The dawn of outsourcing in Wholesale Financial Services and the creation
of Virtual Banks and Operations Services Companies
For the wholesale and investment banking community, the EMU conversion has been a major
success and in 12 months time, I believe we will be saying the same thing about our Year 2000
projects. However, this success has cost our community dearly. Not just in the billions of dollars
that have been spent in updating and testing technology but also in the 2-3 years of lost
opportunity which has resulted in strategies being put on hold and left us with a promulgation of
legacy systems and diverse and over-capacity infrastructures.
Outside of the financial services industry, the world has moved on. We have seen alliances
between competitors, e.g., common platforms for cars, shared-service provision and the
widespread growth of outsourcing particularly in the supply of IT and accounting services.
However, in wholesale financial services industry, growth of these initiatives has been less
widespread. We have standards for how transactions should be legally confirmed, we have
Euroclear, Cedel and Swift and at Bankers Trust, we have started an insourcing business for
Derivatives processing, but in the main, we are behind other industry sectors and this is costing us
billions of dollars every year.
At a business school, the situation would be viewed as remedial. Let’s take an example. You have
two banks engaging in a Swap transaction. Each of them is producing a confirmation, rate set and
payment notices and making payments between each other. The dynamics of the deal are the
same on both sides! Furthermore, after control requirements have been met, there is little
competitive advantage to be gained by raising the level of service. You lose by making a late
payment but do not gain by making it early. Yet both these banks (and many, many more) are
spending millions of dollars on building and maintaining systems to support these deals – and they
are doing this at a time when the trading profit margins are reducing.
So how do we make our industry more efficient? In a way, this is already happening. Systems
integration projects and Straight-Through-Processing initiatives have reduced manual
intervention, the use of Internet and Intranet technology has revolutionalised our ability to get
information to and from clients, and the euro itself, replacing 11 legacy currencies plus the ECU,
will simplify settlement in the European securities industry. However, this is only scratching the
surface and what is required to radically reduce infrastructure costs is a move towards shared
service/outsourcing of wholesale financial operations.
Firstly, let’s define the terms: “Shared Service” is where a group of competitors get together to
fund and provide a service to the group on an arms length basis. “Outsourcing” is where one firm
hands over responsibility for running a non-core part of its business to another. In reality, the end
result of both is very similar for an organisation who wants to trade, but is not interested in building
or maintaining its own processing infrastructure and therefore decides to sub-contract the
processing to a third-party Operations Service Company.
From a trader’s point of view, setting up this type of service should be relatively straightforward. In
most organisations, there is already a divide between front and back-offices. Communication
between front and back is by phone or by the passage of electronic trade data. In some cases,
back-offices are already in separate locations. The big difference comes with a) formalising the
service level agreement (SLA) between the two parties and b) setting a price for operational
services.
Setting up a SLA is painful and involves not just detailing what has to be done for any transaction
but also agreeing the escalation procedures if something goes wrong. The SLA as well has to be
binding on both sides, for example, the traders must input all trades by 5:00pm in order for a first-
cut P&L to be available by 6:00pm. What is key is that this fixing of service levels provides
benefits to both sides and also provides an easily quantifiable method of measuring the services
provided.
Pricing the service is also difficult. Many current outsourcing deals run on a “stepped-volume
basis” but to make costs truly transparent, the art of pricing needs to be developed. One approach
is to develop a matrix based cost structure which allows a price to be set for a function, e.g.,
confirmation production, for a product, e.g., a vanilla Interest-Rate Swap. The advantage of this
method is that marketers can price a deal knowing exactly how much it will cost to deliver (again,
this is hardly a breakthrough when compared to other industries). A second approach is openbook pricing which has become increasingly popular in other outsourcing deals. In this case,
major pricing parameters and targets are set up and cost reductions are shared between both
parties.
From the Operations Service Company’s point of view, the major work comes in setting up the
service. This involves ensuring that sufficient “firewalls” are in place, implementing systems and
interfaces to the client, agreeing service levels, conversion and testing. Once the service is up and
running, maintaining service and control standards become the key to a happy client.
When successfully implemented, major benefits accrue to both parties as economies of scale and
sharing of systems development across combine to reduce transaction costs. Firms will also have
to ability to “shop-around” for service and will be able to enter (and leave) markets without high
set-up or residual charges.
So why are these initiatives not more widespread? and how do we make this happen? It is well
known that a large number of institutions have considered outsourcing all or part of their
infrastructure over the last few years. Many have also discussed with consultants how to
commercialise their own operations. All have deduced that there is a huge market in Operational
Services waiting for someone to set the ball rolling. Yet little apparent progress has been made,
mainly because of conflicting priorities. This is set to change and the marketplace will look very
different in 10 years time.
Two major steps need to be taken: creating the product and creating the market. Taking the
product first. One or more major institutions must decide to invest in the infrastructure needed to
make processing fully multi-client. This will not be cheap as systems that have been built for one
entity to transact with one set of customers must be re-engineered. In addition, secure external
networks will need to be set-up to capture deals and to transmit back settlement and financial
data. However, the economies of scale that could be realised, even without additional process
optimisation, are enormous and would provide a high return on investment.
The second step, creating the market, is more difficult. At the moment, entering into an
outsourcing agreement is considered a) radical and b) risky because in the event of termination of
a contract – who do you turn to? Again it needs one or more major institutions to take the first
steps to open their doors to third-party processing. Others will no doubt follow but the first ones in
will be those who make the largest return.
Finally, let’s jump forward 10 years to a world where this move has taken place and examine the
players in the market. Firstly, there will be virtual banks: some of these will be older institutions
who have shed their infrastructures and now solely consist of trading and risk management
functions. Others will be new start-ups who have benefited from the ability to get into the financial
markets quickly and switch focus from product to product without huge start-up and/or
restructuring costs. Secondly, there will be the Operations Service companies who have reinvested their profits in further efficiencies and who now compete with each other to provide a lowcost and high quality service to their clients. Finally, there will be old monolithic institutions who
have proved resistant and still have their own operations groups. They will have seen rising
internal costs and more and more difficulty in recruiting quality back-office and technology staff.
The winners will be clear!
Jeremy Smith is manager of Bankers Trust’s Derivatives Client Services Group