In a business that is not known for generating huge profits, where providers are under pressure to keep their costs down, custodians must ensure that their outsourcing models will be profitable in the long term. Dan Barnes explains how integration spells domination.
The race is on among custody providers in Europe to develop their outsourcing offerings ahead of the expected wave of demand from investment managers. Back and middle office functions are expected to be shipped out over the next three years.
The market is not fully mature yet and banks must ensure that they are facing up to the technology challenges if their outsourcing offering is to remain economically viable in the long term.
For many, this means integrating multiple systems left over from merger and acquisition activity, in addition to any internal systems and migration from existing client platforms, increasing both risk and cost. Those that fail to do so effectively could find their custody offering challenged.
Custodian business is not hugely profitable and – as Paul Webster, associate partner at Accenture, says – the current circumstances are not helping the situation. “Custody is coming under a lot of margin pressure, because all of the custodians are trying to fight for market share. So they’re all trying to get into investment management operations outsourcing.”
To secure and protect their business, banks must move up the value chain for clients, bundling products together so that economies of scale can be truly utilised to generate increased margins. The banks have proven willing to manage the middle and back offices of investment managers and tie this into custody. However, the ability to truly manage this for their clients requires the construction of the necessary technologies to support such functions.
“Huge investments are required to build these platforms. They need to have simple products like custody so they have relatively good margins. Whoever gets the platform and is able to pull in clients will secure the custody revenue,” says Mr Webster.
Client savings
Outsourcing back and middle office functions removes some serious cost for banks’ clients, says Francois Marion, CEO of Crédit Agricole investor services “Through externalisation of the back offices and middle offices, asset managers have an opportunity to concentrate more on their two core businesses, which are sales and financial management of the assets. As they may not always have the management and financial resources to devote to such functions as middle or back office, they try to find a solution to externalise them.”
The asset management areas of Crédit Agricole, BNP Paribas and Société Générale have all hired off their back offices to in-house subsidiaries. Mr Marion expects the customer base to extend beyond the bank’s own operations, citing examples of life insurance companies that are outsourcing and retirement funds that are expected to follow suit.
This will apply a further pressure to technologies because open architectures will be needed where clients are offering third-party products. Even organisations dealing in single geographies will find they need to supply products from other areas, plus asset managers are becoming increasingly globalised.
“The fund management industry is evolving. We see more and more funds of funds, mixed funds, specialised funds and less pure country funds,” says Mr Marion. “The asset management industry is therefore more and more organised according to global functional lines, such as structured products and quantitative management – which require global services providers for depositary, valuation, custodian.”
If the platforms do not work with specific products, they will clearly create a competitive disadvantage.
Choice of models
The available outsourcing models vary in structure, risk and cost. Component-based outsourcing involves taking out various parts of the operations over a period of time, such as global custody, fund administration or transfer agency. This can lead to the same level of outsourced back and middle office that occurs with an all-in-one ‘lift-out’ but the graduated process can allow a reduction in risk that many banks find appealing.
Full lift-outs can involve taking the people and processes of a client but in some cases this will also involve the original technology being used, which is then not integrated.
“When you see deals where the supplier does a lift-out and doesn’t integrate onto a strategic platform, we think the economics of that model become unsustainable very quickly,” warns Paul Stillabower, head of business development, Europe, at HSBC Securities Services.
HSBC made a significant investment in fund administration, investment accounting and performance measurement systems which provide the base for its service platform. This is run for internal and third-party clients using mainly external components. Last year, the bank announced a deal with Gartmore investment management that covered a wide suite of products and was multi-jurisdictional. This year, it took on its second client: HSBC Asset Management.
Mr Stillabower is clear that any lift-outs in which HSBC is involved include migration onto the bank’s technology. The same has not been true of some competitors and he considers the market to have evolved into “winning the mandate and figuring out what to do after that”. These companies may ultimately want to converge but that will take time.
European design
BNP Paribas is trying to develop a pan-European solution that balances the cost effectiveness of scale with the need to service local clients. In January, it announced that it is providing Fondaco mutual funds with an outsourced solution, including fund accounting and administration, custody, depository bank services and regulatory reporting to the Italian authorities.
