Celent Securities & Investments Newsletter, October 2013
Analyst's Point of View
Back Office Outsourcing by Buy Side Firms
In the last few years, buy side firms have had to make lot of changes in their middle and back offices. There are two primary drivers.
Leading up to 2007, the economic climate was favorable, and profits were rising, which meant technology budgets were also on the rise. Since the front office trading departments are the primary revenue generators in trading firms, technology decisions were largely determined by front office staff and based on their immediate needs. Middle and back office activities were largely ignored and continued to be run by legacy systems.
The crisis changed firms' priorities dramatically. While downsizing enabled short-term cost-cutting, firms had to seek long-term cost savings by improving operational efficiency and making strategic technology decisions. Against this backdrop, the middle/back offices were ripe for attention.
Many institutions still use legacy systems. Most of them are based on simple Excel spreadsheets and offline communication and are handled manually. There is little integration between the middle and back offices and the front office. These issues create huge inefficiencies and can diminish or even nullify efficiency gains achieved in trading execution. Rapid changes in the regulatory environment have created additional obligations. It has become essential that firms address the complete trade cycle in a much more holistic way and stay on top of their processes almost on a real time basis to adequately.
In the short term, most of the budget is being spent to meet regulatory issues, which leaves little room to invest in process improvement. Some firms have mentioned to us that as much as 80% of their change management budget is being spent on compliance.
Against this backdrop, outsourcing of mid-back office processes is becoming popular among buy side institutions. Since almost all of them have to make similar arrangements to adhere to regulators' demands, there is potential for a utility where firms can outsource some or all of their back office functions.
This practice is gaining traction as buy side firms realize the complexities of reconciling higher volumes of more complex trades. At the same time, service providers have improved their capabilities and now offer a wide variety of choice. Custodian banks are seeing a surge of interest in their outsourcing services. Increasingly custodians are finding that clients are asking for solutions 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.
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 need customization to manage firm-specific needs. The challenge in developing a utility service model is to design a common platform that will still address custom needs. Many providers are considering such an offering. There is a race to accomplish this, because the first provider will have a big advantage over the others.
Arin Ray, Analyst
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