Outsourcing: Success comes from letting go
Insight Q3 2015

Buy-side and sell-side firms have found themselves between a rock and a hard place. How do they drive the business forward while under severe pressure to reduce risk, boost transparency and strip out cost? The solution for many investment managers, banks and brokers, to a greater or lesser degree, is to outsource processes and systems across a range of activities – from trading desk, through trade matching, investment accounting and performance reporting, to settlement. We take a top-down look at the wholesale outsourcing of the front, middle and back offices, drilling down to the underlying motivations, challenges and experiences.

Outsourcing is beneficial for many reasons, allowing a firm to focus more on its core competencies, while adapting swiftly to new regulatory demands and opportunities to grow its business. Associated advantages can include greater transparency, increased operational efficiency and freedom from some of the systems-renewal burden. Switching an existing operation to a vendor which has developed its own core competencies should close the gap towards achieving best practice. Furthermore, operating risks can be passed to the provider – in return for a corresponding fee increment – although client and reputation risk remain with the firm.

Asset managers reaching out to expand their footprint into new markets and asset classes face a significant investment in establishing dealing desks. New offerings allow them to outsource this functionality, easing the process of accessing capital markets under best execution, on a variable- rather than fixed-cost basis. Operating an open-architecture model, service providers deliver ready access to liquidity through multiple brokers and counterparties.

Neuflize OBC

In May 2013, the ABN Amro subsidiary outsourced its dealing desk for equities, ETFs, bonds and derivatives across Europe. It picked BNP Paribas Securities Services, which has dealing teams in London, Paris, and Hong Kong. "Asset managers are at a crossroads," says Philippe Boulenguiez, Head of Dealing Services at the bank. "They are looking for revenue streams in new asset classes and geographies, while having to demonstrate best execution and cope with increasingly complex markets and regulations. These factors combine to put pressure on dealing desks, which need ever-more specialist expertise. Many firms are coming to the conclusion that it might be far more efficient – both in terms of liquidity and cost – to use a delegated dealing service instead of setting up multiple dealing desks, some of which might end up being underused."

RPMI Railpen

The investment manager for the Railways Pension Scheme, the sixth-largest UK pension fund, has gone down this route. Having recently decided to bring some of its investment activities in-house, it appointed BNP Paribas in May 2015 to manage its dealing activities on a broker-neutral basis.

While outsourcing is relatively new on the scene for the front office, it is mid-way to maturity for the back office. The phenomenon emerged in the late 1990s among asset managers and broker-dealers, with the major custodians making the natural journey of gearing up to absorb clients' operations, initially across securities record keeping, valuation and accounting. The scope of activities soon evolved to include fund administration, fund accounting and transfer agency, with several fund administrators building capabilities to take on the corresponding functions. Consequently, for clients, outsourcing is fast becoming the new norm. A 2014 survey of 50 UK banks and brokers, carried out by BNP Paribas in conjunction with the YouGov polling company, reported that 22% have outsourced the entire back office and 44% part of the back office. Broker-dealers and asset managers across many jurisdictions are following the same path.

Coming into focus is the strategic outsourcing of the middle office. While taking this step for all investment operations is rare, the aforementioned survey noted that 14% of respondents have done so for part of their middle office. The diverse range of activities makes for significant opportunities for outsourcing, while also presenting the biggest headache in achieving a successful migration. "One early challenge of middle-office outsourcing was pinning down precisely what it does and doesn't include," says Matthew Davey, Senior Vice President and head of client management for asset managers across the UK, Middle East and Africa for State Street Global Services. "There was a much greater degree of variability around the edges fifteen years ago."

For the major asset managers and wealth managers, outsourcing of the entire chain from front through to back office is yet to be catered for. But among mid-tier wealth managers, SCM Private is a prime example of a firm which has handed over the reins for an end-to-end solution.

SCM Private

In October 2014, the firm partnered with Societe Generale Securities Services (SGSS) for a complete solution for its three new direct-to-consumer online wealth management platforms. The firm was after a tailored, turn-key solution that adapts to regulatory and cost-cutting pressures, while allowing it to engage very specific target audiences and offer them low-cost access to high-end investment management. Michael J. Le Garignon, Head of Sales, Business Development & Relationship Management in the UK for SGSS explains: "There is clear regulatory pressure on managers to put end-investors first and reduce costs. They need to future-proof their operating model – driving down trade execution fees and carefully outsourcing investment operations. Our objective is to help clients grow through adapting their operations to cope with scale."

MIDDLE-OFFICE OUTSOURCING

Three phases of evolution

Lift out – whereby the provider takes over the whole of a firm's operation, including staff and systems, as a foundation for building a scalable platform from which it can serve additional clients.

Entire conversion – which involves transferring the middle-office operations, in their entirety, to a provider which has a tried and tested platform.

Component – entailing selected parts of the operations being outsourced over a period of time, easing the headache and conversion risks for the firm.

Many custodians have taken on initial ‘lift out' deals from a select bunch of brave, first-mover investment managers, banks and brokers, while fellow buy-side and sell-side firms waited until a sufficient number of fully developed, competing providers emerged with tried and tested operations. Almost invariably, the early transactions faced teething troubles and providers have taken several years to absorb their initial deals, during which they did not have the appetite for more – and it has been commonplace for both parties to have underestimated the extent of complexity, resource commitment and costs involved in completing the conversion and the migration of the acquired operations onto the provider's strategic platform. This has typically made for slow and steady product development.

The majority of first-mover providers have now integrated additional outsource clients and have been successful in migrating to a single target operating model that uses consistent systems platforms and processes. Their maturing outsourcing platforms offer up opportunities for asset managers, banks and brokers to unlock operational efficiencies. However, a few such providers are experiencing growing pains – with their outsourcing business flat or "just moving along, not making waves" as one spokesperson puts it. With several banks having recently pushed their asset servicing business into their investment bank, some are understood to be finding it difficult to convince colleagues to invest in a business which delivers up annuity income, deferred for a year or more, often with a long time-horizon before a decent profit stream is realized.

Changing global patterns

The early adopters

The UK and Australia led the way in the wholesale outsourcing of the back and middle office, beginning in the second half of the 1990s. The Netherlands and South Africa were also early adopters. "For some time in the UK, outsourcing has been the prevalent model in the regulated fund space for small to medium-size fund managers, driven primarily by the high levels of investment required to acquire the systems, people and infrastructure, even for the most rudimentary set up," explains Patric Foley-Brickley, Head of Business Development and Client Management for Institutional Clients, Europe for Maitland. "For start-up firms in particular, with strong investment skills but little experience of administration, the cost and complexities of regulatory compliance have also been key drivers in pushing managers into the ‘total outsource' model."

In continental Europe, strategic outsourcing took hold a few years later, with the likes of Allianz and Generali engaging in ‘lift out' arrangements. In 2003, AXA Investment Management in both Paris and London went down this route.

Deutsche Asset & Wealth Management

In early 2015, the firm contracted to outsource its real estate and infrastructure fund accounting, property oversight, and client reporting functions to BNY Mellon, with some 70 members of staff transferring.

Edmond de Rothschild Group

More than 110 employees transferred to CACEIS in October 2014. CACEIS took on bookkeeping, custody, transfer agent and accounting functions, while Edmond de Rothschild (Europe) retained the roles of depositary and central administrator.

With employment laws in continental Europe making it uneconomic to reduce headcount, it may prove costly for firms to take the ‘component' or ‘entire' approaches here, except in the case of fast-growing businesses. Notwithstanding this, there has been some relaxation by regulatory authorities in locations such as Luxembourg and Ireland in allowing outsourcing providers to perform the heavy lifting involved in fund accounting, transfer agency and other associated processes in lower-cost centres outside of the jurisdiction. "The regulators require service providers to demonstrate strong governance and oversight capabilities and back-up processes in the local jurisdiction," notes Kavitha Ramachandran, Senior Manager, Business Development and Client Management for Maitland. "This has helped the providers to streamline their global processes into centralized hubs and to underpin their services with a workable financial model, helping support a drive to ‘near shore' activities – moving from high- to low-cost jurisdictions, while retaining support for language, time zones and complex processing," she says.

The latecomers

In the US, early transactions were limited to individual components, such as correspondent clearing, being handed over to specialist firms. The wholesale outsourcing of the back and middle office was slow to get off the ground. Home to many of the world's largest asset management firms, their sheer size allows them to achieve a good degree of scale economies in running their own operations. For smaller firms, self-administration was also considered best practice, while the complexity of the market and sheer size of the country presented added challenges to an outsourcing provider.

