Outsourcing: Problem or Solution?

The regulatory world is getting concerned about the risks associated with outsourcing. They are right to question.
The regulatory world is getting concerned about the risks associated with outsourcing. They are right to question. Experience shows how easy it is to get the process wrong and how hard it is to unwind a problem move. And that is before considering any circumstances where a supplier becomes un-creditworthy or simply unwilling to continue to invest in line with a specific client’s need.

The industry response to the regulatory concern, which appears to focus very much on due diligence and monitoring, is a sensible approach. But it does not really answer the key question of whether a single, or even dual, supplier for post-trade is appropriate. And, in our ever more litigious world, it would have been helpful to consider liability and exclusion clauses in the ever more turgid regulatory environment. The industry response though touches on several important aspects of any outsourcing, namely the need to ensure detailed and ongoing due diligence on the supplier and the importance of contingency planning. And, in line with the current day mantra, there is talk of standardization.

The reality is that, for any large fund group, and especially the diversified ones, outsourcing has to take careful account of supplier risk in all its aspects. The classical areas of outsourcing are custody, fund administration and transfer agency. There are a series of other services that may also be aligned to these three, from prime services through to traditional treasury and banking facilities. And there are simple enough interfaces between those three core functions to allow the sell side to consider component based outsourcing along these disciplines. The related functions of prime service, banking and treasury have been unbundled in many cases for many years, often with a range of providers.

The trouble with outsourcing is that it is driven by several rationales. First, it is to ensure quality service in areas where the fund manager feels they do not have a core competence. Second, it is to gain benefits of scale through access to functionality and price advantage. However, there have been a series of transactions driven by despair. In these cases, the buy side has found managing a back and middle office, in the modern fast changing operational and regulatory environment, to be disruptive to their core business of fund manufacture, performance and distribution. They have therefore sought to rid themselves of a problem rather than solve the problem itself.

One of the first rules for any outsourcing should be an in-depth assessment of the immediate environment within the fund and the shortcomings of operating in-house. Logically that should be followed by consideration of the optimum operating model needed by the fund. This is less complex than it sounds as the fund needs to specify what it expects of its middle and back offices and not how the process should work. However, as part of the negotiations with any potential supplier, that issue needs to be assessed and understood in detail.

This creates the first problem, namely the fund has to have a clear vision of where it wants to go. It has to decide if it wants to be a niche or mainstream player. The more niche its vision, the more risk they assume that the supplier will not be able to meet their requirements. The more they belong to the mainstream, the lower that risk.

The second problem is one of the outsource life cycle. Whilst a pure custody outsourcing can be unwound within weeks or a sub-custody one in an inactive market in days, fund administration and transfer agency services are much more complex. There is the complexity of data—for we are in the field of big data with history being as important as the immediate live data. There is the complexity of process, ranging from simple in a long-only, home-country fund to highly complex in leveraged, derivative overlaid, multi-market and multi-instrument environments. There is diversity in methodologies depending on the nature of the fund, both in terms of geography or structure, for we are in far from a uniform world within the EU, let alone globally. And there is the challenge of maintaining unit holder registers especially in multi-class retail intensive funds. Irrespective of the work undertaken to reduce diversity, for we are far from achieving much semblance of standardization, the time lapse for the relocation of any large fund administration or transfer agency operation is definitely measured in months and needs active cooperation between the ceding and acquiring party.

And we must not overlook the impact of any fund move on banking, treasury or prime service provision. Credit, with the security or, at least, control of the underlying assets, has distinct low risk attributes for the incumbent custodian and administrator. The timing of any change in operator has to be aligned to the maturity profile of the credit providers, unless there is a novation and transfer of such exposures.

The theorist assumes life is simple. I have railed many times against the banal assumption that CCPs could withstand the default of their largest participants due to the excess collateral they carry. That excess will disappear in the resultant turbulent markets.

The thinking on fund outsourcing is similar. For that reason the focus on ongoing due diligence is valid. The need to understand any exit strategy is vital. But these two ideals need to be aligned to two core facts. First outsourcing to a new relationship is very difficult and so funds should consider relationship diversity to ensure they have multiple known exit options. And secondly, outside of core custody, the timeline for a transfer is lengthy. Funds need to be sure of the long term commitment of their supplier to the business and to their strategic needs. And finally, even in a world where big appears to be bad in banking, I personally would opt for the top-tier players. In reality, the systemically important institutions are the ones most likely to come through, or even be nursed through, the inevitable next crisis.