Strategic Advantage of Outsourcing Middle Office Ops
Gone are the days when the middle office is maligned as being strictly a cost-center dragging down investment performance.
Today more fund managers are concluding that more effective management of their middle office can not only reduce operating expenses, but also give them a competitive edge with investors and keep regulators at bay. Fund management operations experts and technologists also tell FinOps Report that it’s clear that better management does not mean slogging along with inefficient legacy systems.
That doesn’t necessarily lead to massive investments in new technology. Instead, outsourcing as many operational functions as possible is becoming the standard modus operandi, say research studies. US fund management firms contacted by FinOps also acknowledge the trend and say that their European and Asian peers have already taken the plunge. Deciding which function must be outsourced, to which firm and how the relationship is managed is generating a lot of talk among compliance, legal, operations and technology managers. While the chief executive, chief financial and chief operating officer may be the ones who sign off on the big decisions, the specialists are the ones that have to live with the outcomes and make them work.
“The middle office is the engine driving functions that fall after the front-office pre-trade analytics and trading,” says Gary Kaminsky, head of regulatory compliance for asset managers and broker-dealers at consultancy BDO in Philadelphia. “It is also where all of the critical regulatory enterprise risk-management work is done.”
That risk management work involves consolidating, validating and crunching a whole lot of data quickly to meet reporting requirements, not just for internal managers and the board but also external clients and regulatory authorities. Compliance with regulations such as the Dodd-Frank Wall Street Reform Act in the US, and MiFID, EMIR, UCITS and AIFMD in the European Union require disclosure of transactions, asset holdings and more granular risk metrics — no small task.
Outsourcing middle office functions mitigates the risk of being unprepared for regulatory deadlines and allows big-set up investments to be effectively mutualized among multiple outsourcer clients. Institutional investors can be reassured that an independent third-party is monitoring the post-trade process and mitigating operational risk. The better the middle office is handled, the greater the potential for higher investment returns. Cleaning up too many mistakes can wipe out hard-earned profits.
“While middle office functions may once have been seen purely as a cost center, there is a growing realization that it is an area where a fund manager can extract value and enhance its competitiveness,” says John Alshefski, managing director of the investment manager services division at fund administrator SEI in Oaks, PA, which released a report in May entitled “Middle Office: A Hidden Source of Competitive Advantage.”
To determine the merits of outsourcing, fund managers need to calculate all of the expenses involved with a particular function such as research and development costs and overhead costs related to manual work and overtime. Do they? Not always. “Sometimes, we don’t include research and development costs or employee training costs in our calculations,” acknowledges one US fund management operations executive. “And we probably don’t give enough attention to projecting the costs of adding new products or growing trade volumes and assets.”
When asked why not, the operations executive at first wouldn’t respond, but ultimately acknowledged the potential conflict of interest. “We just don’t want management to know how cost effective we are or aren’t. Outsourcing is supposed to result in greater efficiency, but it can often cause layoffs,” he admits. As a result, sometimes fund operations specialists are taken out of the decision-making process for outsourcing providers, though they will still have the responsibility for monitoring the service providers and evaluating their performance.
On the Block
What is being outsourced? Anything from post-trade confirmation and affirmation to reconciliation and everything in between. When SEI asked 80 US asset managers which middle-office functions their firms might consider outsourcing over the next 12 to 18 months, 30 percent of diversified asset managers and 20 percent of private equity or hedge fund managers say they would be interested in outsourcing corporate actions and income processing functions. Data management and governance was more likely to be outsourced by alternative fund managers than diversified managers. Trade capture, transaction settlement and regulatory reporting were the next three most selected functions for both types of managers.
Also on the outsourcing horizon: risk reporting and performance attribution. “As service providers continue to invest in their technology capabilities to offer more sophisticated analytics and enhanced reporting, fund managers will want to outsource those functions as well,” predicts Alshefski.
With the exception of custodian/prime broker selection and management, and expense management, every middle office function was under consideration to be outsourced. Some functions are already handled externally to a large degree, but this latest wave of outsourcing will mean that virtually every aspect of middle-office operations will be outsourced by more than 50 percent of firms, according to SEI’s study.
An additional factor that may accelerate the outsourcing of the middle office is the scheduled introduction of a two-day settlement cycle in the US in September 2017. Asset management firms will need to change operating processes and workflows to reduce settlement time from the current three-day cycle. Many asset managers are facing the fact that their existing systems and staffing levels are not going to meet the challenge. In modifying post-trade processes, they are finding that some outsourcing will be critical.
What isn’t being outsourced? Client reporting is the biggest category. Institutional fund managers could decide to outsource this process, but not alternative fund managers who want to pay closer attention to customized reports for far fewer investors. Likewise, processing of swaps contracts and collateral management will likely be kept in house. Fund managers that want more than just the basic mechanics of margin calculations and calls will need to confirm that their administrators and custodians can handle collateral optimization and transformation. Not all are geared up for this work.
Although third-party service providers do offer a modular approach to outsourcing — pick which functions you want — most fund managers can’t afford to rely on a best of breed approach. “In a choice among multiple providers, using a single holistic regulatory ERM driven solution for as many services as possible will end up being far less costly and more operationally efficient,” says Kaminsky. “The fund manager won’t need to address additional reconciliation and oversight costs.”
However, the provider selected must be able to handle not only current products, investment strategies and scale but future ones. The most common error made by fund managers is not thinking ahead. “The service provider needs to be with the fund manager for the long haul,” cautions Kaminsky. Switching providers can be time-consuming and operationally costly because of cleanup costs related to processing mistakes in the transitional period — which could take weeks or even months depending on the function involved and size of the book of business.
Yet another mistake: thinking that an outsourcing provider can provide a “signature-ready” answer for regulatory reporting. A third-party can provide a robust suite of services but someone within the fund management organization needs to own the project, explains Kaminsky. Ultimately, the fund manager is liable for any mistakes.
Once the outsourcing contract is signed and sealed, the hard work begins. “Oversight is critical in outsourcing arrangements,” says Michael DiScipio, an executive in the capital markets practice of global consultancy Accenture in Boston. “Asset managers are asking that key metrics be provided as part of a standard reporting package which will enable them to measure the effectiveness of the outsourced solution.”
The metrics include the timing of reports and services, the accuracy and consistency of data, and how well volume peaks were handled. Periodic meetings — typically quarterly — with the service provider may also be useful to discuss service level concerns, the status of the technology roadmap and the impact of pending or anticipated regulatory changes, according to DiScipio. Bottom line: the asset management firm should always keep tabs on the service provider.
Fund management operations executives who are worried about being displaced by outsourcing their functions, shouldn’t be. Outsourcing shouldn’t be viewed strictly as a way to cut headcount. Fund managers need multiple pairs of eyes watching the middle office to implement a system of checks and balances against errors and delays, suggests Alshefski. There is no such thing as too many cooks in the kitchen.