge is the complexity of products being utilized by asset managers to meet their clients’ needs. With more choices available and structured products becoming popular again in leading Asian jurisdictions, firms have to ensure that their risk management systems are capable of handling greater product complexity. These are only some of the issues asset managers need to keep in mind, and overall they would be well served with taking a more holistic approach to operations management, and ensuring they make sufficient investment in their systems to help them handle the various challenges.

Emerging Trends in the Post Trade Industry

We identified a number of drivers that will have significant impact on the post-trade industry going forward. While some of them act in opposite direction, some reinforce others’ impact. Based on our analysis for each of the several drivers, and interaction with several market participants, we see the following trends emerging in the post-trade business:
  • Regulatory and market pressures will force investment managers to reassess their business models. Limited revenue growth opportunities have meant they are now focusing on optimizing cost and improving efficiencies to remain competitive.
  • There is a move toward automation of processes, upgradation or replacement of legacy systems in the mid-back office, and integration of disparate systems to obtain a more holistic approach.
  • Firms are working under severe budget constraints. A large portion of the technology budget is being spent on addressing regulatory and compliance issues, often in a reactive way. Thus significant investments to achieve true process efficiency and improvement are difficult to come by in the short run. However, automation of large number of manual processes frees up resources, and some firms are looking at the problem from this perspective.
  • Budget constraints are pushing them toward considering outsourcing mid-back office operations. Given that all firms have to adhere to a same set of regulatory requirements, some vendors are considering coming up with a utility model of offering that will allow multiple firms to use a basic core platform to address many of these issues. However, customizing such an offering to suit firm specific needs, especially for large financial institutions, will be a challenge.
  • Growth of alternative trading venues is presenting new opportunities to broker-dealers. They can now internalize trades carried out between two counterparties both of whom are their clients. Institutions with large client base are best suited to take advantage of this. The number of institutions in this market is not large and going further down; therefore share of internalized trades will increase in future.
  • Regulators are trying to achieve harmonization across markets by planning to come up with common legal and tax norms. This trend is particularly visible in Europe. The success of such initiatives depends on political actors and is difficult to predict. They can potentially encourage more cross border trading which should contribute to the growth of settlement volumes.
  • There is also a move toward achieving shorter settlement cycle. While participants in most markets are either operating in, or getting ready for, a T+2 environment, plans to move to T+1 model will have major impact across the board. That is unlikely to happen in the near term.
  • Growth in volumes can be potentially offset by other developments, such as interoperability of CCPs, which can increase netting of trades and therefore suppress settlement volumes. This would be further aggravated by consolidation among market infrastructure providers.
  • Regulators are also promoting competition among market infrastructure providers, particularly among CSDs. Many of them will have to change their business models to stay alive in the market. They will be forced to compete more directly with sub custodians in the asset servicing business. Achieving scale will be important to stay alive in the business and smaller players will be driven out or get acquired.

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

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.

Equities trading in focus: radical cost restructuring is on the agenda

While our capital markets group has been focusing on derivatives and fixed income of late, due to regulatory and technology drivers, the businesses supporting equities markets continue to go through their own wrenching changes. With the equities business having persistently low revenue growth, stubbornly high costs, and capacity challenges, a new wave of thinking is required to get the business out of the mire. Until business improves, managers are no longer tolerant of high IT and operational costs. As a result, we have identified innovative strategies to reduce costs in the equities franchise for front office IT and operations. These strategies conveniently fit with how environmentalists approach their own questions of efficiency with resources, through the concepts of reduce, reuse, and recycle. Hey, it’s a slogan. Another slogan- We believe brokerage firms must think the unthinkable with respect to reducing costs through outsourcing. Some may consider this surprising since outsourcing infrastructure is viewed as a contrarian viewpoint, with infrastructure providing competitive advantage. But this is increasingly not the case. It is far better to assume that any and all IT can be outsourced than to assume none can be outsourced at all. This is the proper starting point, not the reverse. As a result, we expect more mid and top tier brokers to outsource more functions over time through the use of managed services, outsourcing, etc. The business is struggling with low margins and managers must make radical changes. Prime businesses and other derivatives trading are not enough to support an equities business that is very sluggish. For recommendations of how to proceed for brokerage firms, we recommend the latest report: Innovation in Focus: The Future of Cash Equities Trading Operations, which can be found here: http://www.celent.com/reports/innovation-focus-future-cash-equities-trading-operations