Outsourcing derivatives processing is rapidly gaining momentum because asset managers now need to create more efficiency in processing of alternative instruments and the administrators have geared up services to accommodate these new products. Asset managers with investment strategies including more exotic instruments require robust systems and as a result must decide whether investing in technology or outsourcing is the best method forward, said Dean Lumer, head of CSTIM U.K-a London-based consultancy. For firms this means a decision between investing in internal technology to manage these instruments or outsourcing, says asset management operations officials. The decision a firm makes depends greatly on the level and type of usage of the instruments within investment strategies, but other factors, such as the sophistication and integration of the service packages available will contribute to the commoditization of this trend going forward, according to market officials.
Reduction of unit costs of running operations and the initial cost of investment in technology are still main drivers for outsourcing, said Lumer. And like other processing, OTC processing will not be a service differentiator and is expensive to run with the constant product changes systems and processes need to account for, said Daron Pearce, head of client management for fund managers at the Bank of New York. Plus, the increasing regulatory burden also is a driver for asset managers who are conscious of how to best manage costs and improve operational efficiency when processing OTC products, he added. Chris Farias, senior director, hedge funds product manager at Investors Bank & Trust, agreed regulation is a key motivator. Aside from the drivers, outsourcing is more common now and for some fund managers it may be easier to swallow because it can be as simple as just adding more products to the service agreement already in existence with providers, he said. Risk is also something asset managers take into account because these products are have a higher investment and operational risk profile. If a firm decides against investing in systems, it may consider outsourcing as it would then have use of more sophisticated systems and procedures as the service providers are making this investment and leveraging it across multiple clients, said Bill Jooste, head of institutional consulting at CSTIM added.
The traditional custodians have moved into the alternative space, mostly through the acquisition of specialist administrators. The big players are at a stage of system integration now to consolidate functions and offerings and there may even be some more acquisitions in the next year, said Lumer. BNY, for example, is currently expanding its institutional outsourcing platform, SmartSource by linking the platform with its alternative investment accounting and administration business so it can leverage systems and expertise to provide more services capability and support for OTC product processing, noted Pearce. The end result will be the provision of an all inclusive outsourcing package covering the alternative instruments capabilities, he said. This type of integrated package will suit asset managers who integrate the use of traditional and alternative asset classes, he said." One asset management official noted this lack of integration keeps the trend in its infancy. Until they integrate offerings and show processes are streamlined, derivatives outsourcing will not be mature enough to validate the move for some firms.
"The degree to which the provider's integrate and streamline systems will lead them to provide a better price service, Lumer said. Price will be still be a significant differentiator in the future, but quality will also be key so the providers that have the best ability to deal with the underlying data will be a factor considered, said Jooste. Long-only accounting systems struggle with these types of products and need more sophisticated technology to deal with the greater complexity of the data exchanged between systems," Jooste said. A second official at a global asset management firm noted this lack of streamlined processing of data and segregation of systems will limit the range of functions it allocates to a service provider. Only with integrated systems and processes will the service providers be able to provide the level of operational capability, like the daily provision of reports, to asset management clients.
Administrators will also have to improve their systems, rather than just integrate platforms to support the client's needs as this trend matures. IBT provides an OTC offering based on its core fund accounting system and including reconciliation, valuations and trade management. The Boston-based firm is in the process of joining the Depository Trust & Clearing Corp's derivatives confirmation service, Deriv/SERV and already uses SwapsWire, said Mark Bjorstrom, head of global operations at IBT. And the firm is also expanding its independent valuations services, adding valuations on commodities-based derivatives most recently and ramping up its collateral management offering to support more traditional fund manager's eager outsourcing derivatives processing, Bjorstrom added.
Outsourcing is still not smooth sailing, but the market now has more experience under its belt when negotiating deals. "We are coming to recognize it is essential to do a lot of due diligence at the beginning," said Farias. Discussing trade details, volumes and prices in the beginning is necessary to understand the client's needs before we take them on, he said. Outsourcing due diligence has progressed, agrees Lumer. Previously, outsourcing deals mostly were lift-out deals so the platforms were not completed and as a consequence the due diligence process was more about cultural fits and long-term strategies. Increasingly, the focus will be on the platform and its capability in terms of specific functions and sophistication, he said.