PIMCO

It was the PIMCO ‘lift out' deal, struck in 1999 and executed in 2000, that really got US asset managers interested in outsourcing. Pacific Investment Management Co. (PIMCO) had its origins in a cosy partnership which fostered investment ideas, yet had grown its investment operations unit to some 300 people. With the management of this having become a burden and a distraction, the firm outsourced almost all of its investment operations to State Street, so as to get back to its core investment management heritage. Through the lift-out arrangement, PIMCO was able to leverage State Street's infrastructure, knowledge and global network, while retaining legacy staff and systems. Indeed, over the first seven years of their partnership, PIMCO opened trading offices in London, Munich, Tokyo, Sydney and Singapore and their assets under management increased from $206bn in 2000 to $961bn in 2008.

OppenheimerFunds

One notable transaction in the US is the strategic alliance formed in 2010 between OppenheimerFunds, Inc. and Brown Brothers Harriman & Co. (BBH). Believed to be going well, this entailed BBH establishing new operations close to Denver, Colorado, where the OppenheimerFunds investment operations were located, and hiring some 200 former Oppenheimer employees, in order to provide full middle-office, fund accounting and fund administration services for more than $220bn in assets across 350 domestic and offshore investment vehicles. This large-scale outsourcing transaction may be a one-off for BBH, which was driven as much by the desire to have a disaster-recovery site and an operation in the mountain time zone to serve local clients.

T. Rowe Price

The investment firm, headquartered in Baltimore, Maryland and operating globally, has an established in-house investment operations unit. In response to a changing business, technology and regulatory environment, it has taken a strategic decision to outsource certain portfolio record keeping, mutual fund accounting, and other related operations and administrative functions. In June 2015, the firm announced that it has signed a contract to shift those functions, and the approximately 220 associates performing them, to BNY Mellon.

For hedge funds in the US, there has been a fundamental shift in what is considered best practice. "In contrast to many other jurisdictions, these funds were generally self-administrated, only turning to outside administrators relatively recently," notes Scott Price, Head of Business Development and Client Management, North America for Maitland. In the wake of the default of Lehman Brothers in 2008 and, exposed in the same year, the Madoff investment scandal, many institutional investors began to insist on third-party fund administration. "We saw Chicago-based hedge fund Citadel sell its sophisticated fund administration and technology wing, Omnium, to Northern Trust in 2011, becoming a client," says Mr Price. "This acted as a spring board for the newly acquired unit to win business from Connecticut's $120bn Bridgewater Associates, one of the world's largest hedge fund managers. This work, taken on in 2013, was to shadow a whole suite of fund administration services that Bridgewater had outsourced to BNY Mellon in 2011."

Strategic outsourcing is yet to take off in Latin America and the Middle East. In these regions, the capital markets are at an earlier stage of development. "Revenues are growing fast, so there is less incentive to move functions offsite," notes Julien Kasparian, Head of Sales and Relationship Management for UK financial intermediaries at BNP Paribas. "In the Middle East, there has historically been a desire to retain perceived control over operations, although I sense that changing."

In Asia, asset management firms have generally not had sufficient business scale or product complexity to benefit from outsourcing. This is steadily changing, with low yields driving diversification into other asset classes, such as private equity and real estate. Service standards are ‘good enough' and staff costs are low, so unless there are other factors in play, it has been tricky to demonstrate any decent payback from a wholesale migration of functions to a third party.

The fragmented nature of Asia, with different systems, cultures and languages, makes it a complex region in which to do business, both for distributing across multiple markets and accessing markets and their infrastructures. While presenting a barrier for wholesale outsourcing, this is opening up opportunities for the component approach. "Initiatives to reduce the complexity, such as fund passporting and the StockConnect trading link between the Hong Kong and Shanghai bourses, all require investment in the front office and in the back and middle offices too," says Andy Butler, UK head of product for institutionals at BNP Paribas. "An asset manager, whether based in the region or a global firm with a presence there, needs to operate a consistent global operating model."

Nikko Asset Management

On taking over Tyndall Investments, a sprawling group across multi-ethnic markets, Nikko pulled together multiple broken units, making economic sense for it to outsource the wider group's post-trade operational business, choosing to centralize the middle- and back-office systems in Asia Pacific on one unified platform – for which the transition to BNP Paribas was completed in 2013.

One emerging pattern is the use of third-party platforms to ease expansion into Asia. PIMCO leveraged its outsourcing of investment operations to allow it to expand in the region. Liquidnet took the plunge in December 2014.

Liquidnet

Acting for approaching 800 asset management firms globally, and with a growing equity trading business in Asia, the firm handed over its third-party clearing, settlement, and management of the firm's books of records in Asia to BNP Paribas. The bank's Hong Kong head of client development for banks and broker-dealers, James O'Sullivan, comments: "We are seeing more and more organizations, in both Hong Kong and Singapore, partnering with specialist post-trade providers when expanding abroad."

Focus on South Africa

Also an early adopter of outsourcing, South Africa has been experiencing deals since the late 1990s. From the start, local providers made significant in-roads and this is now a very mature market. "Fifteen or so years ago, an asset management firm setting up in business would establish its own back office, but today it will outsource," says Duncan Smith, Senior Business Development Manager, Emerging Markets, at SGSS. "Many existing firms have moved the traditional back office offsite and, increasingly, have done the same with middle-office functions. Turn-key solutions, from dealing desk right the way through to processing dividends and tax reclaims, are offered by a good range of providers. In a similar vein, brokers – which transitioned from partnership to corporate structures with the 1995 Big Bang at the Johannesburg Stock Exchange – were also early to outsourcing, often at the hand of new management or through being taken over by an investment bank. Outsourcing has been a natural extension of South Africa's very high usage of straight-through processing, all the way through from placing a trade to settlement."

Efforts are being made by South African firms to take the outsourcing model north. It's too early for the likes of Kenya and Uganda where, although the East African Community is looking to set up a centralized exchange structure, deal flow – typically a spark followed by no activity for a while – is insufficient to make outsourcing pay. Things are beginning to happen in West Africa, particularly Nigeria which is looking to introduce stock lending. One smaller firm, with a Johannesburg hub, is setting up spokes in Mauritius, Nigeria and a few other countries – starting with investment products to secure distribution and get the flow, and only then making a play for outsourcing the back office.

South Africa's outsourcing history


Where are we now?

Outsourcing of the entire back office has become a common practice. For the sell-side, it is generally the mid-tier firms that have led the way, with larger financial institutions now looking to adopt this approach. Among the buy-side, it is start-ups and the very large firms which have led the way, with mid-tier firms playing catch-up.

For the front office, firms are considering whether to invest in the software and tools needed to achieve best execution and ensure transparency or to look to a third party to run the dealing desks. Sell-side firms have led the way in front-office outsourcing, but demand from buy-side firms is now increasing.

The middle office is typically maturing from a transaction-based support role for the front office into a strategic business partner, driven by a rising tide of product complexity, regulatory obligations and client expectations. As a consequence, transformation of the operating model is becoming essential to provide the flexibility needed to operate efficiently and to scale for business growth – and is a principal factor behind the early outsourcing transactions. "This need is becoming pervasive across the industry," says Paul Gately, Managing Director, Middle Office Outsourcing at BNY Mellon. "Whereas we would regularly have discussions with medium-sized managers, we're now talking with very large asset management firms, some with an excess of $100bn in assets. Several large clients are reassessing their operating models based on their growth aspirations. Our clients' need for change is driven by the desire to enter into new markets, new products and new distribution channels – and perhaps even acquire a new business. Existing operating models that clients have are stretched by these demands and don't easily adapt to the need for change."

The ‘lift out' phase is nearing maturity, with the major providers all having acquired capability across core middle-office functions. Further deals of this type can be expected, but for specific functional capabilities, such as real estate or private equity, or for building geographic footprint. At this stage in the evolution of outsourcing, there is an emerging principle that a wholesale transition of the middle office onto a strategic platform is in the best interests of both parties. However, some firms may consider this too daunting and, for them, the ‘component' approach will likely be the best fit.

