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As the Market Goes Down, Outsourcing Goes Up

In a tough economy, outsourcing may be your best bet for keeping software-maintenance fees under control.

When it comes to managing IT systems, hedge fund Basswood Partners has tried a little bit of everything, says Marc Samit, chief financial officer.

The firm, which manages $500 million in two funds, started out in 1994 in New Jersey with a handful of employees and took care of the systems themselves, says Samit, noting that "We had no idea what we were doing."

As the firm grew, it outsourced the task to a computer-support firm but had a "lot of problems" because the vendor "didn't have expertise and contacts" in the capital markets. Basswood then brought somebody in-house, but that didn't work out. So when the firm, which had grown to 15 employees, relocated to Manhattan in the late 1990s, Samit needed an alternative solution.

That's when he decided to outsource the task to Richard Fleischman & Associates, Inc. (RFA), a Manhattan-based technology firm that services about 200 hedge funds.

The firm now manages Basswood's systems. "We don't need to have anyone internal," Samit says, noting that, "They know us." There's about five to eight people who "know our systems inside out" and, "It feels like having people internally. If we have problems, the response time is quick."

Samit's firm is doing what more and more investment firms are contemplating - outsourcing parts of their operations to third parties. Everything from IT systems to business processes, such as portfolio management, and customer services, like client reporting, are ripe for outsourcing.

According to Boston-based research firm Celent Communications, outsourcing revenues in the financial-services sector will climb to $30 billion by 2006, with companies in North America and Europe leading the way.

The leading categories for outsourcing were trade automation, data management, the development of client extranets, reconciliation and corporate actions.

Pamela Brewster, a senior analyst at Celent, who has studied the outsourcing trend in a number of reports, says that while the decision to scrap T+1 has "dampened" some people's interest in outsourcing, there is still "quite the fervor around the need to outsource."

A number of factors are converging to prompt firms to outsource. The need to cut costs, globalization and "increasingly demanding clients" mean that investment managers must overhaul their operations, she says, and outsourcing will be high on the list of solutions.

Steven M. Papulak, first vice president and business manager for investment solutions at Mellon Global Securities Services, agrees that investment managers are "looking to outsource additional areas" other than traditional services like custody. "There are enough entities out there, including Mellon, which are building products in and around the investment process" and there is a growing array of options for firms.

However, before outsourcing can really take off, Papulak says, messaging standards need to evolve so that firms can seamlessly communicate with each other. The Swift and FIX standards are gaining acceptance, but the "combination of Swift and FIX coming together may take years." As standards evolve, it will "lead to more commodity services" and "open the door for outsourcing."

What drives outsourcing, Papulak says, is the "cost versus the benefit" of undertaking a task.

Another trend that's emerging is offshore outsourcing and using firms from India, Pakistan or China to write code and develop applications. Rich Malone, chief information officer at St. Louis-based Edward Jones, says his firm uses Larson & Toubro out of India. "They primarily do mainframe programming for us," and are "moving into some maintenance work. It's a cost effective way to get things done."

"IT is a big cost issue for any firm," he says, and by outsourcing those functions, internal IT staff can be deployed on new projects.

Bill Moriarty, who's responsible for software development at Edward Jones, says the firm works with on-shore coordinators from Larson & Toubro and with the time difference between North America and India, the IT department is "virtually a 24-hour shop."

So what tasks are ripe for outsourcing? That depends on what the investment firm determines is core to its business and what makes the firm different from its competitors, experts say.

Papulak says "most managers would not outsource the investment decision-making process. That intellectual capital is a core competency."

Brewster says firms need to assess and understand their core investment processes. She categorizes that as portfolio management. In it lie research, analytics, performance measurements, attribution, risk management and compliance. These are virtually untouchable and constitute the essence of an investment firm.

The rest of the processes a firm undergoes on a daily basis are extraneous to the core business and are leading candidates for outsourcing.

In the middle and back office, that includes the post-trade activity category, such as settlement, custody, reconciliation and corporate actions, as well as accounting and record keeping, which involves reference-data management, income accounting and tax reclamation.

In the front office, she says, tasks involving pre-trade activities, including pre-trade decisioning and compliance, trade entry, routing and trade-order management qualify, as do certain client services. Those include performance reporting, invoicing, customer-relationship management and managing the firm's extranet.

"The lowest hanging fruit" is communications, Brewster says. "A lot of investment managers have to communicate with up to 50 different custodians. Outsourcers can come in and centralize that for them."

When it comes to picking an outsource provider, Brewster notes that "an array of firms are lining up to meet the outsourcing needs of the marketplace." They each have advantages and disadvantages.

The best positioned to serve it are the global custodians, such as Mellon, State Street and Bank of New York, which will appeal to investment managers with more than $40 billion in assets. She notes that 80 percent of investment firms say they would consider outsourcing additional services to their global custodian.

But while they have deep pockets and an entrenched customer base, custodians can also be bureaucratic and, in some instances, have divisions that compete in the asset-management space.

There are also traditional outsourcers, firms like SEI and Cogent, which will appeal to asset managers in the $10 to $40 billion range. They tend to be better attuned to client needs and have experience, but lack a global presence and have limited technology budgets, compared to the custodians.

There are also technology firms, such as Thomson Financial and SunGard, which will attract firms with $1 To $10 billion in assets.

As to the type of outsourcing arrangements, Brewster says three models are emerging. First, the lift out - "the most drastic of the models" - sees the vendor take over the back and middle-office operations of the firm, including staff.

Second, the business-service-provider model (BSP) sees the provider operate technology that links into the investment firm's in-house applications, and the provider's technology staff works with the investment firm's technology team.

Third, the application-service-provider model, which is in its infancy and is for firms that desire leading technology but don't want to relinquish control of their operations.

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