Major
custodian banks are buying market share, especially in the
UK, in an effort to become the primary providers of investment
management back office outsourcing. Many of the outsourcing
activity centers around "lift-outs" which are only
transitional solutions until the custodians can complete technology
and operating platforms. Because the custodian offerings remain
immature, the investment manager's decision to outsource is
largely predicated on short-term financial benefits rather
than on the long-term viability of the providers.
Cost Savings v. Risk
Although the short-term cost savings can be attractive,
they carry dubious economics for the providers and risk
for the investment firm. In the UK, providers must do the
same work approximately 50% cheaper than the fund manager
to make a 10% profit. Investment managers expect a 15% savings
to outsource, taxes are 17.5% (in the UK), management overhead
is 10%, and transition depreciation is 10%. Many of the
current deals are unprofitable for the providers and this
could lead to service reduction; as a result, investment
managers need to consider operating risk when evaluating
the outsourcer.
US firms have long outsourced transfer agency and fund
accounting/administration, but in the past two years they
have balked at outsourcing institutional accounting because
of perceived failures of early adopters.
Europeans Have More to Gain
Investment management firms in Europe are much more
active than their US counterparts in considering outsourcing
their back office operations. The driver for change in Europe
is cost control; either straight cost reduction or future
cost avoidance. Firms are attracted to the outsourcing model
because it turns fixed costs into variable costs. European
investment managers currently have high operating costs,
major regulatory change pressures, market restructuring
requirements and high technology upgrade costs. Partnering
with an outsourcing provider should allow a firm to concentrate
on core applications and eliminate the ongoing headaches
of technology upgrades and back office processing.
Success Factors
Firms considering an outsourcing partner should look beyond
the immediate cost savings that are artificially inflated
during the early adopter phase of industry development.
The long-term success of investment management operations
outsourcing will be dependent upon the providers developing
scalable, feature rich multi-national platforms that can
accommodate the needs of a wide variety of firms. Firms
evaluating outsourcing options should carefully consider
the long-term viability of the vendors supporting systems
infrastructure. Custodian banks will achieve long-term sustainability
only if they can migrate a critical mass of firms onto a
single, feature rich platform that has cross-firm reference
data management, reconciliation, market data, message delivery
and other common multi-firm sub-systems.
Where We Are Now
Cutter's research indicates that custodian banks are
at different stages in developing multi-firm technology
platforms:
- State Street has concentrated on lift-outs and now has
many 'islands of technology' supporting different clients.
State Street's clients eventually will need to be consolidated
onto a single core platform and that platform is not yet
available.
- Bank of New York has tried to balance the lift-out of
new clients with migration of clients to their core platform.
- JP Morgan is evolving their platform as each new client
is taken-on.
- Mellon has adopted model that intends to use Eagle PACE
and STAR products as the technology core.
- BNP Paribas has adopted a vendor-based model and is
basing their offering around DST's HiPortfolio.
- CitiGroup and HSBC are concentrating on completing the
full lift-out and migration life-cycle with one client
and will not take on additional clients until they are
completed.
Looking Forward
Since there is no proven track record in operational outsourcing,
many investment managers are taking the view that the risks
are currently too high to make a move into outsourcing at
this point. Cutter estimates that it will take five years
for the providers to have the stable and proven platforms
that will make outsourcing back-office processing viable.
Early adopters should make sure that they have some protection
against partner failure and operational risk. It would be
prudent for these firms to:
- Implement an internal data warehouse to ensure that
they have a copy of their own data.
- Invest in middleware tools so that interfaces to the
custodian's platforms can be controlled through a single
conduit.
- Provide an internal architecture to offer some level
of contingency and make it easier for interfaces to be
quickly redirected to a new provider.
In the longer term the evolution of investment management
operational outsourcing could mirror the trend to outsource
custody in the 80's. The challenge for the outsourcing providers
is to create scalable, functionally rich platforms and an
adequate track record of successes.
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