Component-based Outsourcing to Become the Norm

One of the themes tackled at the recent NeMA conference was the question of outsourcing. What functions can a custodian outsource to utilities without detracting from their value added client proposition?
One of the themes tackled at the recent NeMA conference was the question of outsourcing. What functions can a custodian outsource to utilities without detracting from their value added client proposition? The trouble with such debates is that they look at the service propositions of the different custodians on a modular basis, adopting an “all or nothing” philosophy. In reality, the optimal opportunity to outsource to utilities depends on the custodian re-engineering their process flows and identifying components within modular silos for outsourcing. This is no different from in house offshoring where the approach is to outsource the simple part of a process but retain specialist expertise within the home country.

One such candidate for outsourcing should be fund valuations where the bulk of pricing is a technical exercise requiring comparison of different price feeds. It is true that a sub set of fund assets may require sophisticated analyses of varying elements that combine to give an asset price. The former valuations could easily be outsourced. The latter cannot be outsourced as the computations are judgmental ones. It would be wrong to assume, as a result of the second component, that pricing cannot be outsourced for the reality suggests that just one, and a relatively small subset of pricing, which is simple to unbundle from the bulk of the process, is difficult to outsource.

There are obvious other areas where outsourcing is possible. The major one is in the creation of a “golden source” event utility. There has been a myriad of worthy papers on corporate actions but the key challenge of corporate actions is the accuracy and timeliness of data. A secondary challenge is liability. Buyers want, not only the guarantee of accurate and timely data, but also the ability to lay off corporate event risk. The latter issue is the stumbling block, for technically we could obtain golden source and timely data in 95 per cent plus of markets. As those markets have reliable data, surely the question for potential users is whether they would gain from outsourcing events in those markets and whether they really need a guarantee in such cases. Intuitively, the answer should be yes and no respectively. If they can outsource the bulk by volume of corporate event activity, firms could focus their own efforts on the high risk areas of corporate actions. They are likely to be able to eliminate a material part of their current risk as they focus on the really difficult rather than spread themselves across the entire global market.

And, on a pet theme of mine, industry wide database utilities appear “a no-brainer” especially in the context of standing settlement instructions or legal entity identifiers. The concept of multiple firms managing such databases with the objective of ensuring uniformity with their counterparties is an anachronism, a total waste of money and a risky process.

Outsourcing is, though, not the only solution for the elimination of the unnecessary cost burdens of the industry. As I have mentioned in previous blogs, there are a number of labour intensive and costly processes that could be automated and risk enhanced with will and effort of the authorities and markets. Tax reclamation is a case in point. A global standard is far too complex a proposition but an EU one would be logical. A single portable tax declaration across EU jurisdictions, recognizing common documentation and using common language, would be a huge value to the industry. That, rather than the oft suggested standard process, with appropriate deduction at source being the favored mechanism, should be achievable. It would eliminate many of the problems we have all experienced on EU-wide tax reclamation since as long as four decades ago with the infamous Italian tax reclamation cases.

But processes such as these are not the biggest challenge. The key challenge of the future will lie in the newer components of the custody world. Portfolios are becoming too complex for a single supplier to be able to cover all their needs. In a few cases, the universal banks will seek to achieve this. But component based outsourcing, outside the top few, is bound to become a norm. After all, geographical outsourcing is a standard in the industry and the driver behind the sub custodian world. No global custodian has universal coverage and even the very largest of the global sub custodians, such as Citigroup or HSBC, still require agents in numerous locations. Most custodians will need to consider product specific partners in areas where they do not have critical mass or special competence. The Euroclear collateral highway or Clearstream collateral hub are examples of this. But demand is likely to spread into other fields, beyond collateral management, such as traded derivative clearing, asset financing including collateral swaps, repos activity and classical stock lending and borrowing.

The real winning proposition, however, is unlikely to be in these product modules but in the IT world. Within organizations, there is already a realization that IT architectures cannot be business specific. The classical design is modular and duplication within firms is frowned on. After all it is an unnecessary cost burden for any IT component gives payback against volume usage, and we live in a world where the life expectancy of most IT solutions is reducing in the face of ever faster technological development. Once we cross the Rubicon of internal co-operation in IT, the potential for sharing across different enterprises becomes viable. Large players will always assume that they can go it alone and see that as a competitive advantage. But that is no longer really the case as the technical barriers to cross enterprise cooperation have disappeared with cloud technology and improved technical security.

This is a challenge for the existing utilities, and especially for ones in technological niches such as SWIFT, for it could lead to a wholesale repositioning of both platforms and process in the coming decade or so. And the winners could well be one or two of those monoliths in the world of technology whose current footprint in the financial world is far too specialized and far too fragile.