Clive Triance, global head of broker outsourcing
Colin Brooks, global head of sub-custody and clearing
How has the legacy of the financial crisis impacted clients’ approach to outsourcing?
Brooks: Before the financial crisis there was a heavy focus in terms of time and resources on non-differentiating activities. When times are good there is little pressure for firms to distinguish between what they are really good at and the auxiliary functions that they feel they have to perform. They are relatively relaxed about the economies of scale that outsourcing offers because having fixed costs for processing can be attractive in a rapidly growing market.
Triance: This meant firms put up with new sources of operational risk where they were rushing into a new lucrative market, for example as many did when moving into Russia some years ago. When entering a new market they would be fearful of having a problem with, for example, a corporate action or maybe a tax loss – but they would work around this as best they could and accept the risk that remained.
Keeping processing in-house also made for high staff costs in these cases. In the Russia example, there were a limited number of skilled professionals able to help with facilitating the moves. With each firm looking for their own expert, demand for staff shot up and with it the salaries that experts could command. With the financial crisis – and particularly over the last two to three years – the pressure on operating margins has pushed these firms to look at wholesale reform.
Today, firms know they must concentrate as much of their efforts as possible on their core competencies, notably the speed and quality of execution, the quality of their research and stock picking and potentially their asset allocations skills. This sea change in thinking is reflected in a 2013 KPMG survey – 66% of respondents said they were altering their mindset towards outsourcing and 77% of respondents are intending to increase the amount of processing that they outsource.
How has this shift affected your services?
Brooks: The real shift in emphasis in our services, therefore, has been towards the additional ones that surround the core custody services that we have traditionally offered. When people think about custody they think of settling trades and processing corporate actions – but many providers in the industry can do that well. Traditional sub-custody is a relatively mature business in which there is only minor differentiation in core services between providers and a constant downward pressure on price.
Instead, firms such as HSBC are providing FX, collateral management and a range of other solutions to look after these noncustody functions. Many of these are based around the provision of more detailed information, notably the provision of market intelligence and the internal data that is helping companies better understand and manage their risk profile. This shift has been characterised by the development of a closer partnership model between client and asset service provider, which has replaced the traditional practice of buying a single piece of business from an asset servicer.
What impact has regulation had on this trend?
Brooks: The drive towards greater internal transparency has been matched by demands created by the raft of new regulations. In particular, these now require clients to demonstrate that they are managing risks effectively on behalf of their underlying investors. This means looking at risk through the entire trade lifecycle and it is here that custodians’ attentions have focussed much more.
The speed of change that regulatory reform is forcing on the industry has created a second area where custodians have an opportunity to differentiate themselves. The strength of their relationships with regulators, central securities depositories (CSDs) and stock exchanges will dictate the quality of the access they have to infrastructures and the influence they can help to assert on behalf of clients as regulations and the infrastructure landscape evolves.
Triance: This trend is only going to increase – the first waves have only just hit the shore. It is a global trend. The further you go east of the US the more complicated regulation gets.
What role is cost-saving playing in the appeal of outsourcing?
Triance: Part of the appeal is commercial, yes. Since the financial crisis, the squeeze on costs for clients has seen a shift from a fixed to a variable cost model. The return on investment for the largest banks is around 7% to 8%, with many targeting 12% or more. In an environment where it is difficult to know how to grow revenue, the focus has landed squarely on reducing costs.
Opportunities for achieving 30% to 40% cost savings by outsourcing non-differentiating functions, such as those in the middle and back office, present a compelling argument for boards to consider. Providers everywhere have seen a marked increase in interest beyond settlement and clearing, demands are growing for providers to operate depositary accounts on clients’ behalf, taking on the responsibilities for settling trades and third-party clearing and generally moving up the value chain from the back office to everything that sits in the post-execution space.
Cost factors also come into play for those serving these clients. At a time when it is very hard to persuade bank boards to invest in new technology, and many competitors – and clients – are reducing their investment in this area, HSBC continues to invest in the development of technology to meet the aspirations of our clients, as evidenced with our new bank and broker outsourcing offering.
Can you explain how you developed this?
Triance: We looked a number of thirdparty clearing and account operating models before we started building our outsourcing offering. We became acutely aware that the transactions required to support it were moving up the chain to the very start of post-trade.
