As Investment Managers Feel the T+1 Heat, Outsourcing Looks Better and Better

Investment-management firms, tired of investing huge sums in technology and operations, are beginning to take a closer look at other ways to stay on the cutting edge of securities processing. One of those ways is by outsourcing non-core competencies to third-party service providers.

Though outsourcing has been prevalent in the investment-management community for the last decade, if not longer, it has been relegated to back-office functions, such as portfolio accounting and transfer-agency processing. Now, with T+1 laying in wait, investment managers are investigating what additional processing custodians banks and technology vendors can provide, which will allow them to focus on making sound investment decision for their clients.

According to Pamela Brewster, an analyst with Celent Communications, a Boston-based firm which specializes in the impact of technology on financial services, outsourcing is hitting the radar screen of more investment managers as their pocketbooks are squeezed by the economy, while, at the same time, outsourcing providers are getting their houses in order and their message to the masses.

That message is this: Let us worry about processing your trades. Let us help you achieve straight-through processing. Let us help you get ready to settle trades in a T+1 environment.

Many firms in the investment-management community, and the industry in general, took last year's T+1 postponement by the Securities Industry Association as a sign that they had, at least, a year to focus on other things before resuming their march toward T+1 compliance. But, in the last few months, the tone of talk in the industry has changed from T+1 to straight-through processing. Though interchangeable to the outsider, these two ideas are quite separate.

On the one side, T+1 is an easily definable, specific industry-wide goal. However, it is a goal whose means are not defined. It is possible to piece together a hodge-podge solution that would allow a firm to reach T+1 without delivering true straight-though processing. STP is defined as occurring when a trade, once entered, travels from system to system without ever being manually altered, right through to settlement.

As the dialogue has changed to STP - a process which many feel will reduce the risk of trade failures and allow firms to keep up with the growing volume of business they must support - and firms begin to drill down on what achieving STP will cost them in time and treasure, outsourcing appears worthy of investigation.

Celent's Brewster says there are no easy answers. A critical first question, however, is to ask what your goal is? Is it to transfer the firm's focus back to core competencies or to reduce costs and gain efficiency? Perhaps the goal is to reduce head count.

One of the current models offered by outsourcing venues could do just that. In one of the more extreme forms of the practice, called a "lift out," the investment-management firm actually transfers IT and operations staff to the custodian bank or technology provider, which then assumes responsibility for those employees.

The danger of this model can be seen when looking at SWIFT's now-defunct arrangement with Global Crossing. SWIFT had contracted out maintenance of its networks to Global Crossing but, when the global-telecommunication provider declared bankruptcy, SWIFT was forced to do an about-face and resume control of the network.

Brewster says that ascertaining an outsourcing provider's financial well being is one of the most important steps a potential client can take before signing on. "The number one criteria that investment managers look at when picking a provider is stability," she says. "Stability means believing that they are going to be around for a long time."

Custodian bank State Street has taken on two lift-out clients, inking deals with investment managers Pimco and Scottish Widows.

Outsourcers also offer a business-service provider model in which their personnel remotely operate an investment manager's systems and applications or, for firms that wish to keep their people pushing the buttons, an application-service provider model may be the right fit. In this scenario, an investment manager has its operations professionals remotely accessing a custodian/vendor's systems.

It's also important, says Brewster, to make sure that the vendor has deep pockets and intends to use what's in them to keep its products and services the best on the market.

But, what to outsource? How to outsource? Who to outsource to? To help answer some of these questions, check out a chart created by Celent's Brewster at: https://wstonline.com/rc/im

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To Outsource or Not to Outsource?

The following is an excerpt from this month's Q&A with Denise Arend, director of operations and chief executive of STP, the California Public Employees' Retirement System (Calpers).

Calpers, which has an investment-portfolio market value of $148.5 billion (as of Feb. 28, 2002), provides retirement and health-benefit services to more than 1.2 million members and more than 2,400 employers.

WS&T: You mentioned that you plan to build a messaging hub? Is that something you would outsource to a vendor?

AREND: Yes, it is. We are looking at vendors providing all of these solutions for us and we have not completely decided that we are going to provide the platform for all of this internally or if we're going to outsource the entire solution.

In other words, we obviously have a great deal of technology resources allocated to the other side of our house, the benefits side, the retirement side, and we can build on that infrastructure and have all of these things operating internally or we could say, no, that we really want to outsource all of this to another company. There are a number of businesses out there that have been talking about how they can provide full-service, front-to-back STP solutions for organizations.

The Aladdin product (from BlackRock) is an ASP, so we may even use an ASP solution for the equity side. None of these decisions have been made and we're exploring those as we go out to bid for products.

WS&T: What goes into this kind of outsourcing decision? How do you decide who to go to for help?

AREND: We are a public agency whose staff is based on a civil-service system. Other companies can go out and buy the expertise they need, either through hiring employees off the market or by consulting contracts. I think that is one of the go or no-gos for bringing it inside or having it outsourced. That is probably the case for any organization.

This organization has a tremendous amount of effort going toward building the technology to properly provide retirement benefits, retirement estimates, Web-based service to all members, including employers, who are a part of the system, and there's only so much that an organization can take on and so that's why it's still an option for Calpers to look at outsourcing the services that need to be provided in order for us to achieve an STP solution.

Now, does that mean we would stay with that? It depends on how much we would invest. If we end up outsourcing to another ASP for equities and we can figure out how we can make the connectivity happen to our counter parties through those ASP models, we might be happy with that for a number of years, which will buy us the time that we might need to build up our internal technology staff and resources to support the investment side of the house.

I think that another aspect is clearly going to be cost but, from what we have read and what we have learned, I'm not convinced that it's going to be cheaper one way or the other, to outsource it or to bring it inside, and so that may not be as significant of a factor in the decision as the operational factor I mentioned earlier about how much an organization can take on in a very short period of time.

WS&T: Do you have any vendors in mind? When you think of outsourcing do you think of the large custodian banks?

AREND: Quite honestly we don't have any candidates in mind. We are still gathering information.