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CIO Challenge

Lately, it seems that one investment management firm after another is outsourcing back-office functions. But as providers expand their service offerings beyond the back office, how do CIOs determine which functions to keep in-house?

Charles Schwab Investment Management became the latest Wall Street firm to enter the outsourcing game with the news, announced May 31, that it has turned to JPMorgan Worldwide Securities Services to support Schwab's separately managed accounts program. Under the deal, JPMorgan will provide a range of back-office functions, including shadow accounting, account reconciliation and performance calculation.

The news follows the announcement that Henderson Global Investors, a London-based investment manager with $127 billion in assets, also has tapped JPMorgan's outsourcing services, handing over its $2 billion hedge fund business to JPMorgan Hedge Fund Services (HFS). JPMorgan HFS will assume responsibility for Henderson's hedge fund middle- and back-office functions -- including its employees -- to provide daily operational services and fund administration.

Indeed, 2006 already has seen a fair amount of investment operations outsourcing action. In February, Mellon Financial's Investment Manager Solutions group agreed to provide back-office operations support for Pasadena, Calif.-based Provident Investment Counsel and Evercore Asset Management (New York). Meanwhile, in April, Schroder Investment Management North America decided to outsource investment operations support for its $3 billion private client and fund business to The Bank of New York. The range of responsibilities include trade support, data management, investment accounting and performance measurement, with BNY also developing and hosting a private-labeled Web portal for Schroders.

The BNY agreement adds to the global patchwork of third-party arrangements Schroders has in place. The investment manager outsources, for example, its U.K. unit trust accounting to State Street, while JPMorgan handles fund accounting and custody for Schroders' Luxembourg fund range. Such componentization of service functions is likely to increase, says Dr. Suresh Gupta, a partner in Capco's New York office and codirector of a recent research project, conducted with the London Business School, into outsourcing and offshoring.

Gupta points to an evolution in the outsourcing industry, on both the buy and sell sides of the fence, that will see the financial services industry follow a similar path as has the manufacturing sector. "Eventually, companies will look at their middle-office and back-office services, look at the components of those processes, and find the most appropriate supplier to service particular parts of those, in the same way that General Motors does," he says.

However, the market will follow a dual approach in this regard, reckons Gupta. Small firms, such as start-up hedge funds or boutique investment managers, are more likely to hire a single provider that can provide a complete service package, such as one of the large global custodian banks that have been ramping up their third-party capabilities. By contrast, large players with more experience in outsourcing likely will employ a multitiered strategy that leverages a variety of suppliers, Gupta argues. The large organizations will adopt a cross-product, cross-geography approach that incorporates in-house and outsourced capabilities in a variety of locations, whether provided on-site, near shore, or from lower-cost offshore centers in places such as India and China. Deciding what to outsource where and to which provider will then depend on how much value-add the service offers a firm and how much control it wants to maintain over the function, Gupta explains.

Connecting the Service Dots

Achieving such a multifaceted approach, though, means being able to connect the service dots. And this is where technology developments, in the form of Web services, standardized development tools, messaging protocols and the like come in to play.

For example, correspondent clearing behemoth Pershing has been embracing the concept of open architecture around its technology, according to John Colao, managing director of customer technology with the firm. "For a broker-dealer doing business through Pershing, for them to contract with a software or service provider outside of Pershing may solve a problem or create a solution for them, but it also creates a layer of complexity," he says. Therefore, as part of its NetExchange technology, Pershing has developed a suite of Web services that provides an open-architecture access platform for customers. This way, customers can "link their third-party providers or, in some cases, even their own proprietary technology, but leverage all the technology that Pershing has behind the scenes to present an integrated platform to their planners or reps as well as their clients," Colao relates.

In addition, Pershing has been expanding its array of services, says Ron Fiske, the firm's managing director of product management and development. One area in which Pershing has augmented its capabilities is the lending space. "Firms such as Merrill Lynch have been very active in lending as a whole, including nonpurpose lending and residential lending," says Fiske. "So we have, in effect, integrated, with a single sign-on through our broker workstation NetExchange Pro, much of the functionality that investment professionals require to be able to work with a residential mortgage lender."

Meanwhile, Capco's Gupta points to developments in the sell-side outsourcing proposition around research and reference data collection and management, which he says increasingly are viewed as utility-type models. Capco has been busy developing a reference data management outsourcing service that handles the process chain from data acquisition through cleansing, enrichment and maintenance; Dutch banking giant ING Group became the latest recruit when it signed on for the service in March. Accenture and SunGard also are targeting the reference data space with similar offerings.

Within the investment banking fraternity, and indeed banking in general, there also is an increasing prevalence for firms to rely on third parties for payments processing services, says Gupta. Even confirmations of over-the-counter derivatives transactions can be handled by a third-party provider, although there is the question of managing liabilities and ensuring performance, he adds.

Likewise, Ashik Ardeshna, director in Mercer Oliver Wyman's strategic IT practice, highlights the changes occurring in the derivatives space. "The increasing complexity of derivatives instruments and the growth in volumes is putting great pressure on the middle and back offices," he says. But while they want to reduce their operations costs, market participants need to balance that against protecting intellectual property, so they don't necessarily want someone else touching the trades, Ardeshna notes. One solution, then, is to offshore the processes to India, for example, and establish in-house micro utilities, he explains.

Knowledge Is Power

Having moved through a continuum of IT and then business process outsourcing, a growing trend among financial services firms is "knowledge process outsourcing," adds Ardeshna. This incorporates areas such as risk assessment, quantitative analytics and equity research.

Of course, there is nothing new about the buy side outsourcing research to the sell side. However, with the spotlight on soft commission dollars and a general squeeze on margins, there is intense pressure on sell-side firms' research departments. As such, many may no longer be able to provide research coverage for the smaller companies in their universe, and so are splitting their equity research capabilities, says Ardeshna. Some of that may be passed to captive offshore centers, but also could be outsourced, he notes.

When it comes to the buy side, back-office outsourcing continues to see traction, with those functions the most likely to be farmed out to a third party. Indeed, back-office operations could end up much the same as custody, which few firms support in-house now, according to Ardeshna. However, he also points to a move by providers up the value chain into areas such as client servicing, reporting, performance measurement and shareholder record keeping. And as asset managers continue to narrow their focus on core competencies around investment decision making, and the providers seek ways to offer more value-added components to their services, we can expect to see more slicing and dicing of functions for sometime to come. <<<

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