Back Office Outsourcing by Buy Side Firms

In the last few years buy side firms have had to make lot of changes in their mid and back offices. There are primarily two drivers that have forced firms to make these changes. Leading up to 2007, the economic climate was favorable, and profits were rising, which meant technology budgets were also on the rise. Many firms made technology investments on an ad-hoc, or as per need, basis. Since the front office trading departments are primary revenue generators in trading firms, the technology decisions were largely determined by front office staff based on their immediate needs for certain asset class or execution methods. The mid and back office activities were largely ignored and continued to be run by legacy systems. The crisis of 2008 changed firms’ priorities dramatically. Revenues dwindled and margins were hit. In tumultuous economic climate managing costs became an utmost priority. While downsizing enabled cost cutting in the short run, firms had to consider long term cost savings opportunities by improving operational efficiency and making strategic technology decisions. Against this backdrop the mid-back office was ripe for attention. Many institutions still use legacy systems. Most of them are based on simple excels, offline communication, and handled manually without much automation. There is little integration in the mid-back office of the disparate platforms used in the front office. These create huge operational inefficiencies, and if not addressed adequately, can diminish or even nullify the efficiency gains achieved in the execution of trades. In the aftermath of the financial crisis, the regulatory environment has undergone rapid changes and is still evolving. This has created additional obligations for mid-back office processes in the areas of risk management, reporting and regulatory compliance. It has become essential that firms address the complete trade cycle in a much more holistic way, and are on top of their processes almost on a real time basis to be able to adequately address regulatory and business needs. These two drivers are often conflicting with each other. In the short term, firms have to prioritize technology investments to address regulatory and compliance related issues. Large numbers of impending regulations and a finite technology budget have meant most of the spending is being made to meet regulatory issues, which leaves little room to invest in projects on efficiency and process improvement. Some firms have mentioned to us as much as 60% to 80% of their change management budget is being spent on regulatory and compliance related issues. In this backdrop, outsourcing of mid-back office processes by buy-side institutions is becoming popular. Since almost all of them have to make same, or similar, arrangements to adhere to regulators’ demands, there is good potential for the development of shared utility services whereby firms can outsource some or all of their back office functions to a third party service provider. While the trend of outsourcing in back office function is not new to the industry, this practice is gaining greater traction as buy-side firms realize the complexities of reconciling higher volumes of more complex trades – this is increasing the strain on staff and IT. At the same time, service providers have improved their capabilities and now offer a wide variety of choice for their buy-side clients. Custodian banks are seeing a surge of interest in their outsourcing services from buy-side firms. Increasingly custodians are finding that clients are asking for solutions specifically to deal with the new derivatives regulations. The concentration of flow driven by outsourcing is likely to accelerate within derivatives operations. However, we expect the trend will eventually affect cash securities operations as buy-side look to rationalize their back office functions. Through outsourcing services, investment manager will move fixed cost into variable ones and decrease the complexity of their back office operations. This evolution will be particularly acute in derivatives operations due to the complexity of dealing with the new regulatory regime, DFA and EMIR. Prime brokers will be able to leverage their back office capabilities to insource additional flow, especially around derivatives operations. While there are similarities in the mid-back office functions and processes at global institutions, large banks also need significant customization to manage firm specific needs. The challenge in developing a utility based service model is to design a common platform that will still have room for addressing custom needs. Many providers are considering of coming up with such an offering. There is a race to accomplish this at the earliest as they understand that the first one to offer it would have a big advantage over others.

Fidelity’s exit and the Indian mutual fund industry

Fidelity Mutual Fund, which started its India operations in 2004, recently announced its decision to quit the Indian Mutual fund industry. L&T Finance, a subsidiary of L&T Finance Holdings Ltd., is likely to acquire Fidelity’s India business. The new entity is likely to have a 2% market share and 13th position in the industry in terms of asset base. This will be L&T’s second acquisition in this market after the acquisition of DBS Chola Mutual Fund in 2010. India’s mutual fund industry has witnessed many such exits by market participants at different points in time, but this is perhaps the most high profile case of an internationally established major player deciding to shut down its India operations. In India the mutual fund industry has been heavily dominated by the corporate segment, unlike other countries where retail investors account for most of the industry assets. Fidelity had a very high proportion of its business coming from the retail and the HNI segments. As a result equity investments accounted for bulk of Fidelity’s assets as the focus was on meeting clients’ long term financial goals. Therefore the Fidelity L&T deal has been priced much higher (5-6% of asset) as compared to other such deals in the Indian industry which are usually valued at 1-3% of assets under management. Fidelity’s decision to quit the industry comes in the backdrop of its accumulated losses, driven mainly by a high cost structure. In 2010-11, the company’s staff cost grew around 50% over previous year and was around 90% of its revenue, while staff cost accounts for only 13% for some of its competitors in the industry. This decision has once again brought to the fore issues relating to the regulation of India’s mutual fund industry and its impact on firms’ profitablity. Many argue removal of entry load and limiting payment of upfront commision to distributors (to prevent misselling of products) is hurting fund houses’ ability to sell more and grow the top line at a time when costs are rising rapidly. At the same time it needs to be said that a recent study found that ‘among 15 of 46 AMCs operating in the fund industry, which collectively manage 85-90 per cent of the entire industry’s assets und­er management,10 large AMCs registered net profit in FY11 and 12 AMCs had positive accumulation of net profits over the years till FY11’. This then raises the question if the Indian Mutual Funds industry is more favourable to the larger players and what is the critical asset base a fund house must garner to break even or become profitable, especially in the changing economic scenario. This also raises the question if the new regulations are affecting the smaller players more than the larger players. In this evolving scenario when growth has been hit, regulations are changing fast and firms are increasingly finding hard to stay competitive, some Indian fund houses are looking to partner with global players to attract global funds, investors as well as expertise. In such arrangements, the local expertise of domestic firms complement the supeerior knowledge and capabilities of global partner to create a win win strategy for all.