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Outsourcing by financial institutions is not a new phenomenon and has been growing steadily for well over a decade now. However, the escalating costs and structural market changes of the last five years have led to a radical rethink of operating and business models. In particular, it is the trading arms of banks – the business lines that can no longer make large margins on selling bonds, packaging OTC derivatives and prop trading due to post-crisis regulatory reforms – that are undergoing the most radical changes. After decades of developing their own infrastructure and technology, many firms are deciding to limit building in-house capabilities. Rather than becoming – or maintaining – technology behemoths, they are focusing on their core businesses, and making moves to slash costs by outsourcing to third-party technology service providers or by moving more of their business onto shared platforms.

“A plethora of regulations is requiring firms to make changes in operations, such as reporting and compliance, under a shrinking technology budget,” remarks Arin Ray, an analyst at research group Celent. “Outsourcing is being seen as a viable route to manage all these challenges.” The potential for cutting costs is huge. The consultancy Oliver Wyman estimates that global investment banks could cut up to USD3 billion in annual costs if they bundled parts of their infrastructure, in turn boosting their return on equity by about 0.5 percentage points.

Behind closed doors In this new world, the further a function is from the client interface, the more likely it is to be outsourced. Whereas areas such as research, marketing and product development have gained limited attention, increasing efforts are focused on the provision of shared services for functions including regulatory reporting, client on-boarding, order management, risk management, risk analytics, reconciliation, fund accounting, fund administration, corporate actions and clearing and settlement. “A lot of financial players build similar commoditised technology or buy systems from vendors at a huge cost that do not really help them differentiate from each other,” says Kunal Nandwani, CEO, uTrade Solutions, which has developed a suite of open source trading technologies, from execution management systems to low-latency algo trading systems and risk management platforms. “Every year, an exchange will do so many upgrades, causing the banks to upgrade their connectivity. Exchange connectivity does not offer any distinct advantage beyond a certain point. All firms are going to do the same thing, or will ask vendors to do it for them, which is an expensive proposition,” he observes.

As a major cost centre (up to USD30 million a year for the largest sell-side firms), FIX connectivity has also become a target for outsourcing as it requires large, continuous investments in technology and specially trained staff. Market infrastructure connectivity is increasingly commoditised and several trading technology providers’ service offerings now cover the hosting, management and operational aspects of FIX and non-FIX-based links.

The squeeze on margins and resources means third-party service providers are increasingly being asked to take over data-heavy functions. Says Joe Widner, managing director at financial market data provider Markit, “There is no competitive advantage in multiple institutions maintaining and in some case creating the exact same data. What you want to do is have the right information so you are making the right decisions.”

Deal flow There has been a spate of deals between financial institutions and data management and technology groups. In 2011, Citi selected Fidessa for the provision of a workflow and trading platform for its global listed derivatives business. Recent figures released by Fidessa show that revenues generated from their derivatives capabilities had more than doubled, representing almost 5% of total revenue for 2013. “We have been doing work flow and connectivity outsourcing for 15 years, but the complexity and the fast-moving nature of regulatory change has brought into focus the appeal of an outsourced or managed solution,” says Paul Charie, head of buy-side business development. “Traditionally, outsourcing was the preserve of organisations that had a smaller infrastructure, and fewer people in IT and ops, and which therefore were quite stretched, whereas the tier-one banks would happily buy in and run their own systems. That’s all changed.”

In November 2013, UBS became the first sell-side firm to choose Markit’s hosted platform Enterprise Data Management (EDM), which it will use for instrument reference data mastering across all asset classes. UBS outsourced its securities reference data mangement to iGate which is using Markit’s EDM solution to provide the service to UBS. According to Widner, the deal could form the operating template for arrangements with more banks. Elsewhere, Société Générale Corporate and Investment Banking is in the process of transferring the bank’s securities processing back-office operations to Accenture Post-Trade Processing, an outsourcing solution launched by Accenture and Broadridge Financial Solutions. The utility is designed, among other things, to reduce resources and simplify preparations for compliance with new and existing regulations.

“If there is a corporate action in the market, everybody has the same corporate action, whether they have one holding or 10 million,” says Tom Carey, president, International Securities Processing Solutions, Broadridge. “All the firms that haven’t outsourced will be doing the same action repeatedly, so it lends itself very much to a utility service.” Carey identifies globalisation and market access requirements as drivers of future growth. “The cost of entering a market on your own is high, particularly into Asia. If we have a utility service available, then it can help firms get into new markets and expand the service.”

Still in control? The current moves underline how cutting costs in response to a string of new rules has risen close to the top of the sell-side agenda. A KPMG survey this year, which quizzed 317 anti-money laundering (AML) and compliance professionals in banks and financial institutions across 48 countries, found that around one-third of institutions are continuing to outsource at least some AML functions despite senior management concerns about a lack of control and oversight. Regulators are taking a hard line on compliance failings. In 2012, HSBC paid USD1.92 billion to settle US charges, while in January Standard Bank became the first commercial bank to be penalised in the UK over lax AML controls. Both involved outsourcing units operating without adequate oversight, says Alaric Gibson, research analyst at JWG, a London-based firm of independent analysts on regulation. “There was a general view the banks weren’t in control of their transaction monitoring systems. They weren’t getting a good enough view internally of what the data meant.”

The KPMG survey reported that 35% of respondents believed their AML systems were neither efficient nor effective, fuelling interest in compliance shared service platforms designed to keep down the costs on this non-profit activity. The concept of a know-your-customer (KYC) utility is making gradual progress among financial institutions, with current initiatives covering various aspects of KYC, ranging from tracking tax evasion under US Foreign Account Tax Compliance Act, to knowing trade counterparts under the Dodd-Frank Act and the European market infrastructure regulation. Most recently, SWIFT launched a KYC registry in league with half a dozen global banks (see page 4).

Markit is among the vendors launching KYC utilities, partnering with business process specialist Genpact to develop a shared service dedicated to the management of client on-boarding and other KYC requirements, with HSBC and Morgan Stanley becoming the first banks to sign up for the service. “The entity information on who the banks are doing business with is not unique to each of them,” says Widner. “The layer that is competitive is how they go about deciding if they will do business with these potential customers.”

Access to expertise On the buy-side, investors appear increasingly more accepting of asset managers outsourcing their operations. A Deutsche Bank survey in July 2013 of 68 large institutional investors globally revealed 66% of allocators would tolerate managers outsourcing the compliance function. “Investors are increasingly comfortable with the concept of outsourcing because they understand that getting an expert in to assist with certain aspects of the business is the right thing to do,” says Robert Mirsky, global head of hedge funds, KPMG. “They also understand that it can help with cost efficiencies for the business, and allow the managers to focus on what is really important.”

However, managers need to be careful about how much work they externalise in light of the 2012 letter from the Financial Services Authority, the precursor to UK regulator the Financial Conduct Authority, which warned asset managers about outsourcing regulated activities or activities deemed ‘critical and important’ to regulated activities. It also advised managers to have measures in place to safeguard their operations in the event of a service provider failure. “There are some things the investors will want to see remain under the control of the managers but I would expect the trend to continue,” says Mirsky. “It is hard to make money if your focus is all over the place; you need to have partners to help you.”