"Of the components being outsourced currently, pricing and valuations stands out. Here in particular, the major outsourcing providers are facing competition from smaller vendors which are pitching to perform this ‘value add' function," notes Ms Ramachandran. It is beyond the remit of this article to examine the specialist business process outsourcing firms and technology vendors. However, one particular vendor is worthy of note. The traditional providers may be in for a rude awakening as SS&C makes a big push to evolve its hedge fund administration and middle- and back-office services for global asset managers. Most of the firm's fund administration customers already use it for pricing and independent valuations and the firm has recently rolled this out to asset managers, wealth managers and insurance companies. As they diversify their investment portfolios, SS&C continues to offer and expand accounting and reporting services in support of complex asset classes and has identified performance measurement, client reporting and regulatory reporting as other ‘hot' areas.

Where are firms reluctant to ‘let go'?

It is becoming the norm for firms to hand over the reins for back-office functions and routine transaction-based middle-office activities. Taking this leap of faith can lead to significant upside, with vendors managing standardized processes and delivering superior service and cost savings. Errors or failures in these functions, while impacting business operations, should not damage client relationships or the firm's reputation. In contrast, when it comes to functions close to the client – and sometimes perceived as unique to a firm and part of its character – it has often been a different matter. This is particularly true of a process which requires special skill sets, involves confidential in-house or client data, or engages with multiple, senior-level, front-office and client personnel.

A prime example is performance measurement and analytics. "Some asset managers see this as an integral part of their investment decision-making process and are reluctant to outsource it," Mr Davey tells us, noting that other firms view it as a data management burden which is best performed by a specialist. An outsourcing provider faces similar challenges when it comes to client reporting, and perhaps for other functions such as risk management. For cash management and foreign exchange, there are clear economic benefits – such as stripping out the overhead of a couple of FX dealers, as well as the transfer of liability in return for additional risk premiums due to the provider – but firms are expected to pay particularly careful attention when transferring these activities to providers which have been tainted by past scandals over poor rates.

"For asset managers, it was certainly the case that, the closer you get to the end-investor, the more resistance there was to outsourcing," notes Mr Butler. "The investment reporting and risk reporting functions were guarded by firms as their own. But this is changing. One big factor is that a middle-office outsourcing provider can provide a holistic view of activitity, something that is missing where a manager engages with multiple custodians."

In recent years, broker-dealers have been driven to outsource where it leads to efficiency gains. "On the sell-side, players are looking for economies of scale. We're seeing large, and very large, outsourcings in Western Europe," says Etienne Deniau, Head of Business Development, Asset Managers and Asset Owners at SGSS. The range of activities they are reluctant to outsource has typically been narrower than for buy-side firms. Mr Kasparian adds: "Institutional banks and brokers are increasingly keen on outsourcing their back- and middle-office functions and sometimes even their execution. In the face of tighter capital contraints, everything is being reassessed. As operating models are changed, the scope of outsourcing is sure to evolve. For those firms which are ahead of the pack, from what we can see, they are not yet convinced about outsourcing anything involving direct interactions with their clients."

"For buy-side firms, we are unquestionably seeing an increase in demand for outsourcing contracts to help firms simplify the management of regulatory compliance, reduce associated complexity and benefit from variable costs," notes Mr Deniau. "The level of buy-side outsourcing is definitely increasing and, in particular, for activities previously considered core and managed internally – such as real-time middle-office position keeping, pre-trade compliance and dealing desks."

Data management is a sticking point for many firms. Providers are unwilling to take on liability for inaccurate data and firms are reluctant to lose ownership and control of valuable data.

Capricorn Fund Managers

The Johannesburg- and London-based hedge fund manager had previously outsourced its middle office and fund administration to BNY Mellon. As part of a periodic strategic review, the firm split the two functions – taking back the middle office in February 2015 to outsource it to Viteos under a co-sourcing model, where technology and data are owned and retained by the manager.

What are the hot spots?

Trends in outsourcing are at a turning point, driven by the quantum leap in the complexity faced by asset managers and broker-dealers. There is of course the need to adapt to international regulations, with Mr O'Sullivan pointing to a step-change in demand on account of impositions across derivatives clearing, trade reporting, new capital requirements and collateral management. The middle and back offices have become considerably more challenging environments with the exponential increase in the use of OTC derivatives and illiquid assets, escalating investor reporting requirements and, in the case of hedge funds, increasing valuation frequency. Asset managers need to transform their operations, which are typically structured by asset class. "Today's multi-asset strategies put severe pressure on systems and people," notes Mr Davey. "Having systems and data in traditional silos acts as a barrier to achieving high levels of operational efficiency, while presenting a significant challenge in obtaining a holistic view of risk and performance."

Regulatory reporting has become an outsourcing hot spot in the last five years, notes Laurent Plumet, Product Manager at SGSS, who also serves as their Fund Administration & Solvency II Programme Director. "The first shift came in 2011, driven by the need to produce Key Investor Information Documents under UCITS IV. It moved up a gear in 2013 with the Dodd-Frank Wall Street Reform Act in the US which provides that standard OTC derivatives transactions should be reported on the day of execution. The European Union followed suit in 2014 with the European Market Infrastructure Regulation that enforces reporting to registered trade repositories of both OTC and listed derivatives transactions, as well as the associated collateral. The same year witnessed the reporting obligation enacted under Annex IV of the Alternative Investment Fund Managers Directive (AIFMD)."

"We have been investing in specific regulatory reporting services," Mr Gately tells us, pointing to BNY Mellon's capabilities in providing complex analytic solutions through its front-office services group. "The service helps clients build a data warehouse and manage and consolidate data from various sources from within BNY Mellon and from external parties. We're able to provide operational support and insight into how that data is used in a client's front office, as well as in other operational units of an investment manager."

For managers of alternatives marketing into Europe, AIFMD has brought many previously unregulated fund structures, such as hedge funds, private equity funds, investment trusts and real estate funds into the regulated world. "The requirement to produce detailed and regular reporting data for the regulators has led to an increase in managers seeking outside assistance in the production of those reports," says Mr Foley-Brickley. "Inevitably these managers are now contemplating the outsourcing of this function and whether now is the time to outsource all their administration to a professional provider."

Insurance companies are preparing for Solvency II, which calls for a significant increase in the frequency and level of data to be communicated to regulators – presenting another opportunity for service providers to take on the day-to-day activities of a regulatory imposition. Felix Schachter, who covers the UK insurance sector for BNP Paribas Securities Services, comments: "Solvency II is a major driver for insurance companies to generate cleaner data. The challenge is to harness this data not only for regulatory purposes but also to inform decision-making. This is key to navigating the complexities arising from the hunt for yield and stricter risk management practices and is where a third-party provider can really help."

While there is some reluctance among firms to outsource client-facing activities, it makes great sense for regulatory reporting to be carried out by a fund administrator or custodian. "It is essentially the same data that is being used and repackaged," Mr Plumet tells us. "The provider is often best placed to take on the burden, such as 300 data fields per fund under AIFMD Annex IV, and to handle seasonal peaks. It also provides independent valuation for both risk and performance numbers, while bringing scale economies across report production and translation."

Underlying many of the regulatory obligations is a call for increased transparency. Mr Plumet comments that SGSS is seeing growing requirements from asset managers for the same approach to be applied in the client reporting area, with requests for a look-through approach to bring additional details into, for example, fact-sheet and risk reporting.

On the horizon is the need to manage collateral centrally across a network of multiple counterparties, clearing brokers and central counterparties. "Many firms are beginning to examine whether to outsource the increasingly complex workflow," Clément Phelipeau, Product Manager for Derivatives and Collateral Management at SGSS tells us. "Firms face multiple cut-off constraints with very little leeway – across margin calls, dispute resolution, allocation and reporting – and an outsourcing provider can take on this burden, while helping reduce operational risks and scale down the balance sheet, capital and liquidity commitments through cross-netting."

Electronic settlement and trade matching capabilities in the markets themselves, combined with improvements in technology, have enabled the provision of middle-office services to become more commoditized and easier to control. "The ultimate challenge for the outsource provider has always been the difficulty in reconciling the Investment Book of Records (essentially the investment manager's real-time position) with the Accounting Book of Records (to all intents and purposes the daily net asset valuation)," Mr Price points out. "As technology has evolved, it has become easier for this reconciliation process to become more automated. However, it was a long time before the custodians, who typically based their offering on the ‘accounting systems' started to properly understand the ‘investment systems' that had evolved over many years within managers' back offices, often through the development of convoluted workarounds. For the early-mover outsource providers, attempts to unpick and map out the processes that had been built up over time often proved to be the rock on which these transactions foundered."