We chose not to build a traditional platform or industrialise our existing platforms that were reasonably advanced in years. The truth is that the technology in legacy platforms is very outdated – the average age of a client back office system, for example, is about 18 years. The majority of banks and brokers are still running on green-screen technology.
This contrasts starkly with the technology we are used to seeing in front office trading systems. It seemed that relying on a legacy approach would certainly not equip us for the challenges ahead, such as the collateral visibility, optimisation and velocity requirements of moving OTC derivatives onto CCPs as part of the European Market Infrastructure Regulation (Emir).
So, instead of building a traditional platform or increasing the capacity of our existing infrastructure, we sat down with a blank sheet and designed a new model.
We formulated a number of principles for the new system that we would construct. Firstly, it needed to be a rules-based system. This allowed the system to be asset-class agnostic – it would not matter whether it was processing equities, fixed income instruments or derivatives. From the creation of a trade on the platform right through to the creation of sub-ledgers, books and records, each trade would be treated according to a set of rules for that event.
This enabled the second principle, that the solution be workflow driven – that is to say built around the trade lifecycle. This architectural approach means that you could put any new instrument you want onto the platform without an explanation of what it is – you just need the rules that apply to it.
These first two principles provide the system with a high degree of flexibility. Not only can the system respond to the existing processing challenge in a quick yet optimal manner, but it can also quickly adjust to the next regulatory hurdle, new market or new product. And because it is a rules-based system where you are rarely touching the core of the system you can perform single processing across asset classes, such as data scrubbing for all corporate actions that provide efficiencies around the whole solution while keeping client data segregated.
The final principle was that it could deliver the scale of savings required to get clients to buy. Offering 10% to 20% savings just doesn’t cut it for outsourcing projects. You need to be able to prove far more substantial benefits.
Brooks: It has taken us a year to build the HSBC broker outsourcing solution and we are seeing a huge level of interest in it today. It is facilitating the conversations that we are having with clients who want to shift beyond a third-party clearing model and into these more value-added services.
What is distinctive in our approach is that we are able to bundle outsourcing with the custody service that we offer, although it is not mandatory. It is true that there are some established outsourcing and technology firms out there who are working to develop similar solutions to address functions in the back and middle office.
But none of these other solutions are generally able to offer the type and sophistication of value-added solutions such as cash management and credit that we do. We also believe that we have a key edge over other banks’ offerings in this space in terms of the level of flexibility and modularity that we make available to clients.
How does a modular approach work in practice?
Triance: With the support of a non-disclosure agreement we will start by looking at what clients have now and get a detailed sense of where they want to be.
From there we can guide the client through the 26 different modules that comprise the HSBC outsourcing solution for them to find the most effective operating model for their business. For clients, the ability to retire existing systems is an imperative to the success of outsourcing. HSBC’s bank and brokers outsourcing system is designed in such a way that it allows clients to retire technology as they convert. A final advantage of the modular approach is that it supports the sort of rapid entry into new markets that broker-dealers or asset managers must sometimes engage in.
What will the greater focus on these non-core tasks mean for the traditional asset servicing model?
Triance: Clients know that they cannot outsource their regulatory obligations. This means that they must have complete trust in the technology solution that they are buying. Some smaller technology solution providers will struggle to provide that level of confidence. Part of that is about reputation but most of it is about functionality.
Clients need to be able to access their data via a remove portal to see the status of their transactions in real time. And they need a close level of contact with their relationship manager.
Brooks: It is important to say, though, that our focus on bank and broker outsourcing has not meant that we have taken our eye of the traditional custody function as this also continues to be of critical importance to us. There is a lot going on here for providers to cope with, especially in the Asia Pacific region, where Thailand, Australia, Japan and Singapore are all developing their market interfaces, for example by replacing proprietary messaging formats with ISO standards.
The latest example has been at Jasdec, Japan’s central depositor, which adopted the new ISO 20022. We were an early adopter of this standard, which means we are in a position to apply the knowledge we learnt elsewhere in the region as they come on board with similar standards. We have already experienced much of the learning process.
The HK–Shanghai Connect is another example of the rapid change in the infrastructure and business environment that is happening here. The challenge is to recreate the Shanghai settlement environment in Hong Kong and vice versa. We have to divert considerable IT resources here, and deadlines are tight.