Since the trend to outsource investment operations started over a decade ago, concerns regarding the various risks posed by having an intrinsic tie to a third-party for critical functions have gradually intensified.
At the beginning, discourse on oversight centred on service delivery, such as service level agreements, key performance indicators and how suppliers should be rewarded or penalised.
As the relationship matured, concerns moved onto the operational risks of outsourcing, particularly in terms of compliance. Over the past year, regulators have cast their ever-broadening gaze to outsourcing and have questioned the inherent risks of the relationship itself. The Financial Services Authority, now Financial Conduct Authority (FCA), posed difficult questions to the industry in its Dear CEO letter to asset managers at the end of 2012.
In February, we convened an audience with the FCA to explore the extent of their concerns which fell into two themes: oversight and resilience (exit/contingency plans). They said that they found these to be lacking regardless of size or business model, and were concerned that services delivered to clients would be impacted in the event that the service provider should face financial distress or severe operational disruption.
We have considered these themes in a research report published in October. In terms of current practice, we found that the lack of exit planning seems to be rooted at the start considering only 73% of firms have exit and transition terms in their outsourcing contracts, the quality and scale of which varies. Once outsourcing services have started to be delivered, the task of maintaining a detailed exit plan is not revisited; 67% of firms do not have an operational exit plan and the rest maintain only a general exit plan.
In terms of contingency plans, two-thirds of firms are reliant on a single provider of investment operations; of them, over half could support limited activities through internal resources but nobody has a clear contingency plan to transition functions. The remaining one-third of investment management firms has a relationship with a secondary provider but in reality, transition would still take time and services to clients could still be affected.
In February’s meeting, most participants believed that exit and contingency planning, and transitioning providers, could only come as a result of standardisation of both the engagement and processes.
Much attention has focused on resilience; however, we believe that outsourcing oversight across the industry is critical given only 13% of investment management firms have a mature and comprehensive outsourcing oversight programme to address service and risk.
An exit plan is of no use without a system of controls and checks to tell you that you need to exit. Oversight provides a dashboard and an early warning system of things going wrong, then with the methods to escalate and resolve the issue before it becomes serious. An exit plan should be in place as a final option, supported by contractual terms.
Clearly, each firm needs to weigh up the costs associated with oversight against the risks of not maintaining efficient oversight of your outsourcing provider.
We believe that whether initiating a new or in a well-entrenched relationship, the priority to address the challenges set out by the regulators is to institute a clear outsourcing oversight programme with a governance structure. Good governance of the relationship will enable any problems to be escalated, addressed and managed.
There are a number of collaborative efforts including the outsourcing working group, which are looking at ways to introduce better practices including building robust contractual terms with exit and contingency plans.
In the future, albeit far off into the future, we believe firms will be able to tackle standardisation of processes which will mean that firms can move providers more easily, making the market for outsourcing more viable for both parties.
Dave Reynolds is a principal at Investit
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