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New tenants in the house of cards

Hunker down for a chat with a custodian these days and, sure as apples is apples, soon enough the conversation will turn to outsourcing. To be fair, custodians can be forgiven for getting somewhat over-excited, given that they spent most of the latter part of the 1990s talking up the prospect of third-party providers taking on the running of clients’ middle and back offices, only for the expected mega-deals to fail to materialise in the most conspicuous manner.
Over the past couple of years, however, what was a trickle of deals – among them General Electric with State Street, Prudential with Midland/Mellon, Aberdeen Asset Management with Cogent and Mercury with Warburg – has finally metamorphosed into the long-awaited tsunami of big-dollar outsourcing mandates.
A key milestone was the decision by JPMorgan Investment Management to appoint The Bank of New York to provide client reporting, portfolio accounting, valuations and master recordkeeping services for some $300bn (e340bn) in assets. Another was the $190bn PIMCO mandate won by State Street; the Boston-based bank has also struck outsourcing deals with Scottish Widows Investment Partnership, Merrill Lynch Investment Managers and Liberty Financial.
Meanwhile, not to be outdone by its fellow mega-custodians, JPMorgan Chase took over custody and fund accounting duties for Schroders Investment Management, and latterly struck a five-year deal with BT Fund Management in Australia. Other notable deals have included CI Mutual Funds (RBC Global Services), Trust Company of the West (Mellon Trust), KBC Asset Management (Northern Trust), Close Finsbury and Artemis Unit Trust Managers (both Cogent).
So why the sudden demand for outsourcing? After all, asset managers were clearly unimpressed by the concept for some considerable time. Loss of control – and, by extension, damage to hard-earned reputations – was partly to blame. As a result, the banks have gone out of their way to emphasise the ‘partnership’ nature of outsourcing deals, stressing that while clients may be outsourcing capability, they are not abrogating ultimate responsibility for the outsourced portions of their business. This will be a source of comfort, perhaps, until things go to the bad, at which point the client will have to carry the can along with its outsource provider.
Similarly, aware of the need to demonstrate that they can think and act like the fund managers they are so keen to woo – that is, dynamic and protean in their approach as opposed to being fusty behemoths with all the get up and go of a sloth – many banks established independent outsourcing units. State Street has its Investment Manager Solutions Group, Citibank its Advisory Services Group, while JPMorgan Chase has its Asset Managers Solutions Group. Taking a slightly different tack, The Bank of New York has set up its outsourcing solution, Encompys, in partnership with Accenture, Microsoft and Compaq.
For all the talk of shared objectives and mutual benefit, the primary reason for asset managers’ volte face is straightforward: it’s the economy, dummy. Given the downturn in global markets, managers need to divest themselves of the unwelcome fixed operational costs accumulated back in the days when business still boomed. Throw looming industry initiatives such as the implementation of the GSTPA and Omgeo trade matching utilities and the proposed transition to T+1 settlement into the mix, which depend on a significant level of investment in new technologies, and the case for outsourcing non-core activities becomes still more compelling.
In the run-up to Christmas, The Bank of New York suggested that the potential savings generated by outsourcing of middle and back-office functions within the UK fund management industry alone could exceed £1bn (e1.6bn). The bank estimates that within the next five years 25–30% of fund managers worldwide will have outsourced – or will actively be looking to outsource – their back/middle office functions, a figure that equates to some $10trn– 20trn in assets under management.
All of which suits custodians just fine, not least because an outsource agreements is by its very nature a long-term proposition. Given the sheer scope of the task required to effect the necessary transition of staff and systems, most deals would be expected to have a minimum lifespan of five years, not least because – as custodians cheerfully admit – any cost savings will not begin to manifest themselves until the third year at the earliest. Having seen mandate ‘churn’ rise exponentially in recent years, the opportunity to tie down a particular client for a set period is clearly not to be sniffed at.
However, the involved nature of outsourcing deals has a distinct downside in that custodians can only take on so many at a time – and, as The Bank of New York concedes, should their growth projections be borne out, then “demand for outsourcing services outstripping supply in the near future”. This constraint of capacity will pose a significant challenge for custodians in 2002 and beyond – certainly it is a problem that needs to be resolved if the current round of deals is to be more than a flash in the pan. The long-term success of outsourcing is predicated on economies of scale, but if the necessary critical mass cannot be built up quickly enough, then there is a very real danger that those deals already in place will prove unsustainable, and the whole house of cards will ultimately come tumbling down.
Tim Steele is a freelance editor
timjsteele@btinternet.com

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