It's not all about cost

Ten or fifteen years ago, cost efficiency was the core driver behind the outsourcing of investment operations. At the extreme, some firms benefitted from significant immediate savings, where providers engaged in fierce price competition to gain market share and capability. In the main, the ‘lift out' arrangements do not generate huge, immediate cost savings, as the provider takes on the same people and runs the existing systems. Cost savings should come in the medium term, with the firm avoiding systems-replacement and other costs. The economics of the transaction depend upon the provider successfully transitioning the operations onto a standardized platform, and there are problematical examples of early deals where providers failed to move from a client's bespoke operating model to a standardized platform.

The motivations for outsourcing have changed markedly over the past few years. Ten years ago, the perspective was purely internal, with the availability of resources, the need to avoid a large systems-renewal cost, or a wish to focus on core competencies as typical drivers. Today, a wide range of external factors have also come into play – investor requirements, regulatory oversight and changes in the operating environment. Appropriate segregation of duties, combined with competent and independent oversight, is seen as best practice and is increasingly being demanded by investors and regulators alike. Where a firm's size and reputation were previously seen as grounds for exemption, even this is changing.

In the past few years, providers have developed their middle-office outsourcing platforms, extending the breadth and depth of their service offerings. The corresponding new capabilities have allowed firms to transition more activities and have become important distinguishing characteristics among providers.

We are seeing the beginnings of a shift in what is driving outsourcing "from a pure process-led model to a data-driven one," Mr Davey tells us. A 2014 survey of 400 investment firms from eleven countries, conducted by State Street, revealed that 34% considered investment data and analytics to be the most important strategic priority, and only 2% considered it to be a low-level strategic priority.

"Data and analytics have certainly come to the fore," notes Mr Davey. "They are becoming critical for an asset manager to gain competitive advantage through operational efficiencies in the middle office and improved client reporting. Ultimately, this ties in to the wider issue for fund manufacturers – of how to get access to Generation Z which has grown up with the smartphone as their window to the world."

"We are seeing a lot of activity around the data and the value it can bring, in particular the very rich data in the middle office," says Mr Butler. "A great deal of innovation is under way at BNP Paribas, to help the asset manager's bottom line and to add value to the end-investor."

As outsourcing matures, firms will be able to focus increasingly on their core competencies – whether that is trading assets or accumulating and managing assets to create value for their clients.

Successes and failures

A firm should look to a provider's success in retaining clients after the first contract-renewal period. It is these ‘second generation' deals which highlight the strengths of the partnership struck between the respective parties.

In 1997, Aberdeen Asset Management migrated its investment administration to Cogent Investment Operations, now part of BNP Paribas Securities Services. In the course of contract renewals and extensions, the firm stayed with BNP Paribas. Similarly, Scottish Widows Investment Partnership (SWIP) outsourced its investment operations in 2000, picking State Street. On expiry of the initial contract, they stayed where they were. Since the acquisition of SWIP by Aberdeen, which completed in early 2014, the enlarged group has retained the two providers. While the firm faces the added burden of managing a second relationship, this has the advantage of keeping two competing firms on their toes. In such cases, there may be some upside in contingency planning – although this should not be assumed, as there may not be a direct mapping of capabilities from one provider to the other.

By contrast, other acquisitions among asset managers have led to some consolidation of outsourcing provision. For example, Old Mutual had outsourced to RBC, while the Skandia business it acquired in 2006 had picked Citi. Post acquisition, Old Mutual consolidated with Citi. Following the 2014 acquisition of Ignis Asset Management by Standard Life, two providers were retained for a while, but HSBC is to lose the Ignis business as it is being consolidated into Citi with the Standard Life business.

In some cases, short-term cost savings were too high on the agenda and the two parties failed to adopt a partnership mentality. Fundamental to the success of an outsourcing arrangement, this calls for close co-operation and trust, so that contracts are drawn up and managed to be sure the deal is a ‘win-win' for the two organizations. One example of a deal falling foul of this and unravelling is Threadneedle Asset Management, with its outsourcing of investment operations to JP Morgan in 2006. The asset manager has a reputation as a tough negotiator. A variety of factors, including an undertaking by the bank to fund a platform for OTC derivatives processing, contributed to a difficult relationship. Consequently, the business is going through a lengthy process of migration to Citi.

"There are two phrases which underpin the success or failure of an outsourcing contract," says Ms Ramachandran. "The first, ‘better to do it well, than do it quickly' sums up the need for the contract to sit on firm foundations. The second phrase is ‘outsourcing is not a relationship, it's a marriage'. Unless the transaction has the total commitment of both parties to its ultimate success, it will fail."

Outsourcing: best practice

For a firm wishing to move an existing operation to a third party, it is no walk in the park. A sourcing strategy and roadmap must be designed – followed by thorough selection and provider due diligence, careful contracting, and detailed transition planning. Once implemented, the firm faces new challenges with regard to vendor management and business continuity planning.

Outsourcing relieves a firm of the day-to-day processing burden – and may allow for certain risks to be passed to the provider – but it does not absolve the firm's management from responsibility for gaining appropriate assurances that the provider applies sound control objectives and procedures. Increased attention from regulators and clients is encouraging more and more service providers to have their auditors report on their internal controls under the international reporting standard ISAE 3402.

The firm itself must build an effective oversight function, to monitor the provider and mitigate the risks of poor outcomes which are detrimental to the firm and its customers. Transferring processes to a third party presents resilience risk: a sudden failure of the service provider, with no adequate continuity plan, would lead to a damaging absence of service for an extended period.

A survey conducted in 2014 by Milestone Group revealed that 25 percent of the North American asset manager, wealth manager and pensions adviser respondents conducted no oversight whatsoever of their fund administration outsourcing providers. In 2012, following a review of UK asset managers' outsourcing arrangements, the Financial Services Authority (FSA) concluded that most firms were not fully in compliance with the regulations in section 8 of the Systems and Controls sourcebook (SYSC). This led to it writing a ‘Dear CEO' letter to asset management firms in the UK.

While the UK regulator was one of the first to focus on outsourcing risks, it is not alone. The Central Bank of Ireland has written a similar ‘Dear CEO' letter to asset managers operating in Ireland. Other countries with regulations on outsourcing include Australia, France, Germany, Luxembourg, Hong Kong and Singapore. We can expect to see a standardization of principles across the world, driven by the increasing practice of regulators to work together and also by many global asset managers holding their worldwide group to the developing best practice.

The UK's regulator expects asset managers to exercise due skill, care and diligence when entering into, managing or terminating any outsourcing arrangement. ‘Viable, robust and realistic' contingency plans should set out a clearly defined exit strategy in the event of the failure or termination of outsourced activity under any circumstances, including stressed market conditions. "What was different with their ‘Dear CEO' letter is that the FSA asked the industry to come up with a solution. This led to a unique collaboration between service providers and asset managers," says State Street's Mr Davey.

In May 2013, shortly after the UK's Financial Conduct Authority (FCA) replaced the FSA, it was presented with an initial set of recommendations by a seven-strong group of outsourcing providers, instigated and chaired by State Street's Mark Westwell. Working with the Investment Management Association (now known as the Investment Association), fifteen leading asset managers came together with the seven outsourcing providers – as the Outsourcing Working Group (OWG) – to define good practice for the industry, with the Big Four accounting firms as moderators. Their efforts culminated in a set of practical guidelines encompassing oversight, exit planning and standardization. These were published in December 2013 and presented to the FCA, which formally recognized them as being the ‘guiding principles' for the asset management community.

The OWG ‘guiding principles' are essentially a supplement to the very brief sentences in the UK Systems and Controls sourcebook. To help firms comply with SYSC 8, and apply the guidelines, providers such as State Street make available a series of templates for adapting to the firm's circumstances.

As recently as February 2015, the FCA noted, in a feedback statement on its wholesale sector competition review, that the asset management industry – while having made some progress – still has some way to go in enhancing oversight and contingency planning. It will be interesting to see whether outsourcing will form part of the FCA's 2015/2016 review of asset management.

Until recently, oversight was focused almost exclusively on service monitoring: applying service metrics under a service level agreement. This remains important, with advances in applying a flexible approach – aligning interests of firm and provider, with penalties for poor performance and rewards for excellence. But the scope of oversight is expanding to a broad risk management remit: the provider's balance sheet strength and financial stability, and what to do if one of the outsourced functions ceased to exist.





