At NeMa, several speakers raised the topical question of outsourcing. This ranged from advocacy of a traditional post-trade (and in some cases earlier) land grab by custodians through to thoughtful debate about component-based outsourcing.
One of the challenges we currently face is that of language. Outsourcing is seen as a mega project, usually entailing the migration of substantial activities to a third party. In effect, this is a model of the last decade. Today, markets contemplate component-based, regional based, country-based or modular outsourcing propositions ranging from single function through to full service.
When outsourcing, it is critical to differentiate between the value-added and non-value added services undertaken within any firm. The distinction does not imply any commoditisation of non- value added services. They are simply the services needed to deliver one’s core value added rather than being product differentiators in their own right. Thus, a fund manager may outsource their entire post-trade environment to a third party global custodian, whilst recognising that quality delivery in this area is still an imperative and thus a value. The core competencies of a fund manager are, though, managing fund range, fund structure, fund performance and distribution - not operations processing.
Similarly, global custodians outsource local custody to their agents. This is driven by necessity as few have the wide coverage of multiple domestic markets which would allow them to interact with all the indigenous infrastructures. That does not detract from the fact that the action is an outsourcing. This is best encapsulated in the view that the local agent is the local back office of the global custodian. As such, they are not just a service supplier but a partner. And the difference between the two is meaningful. A service provider seeks to deliver excellence within a given pre-defined range of services. A partner does likewise, but also aims to add value through an understanding of client need in all aspects of their local market. This is the advocacy role, the problem solving dimension, the mapping of local change to each relevant client need and, above all, going that extra mile whenever there is an issue.
Looking across the value chain, the potential outsourcing components are multiple. Scale will drive many to look for multiple-provider outsourcing to avoid concentration risk. Back-up providers have become more common. Some interpret the stringent, if still vague, contingency and business recovery requirements of regulators to require them to either split their business or appoint shadow suppliers.
The reality is that the more parties there are to a single client proposition, the more difficult the process, the greater the potential points of failure and the riskier the process. Effectively component based outsourcing sounds logical but the allocation of components and their interaction needs to be carefully considered.
Institutions can easily segment their outsource proposition, both by component and by fund structure. It appears logical to avoid a split within a fund as distinct from across funds. A split has obviously financial implications as scale creates discounts. But the driver for multiple outsourcing has to be risk rather than cost.
At the component level, the easiest conceptual split is between custody, fund administration and transfer agency. Splitting off transfer agency is the easiest decision. Its links into the other two are modest, although critically it has to feed them the cash product of creation and liquidations as well as garnering from them the NAV at which to execute transactions. In practise, transfer agents have an umbilical cord to the fund administrator. But from a fund perspective, transfer agency is different as it touches directly its client base. Its efficiency will always be measured by the investor experience and it is not surprising that the fund company client management function and transfer agents have often turbulent relationships.
The more difficult decision lies in truncating, or not, the fund administration and global custodian functions. The major rationale for commingling these lies in the fact that they both use a similar, but not uniform, core database. The fund administrator will operate a trade-date based portfolio whilst the custodian operates a settlement-date driven one. The delta between the two is evidenced by the pending trades in the custodian records, although these are usually identified later than in the administrator records; and may even be initially captured through a message from that entity. The fund administrator also treats cash and accruals differently. Their valuation methodologies may differ with the administrator using clean prices to create a daily NAV and the custodian using unadjusted ones primarily for fee billing purposes. But the reality is that there is substantial overlap and thus inefficiency in separating the two functions.
And the inefficiencies, and added costs, of bifurcated outsourcing, do not stop there. There is cost in two providers operating separate securities databases, dual data feeds, dual incidences of SWIFT standard messaging, duplicative contingency, overlapping functions, especially in the labour intensive asset servicing area, and, above all, duplicative client support.
And we should not overlook the fact that the investment banking community are also looking for options to outsource. Too much of their cost base and capital is tied into the non-trading arena. Do broker dealers need to operate monolithic structures to support their core competencies of trading, origination, corporate and market analysis, distribution and client service? Outsourcing is easier for an agency rather than a principal dealer. Regional structures are more logical than global ones, especially if the package includes regulatory reporting. Cost is a driver as much as risk. But risk is the key. Broker outsourcing has a substantial reputational risk component for the outsource providers. The broker dealer business model is higher risk than the financial institutional one. And the regulatory world of the broker dealer is far more complex, embracing those three core stages of a transaction life cycle, namely pre-trade, trade as well as post-trade.
As all in our sector cover ever more complex a range of instruments and spread of geographies, with an IT infrastructure that will remain turbulent, outsourcing will provide solutions, whether component- or full-service based. The reality is that few will be able, or willing, to offer an end-to-end total service, or at least be able to offer one to the quality that clients rightfully demand. It looks, despite its high cost and identifiable risks, as if component outsourcing based by function or geography is here to stay!
John Gubert
Chairman
Global Securities Services
Executive Committee