The logic of FCA policy is the unscrambling of fund management outsourcing to global custodian banks

Categories: 
Outsourcing
02 Dec, 2013

There is an inexorable logic to the concern expressed by the Financial Conduct Authority (FCA) about the risks to investors that fund managers have created by outsourcing their middle and back office operations to global custodian banks. The chief concern of the FCA is that a major custodian will fail, leaving its fund management clients unable to process transactions or value assets. If the United Kingdom securities regulator is serious about forcing fund managers to mitigate that risk – and there is every indication that it is - it is setting in motion some momentous changes.

Fund managers will have to reacquire the knowledge, data and technology they lost when they outsourced back and middle office functions to banks. If they do not, they can neither take on the work themselves nor switch to a new service provider quickly if their existing custodian gets into trouble. The prudent fund manager will also spread its outsourced business across more than one service provider.

In other words, the fund manager that wants to be certain of avoiding an enforcement action by the FCA will be hiring operational experts, insourcing some functions, and dividing its custody and asset servicing, fund accounting, transfer agency and middle office outsourcing across at least four separate providers, and possibly more. However, we should not expect any of these outcomes to be discussed in the report, due next month, from the Outsourcing Working Group (OWG).

The OWG is an informal collection of London-based fund managers and custodian bankers brought together by the concerns the FCA has expressed in two documents over the last year. In the first, one of its now notorious "Dear CEO" letters sent on 11 December 2012, the FCA told the leaders of all the major fund managers in London that it believed they had taken insufficient account of the risk that their investors will be harmed if the bank to which they have outsourced a large proportion of their back and middle office operations happens to fail. It also wanted to know what fund managers were doing to monitor that risk.

This was followed last month by a Thematic Report (TR 13/10 on Outsourcing in the asset management industry – see our earlier assessment at http://cooconnect.com/news/screen-your-investors-and-monitor-your-custodians-and-administrators - based on a detailed review of 17 separate asset managers of various sizes. The FCA was dismayed to find that some of the 17 were totally unprepared for the failure of their custodian, fondly imagining their provider is either Too Big To Fail (though there is no guarantee a rescued bank would stay in the custody business), or that they could "step in" to the role (though they lack the expertise in-house) or switch to another provider (even though this would take 18-24 months to pull off, even on the optimistic assumption they  could find one with spare capacity).

Accordingly, the FCA told fund managers as bluntly as it dared at a conference it hosted for them on 30 October to obtain a clear and detailed understanding of what their service provider does for them; list the services they regard as essential to continue to support their clients; retain or recruit sufficient knowledge to deliver those services in the event their outsourcing provider fails; and (not or) work out how to stay in business or transition to a new provider successfully if the worst happens.

It was to avert the idea gaining hold that outsourcing is risky and ought to be reversed that the Investment Management Association (IMA) - the trade body for institutional fund managers in London – elected to address the Dear CEO letter on behalf of its members. By May this year, it had published a white paper (Key issues arising for asset managers from the regulatory regime on outsourcing) offering fund managers 11 “ideas” for dealing with the FCA challenge. They included all the ideas now being advanced: staff who know what they are doing, an exit plan, and standardisation of working methods to make business more “portable” between providers.

The custodians were slower off the mark but, once they understood the threat, were alarmed at the possible impact on their revenues of serious changes to their existing model of business. By July they were in cahoots with the IMA, and between them they set up the OWG to formulate solutions capable of satisfying the regulator without disturbing the status quo.  Three "work streams" were set up, and steering committees populated by fund management COOs and global custodians appointed to direct their work. The witty slogan under which they have proceeded is "Know Your Outsourcing" (KYO).

The first work stream, on oversight, is expected to tell fund managers how to KYO. In other words, it will advise managers to remind themselves what has been outsourced;  understand how the relationship works; check where the services are provided from; assess the level of dependence on the technology systems of the custodian;  check the levels of in-house expertise; put somebody in charge of mitigating the outsourcing risk; and document how everything operates. It will of course stop far short of recommending repatriating the work, or duplicating it, or appointing back-up providers.

The second work stream, on exit planning, is expected to recommend the development of detailed off- boarding and on- boarding plans for fund accounting, transfer agency and middle office functions. These clearly need to be formulated in conjunction with existing providers and kept up to date through regular reviews, but it is hard to believe custodians will engage enthusiastically in making it easier for clients to exit the relationship. Any plan will almost by definition have to be executed in stressed market conditions, rendering it effectively useless  except as a sop to the regulator.

The third work stream, on standardisation, is even more pie-in-the-sky. Nobody has yet defined where the middle office is and what it contains, let alone which of its components should be standardised. Of course, straight-through processing of standardised SWIFT messages in the clearing and settlement of trades is well established. But it is difficult to see how the delivery of fund accounting, transfer agency and middle office devices can be standardised. Which makes it unlikely this concept will progress much beyond measuring the performance of custodians against SLAs, in much the same fashion as best practice dictates already.

Given the improbability of any of these steps satisfying the FCA, fund managers and custodian banks ought to be preparing for the dissolution of deep relationships that were formed in less anxious times. Meanwhile, investors must brace themselves to pick of the cost of unscrambling outsourcing relationships which in some cases date back to the 1990s. For rebuilding internal capabilities at fund management houses will cost money, and so will spreading business across multiple providers.

After all, most fund management outsourcings were built on bundled pricing, in which the cost of any one service was discounted to reflect the fact that all services were placed with the same provider. Proprietary technologies were specifically designed to make it hard for fund managers to change relationships, which is why contracts are invariably renewed after expiry, irrespective of how ineffectual the service or egregious the behaviour of the service provider.

The FCA has a point about the concentration risk this has created, but is as yet unwilling to acknowledge that the price of rectifying it is higher charges to investors. If the operating costs of fund managers rise by 3 to 5 per cent – a reasonable rule of thumb in regulatory compliance - the charges passed on to investors will rise 1.5 to 2.5 basis points, assuming the cost of manufacturing funds is around 50 basis points. Custodian bank re-pricing will add more to this charge, as the loss of revenue from additional services encourages them to re-price the services they continue to provide.

After all, it is not as if price crises will be contained by intense competition to supply stand-alone fund accounting, transfer agency, middle office and custody services. None of these services has attracted healthy margins for 20 years. Full fund management outsourcing is already the preserve of no more than five or six global custodians. The number of independent fund accountants is shrinking, accelerated by the regulation of the hedge fund industry in general, and the depositary bank requirements of the Alternative Investment Fund Managers Directive (AIFMD) in particular. Fewer providers, plus higher prices? Custodians have not heard of that combination for 20 years. Thanks to the regulators, a golden age of custody could be about to begin. That is not necessarily good news for fund managers, or their investors.
 

Dominic Hobson

 

Tags: 
outsourcingFCA

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