Outsourcing in Wealth Management: A Growing Trend

Outsourcing has been in use in the financial services industry for quite some time, at least for a couple of decades. However, wealth management firms have lagged the financial services industry in adopting outsourcing, primarily due to issues relating to privacy, data security, and loss of control. Many of them did not invest in technology from a strategic point of view for a long time, instead taking a siloed approach depending on specific business needs. The global financial crisis has contributed to a major paradigm shift in this regard. The crisis has significantly impacted both revenue and costs. Lacklustre market conditions have prevented them from generating superior returns impacting top line; this has been exacerbated by loss of clients, who, driven by disappointing returns and loss of trust, have looked away from their advisors or looked to diversify wealth management relationships. At the same time increasing regulatory pressures and newer regulations have compelled wealth managers to grapple with newer challenges in terms of control, compliance, risk management and streamlining operations. In this evolving environment wealth managers have slowly started to wake up and embrace technology and operations outsourcing as one of the solutions to meet the challenges. Cost cutting remains the primary driver behind adoption of outsourcing, which typically can save 20% to 30% of costs over a 3 to 5 year period. Secondly, outsourcing also offers easy scalability options; this is more relevant now as firms are either cutting down or closing operations in certain markets, while looking to expand in others – all in a short period of time. Time to market has therefore become critical. Data management, especially in large organizations offering multiple services, is another aspect that firms are looking to outsource. Along with benefits, there are a number of areas for concern with outsourcing. The most important of them is loss of control and security, both of great importance to wealth managers. Data privacy and data hosting constraints continue to be key concerns; violations in this area can be harmful for wealth managers’ brand image, which somewhat limits the universe of functionalities that wealth managers are comfortable to outsource. Another concern is around fiduciary responsibility and compliance and operational risk. Since the firm is responsible for regulatory compliance for all operations, including the ones outsourced, there is an increased need for easily accessing data and information for enhanced control and client and enterprise reporting. Firms will need to demonstrate their ability to provide the information requested by both clients and the regulatory authorities on-demand and in formats for consumption tailored to the individual’s preferences. Over time the industry has evolved a set of norms to overcome the concerns related to outsourcing. Extent of outsourcing adoption varies by region, the US being far ahead of Europe, while Asia lags the other two regions by some distance. Adoption also depends on the size and nature of wealth management firms. While Tier I and Tier II retail banks, insurance companies and brokerages have outsourced significantly, adoption of outsourcing remains moderate in smaller sized firms, especially in trust companies and family offices. In terms of functionalities, the further a wealth management function is from a client “touch point,” the more likely it is to be outsourced. Therefore, mid and back office functionalities are more likely to be outsourced. Outsourcing in the areas of global custody, securities lending, client servicing, and accounting and settlement of trades in is relatively widespread. Front office functionalities have been outsourced less; while some firms are slowly outsourcing their client on boarding or financial planning functions, outsourcing in the areas of product development, marketing, and fraud management is still limited. Outsourcing in the wealth management industry is likely to see further adoption in the near future. This will be mainly driven by firms in the US and Europe. Outsourcing practices in wealth management is still not as mature as those in other parts of the financial services industry and wealth management firms are starting to realize its benefits. In addition, existing market conditions as well as external factors like regulation will drive the growth in outsourcing business. IT budgets are expected to remain flat or decline in most markets. This will restrict firms’ ability to spend on technology. However, this also means firms will now have to do more with less and channel investments efficiently. Outsourcing provides one option for increasing efficiency without needing significant investments in infrastructure. Tier II and tier III firms will embrace outsourcing following the lead of tier I firms. While IT outsourcing has been the dominant part of outsourcing practices till now, process outsourcing is likely to gain more traction in future.