Nick Kirk, managing director of BNP Paribas fund services, says that creating a European model is clearly something with which their competitor banks – mainly in the US – are grappling. “Take State Street, which has signed some major deals on the continent – one with ABN AMRO and one with AXA in Paris. I think it has a huge challenge but clearly it is playing for high stakes to get to a uniform operating model to generate some benefit.”
For Alain Closier, head of global securities services for investors (GSSI) at Société Générale, integrated service is the key to back office outsourcing. The bank launched its GSSI division in February to take charge of outsourcing. It announced its provision of equities clearing and settlement operations to ING Wholesale Banking’s proprietary and institutional clients via an outsourced model.
But, as Mr Closier explains, making a bank’s full range of services pan-European on single platforms is not always possible because of Europe’s different tax jurisdictions. “With clearing, for example, it is not possible to have the same system in Paris and London. You need to adapt your French system when in London and you need to adapt your English system when in Paris. It’s more or less the same for Germany, Switzerland and Spain. Our programme is to have only one system. But we need to go step-by-step,” he says.
Target timeframe
Mr Closier sees a possibility for this to change as Europe becomes more integrated in regulatory terms. Mr Stillabower confirms this likelihood, although he poses the timescale for this as being the million-dollar question. “As clearing and settlement infrastructure and tax harmonisation continue to converge, we think that eventually there will be sufficient standardisation to enable service providers to have a single global fund administration platform.”
Mr Closier explains that one advantage some Europeans banks have is that their growth has been organic until now so they have less integration to consider. “When you compare that to the American banks, they have to invest a great deal of money in their systems integration because of their acquisition policy. You have to integrate your new acquisition with all of the necessary systems. If you are not able to migrate rapidly across to one system, the economies of scale are not effective, the costs are not declining and the quality of product you provide to your client is not there.”
Certainly US banks are looking to achieve these efficiencies. Robert Binney, managing director of Citigroup Global Transaction Services (GTS), believes that without integrating, the company would not then be able to reach the next levels of service that customers demand. “If you take the view – which some of our competitors have – that when times are tough you cut back on incremental expenditure on systems or technology, I think, in the long run, that’s the kiss of death. You’re going to end upselling your business or having it atrophy. Or find someone else has stolen it from you.”
Top to bottom
Integration is not just needed on a horizontal basis. Mr Kirk says that BNP Paribas has been looking hard at vertical integration. “Where we act as outsource provider and global custodian, we will process transactions from our fund management clients that then pass to our global custody unit and in turn to our local custody unit. We use the same messaging techniques and technologies across fund management, global custody and local custody systems, delivering significant synergies to our clients.”
In other banks, additional integration is occurring between systems shared between cash management and securities services to reduce costs and potentially improve customer service, even following merger activity (see JPMorgan case study).
Banks that fail in supporting their outsourcing provision will definitely lose out, says Mr Webster. “I’m sure some of the smaller ones will drop off because they’ve found that they cannot build into some of these revenue streams. What they’ll find is that if they don’t have a product, they’ll start losing some of the custody to providers that have got platforms where they give the middle office and the custody business.”
Mr Stillabower says that over the next two to three years the impact these challenges have on suppliers will become apparent. “Lift-outs are difficult transactions to execute and I think some organisations are making expensive mistakes. Leaving a client on an un-integrated platform is a risky model to operate.”
CASE STUDY: JP MORGAN CHASE & BANK ONE MERGER
Mergers are not just about complexity. Lori Hricik is global head of treasury services at JPMorgan Chase and oversaw the re-creation of the department following the merger with Bank One. While mergers clearly create the potential for added complexity, scale can prove advantageous. The bank’s securities and treasury services are proving able to find synergies between the functions, potentially reducing cost and improving customer service.
Ms Hricik explains how the divisions are working together: “In liquidity management, we hold billions of dollars in deposits and money market fund assets. We used to manage these assets separately within our treasury and securities services divisions. Now, we have brought these assets together with a treasurer dedicated to the combined liquidity management business.”
Another example she gives is the integration of access products, online reporting and initiation.
Lowering the expense of systems is not the only motivator, she says. “We need to be the low-cost producer but that does not mean plain vanilla. Rather, we need to be highly efficient by looking smartly at synergies that leverage common approaches, technologies and processes. On client coverage, we are creating more unified coverage models so that we can take advantage of client relationships in order to best service them across the entire spectrum of cash management and securities solutions,” she says.
