Times they are a-changin’: Outsourcing impacts on the front office

Read the article and learn about:

• Why investment managers have increasingly chosen to outsource over the past 20 years
• Why outsourcing is not a ‘no brainer’ decision
• Whether the supposed benefits of outsourcing will ever actually materialize

Marlena Fitts
Global Front Office Product Marketing

The reasons investment management firms have increasingly chosen to outsource their back and potentially their middle office operations over the last 20 years are numerous.  Roughly 86% of banks, brokers and broker dealers outsource at least part of their middle and back office functions¹, and from what I’ve seen, the outsourcing statistics are much the same for institutional asset managers.  The market trend, benefits and justification for outsourcing is crystal clear, right?  Well, before answering that, let’s take a moment to break it down.

As I see it, the top reasons firms outsource include:

• To focus on core competencies
• Free up existing resources for other purposes
• Create operational efficiency and reduce costs
• Reduce time-to-market
• Spread risk

For firms contemplating outsourcing, it’s a game-changing decision, and its impact on the front office should not go unaddressed. Once you go down this road, it becomes very difficult to turn back when you consider that all infrastructure and cost controls are moved externally. That is not to say that it can’t be “undone” – we’ve actually had several clients in the last two years that brought their overall position-keeping and investment book of record (IBOR) back inhouse because of the negative impact on their business from having these maintained externally.

The point is more that escalating market conditions, such as growth and proliferation of data, increased regulation, transparency demands and legacy technology, to name a few, are altering the required solutioning at play. Before embarking on this journey, firms need to realize that it is not the “no brainer” decision it is perceived to be by so many.  For those that have already made the outsourcing decision, a checkpoint or reassessment may be in order, at minimum, to ensure current and projected growth targets will continue to be met as competition heightens.

Breaking it down

Regarding the focus on core competencies, there is no arguing that outsourcing “commoditized” functions allows for this, though there is a front office trade-off here with reduced control and communication capability as a result. The offsite nature of the setup alone can make it difficult to maintain the desired level of control, but the method and timing of transferring mission-critical data trumps everything. Without a consolidated approach, investment managers will not have the ability to act quickly when divergences arise. It is important to make the distinction between a consolidated and an integrated approach. Integrations between systems that only transfer data once a day or periodically will continue to present multiple latency and accuracy issues.  These communication inefficiencies can exist both internal to the service provider, depending on the platform(s) utilized, and between the service provider and asset manager, potentially far outweighing the benefits.

There is also no doubt that with an outsourcing relationship established, investment manager staff reductions can take place and those resources that remain can focus on other less commoditized functions.  However, with an outsourcing decision, the pool and quality of those supporting the front office will naturally diminish, and dependency on the service provider grow stronger, over time.  Many firms are challenged with attracting and keeping talent.  Having a strong integrated platform with a top of the art front office can really help with this.

To determine the level of operational efficiency and cost reduction, investment managers would need to calculate and factor in all line item expenses involved, such as infrastructure, new technology and staff to support the vendor oversight process, any overhead costs related to continuing to get the required data over to the front office, and then compare that to:

• Their current costs, and
• The cost/benefits achieved if they consolidated their in-house platform.

Do they? Not usually, based on my experience, having worked on many relevant projects over the years, on both the consulting and vendor side of the industry. At least not to the detailed extent that would allow them to put concrete analysis behind the decision.  Having also worked for a service provider for over eight years at the start of my career, I can tell you first hand that from a cost and efficiency standpoint, the grass isn’t always greener.  Some outsourcing providers have just as many, if not more infrastructure challenges than the investment manager.

And where the front office is concerned, it’s more than that.  Whether insourced or outsourced, it is the soundness of the infrastructure, consistency of process and cohesion of workflow that makes the difference. Outsourcing can compile issues with an inefficient provider, since, as previously mentioned, there are forces both internal to the service provider and between service provider and investment manager that can negatively impact time to market. The recent flurry of acquisitions that have brought promises of straight-through processing and single platform solutioning are far from the perfect answer.  For some added insight, the challenges at hand, risks of failure and the years of technology evolution required to make good on these promises are all discussed in the recent webinar Acquisition mania: What happens when the dust settles, with industry experts from Olmstead Associates, Bobsguide and SimCorp.

Now, some have argued that they don’t need to factor in the costs of performing any oversight when weighing the decision because they “trust” their vendor.  My detailed opinions on that thought process can be saved for another blog, but whether you are domiciled in a location where regulation requires oversight or not, reputationally, it’s the investment manager that will suffer the consequences of any flaws.  When it comes down to it, reputation largely determines success or failure of the firm (i.e. inflows vs. outflows), so I’m not personally buying into the shared risks perspective of outsourcing benefits, regardless of who is paying for the error correction/unwind costs.  We all know who is really paying for it in the end.

The right path

In truth, my career path: from service provider to consulting, to now software, was in large part so I could make a difference in what I believed was a very flawed way of supporting the front office in growing their business.  The ability to bring accurate real-time, back office/analytics data into front office decisions is so crucial and far more a necessity than a nice to have at this stage, given the mentioned challenges investment management firms face today. The front office can’t effectively do their jobs without it. 

Think about running a Liability Driven Investment (LDI) strategy or a tax sensitive investment strategy.  Do you think it’s reasonable to expect a portfolio manager to wait for a batch process that runs once a day at best, and typically overnight, to have access to mission-critical P&L information he needs to make a decision regarding any required adjustments?  The portfolio manager should have access to all the accounting analytics needed to optimize their portfolio and these should become an integral part of the investment decision process.

Another example would be real-time accurate cash and position information.  A portfolio manager might overdraw the portfolio if he’s not aware of a change during the day that impacted his cash balance. Worse yet, the portfolio manager maintains a very costly cash buffer because he doesn’t feel he can trust the cash balance information he is given.  Getting this data over to the portfolio managers was a constant struggle in my earlier years.

Collateral is another key analytic, where the portfolio manager needs to know, ideally before he makes a trade decision, whether a particular position is out for collateral and thus blocked from trading, or whether there is a compliance breach because the market value of what is held for collateral has changed significantly, and thus a trade is required.   

The list is endless. And, it’s not always something that decision makers think about ahead of an outsourcing decision, but not having this key analytics data immediately available can have a huge impact on a firms’ ability to perform. 

Sure, there are tools that provide analytics and reporting dashboards, but few that apply a real-time, single source of data and calculations within the core platform, feeding across all front-to-back office functionality, giving confidence in the actual output being displayed.  This is the key that allows for real straight-through-processing (STP), and this type of tight knit workflow across functions is perhaps not impossible, but difficult to achieve in an outsourced situation.  Yet, it is one of the most important criteria in ensuring front office success.

My advice – think more than twice before going down that road and do the proper due diligence (i.e. the full detailed analysis on cost-benefit options, along with service provider operational reviews) prior to making any decisions.