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Buy-side and sell-side firms have found themselves between a rock and a hard place. How do they drive the business forward while under severe pressure to reduce risk, boost transparency and strip out cost? The solution for many investment managers, banks and brokers, to a greater or lesser degree, is to outsource processes and systems across a range of activities – from trading desk, through trade matching, investment accounting and performance reporting, to settlement. We take a top-down look at the wholesale outsourcing of the front, middle and back offices, drilling down to the underlying motivations, challenges and experiences.

Outsourcing is beneficial for many reasons, allowing a firm to focus more on its core competencies, while adapting swiftly to new regulatory demands and opportunities to grow its business. Associated advantages can include greater transparency, increased operational efficiency and freedom from some of the systems-renewal burden. Switching an existing operation to a vendor which has developed its own core competencies should close the gap towards achieving best practice. Furthermore, operating risks can be passed to the provider – in return for a corresponding fee increment – although client and reputation risk remain with the firm.

Asset managers reaching out to expand their footprint into new markets and asset classes face a significant investment in establishing dealing desks. New offerings allow them to outsource this functionality, easing the process of accessing capital markets under best execution, on a variable- rather than fixed-cost basis. Operating an open-architecture model, service providers deliver ready access to liquidity through multiple brokers and counterparties.

Neuflize OBC

In May 2013, the ABN Amro subsidiary outsourced its dealing desk for equities, ETFs, bonds and derivatives across Europe. It picked BNP Paribas Securities Services, which has dealing teams in London, Paris, and Hong Kong. "Asset managers are at a crossroads," says Philippe Boulenguiez, Head of Dealing Services at the bank. "They are looking for revenue streams in new asset classes and geographies, while having to demonstrate best execution and cope with increasingly complex markets and regulations. These factors combine to put pressure on dealing desks, which need ever-more specialist expertise. Many firms are coming to the conclusion that it might be far more efficient – both in terms of liquidity and cost – to use a delegated dealing service instead of setting up multiple dealing desks, some of which might end up being underused."

RPMI Railpen

The investment manager for the Railways Pension Scheme, the sixth-largest UK pension fund, has gone down this route. Having recently decided to bring some of its investment activities in-house, it appointed BNP Paribas in May 2015 to manage its dealing activities on a broker-neutral basis.

While outsourcing is relatively new on the scene for the front office, it is mid-way to maturity for the back office. The phenomenon emerged in the late 1990s among asset managers and broker-dealers, with the major custodians making the natural journey of gearing up to absorb clients' operations, initially across securities record keeping, valuation and accounting. The scope of activities soon evolved to include fund administration, fund accounting and transfer agency, with several fund administrators building capabilities to take on the corresponding functions. Consequently, for clients, outsourcing is fast becoming the new norm. A 2014 survey of 50 UK banks and brokers, carried out by BNP Paribas in conjunction with the YouGov polling company, reported that 22% have outsourced the entire back office and 44% part of the back office. Broker-dealers and asset managers across many jurisdictions are following the same path.

Coming into focus is the strategic outsourcing of the middle office. While taking this step for all investment operations is rare, the aforementioned survey noted that 14% of respondents have done so for part of their middle office. The diverse range of activities makes for significant opportunities for outsourcing, while also presenting the biggest headache in achieving a successful migration. "One early challenge of middle-office outsourcing was pinning down precisely what it does and doesn't include," says Matthew Davey, Senior Vice President and head of client management for asset managers across the UK, Middle East and Africa for State Street Global Services. "There was a much greater degree of variability around the edges fifteen years ago."

For the major asset managers and wealth managers, outsourcing of the entire chain from front through to back office is yet to be catered for. But among mid-tier wealth managers, SCM Private is a prime example of a firm which has handed over the reins for an end-to-end solution.

SCM Private

In October 2014, the firm partnered with Societe Generale Securities Services (SGSS) for a complete solution for its three new direct-to-consumer online wealth management platforms. The firm was after a tailored, turn-key solution that adapts to regulatory and cost-cutting pressures, while allowing it to engage very specific target audiences and offer them low-cost access to high-end investment management. Michael J. Le Garignon, Head of Sales, Business Development & Relationship Management in the UK for SGSS explains: "There is clear regulatory pressure on managers to put end-investors first and reduce costs. They need to future-proof their operating model – driving down trade execution fees and carefully outsourcing investment operations. Our objective is to help clients grow through adapting their operations to cope with scale."

MIDDLE-OFFICE OUTSOURCING

Three phases of evolution

Lift out – whereby the provider takes over the whole of a firm's operation, including staff and systems, as a foundation for building a scalable platform from which it can serve additional clients.

Entire conversion – which involves transferring the middle-office operations, in their entirety, to a provider which has a tried and tested platform.

Component – entailing selected parts of the operations being outsourced over a period of time, easing the headache and conversion risks for the firm.

Many custodians have taken on initial ‘lift out' deals from a select bunch of brave, first-mover investment managers, banks and brokers, while fellow buy-side and sell-side firms waited until a sufficient number of fully developed, competing providers emerged with tried and tested operations. Almost invariably, the early transactions faced teething troubles and providers have taken several years to absorb their initial deals, during which they did not have the appetite for more – and it has been commonplace for both parties to have underestimated the extent of complexity, resource commitment and costs involved in completing the conversion and the migration of the acquired operations onto the provider's strategic platform. This has typically made for slow and steady product development.

The majority of first-mover providers have now integrated additional outsource clients and have been successful in migrating to a single target operating model that uses consistent systems platforms and processes. Their maturing outsourcing platforms offer up opportunities for asset managers, banks and brokers to unlock operational efficiencies. However, a few such providers are experiencing growing pains – with their outsourcing business flat or "just moving along, not making waves" as one spokesperson puts it. With several banks having recently pushed their asset servicing business into their investment bank, some are understood to be finding it difficult to convince colleagues to invest in a business which delivers up annuity income, deferred for a year or more, often with a long time-horizon before a decent profit stream is realized.

Changing global patterns

The early adopters

The UK and Australia led the way in the wholesale outsourcing of the back and middle office, beginning in the second half of the 1990s. The Netherlands and South Africa were also early adopters. "For some time in the UK, outsourcing has been the prevalent model in the regulated fund space for small to medium-size fund managers, driven primarily by the high levels of investment required to acquire the systems, people and infrastructure, even for the most rudimentary set up," explains Patric Foley-Brickley, Head of Business Development and Client Management for Institutional Clients, Europe for Maitland. "For start-up firms in particular, with strong investment skills but little experience of administration, the cost and complexities of regulatory compliance have also been key drivers in pushing managers into the ‘total outsource' model."

In continental Europe, strategic outsourcing took hold a few years later, with the likes of Allianz and Generali engaging in ‘lift out' arrangements. In 2003, AXA Investment Management in both Paris and London went down this route.

Deutsche Asset & Wealth Management

In early 2015, the firm contracted to outsource its real estate and infrastructure fund accounting, property oversight, and client reporting functions to BNY Mellon, with some 70 members of staff transferring.

Edmond de Rothschild Group

More than 110 employees transferred to CACEIS in October 2014. CACEIS took on bookkeeping, custody, transfer agent and accounting functions, while Edmond de Rothschild (Europe) retained the roles of depositary and central administrator.

With employment laws in continental Europe making it uneconomic to reduce headcount, it may prove costly for firms to take the ‘component' or ‘entire' approaches here, except in the case of fast-growing businesses. Notwithstanding this, there has been some relaxation by regulatory authorities in locations such as Luxembourg and Ireland in allowing outsourcing providers to perform the heavy lifting involved in fund accounting, transfer agency and other associated processes in lower-cost centres outside of the jurisdiction. "The regulators require service providers to demonstrate strong governance and oversight capabilities and back-up processes in the local jurisdiction," notes Kavitha Ramachandran, Senior Manager, Business Development and Client Management for Maitland. "This has helped the providers to streamline their global processes into centralized hubs and to underpin their services with a workable financial model, helping support a drive to ‘near shore' activities – moving from high- to low-cost jurisdictions, while retaining support for language, time zones and complex processing," she says.

The latecomers

In the US, early transactions were limited to individual components, such as correspondent clearing, being handed over to specialist firms. The wholesale outsourcing of the back and middle office was slow to get off the ground. Home to many of the world's largest asset management firms, their sheer size allows them to achieve a good degree of scale economies in running their own operations. For smaller firms, self-administration was also considered best practice, while the complexity of the market and sheer size of the country presented added challenges to an outsourcing provider.

