In this article, Steve Young, chief executive of Citisoft, and his colleagues, examine the issue of outsourcing, a crucial one across not just wealth management but financial services as a whole.

This publication has approached a raft of consultants operating in the wealth management sector to give their views about a range of challenges and opportunities for the industry in different parts of the world. A number of articles will be released in these pages in the coming weeks and we hope readers find them stimulating. The articles have been sought by this publication and also by Bruce Weatherill, of Weatherill Consulting, and also chairman of ClearView Financial Media, publisher of this news service. In this article, Steve Young, chief executive of Citisoft, and his colleagues, examine the issue of outsourcing, a crucial one across not just wealth management but financial services as a whole.

In November the Financial Conduct Authority published their Thematic Project Findings Report on outsourcing in the asset management industry. This followed the “Dear CEO” letter issued to 125 asset managers in December 2012.

The letter raised the concern that “if an outsource provider were to face financial distress or severe operational disruption, UK asset managers would not be able to perform critical and important regulated activities, thereby causing detriment to customers”.

Within the letter, the regulator discounted a number of potential solutions the industry had been relying on as responses to similar concerns raised in response to the unfolding financial crisis following the collapse of Lehman in 2008, namely:

-    Public rescue of financial institutions – too big to fail;
-    Taking activities back in-house;
-    Transfer to another External Service Provider (ESP); and
-    Exercising step-in rights.

The thematic report focuses on assessing two key areas of risk relating to outsourcing of critical activities that could result in poor outcomes for customers if not mitigated effectively. These are:

-    Asset managers having inadequate contingency plans in place to deal with a failure of their service provider (‘resilience risk’) and
-    Asset managers applying inadequate oversight of their service provider (‘oversight risk’).

In response to the FCA’s concerns, the Investment Management Association, together with a number of asset managers and outsource providers, formed the Outsourcing Working Group, which has been looking at providing an industry response to the regulator. The OWG is producing proposed guidelines in respect of oversight, standardisation and exit planning. Whilst increased oversight and monitoring are key elements of the solution, given the complex ownership of many of the current service providers it is difficult to see how this can really answer the issues raised in the original Dear CEO letter.

In its November report, the FCA stated that it is pleased with the level of engagement from asset managers in response to the Dear CEO letter and during 2013 has started to see improvements in asset managers’ planning for the failure of a service provider. It also praised the industry-led work intended to help firms with contingency planning; the OWG principles aim to guide the industry, with a key aim of improving portability between providers. In addition to helping mitigate the resilience risk, there could be wider benefits to the industry and its customers if asset managers were able to move between service providers more readily.

The report does though bring more focus and demands around oversight risk. Here the FCA states that the effectiveness of oversight arrangements varies from firm to firm, and many firms are unable to demonstrate high standards of oversight consistently across all outsourced activities: “Where oversight of an activity was lacking, we found the main cause was insufficient internal expertise to carry out the oversight.”

Each asset management firm typically hires one or more administrators for specific business functions or operational areas, and employs an in-house team to supplement and provide oversight to the administrators’ work. Some firms take the view that for many reasons, operational as well as business continuity, they should provide a “shadow function” internally. In reality it could be argued that this is the only practical means of mitigating the resilience and oversight risks highlighted by the regulator.

If this is the case how do firms who do not currently shadow their service providers justify the investment required to obtain this capability?  If this is undertaken in-house, or by having two of the current providers covering the same functions, it will be extremely difficult to create a viable business case. However, this shadow function could be provided by a third party utility. To be viable this would need to have:

-    A disciplined and agreed scope of service;
-    Shared cost of ownership and a single agreed operating model;
-    Using of existing and proven market leading technology;
-    Use of low cost resourcing centres;
-    Experienced and proven implementation management;
-    A clear and well-defined view of the considerable business benefits the shadow service can provide.

This utility could provide a shadow record of a firm’s service provider and, in the case of service provider failure, could step in and provide key elements of its service. This would enable the asset manager to remain operational.

Additionally, unrelated to service provider failure contingency, the asset manager could utilise the shadow service within the context of normal business planning to test a migration to another service supplier. In this way, should a migration be necessary at some point, this will already be proven and timescales and implementation efforts will be both known to a fair degree of accuracy and dramatically reduced.

Servicing clients better
The real goal is not just to satisfy the FCA but to service clients better. Besides providing enhanced oversight and improving the resilience of the continuity of business in stressed circumstances, a shadow service gives an asset manager flexibility in terms of its servicing options. It will also ensure that information is more accurate and timely; that can only be of benefit to the end client.

It is also extremely likely that if a service provider did fail it would result in, or be the result of, some major turmoil in the market. In such times, an asset manager’s key operational management would need to have the capacity to react to the needs of clients and to allow the firm to be at its most effective. Having some of the contingency services provided by a third party utility that has regularly tested and proven its capacity to deliver should give significant competitive advantage at a critical time.

Conclusion
Having multiple administrators is increasingly the reality in the market today. Should one of these administrators fail a shadow service proposed would allow the asset manager to access business critical investment information and to ensure the end investor is isolated from the affects of such an event. Improved oversight capabilities will also ensure that for business as usual, the information provided by the outsource provider is timely and accurate.  An additional benefit of a shadow service is that it lowers reliance on any single supplier and creates a more flexible environment where changing providers becomes more straightforward.

It is difficult to see how firms can satisfy the demands of the FCA, and more importantly best serve and protect their clients, without having some element of shadow servicing in place. Unless an in-house shadow function provides clear competitive advantage to a firm, it should be managed by a specialised third party provider.