More vendors are dreaming up ways to relieve back-office headaches.

By Elizabeth Block

Hardware and software may be essential to run a back office, but how much of it do you actually have to own? That’s the question more investment banks are asking these days as they seek ways to lower their burgeoning IT and personnel costs. A number of vendors are arguing that banks can lower costs and improve controls by letting them do some of the heavy lifting. And some banks are even beginning to market back-office services of their own.

Outsourcing of back-office IT operations, of course, is not new in itself, since some vendors have made IT systems available on a leased or “bureau-service” basis for years. But these days, vendors are expanding their outsourcing efforts to cover more financial instruments, including derivatives. They are also using new technology, including the Internet, to expand their solutions and provide more than IT.

Currently, banks can outsource much of their back-office IT, while retaining full responsibility for the actual processing. In the future, it may be possible to outsource the processing itself. In this scenario, outsourcing would transcend straight-through processing and dramatically change the relationship between bank and vendor.

Advantages of outsourcing

Outsourcing has several key advantages. First, it can help cut back-office costs through economies of scale. While the largest investment banks have invested in advanced back-office systems, many smaller and mid-tier banks still have a highly labor-intensive back office. Mark Rodrigues, general manager of global financial services at AMS in London, estimates that an average of 60 percent of the staff at a typical investment bank work in operations, including operations, IT and back office.

Second, outsourcing changes the cost basis of a firm by converting fixed overhead costs into volume-related costs. A typical license arrangement, for example, involves a fixed cost or overhead—whether monthly or annual—that is independent of the volume of trades. The client bank pays the same license fee whether trading volumes are high or low. But under a “per-ticket” arrangement, banks would incur costs only when trades actually take place. This cost-savings alternative is expected to appeal particularly to smaller and mid-tier banks that have not yet invested heavily in back-office systems—or that face high upgrading costs.

Outsourcing also promises to make back offices more efficient—and cut operational risk—by using better technology and more highly motivated staff. “Advances in technology can cut a bank’s operational risk,” says Christophe Reech, CEO of London-based Reech Capital, a financing and derivatives consultancy. “The error rate on the processing should improve significantly as a result of the outsourcing firm being more motivated as a profit center in its own right.”

“The error rate on the processing should improve significantly because the outsourcing firm is more motivated as a profit center in its own right.” —Christophe Reech Reech Capital

Outsourcing may also help banks overcome one of their major headaches: recruiting qualified personnel. The skill level required of back-office staff has risen as derivatives trading has expanded and more complex instruments have come into wider usage. Yet it is difficult to attract top talent to work in comparative obscurity behind the scenes—and to motivate them once they’re found. “Settling complex derivatives requires financial, analytical and technical skills equal to—or even exceeding—those needed to originate the deal,” says AMS’s Rodrigues. “Yet these people are paid a fraction of front-office salaries and bonuses.”

A number of vendors are already lining up to expand their back-office offerings. Early next year, Infinity, a SunGard company, will introduce eFinity, a back-office service package that will be delivered via an application service provider (ASP) framework. The package will provide complete processing functionality, from trade enrichment to confirmations, payments, settlements, SWIFT messaging and general-ledger postings for derivatives, foreign exchange and money-market instruments. It will be offered on a monthly fee basis, plus transaction-based charges. The service has been developed by Infinity and its corporate affiliate, SunGard Computer Services, a major outsourcing and network services provider.

Brian Robins, Infinity’s senior vice president of marketing, says the Internet-enabled service is aimed at smaller banks, corporates and larger banks that want to focus on their core competencies. He believes outsourcing will grow and predicts the emergence of specialist processors. “There may be specialists in rate reset or in liquidations and early terminations,” he says. “With the power of the Internet, you can distribute the processing among a number of specialists.” For the future, Robins sees a three-stage process with his company shifting from being an ASP to being a full-service or applications-on-tap provider to being an e-commerce provider.

Last summer, OMR, which is testing a web-based deal-capture and position/P&L-keeping front end, intro-duced its Outsourcing Solution for foreign exchange, money markets and related derivatives. Designed to accompany the company’s widely used Trading Assistant engine, the Outsourcing Solution allows clients to pay for trades on a fixed per-ticket price, as opposed to buying a license and incurring annual maintenance costs regardless of volume. “We think this is going to blow the lid off the market,” says sales and marketing director Jay Pila, who claims that around 50 percent can be saved with this approach compared with in-house processing.

Financial Models currently offers a choice of outsourcing methods for its investment accounting system: renting the hardware and software on a shared-access or service-bureau arrangement, or buying the actual hardware and leaving it in the vendor’s data center under a facilities management contract. The company also expects to release FMC View, a browser front end to its system, by the end of the year. Users of both outsourcing methods will benefit from the new browser front end, says Phil Banas, European sales and marketing director, who adds that he’s seen more interest in facilities management lately.

Bank solutions

A number of banks are also busy developing new web-enabled back-office services. Last summer, London-based Greenwich NatWest Futures introduced on-line clearing for exchange-traded products. The service, called Greenscope, links the bank with clients and permits same-day rather than next-day position reporting and reconciliation. “Our reconciliation model allows our clients to see their positions—both overall and individual trades—on the screen in real time, thus saving time for us and the client,” says Gerard Joynson, vice president of futures marketing at GNWF. He also notes that Greenscope will soon be enhanced to include cash management and more extensive reconciliation.

“With the power of the Internet, you can distribute the processing among a number of specialists.” —Brian Robins Infinity

Deutsche Bank, meanwhile, has taken a giant step in a different direction by spinning off its entire payments and securities processing expertise into a legally independent, wholly owned subsidiary. The new specialist bank, called the European Transaction Bank, has a staff of 3,000. It will offer services to the Deutsche Bank Group and to external financial institutions. Deutsche Bank plans to reassure competing institutions by guaranteeing neutrality in the market and the confidentiality of customer-related information. The first external customer was Bank Sal. Oppenheim in Cologne.

Troublesome issues

Outsourcing is not without its opponents. The biggest issue involves systems integration. Software vendors and systems consultants have long argued that better integration of front, middle and back offices is the key to better risk management. For banks that have invested heavily in integrated systems, it may be difficult or painful to give up some of the systems integration they have worked hard to achieve.

A number of control issues—such as confidentiality, liability and security—must also be addressed. How, for instance, will firms resolve the inevitable disputes over trade errors and other instructions? Liability limits for both parties would have to be written into contracts or service agreements. Confidentiality will also be critical to maintaining trust among the parties. If outsourcing expands to include clearing, regulatory and capital-adequacy issues may arise as well.

Graham Duncan of KM Partnership in London is particularly concerned about the capital-adequacy implications. “Right now we’re talking about the outsourcing only of systems, so the liability issue may not arise, but the question of handling other people’s money is always touchy,” he says. Much would depend on whether the outsourcer is incorporated as a bank. For example, if an outsourcer were to clear a trade and incur an overdraft, who takes the capital-adequacy hit?

It seems likely that the advent of real-time systems and Internet capability will encourage banks to outsource an increasing proportion of their derivatives processing. They may cut operational risk and reduce costs. But if mistakes are made, we are likely to see a new category: outsourcing risk.

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