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Outsourcing here to stay

What do Schroders, Scottish Widows, Merrill Lynch, PIMCO and Julius Baer have in common? The answer is that they have all recently decided to outsource part or all of their investment operations - Schroders to Chase, Scottish Widows (see above), Merrill and PIMCO to State Street and Julius Baer to The Bank of New York.
After a good five years of talking about outsourcing, international fund managers are finally starting to take action. The floodgates opened last year when JP Morgan Investment Management outsourced administration of $320 bn (e381bn) in assets to The Bank of New York (BNY). That deal is still in transition as the full complexities of the business become clearer to BNY, which has subsequently set up a specialist outsourcing ‘hit’ team to evaluate the ramifications of such contracts.
In fact, all the three largest custodians - BNY, Chase and State Street - now have dedicated outsourcing units. These have been established both to avoid bottlenecks building up during the evaluation process, which can be tortuous and arcane, and to send a message to potential clients that these providers understand that there is a big difference between custody and outsourcing. With custody, the relationship is often little more than that of vendor and buyer; with outsourcing, it has to be a partnership.
Why outsource? Schroders perfectly summed up the three key benefits when it announced its decision earlier this year:
q It will allow Schroders to focus on its core business of investment management and client service;
q It will allow Schroders to improve its ability to offer more sophisticated products and technology to clients; and
q It will enable Schroders to focus its systems spend on areas which give it a competitive advantage.
But it is not simply the big global asset managers who appreciate the flexibility offered by outsourcing. Banks themselves are becoming increasingly willing to hand over their operational activity to a provider with better facilities and deeper pockets. Deutsche Bank, which has established the European Transaction Bank in Frankfurt as a third-party supplier of cash management and securities services, reports that small and medium sized banks are ‘queuing at our door’. What these banks recognise is that they cannot afford to be all things to all clients, but that should not hinder them from delivering a white-label service, branded with their name but supplied by a third party.
Other banks, like MeesPierson, are looking at the feasibility of delivering a total outsourcing package for the on-line brokerage community, which would probably include order routing and management, trade execution, clearing and settlement. BNY, which is already a major clearing agent for broker/dealers, also sees strong demand from this sector, particularly in continental Europe.
With announced outsourcing deals covering assets of well over $500 bn in the last six months alone, the future for the business looks healthy. But the successes of this year only serve to mask the fact that there are too few credible suppliers of outsourcing services. Aside from the big three custodians, there are only a handful of genuine contenders: Deutsche Bank and Mellon Trust have the products, BNP Paribas and Citibank have the ambition, and the rest are nowhere. Uniquely, Northern Trust has made it abundantly clear that it is highly sceptical about the profitability of the outsourcing business, and has so far avoided the sector to concentrate on its core pension fund client base.
This shortage of suppliers presents a serious problem to the market. Unsurprisingly, the leading players have tended to focus all their attention of the high profile, large managers as their top priority. But, ironically, the major beneficiaries of outsourcing should be the smaller managers, those without the resources to run everything in-house: when they outsource, they free up precious time and money for their core business of asset management. These managers’ needs are being overlooked, and there is a significant danger that they will be driven into the arms of so-called ‘specialist’ third-party administrators that have neither the expertise nor the capital to do the job properly.
Additionally, the intellectual challenge and potential profitability of outsourcing make custody seem very dull in comparison. Tiresome pension funds and asset managers that are looking for nothing more than a competent and cost effective custody service may find it increasingly difficult to find a supplier willing and able to meet that demand. Some of the bigger custodians are openly talking about a time when no client will be willing to pay for transaction processing, and are planning for that eventuality by branching out into outsourcing, fund administration and advisory work.

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