Part 4 of the OMG Commitments Series
The back to basics mentality many financial institutions are adopting in the market downturn is driving many firms to review outsourcing strategies with fresh eyes as they seek to optimize operational infrastructure but keep operating costs low. Sapient’s Chip Register talks about new and emerging trends in post-trade outsourcing.
1. How have current market conditions affected the outsourcing industry?
In the last year, there has been a huge change in the capital structure and even economic viability of various financial institutions. As consequence, the focus on realigning their efforts toward their core competencies as well as their overall business costs is very acute today and now many firms are reassessing their entire operational infrastructure looking for optimization potential. In this re-assessment, many financial institutions, even those who have never considered outsourcing before, are now evaluating it for technology, post-trade processes, compliance, regulatory reporting, and a host of other business functions.
We’ve also seen a change in the current view of outsourcing in that financial institutions who were big believers in outsourcing, but outsourcing to themselves via their own captives (wholly-owned offshore subsidiaries), are recognizing that that this method of outsourcing does not reap them near the same benefits as outsourcing to a specialist provider whose core competency is managing these initiatives in an offshore format.
For instance, running a post-trade processing operation is very expensive, and if done incorrectly, can incur very highs costs and even higher risks. Both risk and costs can be minimized by utilizing an organization built for purpose, but also perfected by constant exposure to market forces. The history of this activity, and most captives agencies, is that a lack of competitive incentive almost always leads to poorer service delivered at a higher price. I think you’ll see a lot of global professional service firms, such as Sapient, investing heavily in their capability to deliver outsourced post-trade processing and technology services in response to an increasing interest in outsourcing in the current market climate, and a lots of financial institutions shed their captives.
2. What are the challenges and opportunities for users and providers of outsourcing services?
There has always been the perception that you can only outsource a function that is completely static, unchangeable and fairly simple to understand. But this paradigm is slowly crumbling.
The focus and opportunity in the future lies in the provision of a flexible, high-end outsourcing service. Firms want to outsource to a trusted partner that is capable of handling all their static processes, but also able to adapt to the twists and turns of its business’ evolving operational paradigm. Flexibility is also crucial to keep up with a second trend in this space – the outsourcing more of complex and upstream business processes.
This new opportunity is a challenge because firms are really looking for something that hasn’t been provided yet. To take outsourcing to the next level the industry needs to phase out from the linear client-supplier relationship to one which is much more partner-based.
3. Why should trading organizations outsource their operational processes?
An operational manager recently asked me the opposite question. He asked; ‘why should a bank do any of the post-trade operations? Our core competency is to place capital against risk so why should this firm dilute its focus to manage non-core functions when there is a company out there whose core business is managing these very operational processes?’
This may be an extreme example, but it is the tip of the iceberg of the larger question – ‘who should do what?’ If we evaluated the most optimal division of labor across the financial industry, would we find the right people in the right places doing the right thing? The industry as a whole is beginning to realize the answer to this question is no; the division of labor of the current structure is not optimal and outsourcing is a way of harmonizing this imbalance.
Cost is another obvious driver for outsourcing as there is tremendous cost associated with the middle and back office. Many of the post-trade processes are simple procedures which can easily be outsourced to a company who can manage these processes more efficiently, at a more efficient location and executed by staff that are equally well experienced, lead and trained. So the question is why would a company pay to do this in-house when it could be done more efficiently and at a lower cost in an outsourced capacity?
Another change to the paradigm will come when partners like Sapient, who are suppliers of both technology services and operations outsourcing, begin to apply their technology skills to better deliver manual process for their customers. Again, opening the operations landscape up to competitive markets forces will be a key driver of this trend.
4. What types of operational processes should be outsourced?
We are all familiar with the items that have been outsourced in past which center around static operations (management of confirmations, invoicing, reporting, etc.), but there are some bigger trends that reveal the direction outsourcing is moving towards, such as the outsourcing of more complex and upstream processes. I’ll give you a couple examples.
