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Outsourcing Middle Office – Reaching its Full Potential for Both Sides

Outsourcing middle office functions to custodians has been a consistent theme over the past five years. Unfortunately this has been met with mixed success. In many cases the services do not live up to the promise made by custodians and fund manager expectations, whilst sometimes unreasonable, have not been met.

To see what’s possible let us look at a possible future scenario.

A fictitious manager, Global Investment Management (GIM), manages a global long/short equities portfolio. GIM has a successful trusted relationship with its custodian which is responsible for all back and middle office support services. In addition to outsourcing all administration functions, GIM does not retain any in-house IT systems but instead relies on its custodian to provide all order management, administration and accounting platforms.

GIM manages it’s outsource relationship with the custodian by a 20-page Service Level Agreement that captures all key service requirements. There are financial incentives for both parties to improve the efficiency of processes and KPI reporting provided by the custodian is independently verified and benchmarked to industry service levels.

To achieve this outcome there are a number of hurdles to overcome. Whilst the technological challenges are generally understood, it is Shoreline’s view that relationship and service issues are of equal significance. The following summarises our view on the steps that should be taken to address these issues to achieve the full potential of a successful outsourcing relationship.

 

Repair Trust Between Fund Managers and Custodians

Lack of trust between fund managers and custodians is a persistent undertone in the industry. As with all difficult relationships, a history of over-promise and under-delivery is the major contributor. In one recent example, a new custodian was appointed by a fund manager based on their compliance monitoring capability only to subsequently discover that the service was being undertaken on spreadsheets.

To repair trust, both parties need to take responsibility for the relationship and in so doing, invest time and effort into understanding each party’s offering and requirements. Fund managers need to be very specific about their required services, and custodians fully transparent on what they can deliver. Also, to regain trust a ‘can do’ attitude by both parties is a necessity. In one industry example, a large investment manager attempted to outsource services to a custodian three times. In the fourth attempt staff were directly ‘incentivised’ and the result was a successful outsourcing relationship.

 

Standardise All Key Processes

Fund managers sometimes have a crisis of self discovery when outsourcing functions. Procedures and processes that are highly customised because the fund manager has “special requirements” often need to be standardised in order to fit into the operating model of the custodian. This can lead to tension between both parties and in many cases the custodian will agree merely to appease the fund manager. In the vast majority of situations this is a bad outcome for both the fund manager and the custodian and is a significant cause of operational errors and inefficiencies.

Middle Office 2

Prior to outsourcing, fund managers should critically evaluate if their operations depart from industry standard. In the case that they are different, they should seek to standardise operating processes, where possible, and objectively question the need for customisation. Conversely, custodians should have the conviction to push back on customisation requirements and be fully transparent regarding associated risks and inefficiencies that are likely to materialise.

 

Re-align Commercial Goals

Whilst custodians endeavour to differentiate themselves from their competitors on the basis of service, the reality is that fund managers typically use price as the main determinant in selecting a custodian. Further, to prevent being subjected to a re-tender there has been a common practice by custodians of discounting their rate cards as a means of retaining key clients.

From an industry perspective the results are telling. From our industry cost analysis, fees paid to custodians by super funds in 2013 averaged 0.025% of total assets. This compares with total operational costs passed to investors of 0.6% for this same period.

Custodians need to ensure that the financials associated with providing outsource services properly reflect the cost of providing these services. Fund managers should recognise that the current ‘price war’ is not to their advantage and that this is a key contributor to the current service level standards. When considering whether to outsource, measuring outsource costs against the costs of in-house proprietary technology development, investment and maintenance is not a meaningful comparison.

Middle Office 1

 Standardise the SLA (20 pages versus producing War and Peace)

There has been good progress made towards standardising the exchange of data between fund managers and custodians, e.g. SWIFT communications and straight through processing (STP). However, many fund managers and custodians still operate within the constraints of archaic and highly customised service level agreements that do not reflect the “real” services being offered by the custodian.

To enable fund managers to compare and benchmark services they receive there is merit in developing an industry standard service level agreement between fund managers and custodians. This independent document would succinctly describe services to be provided, service expectations and how they will be measured and reported. Contrast this to the 200-page “war and peace” documents currently in existence; this document should be succinct and structured in a clear and concise format for the mutual benefit of both parties.

If we are to capture the full benefits of a successful outsourcing relationship, there needs to be a focused effort undertaken at an industry level to repair trust and to re-align service expectations between fund managers and custodians. We have the technology and we have the desire. It is the issues of trust and service expectation that remain as the real roadblocks.

By addressing the steps mentioned above it is Shoreline’s view that we can achieve the full potential of outsourcing.

 

Bruce Russell 
Director

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