As investment banks join the hunt for outsourcing support, they may end up helping each other.
By Tom Groenfeldt
March 2002
Institutional Investor Magazine
As long as profit margins were fat and back-office operations adequate to their straightforward tasks, investment banks didn’t spend a lot of time worrying about such mundane areas as account processing or settlement accounting. They poured their resources instead into front- and middle-office technologies: high-powered trading systems and broadband telecommunications, sophisticated analytics and Internet-based e-business platforms that could distinguish a brokerage from its competitors.
But now the investment banks’ seemingly benign neglect of the back office is about to change. The end of the decade-long bull market has squeezed profits, prompting urgent searches for cost cuts and efficiency improvements. With the memory of collective multibillion-dollar Y2K upgrades still fresh, the securities industry is embarking on the potentially more costly T+1 initiative to shorten the settlement time on trades from three days to one day after the transaction.
The prospect of expensive new back-office projects in the midst of a sharp market downturn has led major firms to evaluate a variety of outsourcing alternatives for the first time. “More banks and brokers are looking to outsource back-office functions than ever before,” says Robert Iati, director of security and capital markets research at TowerGroup in Needham, Massachusetts.
“Technology has moved ahead at lightning speed, but at many of these banks, you still see applications that are from the 1970s because all their focus has been on the front office,” adds Rob Heyvaert, chairman and chief executive officer of capital markets consulting firm Capco. Now it’s the back office’s turn, he suggests.
Boston Consulting Group partner Antonio Riera points out that the key to efficiency in securities processing is large scale, which minimizes unit costs. But, he says, “even the largest financial institutions often do not have sufficient scale along certain product lines.” The solution? Riera calls it “strategic sourcing,” which can range from contracts with vendors to joint ventures with peers.
So far there are only hints of the flow of outsourcing work from investment banks that is anticipated by consultants like Riera and technology vendors like Hewlett-Packard Co., IBM Corp. and Sun Microsystems. But these organizations are preparing for a much bigger wave of business.
In January Hewlett-Packard announced an agreement with the Antwerp, Belgium-based Capco to jointly develop what they describe as “comprehensive solutions for customers in the capital markets, private client and asset management segments of the financial services industry.” Outsourcing services will be part of the deal, which HP sealed with a $30 million investment in Capco.
The outsourcing may take novel forms, says Heyvaert. For example, some European institutions are talking about forming a shared back-office processing utility, a major departure for vigorous competitors. Necessity is prompting such creative thinking, particularly in light of the U.S. Securities Industry Association’s 2005 deadline for T+1, he says. As major investment banks look at installing the straight-through processing, or STP, technologies needed to comply with that standard throughout their global networks, they will have to reengineer basic back-office processes, if not outsource them entirely.
“We are not yet seeing signatures on contracts every day, but we are hearing strong statements about letting the back office go,” says Heyvaert. “We will definitely see signatures this year.”
One global behemoth - Deutsche Bank - has already committed to outsourcing, but with a twist. Deutsche is the first customer of SOCX, a 50-50 joint venture that it formed last year with New York-based software house Wall Street Systems. SOCX, which stands for Settlements & Operations Clearing Exchange, will handle banks’ clearing and settlement for money market, foreign exchange, fixed-income and derivative instruments. The system runs on HP computers in an Atlanta data center.
Deutsche is using SOCX to process money market trades in the U.K., and it expects to turn over other business in New York, the Asia-Pacific region and the rest of Europe this year.
“The future of operations across the financial services industry lies with specialist outsourcing vehicles such as SOCX,” says Paul Lewis, managing director for global markets at Deutsche Bank in London. He says that his bank can identify cost savings as well as strategic benefit; It can focus its resources on its business activities rather than systems needs.
SOCX grew out of a long-standing relationship between Deutsche Bank and Wall Street Systems, explains Mark Bradbury, a former head of Deutsche’s global money market operations who is now the joint venture’s COO. The bank relied on Wall Street Systems for its front-office money market trading platform; typically, its back-office counterpart was an aging, in-house system.
