Outsourcing: making oversight a forward-looking benefit

Ian Mainwaring is a principal consultant at Citisoft

Could the establishment of an enhanced outsourcing oversight capability do more for asset managers than simply satisfy the FCA? A more mature set of oversight metrics could be used to provide foresight into how the outsourcer might perform in the future, writes Ian Mainwaring.

The FCA’s thematic review into outsourcing, published in November 2013, focussed on two key areas of risk management: ‘resilience risk’ (asset managers having inadequate contingency plans in place to deal with a failure of their service provider) and ‘oversight risk’ (asset managers applying inadequate oversight of their service provider).

The part of the FCA’s review that is arguably the easiest to implement is the outsourcer oversight requirements. The dilemma for asset managers, however, is to what extent must they independently verify that their outsourcers are doing what they say they are doing (and are contractually obliged to do)?

In my view, there is an opportunity here for the adoption of a more mature approach to monitoring – not only in terms of asset managers improving the quality and independence of oversight metrics (which I certainly believe asset managers can improve upon), but also in terms of developing how these measures can be used in order to provide insights concerning outsourcers’ effectiveness.

Room for improvement

Asset managers do conduct oversight, but few in the industry would argue with the viewpoint that in terms of truly independent supervision, there is much room for improvement. Few asset managers would claim that their oversight of outsourcers is perfect in all investment management processes. Some of the oversight procedures that were originally conceived will now be outdated, as the outsourcing agreement evolves and the needs of the asset manager change. Furthermore, as with all outsourcing agreements in any industry, the asset manager would typically be enthusiastic about oversight initially but as the years go by, inevitably some complacency creeps in.

The problem is exacerbated by the fact that many of the original staff that signed the outsourcing agreement will have left the company or moved into different roles by the time of renewal. And perhaps most worrying of all, does the asset manager have the correct expertise in-house to actually address the concerns of the FCA?

Moving away from retrospective oversight metrics

If we are to move from a position of oversight to one of foresight, it is useful to remind ourselves of the definitions of the two words in question:

• Oversight: Watchful care; superintendence; general supervision. Escape from an overlooked peril.
• Foresight: The ability to predict what will happen or be needed in the future.

The shift implies a change in emphasis – from knowledge based upon current or past performance to the prediction of future threat. Traditional outsourcing oversight measures tend to be somewhat retrospective, ascertaining how well certain functions performed. By their very nature, service level agreements are also retrospective: for example, the service provider will match 80% of the asset manager’s trades within 24 hours, with the remainder completed within two days.

In contrast, a more advanced set of metrics and data visualisation tools could provide foresight into how the outsourcer may perform in the future; against, for example, increased volumes or more complex products. This is where an opportunity resides for asset managers.

Applying business intelligence

I am advocating that when an asset management firm reviews its oversight arrangements under the FCA’s thematic review, it should be aiming to transform this process into a more forward-looking activity, providing real perception to the business. In practice, this means taking the same information and applying some business intelligence. For example, if the outsourcer is processing x number of trades and is almost up to capacity, if the asset manager were to grow its derivatives business by 25% to y as a result of an acquisition, would it be able to cope?

Let me be clear: I don’t expect the asset management staff at the operations ‘coalface’ to be given sight of the firm’s highly sensitive strategic plans. What I am suggesting is that if the requisite business intelligence were passed up the ‘food chain’ in the correct way, then the executives that are making those strategic decisions would be able to consider the impact on their outsourcer.

Know your outsourcer

From my own experience, I would say that if an asset manager does not know that its outsourcer is already stretched to the limit, when the asset manager says that its volumes are going to increase by 25%, its outsourcer is highly unlikely to say ‘we can’t help’. After all, this isn’t what any asset manager wants to hear from its outsourcer. Nevertheless, the problems will emerge over time, as certain spikes in activity are reflected in errors, exceptions management reports – or simply that settling all trades takes three days instead of two.

Unless an asset manager has a tool – a window – to improve the transparency between the asset manager and the outsourcer, the fundamental relationship between the two parties will not change.

In summary, if an asset management firm’s retrospective oversight procedures are not as effective as they used to be, then the FCA’s ‘warning shot’ is a good thing for the industry. There is an opportunity, however, to consider a more fundamental review of these processes. New metrics and data visualisation techniques could reflect that the outsourcer is struggling under certain circumstances – because the ‘oversight’ function has evolved into ‘foresight’.

As the markets recover and growth is back on the agenda for most asset management firms, this kind of forward-looking insight will become increasingly important.