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Stuck in the middle: Outsourcing the middle office 

Outsourcing back-office functions – accounting, custody and administration – has been common practice in financial services for many years. As a mature service, the benefits and pitfalls are fairly well-known. But in the last decade, outsourcing has expanded to the middle office of investment management companies. Functions such as transaction management, derivatives processing, performance analytics, reconciliations, compliance and client reporting are now being outsourced to third-party providers. These middle-office activities carry a different mix of risks and benefits and require different strategic considerations. Others raise similar issues to those associated with back office outsourcing, but in a more acute way.

The U.S market has been a little slower to embrace middle-office outsourcing than its European counterparts. There has been a natural reluctance to cede control over what are seen as functions closer to the core of the investment manager. Companies tend to be risk-averse and prefer to continue to invest in technology and improving in-house processes rather than to consider delegating the responsibility for improved performance and capability to external providers. Sentiment, however, is changing. Most of the largest global providers of middle-office functions are US-based and the pace of change is now increasing in the US market.


However, there are a number of key strategic issues that senior executives and board members need to seek specific expertise before formulating a middle office outsourcing strategy. This is important, since appropriate solutions will differ more from manager to manager than typically is the case with the more routine sourcing of back office activities, depending on a number of factors, such as the nature of the particular business model, the investment strategies employed and the manager’s current state of middle office operations.

Risks

One of the key risks with middle office outsourcing – often perceived rather than real –  is the loss of strategic control. Managers and senior executives have to ‘let go’ of their instinct for end-to-end operational ownership and consider that middle office outsourcing providers have the capability, focused resources, incentive and domain expertise to perform effectively. Penalties for poor performance, along with incentives for exceptional performance, should align interests. And, given this alignment and the third party commercial nature of the relationship, performance challenges can sometimes be easier to resolve with service providers than in the case of in-house service delivery.


When outsourcing the middle office, the potential impact of service delivery issues can be significant. Back office functions are typically routine, repetitive and administrative in nature. Although failure can cause serious impacts on business operations, they are not likely to be critical in a strategic sense. But middle-office functions come closer to the core of a firm’s unique character and core activities. Failure here can be transparent to the client and have more fundamental and long-lasting consequences.


All this means that managing outsourcing contracts for middle-office functions is more demanding. Specifications need to be tighter and more specific, service provider technology must be well understood, oversight must be more vigilant and performance reviews need to be more robust. Governance of the service provider relationship is key. An effective and well-structured service level agreement (SlA) will specify core services, quality, performance metrics and provisions for exceptions and  variations in a rigorous but flexible manner. It will also detail the calculations that will be used to evaluate service level performance in order to minimize the possibility of discrepancies around whether a service level has been achieved or not. In this way, outsourcing can drive the discipline  to analyze and specify the core characteristics  of specific functions for a purpose which may not always exist for these functions when they remain in-house.


Once an effective outsourcing arrangement is in place, one of the collateral advantages it can bring is the benefit of leveraging the service provider’s risk management framework, which should reflect industry leading practice.

Systems and data

One of the principal, and most challenging, tasks in preparing for outsourcing is the need to document, scrub and validate existing systems and data. This is required as part of conversion to the service provider’s systems. Companies face the shock of migrating to a supplier’s systems and processes, giving up their own and learning to work with unfamiliar definitions, operations, reports. However, once the transition is achieved and the relevant data and operations are being managed by the service provider, significant advantages can accrue: outsourcing can provide the benefits of major systems upgrades without entailing the risks and challenges of undertaking them in-house.




An effective and wellstructured service level agreement (SLA) will specify core services, quality, performance metrics and provisions for exceptions and variations in a rigorous but flexible manner. It will also detail the calculations that will be used to evaluate service level performance in order to minimize the possibility of discrepancies around whether a service level has been achieved or not.



There can also be data privacy issues. There have been too many cases in  recent years of sensitive client data being inadvertently released. Tools, such as data masking, double locks and strong encryption, along with strong oversight and periodic auditing of service provider methods and policies, can help safeguard data. Introducing the necessary rights, representations and warranties in the context of an outsourcing contract could actually result in enhancements to data security. These enhancements can lead not only to operational efficiencies; they can also drive qualitative improvements in capabilities through access to new tools, technologies and specialized expertise, which may enable the firm to introduce new products or enter new markets. Replacing proprietary and legacy in-house systems with open systems architecture will not only  lower costs but may facilitate support for new distribution channels.

