Asset Managers Find T+1 Help at the Back Door

Despite all the technology required just to keep its doors open, the buy side is not in the technology business but rather that of investment management-the aggregation and growth of client assets as a result of sound investment advice. Dealing with the technological requirements necessary to bring about a one-day settlement cycle (T+1), which the industry has slated for June 2004, doesn't necessarily fall under the job description. That makes the outsourcing of back-office functionality an attractive option.

Enter the custodian bank, whose historically intimate involvement with the buy side puts it in just the right position to take advantage of the windfall T+1 is creating for straight-through processing (STP) facilitators. Some custodian banks feel they can do just that-including offering connectivity to GSTPA, Omgeo, or both-for investment managers and don't want to be left out.

Though providing outsourcing services for back-office processing is a recent trend, custodian banks have long been racing up the trade chain from their initial fiduciary responsibilities; encompassing custody, trade settlement and cash movement, to fund-administration accounting and record keeping, finally to full back-office outsourcing and beyond. Market events like globalization, the Euro, Y2K, T+1-and the constant technological innovation they demand-have caused many investment management firms to look outside their four walls for help. Why, though, to custodians?

"The custodian banks have all the details-they have all the information that people need to manage their portfolios," says Thomas Perna, senior executive vice president with The Bank of New York (BONY), which counts firms like JP Morgan among its buy-side, back-office clients. "They (custodians) have the securities, so they have all the information on things like corporate actions, income, the security movements, the cash flows. They have all the information, so it was a very natural process for the custodians to morph into what some of us are today."

Kathy Dugan, vice president and manager of Northern Trust's Global Custody Product team, which selectively takes on investment management clients as a back-office provider, says custodians have morphed into their new role rather recently, creating many questions about the proper pricing and business models. Northern Trust, she says, is only selectively taking on clients in the new capacity because custodians are still not quite sure of the risks involved.

Dugan explains that while custodian banks are easing into the nascent business, it is apparent the custodian/investment manger relationship can only bear STP if industry standards, such as uniform communication protocols, are embraced. "We can't take everybody's format and say whatever you want to do, we'll do. What we have to do it be able to identify a number of standard formats."

For large investment management firms, which have the resources and time to invest in their development, Dugan says communication by way of SWIFT messaging works just fine. For mid-sized firms, she says the Northern Trust can accept flat files, if configured according to the custodian's specifications. "We can give them a format that is relatively easy for them to figure out," she adds.

For small money-management firms, Dugan says her company has developed an Internet-based offering where clients can log onto a Web site and input trades, which are then routed into Northern Trust's straight-through environment. "That's not STP from their perspective because they have to enter the trade, but it may be the only technology they can support," she says.

In addition to accepting information from their investment management clients in multiple formats, custodian banks also offer a variety of business-model options. State Street, for example, has three variants for potential clients to choose from, depending on their size and requirements.

The first, and the option selected by the Pacific Investment Management Company (PIMCO), is the Business Provider Outsourcer (BPO) model. In that scenario, State Street takes over the physical outsourcing facilities of an investment manager with its own people. "All we did on August 1 of last year was take down the shingle that said PIMCO and change it to State Street," says Tom McCrossan executive vice president and head of the State Street Investment Managers' Solutions business.

Bob Ettl, managing director and chief technology officer with Allianz Asset Management, which acquired PIMCO, explains the reasoning behind such decisions. "My thinking is that heads of technology in institutional firms are going to have to really decide for themselves what's strategic and what's proprietary, what they need to build for themselves and what they do not. In those cases where it's not but there are pressures of T+1 and globalization, then we'll need to identify industry solutions or vendor products that can really meet our needs."

State Street also offers an Application Services Provider (ASP) solution, where it hosts the back-office applications required by an investment manager. The applications are then accessed and run by the investment manager's personnel. As a third option, the custodian has a Business Service Provider (BSP) model where State Street would use its people and technology to support an asset manager's back-office capabilities.

Not content in the back office, State Street is attempting to break out of that environment by offering pre-trade risk metrics and compliance tools as well as a trade order management system, workflow tools and a portfolio management system. "We don't necessarily see our competitor offering all of these choices," notes McCrossan.

Those competitors include custodians like BONY and the Northern Trust, which also act as outsourcers for investment management firms. Perna says BONY offers a client-data warehouse, security-master database, global-accounting system and processing engine. "Those are the four main things that are hooked together," says Perna. "It depends on exactly what the investment manager is looking for, from an outsourcing perspective, which will determine how we hook up with them and what we offer them."

Perna says BONY has a few advantages over custodians like State Street and the Northern Trust. "One of the big advantages is that we're not a competitor. We're not in the asset management business to any degree, so I think when an asset manager looks at who they're going to partner with, one of the things you have to consider is: Are you hooking up with a competitor?"

Comparing competitor pricing is difficult because every asset manager is slightly different, resulting in highly tailored arrangements. Perna says BONY will sit down with an investment manager of any size and determine price according to what is required. Though he refused to be specific, he says, "There are a whole bunch of ways to price it to allow managers to pay for it."

McCrossan says State Street is ideally looking to work with firms managing at least $40 billion, though the ASP model should suit smaller organizations. Dugan also would not discuss specific pricing, citing the fact that the business is so new that there are still more questions than answers. "What are the risks, the controls, and can we make money on it?" she asks.

McCrossan echoes that sentiment, saying, "the business is in its infancy stage, so you really have to look at the asset manager on an individual basis." He says State Street's billing can be either asset-based or a combination of transaction charges and asset-based fees.

With custodians moving farther and farther upstream, the question becomes: How far can they go? There is a limit, says Dugan. "The things that the investment managers needs to keep are the execution of the trade and the client management. That may or may not include performance measurement but really anything that really touches a client, they may want to keep."

Perna says he, like Ettl, sees many investment managers confronting the build or buy decision as the industry gets closer to T+1. "I think many, many more (asset managers) are making the decision that you can't invest in every aspect of the business and they'll continue to invest in things that will distinguish them from their competitors and outsource some of their operations to people like ourselves."

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Why Does JP Morgan Fleming Outsource?

JP Morgan Fleming Asset Management, a $611 billion firm, has an outsourcing arrangement with The Bank Of New York in which BONY handles the investment manager's operations activities that are "south of the trading desk and north of performance measurement," says Kin Corning, managing director with JP Morgan Fleming Asset Management.

Those activities include managing trade settlement as an agent, monitoring income collection and corporate action events, reconciliation with third-party custodians, multi-currency portfolio accounting and asset servicing.

Corning says custodians like BONY make good outsourcing partners because they have excellent operational skills and the latest technology. Additionally, "They (custodians) need to keep up with industry change and they need to develop, substantively, the same capabilities that one needs in an investment-management back office in support of their master trust and other value-added services," says Corning. "We think that the major global custodian banks are better positioned than anybody in the world to deal with industry change and T+1 is the best example of that."

Kathy Dugan, vice president and manager of Northern Trust's Global Custody Product team