– ISDA Contract Negotiation
The negotiation of ISDA contract agreements is a very expensive process. By their nature, these agreements, which are the basic frameworks of contracts governing certain derivative transactions , aren’t that complicated, nor is the negotiation process if a firm has established guidelines in place. However, financial institutions typically outsource this function to law firms at enormously high rates simply because internal legal departments are too busy to manage the process themselves.
– Reference Data Management
The outsourcing of reference data management is another trend. If you were to compare two financial institutions, they would probably have a 90% overlap in their reference data operations (counterparty set up, managing data, etc ) because both firms would be trading with the same institutions. This means there is a huge benefit of economies of scale and cost savings to be had if each firm would outsource the management of reference data to the same entity that had a team working on the same information across multiple clients. Also, a specialist service provider would have a better understanding of underlying reference data then any individual firm would.
In general, I think reference data management is one of those areas you’ll see firms outsourcing more in the near future. We haven’t seen taken off to date for some structural reasons, but I think the imperative is there. The driver goes back to who has what core competency to complete the function most efficiently and at the lowest cost.
– P&L Explains Processing
Outsourcing of “P&L explains” is also something we are seeing more and more of today. For many firms, particularly those trading things like complex derivatives or physical commodities, the P&L is typically processed overnight and the actual figures are reviewed the next morning by the trading desk. The problem with P&L is that it will never come in exactly as you expect it. Invariably, there are questions about the P&L which requires a trader or trading desk to spend the first part of every morning as a ‘forensic accountant’ reviewing prices, trades, volatility curves, and correlation matrices trying to figure why the P&L looks the way it does.
In an outsourced P&L explains situation, the batch statements are sent overnight to the facility (ideally offshore) where the ‘forensic’ analysis is executed and the full report sent back to the firm by the next morning. In this scenario, when a trader finds something within the P&L that requires an explanation, the background on the variance, such an erroneous marked curve or data error, has already been researched and explained in the report.
P&L explain processing is very advanced work for outsourcing and is way up the curve of the current scale of what processes are outsourced to third party providers. The outsourcing of this process is enormously valuable to firms.
5. How can trading organizations become more efficient and cost effective through outsourcing?
Two advantages of outsourcing business processes are improvements in scale and flexibility. It is easier for a firm to make adjustments to organizational structure when operations is outsourced rather than changing a team of permanent, onshore staff and infrastructure. Also, in many cases with outsourcing a firm gains time zone benefits where you can have people essentially working overnight for you, such as with P&L explains processing.
Cost is also certainly is a driver for firms looking to outsource or offshore any business process because there are significant cost differentials between maintaining an operations, (systems and in-house staff) and outsourcing to a reputable service provider.
6. What are the preconceived notions about outsourcing?
I think one of the biggest knocks is that the reason you can only do really simple and basic functions in an outsourcing capacity is because there is some sort of quality issue. A common misconception is that it takes a few people offshore to complete the job of one onsite employee because of advantages of being onsite (same time zone) or because the outsourcing team isn’t as experienced as in-house staff. This is simply not true. Having a resource offshore can be just as good as having one onsite. Luckily, this misconception is slowly disappearing as firms begin to outsource more complicated functions and see just what is possible. There is nothing that experience, technology and a little perspiration can’t overcome.
7. What surprises people about outsourcing?
I think what surprises financial institutions is what can be outsourced if they give it a try and if they select the right partner. With the right partner, it is possible to outsource more complicated processes and perform more simple ones better. This is not because it wasn’t possible before, but because insitutions were not willing to challenge their existing “we’ll do it ourselves” paradigm and the offerings by service providers just weren’t that good. This is all changing now.
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* "Outsourcing in a New Economy" is the fourth installment of the series on the OMG Commitments. In each article Sapient consultants provides its expert insight and practical advice on how financial institutions should change internal processes to improve efficiency and comply with commitments outlined by the Operations Management Group.
Read first article of the series – "The Rise and Sprawl of CDS," written by Christopher Natale of Sapient.
Read second article of the series – "Lifecycle Event Processing," also written by Christopher Natale.
Read third article of the series – "Electronic Matching: the Challenges Facing the OTC Equity Derivatives Market, " written by Nick Fry and Gil Koenigsberg.