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COVID-19 Accelerates Move From Niche to Norm for Front Office Outsourcing
Adoption of front office outsourcing has accelerated through the COVID-19 pandemic as investment managers seek to improve margins, enhance business resiliency and future-proof operations.
Gary Paulin, Global Head of Integrated Trading Solutions - Northern Trust Capital Markets, explores the underlying trends and the importance of asking the right questions on outsourcing.
While the move to less capital intensive, variable cost models has been a feature of knowledge-based industries generally - and in technology particularly - for some time, the pandemic has accelerated a growing trend for this transition in financial services. COVID-19 has exacerbated existing margin pressures, created new ones – for example, prolonged staff absence, social distancing, remote surveillance - and, for many firms, triggered a reassessment of operating models. Outsourcing not only offers potential margin flexibility in the face of volatility, but business agility in the face of accelerating change without being anchored to fixed costs.
Accelerating the Evolution
The challenges and change can be summed up in the idea of ‘decades in weeks’ – inefficiencies that were hidden by strong markets or operational inertia are being exposed and thoroughly tested. Bad relationships going into the pandemic are now much worse, discretionary goods are more discretionary and weak balance sheets are untenable.
However, this is simply an escalation of change that, for many firms, was already being made inevitable, whether consciously or not, by the impact of pressure from competition, fees, technology costs and shifting product demand.
The challenge of the pandemic is also an opportunity and, in some cases, an excuse to review and reset operations. For example, extended periods of working remotely challenged the assumption of proximity between dealing teams and investment teams being an essential element of the investment process. With dealers already ‘off-premises’, there is minimal disruption with a move to outsourced trading and, with no break, in connectivity between teams, the only difference is who is paying the bills.
Technology at the Crest of the Wave
The growth of outsourced trading is similar to the growth of cloud computing in the 1990s. At first, the notion of cloud computing was a difficult concept for many people. There were concerns about security, about sharing infrastructure with third party providers, and about losing control. But as technology developed, it became increasingly obvious that cloud-based models would provide scale, reduce complexity, be cost effective, and efficient. In the same way, hyper-scale operational solutions provide higher levels of productivity, efficiency, flexibility, resiliency and lower operational costs in the financial services industry.
Back in 2018, Oliver Wyman and Morgan Stanley estimated that technology was already 15%-20% of the industry cost base1 and, in order to remain competitive, asset managers must have access to the newest technological innovations. Outsourcing enables firms of all sizes to access those innovations and leverage the resources of hyper-scale outsourcing providers – with the added benefit that the industry enjoys a more level playing field, not biased to size, where firms can compete on alpha.
A Renewed Focus on Governance
Furthermore, as regulators increasingly require greater transparency in order to restore trust, and as investors become more digitally conversant, decision-making is becoming more evidenced-based. The presumption now is that decisions should be based on full information, and not beliefs or preconceptions, for these often blind us to accepting reality, change, or new ideas. This puts renewed emphasis on governance and, contrary to the mistaken belief that outsourcing reduces a firm’s operational control, effective outsourcing can improve trading oversight through enhanced data analytics and reporting.
Additionally, as interest and investment in Environmental, Social, and Governance (ESG) strategies continues to rise, the need to evidence effective decision-making will be reinforced. Governance is not something only regulators care for - Boards and Trustees are expected to implement good stewardship standards, and to ensure that investment strategies consider ESG as an area of concern. If savers demand their money is put into companies with good governance, then the guardians of those savings, the asset managers, must be able to display strong governance at every stage of their operational process – including the trading desk.
Asking the Right Questions
Ultimately, the discussion around outsourcing should be more focussed on the question of value than it is on cost. The assumption that the activity of dealing delivers value to the firm, and to the investment process, must now be evidenced. Sentiment aside, it’s no longer acceptable for a firm to in-house the dealing function if they can’t demonstrate their reason for doing so. Northern Trust’s recent white paper From Niche to Norm explores this in more detail and explains how, for many firms, outsourcing could be the optimal state. This is especially true in light of a number of service providers who may provide lower cost, and often better dealing services, and can quantify that through lower brokerage fees and independent transaction cost analysis.
Margin pressure will always be an important driver, but so will the requirement for good governance, the need for operational resilience, the demand for technological innovation, and the need to build efficiencies.
1 Morgan Stanley & Oliver Wyman. Winning Under Pressure, 2018. https://www.oliverwyman.com/content/dam/oliver-wyman/v2/publications/2018/march/Wholesale-Banks-Asset-Managers-Winning-Under-Pressure-2018.pdf