PIMCO

It was the PIMCO ‘lift out' deal, struck in 1999 and executed in 2000, that really got US asset managers interested in outsourcing. Pacific Investment Management Co. (PIMCO) had its origins in a cosy partnership which fostered investment ideas, yet had grown its investment operations unit to some 300 people. With the management of this having become a burden and a distraction, the firm outsourced almost all of its investment operations to State Street, so as to get back to its core investment management heritage. Through the lift-out arrangement, PIMCO was able to leverage State Street's infrastructure, knowledge and global network, while retaining legacy staff and systems. Indeed, over the first seven years of their partnership, PIMCO opened trading offices in London, Munich, Tokyo, Sydney and Singapore and their assets under management increased from $206bn in 2000 to $961bn in 2008.

OppenheimerFunds

One notable transaction in the US is the strategic alliance formed in 2010 between OppenheimerFunds, Inc. and Brown Brothers Harriman & Co. (BBH). Believed to be going well, this entailed BBH establishing new operations close to Denver, Colorado, where the OppenheimerFunds investment operations were located, and hiring some 200 former Oppenheimer employees, in order to provide full middle-office, fund accounting and fund administration services for more than $220bn in assets across 350 domestic and offshore investment vehicles. This large-scale outsourcing transaction may be a one-off for BBH, which was driven as much by the desire to have a disaster-recovery site and an operation in the mountain time zone to serve local clients.

T. Rowe Price

The investment firm, headquartered in Baltimore, Maryland and operating globally, has an established in-house investment operations unit. In response to a changing business, technology and regulatory environment, it has taken a strategic decision to outsource certain portfolio record keeping, mutual fund accounting, and other related operations and administrative functions. In June 2015, the firm announced that it has signed a contract to shift those functions, and the approximately 220 associates performing them, to BNY Mellon.

For hedge funds in the US, there has been a fundamental shift in what is considered best practice. "In contrast to many other jurisdictions, these funds were generally self-administrated, only turning to outside administrators relatively recently," notes Scott Price, Head of Business Development and Client Management, North America for Maitland. In the wake of the default of Lehman Brothers in 2008 and, exposed in the same year, the Madoff investment scandal, many institutional investors began to insist on third-party fund administration. "We saw Chicago-based hedge fund Citadel sell its sophisticated fund administration and technology wing, Omnium, to Northern Trust in 2011, becoming a client," says Mr Price. "This acted as a spring board for the newly acquired unit to win business from Connecticut's $120bn Bridgewater Associates, one of the world's largest hedge fund managers. This work, taken on in 2013, was to shadow a whole suite of fund administration services that Bridgewater had outsourced to BNY Mellon in 2011."

Strategic outsourcing is yet to take off in Latin America and the Middle East. In these regions, the capital markets are at an earlier stage of development. "Revenues are growing fast, so there is less incentive to move functions offsite," notes Julien Kasparian, Head of Sales and Relationship Management for UK financial intermediaries at BNP Paribas. "In the Middle East, there has historically been a desire to retain perceived control over operations, although I sense that changing."

In Asia, asset management firms have generally not had sufficient business scale or product complexity to benefit from outsourcing. This is steadily changing, with low yields driving diversification into other asset classes, such as private equity and real estate. Service standards are ‘good enough' and staff costs are low, so unless there are other factors in play, it has been tricky to demonstrate any decent payback from a wholesale migration of functions to a third party.

The fragmented nature of Asia, with different systems, cultures and languages, makes it a complex region in which to do business, both for distributing across multiple markets and accessing markets and their infrastructures. While presenting a barrier for wholesale outsourcing, this is opening up opportunities for the component approach. "Initiatives to reduce the complexity, such as fund passporting and the StockConnect trading link between the Hong Kong and Shanghai bourses, all require investment in the front office and in the back and middle offices too," says Andy Butler, UK head of product for institutionals at BNP Paribas. "An asset manager, whether based in the region or a global firm with a presence there, needs to operate a consistent global operating model."

Nikko Asset Management

On taking over Tyndall Investments, a sprawling group across multi-ethnic markets, Nikko pulled together multiple broken units, making economic sense for it to outsource the wider group's post-trade operational business, choosing to centralize the middle- and back-office systems in Asia Pacific on one unified platform – for which the transition to BNP Paribas was completed in 2013.

One emerging pattern is the use of third-party platforms to ease expansion into Asia. PIMCO leveraged its outsourcing of investment operations to allow it to expand in the region. Liquidnet took the plunge in December 2014.

Liquidnet

Acting for approaching 800 asset management firms globally, and with a growing equity trading business in Asia, the firm handed over its third-party clearing, settlement, and management of the firm's books of records in Asia to BNP Paribas. The bank's Hong Kong head of client development for banks and broker-dealers, James O'Sullivan, comments: "We are seeing more and more organizations, in both Hong Kong and Singapore, partnering with specialist post-trade providers when expanding abroad."

Focus on South Africa

Also an early adopter of outsourcing, South Africa has been experiencing deals since the late 1990s. From the start, local providers made significant in-roads and this is now a very mature market. "Fifteen or so years ago, an asset management firm setting up in business would establish its own back office, but today it will outsource," says Duncan Smith, Senior Business Development Manager, Emerging Markets, at SGSS. "Many existing firms have moved the traditional back office offsite and, increasingly, have done the same with middle-office functions. Turn-key solutions, from dealing desk right the way through to processing dividends and tax reclaims, are offered by a good range of providers. In a similar vein, brokers – which transitioned from partnership to corporate structures with the 1995 Big Bang at the Johannesburg Stock Exchange – were also early to outsourcing, often at the hand of new management or through being taken over by an investment bank. Outsourcing has been a natural extension of South Africa's very high usage of straight-through processing, all the way through from placing a trade to settlement."

Efforts are being made by South African firms to take the outsourcing model north. It's too early for the likes of Kenya and Uganda where, although the East African Community is looking to set up a centralized exchange structure, deal flow – typically a spark followed by no activity for a while – is insufficient to make outsourcing pay. Things are beginning to happen in West Africa, particularly Nigeria which is looking to introduce stock lending. One smaller firm, with a Johannesburg hub, is setting up spokes in Mauritius, Nigeria and a few other countries – starting with investment products to secure distribution and get the flow, and only then making a play for outsourcing the back office.

South Africa's outsourcing history


Where are we now?

Outsourcing of the entire back office has become a common practice. For the sell-side, it is generally the mid-tier firms that have led the way, with larger financial institutions now looking to adopt this approach. Among the buy-side, it is start-ups and the very large firms which have led the way, with mid-tier firms playing catch-up.

For the front office, firms are considering whether to invest in the software and tools needed to achieve best execution and ensure transparency or to look to a third party to run the dealing desks. Sell-side firms have led the way in front-office outsourcing, but demand from buy-side firms is now increasing.

The middle office is typically maturing from a transaction-based support role for the front office into a strategic business partner, driven by a rising tide of product complexity, regulatory obligations and client expectations. As a consequence, transformation of the operating model is becoming essential to provide the flexibility needed to operate efficiently and to scale for business growth – and is a principal factor behind the early outsourcing transactions. "This need is becoming pervasive across the industry," says Paul Gately, Managing Director, Middle Office Outsourcing at BNY Mellon. "Whereas we would regularly have discussions with medium-sized managers, we're now talking with very large asset management firms, some with an excess of $100bn in assets. Several large clients are reassessing their operating models based on their growth aspirations. Our clients' need for change is driven by the desire to enter into new markets, new products and new distribution channels – and perhaps even acquire a new business. Existing operating models that clients have are stretched by these demands and don't easily adapt to the need for change."

The ‘lift out' phase is nearing maturity, with the major providers all having acquired capability across core middle-office functions. Further deals of this type can be expected, but for specific functional capabilities, such as real estate or private equity, or for building geographic footprint. At this stage in the evolution of outsourcing, there is an emerging principle that a wholesale transition of the middle office onto a strategic platform is in the best interests of both parties. However, some firms may consider this too daunting and, for them, the ‘component' approach will likely be the best fit.