Strains on the back-office system from Deutsche’s Y2K conversions and its postmerger integration of Bankers Trust Co. led Bradbury’s operations group to explore potential upgrades. At the same time, another group at the bank was talking with Wall Street Systems about launching a joint venture. The two initiatives merged into SOCX.
“This could be an interesting play, because Wall Street Systems does well in money markets and foreign exchange, and there is an industry focus on STP, putting everything together to make sure you have a seamless data flow,” says TowerGroup’s Iati.
Deutsche is not alone in trying to play a vendor-type support role for other banks. About the time that SOCX was getting off the ground last fall, UBS launched what it calls “The Bank for Banks.” It’s essentially an offer to let other banks share UBS back-office resources across a broader spectrum than that of SOCX, including cash management and custody, foreign exchange, securities lending, institutional asset management, private banking and corporate finance. The Zurich-based bank says that it has sold individual “modules” of its service - for example, continuous linked settlement of forex transactions - to hundreds of clients and that a handful have opted for more comprehensive packages.
To be sure, some service purveyors face a reluctant customer base. Financial institutions have been known to take years in coming to outsourcing decisions, because they can mean a radical departure from internal cultural orthodoxy. A case in point is global custody. Industry leaders like Bank of New York Co. and State Street Corp. have little to show for a two-year struggle to convince investment managers to outsource more functions, such as foreign exchange and securities lending.
SOCX’s Bradbury, for one, does not anticipate an overnight shift, nor does he expect every institution to act alike. “Larger firms will test us in one product line to begin with,” he predicts. In other words, they might try foreign exchange first, then, when satisfied, move on to fixed-income operations or derivatives.
BCG’s Riera sees banks managing multiple outsourcing relationships in much the same way that Nike designs its footwear but relies on many contract manufacturers to produce them - a process Riera calls orchestration.
“Somewhat in the way that banks may clear through Citibank in some markets and Euroclear or Paribas in others, you will see a variety of providers appearing,” adds Bradbury. “Top-tier firms will source from different technology providers, while the smaller firms will probably try to work with just one outsourcing company.” Hence the willingness among outsourcing providers to be as narrow or as broad as a client desires.
Some highly specialized outsourcers have failed. J.P. Morgan Chase & Co. decided in November to shut down Arcordia, an applications service provider that it founded to handle over-the-counter derivatives operations. Arcordia had managed to recruit just one outside customer, Bank One Corp. Another J.P. Morgan dot-com-era spin-off, Cygnifi Derivatives Services, filed for Chapter 11 bankruptcy protection in October.
These failures raise questions about whether the new entrants are seeking an illusory goal.
“Outsourcing is a not a new idea,” notes SOCX’s Bradbury. But he draws a distinction between his company and Arcordia. The latter, he says, “was very much a J.P. Morgan-led venture, while SOCX is independent from both of its parents, without being left high and dry. It has the backing of a technology provider and a bank without being in either of the camps. That differentiates it well in a market where there may be quite a lot of bank-led solutions.”
In theory, an independent ASP can focus on technology - keeping pace with the latest releases of applications and operating systems - and thus free its clients to pursue their own business objectives. The service provider, not the bank, worries about computer system capacity and maintenance. Instead of paying a fixed price up front for software and hardware, users pay a variable per-transaction cost.
“Organizations are starting to ask whether having operations in-house makes any difference to their top-line revenue,” says Bradbury. He and other outsourcing providers make persuasive economic and managerial arguments, but for now they can only wait and see how major investment banks respond.
“Wall Street has never been prime outsourcing territory,” says Scott Ganeles, CEO of I-Deal, a New York-based company recently formed by Merrill Lynch & Co., Microsoft Corp., Salomon Smith Barney and Thomson Financial to support securities issuance. “It really takes a macro event to focus attention and reflect on business-process efficiencies, and this economy could be what finally makes that happen.”
