The limitations of contingency planning for outsourcing arrangements have recently been highlighted by the Financial Services Authority. Nicholas Pratt investigates.

Operational costs and regulatory burdens are twin forces that might drive fund managers to outsource. With compliance an ever-increasing challenge for the fund management industry, it is the middle office feeling it most.

Jonathan Clark, group chief executive at Citisoft, a consulting firm, says a fund management company planning to outsource these functions must consider its core competencies and risk reduction as well as cost.

In the middle office, the biggest focus is on client reporting – something that was previously kept separate from outsourcing contracts.

Asset servicing firms are now either building their own quarterly reporting solutions (such as JP Morgan) or partnering with reporting vendors (such as BNY Mellon and Vermilion).

“This is a significant departure and shows that asset managers want to improve their client reporting,” says Clark.

But while managers are seemingly willing to let outsourcers deeper into their middle-office processes, there is also a greater interest in operational due diligence.

According to Andre le Roux, business development director at investment services firm Maitland, fund manager clients insist on more regular and extensive due diligence exercises. “They are requiring access to the latest copy of financial statements and tax clearance certificates and any updates on changes to indemnity insurance.

“They insist that we are on the latest version of the core software to demonstrate our ability to re-invest. And we meet clients more regularly at a strategic level and these meetings are formally minuted and distributed to their risk and audit committees.”

While it will be rewarding for regulators to see managers taking more notice to ensure their outsourcing providers do not fall into financial distress, what contingency plans are in place if they were to?

The Financial Services Authority (FSA), the UK regulator, recently sent a “Dear CEO” letter to a number of asset management firms outlining concerns over risks posed by the increasing amount of outsourcing.

More specifically, the FSA has highlighted the limitations of current contingency planning for outsourcing arrangements. It outlines the four plans that most firms have in place, which include a belief that the regulator will save the group of which the service provider is a member should that group, typically a large financial institution, fail. Other plans are: taking activities back in-house; transferring to another provider; or exercising “step-in” rights.

The FSA’s concern is that these measures either lack prudence or underestimate the operational challenges involved and the time taken to resolve these challenges.

“In all cases we expect firms to have devised adequate contingency plans which are viable, robust and realistic and set out a clearly defined exit strategy in the event of a termination of outsourced activity,” says the letter.

“The way I read it is that most contingency plans are not adequate and that the FSA wants more robust plans in place,” says Clark.

The regulator’s concern opens the possibility that asset managers will be required to keep some kind of shadow record-keeping functions. This has been given more credence by a recent announcement from asset servicing firm Northern Trust that it had been selected by Bridgewater, a $140 billion US hedge fund, to provide a “shadow” back and middle office outsourcing service that will replicate the functions performed by existing administrator and primary outsourcing provider BNY Mellon.

The shadow service will kick in around the beginning of 2014 once Bridgewater has completed its move to the BNY Mellon platform and will involve the creation of 100 new roles to be filled by Northern Trust employees.

“In this instance we will shadow and compare everything across the trade life-cycle – reconciliation, valuation, NAVs [net asset values], P&L [profit and loss] and other functions,” says Peter Sanchez, chief executive at Northern Trust Hedge Fund Services.

It may seem an extravagant step to take in employing such an extensive arrangement and one that could possibly negate the economics of outsourcing, but Sanchez maintains that there is a cost saving aspect.

“Most hedge funds will have an in-house middle and back-office team that shadows the outsourcing provider, so this is just another example of outsourcing and reducing the in-house head count.”

According to Clark, adopting a similar approach for UK outsourcing arrangements with traditional asset managers could be a very expensive approach to the problem, but if this is what the FSA wants, then something shadow-like is likely to be an increasing feature in outsourcing arrangements.

Another option is for asset managers to consider business prcess outsourcing specialists, or data specialists, that can hold the data and act as a transitional provider or as a soft-landing in provider transitions.

How long it will take for the FSA’s concerns to become a pressing business issue is unclear. It is only a letter, not a mandate, even though the regulator does intend to host an event on the subject in early 2013, but it must surely be a concern for managers, says Clark.

“If managers are considering outsourcing, they will still look at the business case, but the contingency plans will be a more discussed feature. And for those managers already in an outsourcing agreement, some may want to go back and review their arrangements. The providers might not be keen on this but asset managers would be wise to take such a step.”

“The exit strategy is an issue that we always get questions on,” says Holly Miller, managing director of middle office services within the investment manager services division of SEI. “This is the ultimate business where exits can be difficult because there are a lot of things that can make an exit challenging.”

For example, a new provider might not have the capacity to bring a new client on board instantly. The client review process may also take a long time, especially where the functions are fund-specific.  And in the middle office there are data feeds and workflows that need to be replicated which takes a lot of co-ordination.

Therefore, says Miller, it is vital that the investment manager is able to get its hands on the data.

“We have some clients that take daily data feeds which gives them much more security. Some will set up their own warehouse for managing this data and others will use an external repository.”
If clients are not allowed regular access to their data, Miller warns, then it should raise concern.

©2013 funds europe



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