"Of the components being outsourced currently, pricing and valuations stands out. Here in particular, the major outsourcing providers are facing competition from smaller vendors which are pitching to perform this ‘value add' function," notes Ms Ramachandran. It is beyond the remit of this article to examine the specialist business process outsourcing firms and technology vendors. However, one particular vendor is worthy of note. The traditional providers may be in for a rude awakening as SS&C makes a big push to evolve its hedge fund administration and middle- and back-office services for global asset managers. Most of the firm's fund administration customers already use it for pricing and independent valuations and the firm has recently rolled this out to asset managers, wealth managers and insurance companies. As they diversify their investment portfolios, SS&C continues to offer and expand accounting and reporting services in support of complex asset classes and has identified performance measurement, client reporting and regulatory reporting as other ‘hot' areas.

Where are firms reluctant to ‘let go'?

It is becoming the norm for firms to hand over the reins for back-office functions and routine transaction-based middle-office activities. Taking this leap of faith can lead to significant upside, with vendors managing standardized processes and delivering superior service and cost savings. Errors or failures in these functions, while impacting business operations, should not damage client relationships or the firm's reputation. In contrast, when it comes to functions close to the client – and sometimes perceived as unique to a firm and part of its character – it has often been a different matter. This is particularly true of a process which requires special skill sets, involves confidential in-house or client data, or engages with multiple, senior-level, front-office and client personnel.

A prime example is performance measurement and analytics. "Some asset managers see this as an integral part of their investment decision-making process and are reluctant to outsource it," Mr Davey tells us, noting that other firms view it as a data management burden which is best performed by a specialist. An outsourcing provider faces similar challenges when it comes to client reporting, and perhaps for other functions such as risk management. For cash management and foreign exchange, there are clear economic benefits – such as stripping out the overhead of a couple of FX dealers, as well as the transfer of liability in return for additional risk premiums due to the provider – but firms are expected to pay particularly careful attention when transferring these activities to providers which have been tainted by past scandals over poor rates.

"For asset managers, it was certainly the case that, the closer you get to the end-investor, the more resistance there was to outsourcing," notes Mr Butler. "The investment reporting and risk reporting functions were guarded by firms as their own. But this is changing. One big factor is that a middle-office outsourcing provider can provide a holistic view of activitity, something that is missing where a manager engages with multiple custodians."

In recent years, broker-dealers have been driven to outsource where it leads to efficiency gains. "On the sell-side, players are looking for economies of scale. We're seeing large, and very large, outsourcings in Western Europe," says Etienne Deniau, Head of Business Development, Asset Managers and Asset Owners at SGSS. The range of activities they are reluctant to outsource has typically been narrower than for buy-side firms. Mr Kasparian adds: "Institutional banks and brokers are increasingly keen on outsourcing their back- and middle-office functions and sometimes even their execution. In the face of tighter capital contraints, everything is being reassessed. As operating models are changed, the scope of outsourcing is sure to evolve. For those firms which are ahead of the pack, from what we can see, they are not yet convinced about outsourcing anything involving direct interactions with their clients."

"For buy-side firms, we are unquestionably seeing an increase in demand for outsourcing contracts to help firms simplify the management of regulatory compliance, reduce associated complexity and benefit from variable costs," notes Mr Deniau. "The level of buy-side outsourcing is definitely increasing and, in particular, for activities previously considered core and managed internally – such as real-time middle-office position keeping, pre-trade compliance and dealing desks."

Data management is a sticking point for many firms. Providers are unwilling to take on liability for inaccurate data and firms are reluctant to lose ownership and control of valuable data.

Capricorn Fund Managers

The Johannesburg- and London-based hedge fund manager had previously outsourced its middle office and fund administration to BNY Mellon. As part of a periodic strategic review, the firm split the two functions – taking back the middle office in February 2015 to outsource it to Viteos under a co-sourcing model, where technology and data are owned and retained by the manager.

What are the hot spots?

Trends in outsourcing are at a turning point, driven by the quantum leap in the complexity faced by asset managers and broker-dealers. There is of course the need to adapt to international regulations, with Mr O'Sullivan pointing to a step-change in demand on account of impositions across derivatives clearing, trade reporting, new capital requirements and collateral management. The middle and back offices have become considerably more challenging environments with the exponential increase in the use of OTC derivatives and illiquid assets, escalating investor reporting requirements and, in the case of hedge funds, increasing valuation frequency. Asset managers need to transform their operations, which are typically structured by asset class. "Today's multi-asset strategies put severe pressure on systems and people," notes Mr Davey. "Having systems and data in traditional silos acts as a barrier to achieving high levels of operational efficiency, while presenting a significant challenge in obtaining a holistic view of risk and performance."

Regulatory reporting has become an outsourcing hot spot in the last five years, notes Laurent Plumet, Product Manager at SGSS, who also serves as their Fund Administration & Solvency II Programme Director. "The first shift came in 2011, driven by the need to produce Key Investor Information Documents under UCITS IV. It moved up a gear in 2013 with the Dodd-Frank Wall Street Reform Act in the US which provides that standard OTC derivatives transactions should be reported on the day of execution. The European Union followed suit in 2014 with the European Market Infrastructure Regulation that enforces reporting to registered trade repositories of both OTC and listed derivatives transactions, as well as the associated collateral. The same year witnessed the reporting obligation enacted under Annex IV of the Alternative Investment Fund Managers Directive (AIFMD)."

"We have been investing in specific regulatory reporting services," Mr Gately tells us, pointing to BNY Mellon's capabilities in providing complex analytic solutions through its front-office services group. "The service helps clients build a data warehouse and manage and consolidate data from various sources from within BNY Mellon and from external parties. We're able to provide operational support and insight into how that data is used in a client's front office, as well as in other operational units of an investment manager."

For managers of alternatives marketing into Europe, AIFMD has brought many previously unregulated fund structures, such as hedge funds, private equity funds, investment trusts and real estate funds into the regulated world. "The requirement to produce detailed and regular reporting data for the regulators has led to an increase in managers seeking outside assistance in the production of those reports," says Mr Foley-Brickley. "Inevitably these managers are now contemplating the outsourcing of this function and whether now is the time to outsource all their administration to a professional provider."

Insurance companies are preparing for Solvency II, which calls for a significant increase in the frequency and level of data to be communicated to regulators – presenting another opportunity for service providers to take on the day-to-day activities of a regulatory imposition. Felix Schachter, who covers the UK insurance sector for BNP Paribas Securities Services, comments: "Solvency II is a major driver for insurance companies to generate cleaner data. The challenge is to harness this data not only for regulatory purposes but also to inform decision-making. This is key to navigating the complexities arising from the hunt for yield and stricter risk management practices and is where a third-party provider can really help."

While there is some reluctance among firms to outsource client-facing activities, it makes great sense for regulatory reporting to be carried out by a fund administrator or custodian. "It is essentially the same data that is being used and repackaged," Mr Plumet tells us. "The provider is often best placed to take on the burden, such as 300 data fields per fund under AIFMD Annex IV, and to handle seasonal peaks. It also provides independent valuation for both risk and performance numbers, while bringing scale economies across report production and translation."

Underlying many of the regulatory obligations is a call for increased transparency. Mr Plumet comments that SGSS is seeing growing requirements from asset managers for the same approach to be applied in the client reporting area, with requests for a look-through approach to bring additional details into, for example, fact-sheet and risk reporting.

On the horizon is the need to manage collateral centrally across a network of multiple counterparties, clearing brokers and central counterparties. "Many firms are beginning to examine whether to outsource the increasingly complex workflow," Clément Phelipeau, Product Manager for Derivatives and Collateral Management at SGSS tells us. "Firms face multiple cut-off constraints with very little leeway – across margin calls, dispute resolution, allocation and reporting – and an outsourcing provider can take on this burden, while helping reduce operational risks and scale down the balance sheet, capital and liquidity commitments through cross-netting."

Electronic settlement and trade matching capabilities in the markets themselves, combined with improvements in technology, have enabled the provision of middle-office services to become more commoditized and easier to control. "The ultimate challenge for the outsource provider has always been the difficulty in reconciling the Investment Book of Records (essentially the investment manager's real-time position) with the Accounting Book of Records (to all intents and purposes the daily net asset valuation)," Mr Price points out. "As technology has evolved, it has become easier for this reconciliation process to become more automated. However, it was a long time before the custodians, who typically based their offering on the ‘accounting systems' started to properly understand the ‘investment systems' that had evolved over many years within managers' back offices, often through the development of convoluted workarounds. For the early-mover outsource providers, attempts to unpick and map out the processes that had been built up over time often proved to be the rock on which these transactions foundered."