Navigating through tumultuous WM landscape in India

The Indian wealth management market is dominated by domestic wealth management providers in the mass affluent segment, while international firms and private banks are strong players in the high and ultra-high net worth segment. Insurance providers are dominant players in the mass market. Brokerages and retail banks have started separate wealth management businesses and they are gaining strong ground in high affluent segments. Another characteristic of the Indian wealth management market is the large share of the business captured by unorganized players. The size of this business is estimated to be about twice the size of the business of organized players. The unorganized segment mainly comprises of private financial advisors and chartered accountants who provide personalized financial advisory such as tax and investment advisory. Increased penetration of the organized players is slowly drawing the clients away from the unorganized players. However, the picture is not all hunky dory for wealth management providers, as the industry is beset with several challenges. Rising competition and resulting downward pressure on advisory fees, along with a large chunk of ‘invisible’ wealth are some of the reasons why private banks and wealth management providers are not able to monetize the opportunity easily. By ‘invisible’ wealth, we refer to wealth that is hidden away in tax havens and black money which has become a topic for heated public debate in the country today. Also, not to forget the negative investor sentiment caused by a series of scams and the slide in equity markets, which has made the challenge greater. Lack of product variety is also a matter of concern. Alternative investment vehicles such as hedge funds and private equity provide limited options for investment, and regulatory constraints on overseas investments have resulted in poor product variety comprising mostly of vanilla products. The Indian market is still nascent for exotic investments such as art and luxury goods. Also, the affinity of wealthy individuals towards investments in gold and real estate which do not require the specialized services of a wealth manager further contributes to target segment shrinkage. There is a gradual shift to advisory based feel model from transaction based fee models, with regulators stepping in protect investor interests. While it seeks to remedy conflict-of-interest between wealth managers and their clients, it also exerts downward pressure on fees. We might eventually see smaller players being forced out of the business. Large players would have to stay invested for sufficient length of time before returns start trickling in. Therefore, large banks and brokerages which have high reach and who can monetize the potential for cross-selling banking/mutual fund products would be placed at an advantage in capturing this market.

Accepting the need for Electronic Trading

In its recent history,the Asian market has been characterized by the adoption of technology in a much more compressed time-frame as compared to its counterparts in the western world. This has been true of the industrial as well as the services sector, where it is also holds true for electronic equity trading. Asia is well poised for a rise in the share of electronic trading in the next few years. Markets such as Japan, Australia, Singapore, Hong Kong and India are seeing a lot of investment happening that is related to Direct Market Access (DMA), Smart Order Routing (SOR) and High Frequency Trading (HFT). The associated infrastructure such as market data services, co-location and so on are also being paid attention to, as is the requirement for helpful regulation. However, in some markets, the regulators are not very confident about and supportive of the needs of greater electronic trading. This is partly because of the financial crisis and rising requirements for risk management, and also due to the flash crashes that have occurred in the NYSE and OSE markets. We expect the regulatory framework to become more flexible in most markets, but there is still an important element that needs to be addressed across the board in the Asia-Pacific. That is the role of smaller brokerages and the buy-side. Unlike larger brokerages, these are still reluctant to adopt electronic trading and to make the investments required to have the same. While attitudes and capabilities do not change overnight, I believe that market investors in Asia need to be made aware of some harsh realities. To start with, the way HFT and algorithmic trading evolved in the US and European markets, there was very little time for market participants to react to and adopt such trading. The change happened so quickly that a number of brokerages and buy-side firms were unable to cope and had to operate in a more constrained fashion or even shut down. The incentive that HFT provides for those trading larger volumes means that the smaller players are at a relative disadvantage. This increases even more if they are slow to react and do not adopt electronic trading. So it is not just the speed of trading that is important to succeed, it is also the speed of thought. Hence, smaller brokerages and buy-side firms in Asia should be more positive and not be afraid of investing in DMA, SOR or HFT. The gains from these might not be apparent immediately, but if the lessons from the western markets teach us anything, it is that the quick and nimble-footed firms were the most successful during the rise of electronic trading. With the trading infrastructure in Asia changing so rapidly, there is little reason to believe things are going to be different here.