People impacts

People impacts are critical in any outsourcing strategy. Clear objectives and appropriate communications are essential, since there will be a number of interlocking objectives some employees may l be let go; others may continue to be needed, but will transfer off the books onto those of the external service  provider; and others will continue to be needed in new roles to manage service provider performance and to facilitate the integration  of the firm and the service provider. A further category is perhaps the most critical, at  least initially. These are people whose firm knowledge and subject matter expertise are important in defining the scope of work, formulating the outsourcing proposal and in managing the transition. There will be no shortage of ‘people issues’ to contend with. A well thought-out people and change strategy is a critical part of any outsourcing initiative.


As with any other outsourcing project, throughout the process, clear and open communications with all employees and stakeholders are essential at the right times, as appropriate.

Governance

Just as the risks and strategic implications can be more complex in middle office outsourcing, the governance arrangements – both for ongoing service delivery management and  for the transition process itself – need to be tighter. Transition risks are especially acute, so management attention needs to be constant and focused during this phase in particular.


These requirements call for highly capable and professional project management specialists during the peak demands of the solution, implementation and transitional phases, as well as clear, well-defined roles and responsibilities, decision rights and  accountabilities. Robust planning, performance- monitoring and progress-tracking are especially critical during these phases. In view of the significance of middle-office functions to overall firm operations, the governance of the service provider relationship should be a priority for senior the investment operations executive given the potential risk impact and role facilitating the investment strategies of the firm.


Middle-office service contracts tend to be longer and more in the nature of strategic partnerships. They need the same kind of scrutiny and due diligence in selecting a partner that is involved in similar mergers and acquisitions decisions.

Regulation

Companies that are outsourcing activities in the financial services sector are often concerned about compliance with regulatory requirements in an outsourced environment. This is a well-founded concern: although compliance activities may be outsourced, accountability for performance of those compliance activities remains with the investment manager. Clearly, if contracting out affects operations of direct regulatory interest or those which bear closely on in-house ability to provide relevant reports and assurances, specific attention needs to be paid to ensure that regulatory obligations are met.


It may be the case, however, that regulatory authorities look favorably on outsourcing middle-office functions. Through past experience with both middle- and back- office activities, regulators typically have deep knowledge of the major providers in  this space. Frequently, outsourcing to one of  these providers carries with it the reassurance that operations are now in the hands of industry specialists whose systems and risk management frameworks may be more advanced, better-resourced and may receive more consistent investments/upgrades and, as a result, are better able to cope with ongoing changes and developments in the markets and industry. Developing the necessary confidence and trust in the outsource provider is vital. An attitude of partnership that is focused on outcomes, not a customer-vendor relationship that is focused on transactional management, is the key.

Benefits

Obviously, the primary drivers for middle office outsourcing are financial. The considerations outlined above summarize the source and scope of potential benefits to cost structures. Outsourcing can convert fixed costs to variable costs, reduce capital investment and create a model which is scalable across a number of dimensions:


  • staffing resources and domain knowledge
  • systems capabilities that can support organic growth, expansion into new instruments or statutory/regulatory change
  • expertise to support expansion into new instruments or operating geographies
  • global operating footprint to leverage as an investment manager expands into new countries and leverages a service provider’s operating assets there.

But there are other less tangible benefits. Outsourcing frees up firm executives from the non-differentiating mundane middle-office activities and allows them to focus on the core differentiating aspects of their business: the front office strategy and trading, which genuinely provide the firm and its client’s distinctive value; and on critical relationship management issues, whether with clients or other business partners.


It also brings the advantages of tapping into leading practices. Just because a company has developed middle-office systems and processes which work well and match its business model does not mean that the operation represents leading practice in investment operations. A top-tier outsourcing provider should be on the forefront in identifying industry leading practices and bring these leading practices to bear for the benefit of their clients. This implies not only cost-effectiveness, but also high-quality performance and enhanced capability, a benefit which should provide up- and downstream benefit to the investment managers’ front and back offices, respectively.

Conclusion

Forward-thinking asset managers should be taking a strategic view of the potential risks and benefits of outsourcing certain middle-office functions. However, though the middle and back offices may be looked at in a similar vein, the outsourcing of middle-office functions is a less mature industry and inherently more challenging. While the benefits may be clear, the potential pitfalls can be numerous. Companies need to be clear about their middle office outsourcing objectives and ensure they have the appropriate expertise to define requirements, manage the selection of a middle-office service provider, negotiate a favorable contract and manage the transition of in-scope activities to the selected service provider. In the end, the overarching goal should be to build a relationship based on partnership that delivers sustained value to both parties.




By:


  • Peter J. Iannone, Managing Director, Shared Services & Outsourcing, KPMG in the U.S
  • Greg Shaw, Director, Shared Services and Outsourcing Advisory, KPMG in the U.S

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