It's not all about cost

Ten or fifteen years ago, cost efficiency was the core driver behind the outsourcing of investment operations. At the extreme, some firms benefitted from significant immediate savings, where providers engaged in fierce price competition to gain market share and capability. In the main, the ‘lift out' arrangements do not generate huge, immediate cost savings, as the provider takes on the same people and runs the existing systems. Cost savings should come in the medium term, with the firm avoiding systems-replacement and other costs. The economics of the transaction depend upon the provider successfully transitioning the operations onto a standardized platform, and there are problematical examples of early deals where providers failed to move from a client's bespoke operating model to a standardized platform.

The motivations for outsourcing have changed markedly over the past few years. Ten years ago, the perspective was purely internal, with the availability of resources, the need to avoid a large systems-renewal cost, or a wish to focus on core competencies as typical drivers. Today, a wide range of external factors have also come into play – investor requirements, regulatory oversight and changes in the operating environment. Appropriate segregation of duties, combined with competent and independent oversight, is seen as best practice and is increasingly being demanded by investors and regulators alike. Where a firm's size and reputation were previously seen as grounds for exemption, even this is changing.

In the past few years, providers have developed their middle-office outsourcing platforms, extending the breadth and depth of their service offerings. The corresponding new capabilities have allowed firms to transition more activities and have become important distinguishing characteristics among providers.

We are seeing the beginnings of a shift in what is driving outsourcing "from a pure process-led model to a data-driven one," Mr Davey tells us. A 2014 survey of 400 investment firms from eleven countries, conducted by State Street, revealed that 34% considered investment data and analytics to be the most important strategic priority, and only 2% considered it to be a low-level strategic priority.

"Data and analytics have certainly come to the fore," notes Mr Davey. "They are becoming critical for an asset manager to gain competitive advantage through operational efficiencies in the middle office and improved client reporting. Ultimately, this ties in to the wider issue for fund manufacturers – of how to get access to Generation Z which has grown up with the smartphone as their window to the world."

"We are seeing a lot of activity around the data and the value it can bring, in particular the very rich data in the middle office," says Mr Butler. "A great deal of innovation is under way at BNP Paribas, to help the asset manager's bottom line and to add value to the end-investor."

As outsourcing matures, firms will be able to focus increasingly on their core competencies – whether that is trading assets or accumulating and managing assets to create value for their clients.

Successes and failures

A firm should look to a provider's success in retaining clients after the first contract-renewal period. It is these ‘second generation' deals which highlight the strengths of the partnership struck between the respective parties.

In 1997, Aberdeen Asset Management migrated its investment administration to Cogent Investment Operations, now part of BNP Paribas Securities Services. In the course of contract renewals and extensions, the firm stayed with BNP Paribas. Similarly, Scottish Widows Investment Partnership (SWIP) outsourced its investment operations in 2000, picking State Street. On expiry of the initial contract, they stayed where they were. Since the acquisition of SWIP by Aberdeen, which completed in early 2014, the enlarged group has retained the two providers. While the firm faces the added burden of managing a second relationship, this has the advantage of keeping two competing firms on their toes. In such cases, there may be some upside in contingency planning – although this should not be assumed, as there may not be a direct mapping of capabilities from one provider to the other.

By contrast, other acquisitions among asset managers have led to some consolidation of outsourcing provision. For example, Old Mutual had outsourced to RBC, while the Skandia business it acquired in 2006 had picked Citi. Post acquisition, Old Mutual consolidated with Citi. Following the 2014 acquisition of Ignis Asset Management by Standard Life, two providers were retained for a while, but HSBC is to lose the Ignis business as it is being consolidated into Citi with the Standard Life business.

In some cases, short-term cost savings were too high on the agenda and the two parties failed to adopt a partnership mentality. Fundamental to the success of an outsourcing arrangement, this calls for close co-operation and trust, so that contracts are drawn up and managed to be sure the deal is a ‘win-win' for the two organizations. One example of a deal falling foul of this and unravelling is Threadneedle Asset Management, with its outsourcing of investment operations to JP Morgan in 2006. The asset manager has a reputation as a tough negotiator. A variety of factors, including an undertaking by the bank to fund a platform for OTC derivatives processing, contributed to a difficult relationship. Consequently, the business is going through a lengthy process of migration to Citi.

"There are two phrases which underpin the success or failure of an outsourcing contract," says Ms Ramachandran. "The first, ‘better to do it well, than do it quickly' sums up the need for the contract to sit on firm foundations. The second phrase is ‘outsourcing is not a relationship, it's a marriage'. Unless the transaction has the total commitment of both parties to its ultimate success, it will fail."

Outsourcing: best practice

For a firm wishing to move an existing operation to a third party, it is no walk in the park. A sourcing strategy and roadmap must be designed – followed by thorough selection and provider due diligence, careful contracting, and detailed transition planning. Once implemented, the firm faces new challenges with regard to vendor management and business continuity planning.

Outsourcing relieves a firm of the day-to-day processing burden – and may allow for certain risks to be passed to the provider – but it does not absolve the firm's management from responsibility for gaining appropriate assurances that the provider applies sound control objectives and procedures. Increased attention from regulators and clients is encouraging more and more service providers to have their auditors report on their internal controls under the international reporting standard ISAE 3402.

The firm itself must build an effective oversight function, to monitor the provider and mitigate the risks of poor outcomes which are detrimental to the firm and its customers. Transferring processes to a third party presents resilience risk: a sudden failure of the service provider, with no adequate continuity plan, would lead to a damaging absence of service for an extended period.

A survey conducted in 2014 by Milestone Group revealed that 25 percent of the North American asset manager, wealth manager and pensions adviser respondents conducted no oversight whatsoever of their fund administration outsourcing providers. In 2012, following a review of UK asset managers' outsourcing arrangements, the Financial Services Authority (FSA) concluded that most firms were not fully in compliance with the regulations in section 8 of the Systems and Controls sourcebook (SYSC). This led to it writing a ‘Dear CEO' letter to asset management firms in the UK.

While the UK regulator was one of the first to focus on outsourcing risks, it is not alone. The Central Bank of Ireland has written a similar ‘Dear CEO' letter to asset managers operating in Ireland. Other countries with regulations on outsourcing include Australia, France, Germany, Luxembourg, Hong Kong and Singapore. We can expect to see a standardization of principles across the world, driven by the increasing practice of regulators to work together and also by many global asset managers holding their worldwide group to the developing best practice.

The UK's regulator expects asset managers to exercise due skill, care and diligence when entering into, managing or terminating any outsourcing arrangement. ‘Viable, robust and realistic' contingency plans should set out a clearly defined exit strategy in the event of the failure or termination of outsourced activity under any circumstances, including stressed market conditions. "What was different with their ‘Dear CEO' letter is that the FSA asked the industry to come up with a solution. This led to a unique collaboration between service providers and asset managers," says State Street's Mr Davey.

In May 2013, shortly after the UK's Financial Conduct Authority (FCA) replaced the FSA, it was presented with an initial set of recommendations by a seven-strong group of outsourcing providers, instigated and chaired by State Street's Mark Westwell. Working with the Investment Management Association (now known as the Investment Association), fifteen leading asset managers came together with the seven outsourcing providers – as the Outsourcing Working Group (OWG) – to define good practice for the industry, with the Big Four accounting firms as moderators. Their efforts culminated in a set of practical guidelines encompassing oversight, exit planning and standardization. These were published in December 2013 and presented to the FCA, which formally recognized them as being the ‘guiding principles' for the asset management community.

The OWG ‘guiding principles' are essentially a supplement to the very brief sentences in the UK Systems and Controls sourcebook. To help firms comply with SYSC 8, and apply the guidelines, providers such as State Street make available a series of templates for adapting to the firm's circumstances.

As recently as February 2015, the FCA noted, in a feedback statement on its wholesale sector competition review, that the asset management industry – while having made some progress – still has some way to go in enhancing oversight and contingency planning. It will be interesting to see whether outsourcing will form part of the FCA's 2015/2016 review of asset management.

Until recently, oversight was focused almost exclusively on service monitoring: applying service metrics under a service level agreement. This remains important, with advances in applying a flexible approach – aligning interests of firm and provider, with penalties for poor performance and rewards for excellence. But the scope of oversight is expanding to a broad risk management remit: the provider's balance sheet strength and financial stability, and what to do if one of the outsourced functions ceased to exist.