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Expect Scrutiny of Outsourcing Post-COVID-19

For many asset managers – including members of the Independent Investment Management Initiative (IIMI) – outsourcing has been a fantastic enabler, allowing firms to net meaningful operational savings and transition away from a fixed to a more variable costing structure. With returns so volatile and margins being eroded away by rising management fee compression, an intelligent and thoughtful outsourcing strategy can be a huge value-add. Nonetheless, the pandemic has exposed some serious deficiencies in the conventional outsourcing approach, which urgently need addressing.

Outsourcing has been an area of focus for the Financial Conduct Authority (FCA) for a long time. Nine years ago, the FCA’s predecessor – the Financial Services Authority – admonished asset managers for being too reliant on their outsourcing partners, warning that a failure by a service provider could result in serious operational disruption at their businesses. Since then, improvements have been made although in 2020 the FCA issued a note – published before the seriousness of COVID-19 became so obvious – warning asset managers that they had inadequate governance; oversight; risk management and clear contractual arrangements with their outsourced providers. The FCA continued that it expected fund managers to have in place processes to deal with outages and wind downs. It also urged managers to keep an eye on concentration risk, and the impact this could have on business continuity.

COVID-19 will be a case study in business continuity for many years to come. During COVID-19, a number of problems emerged with managers’ outsourcing arrangements. There were those firms who externalised a lot of their operational activities albeit to a number of different providers. While sound from a counterparty risk perspective, it can have drawbacks. Just as too many cooks in the kitchen can spoil the broth, an abundance of outsourced providers creates an additional layer of operational complexity, increasing the scope for errors or mistakes, especially during a fast moving pandemic situation. At the other end of the spectrum,  some service providers are encouraging managers to consolidate their outsourcing relationships. While it is economical and easier to have processes like administration, custody, depositary, collateral management, FX and prime brokerage being carried out by a single entity, it is a major counterparty risk , and one that could elicit scrutiny from institutional investors, especially those who have the Lehman Bros’ default etched in their memories. A balanced, sensible approach towards outsourcing therefore needs to be adopted by asset managers.

Outsourcing practices have also been found wanting by events in India. At the beginning of the pandemic – when India implemented one of the world’s most draconian lockdowns – a number of outsourcing providers were caught off guard. With a number of staff working in back office roles prohibited from going into work, providers were forced to dispatch laptops, mobiles and even install home Broadband networks to ensure that processes such as NAV calculations and trade reconciliations were not disrupted. Barring a few glitches, the industry weathered the initial storm successfully. A year later and with India suffering a catastrophic second wave, disruption to back office operational activities caused by staff sickness is an issue many providers are having to confront. In response, asset managers need to scrutinise their own providers’ outsourcing arrangements, and ascertain that they too have contingency plans in place to weather the ongoing COVID-19 disruption.

It is highly likely that institutional investors and regulators will conduct a thorough review of asset managers’ outsourcing arrangements and business continuity processes. As a result, investment firms will need to think very carefully about how they outsource core operational activities moving forward.