Asset managers are in the midst of adjusting their business from an environment of low rates, low inflation and low growth, to a period of higher rates, rising inflation and what they hope to be higher growth.
There is just one problem, much like the UK government on its tax credits, many asset managers are chronically underprepared for this new world.
One of the reasons is a ballooning demand for outsourcing services since the financial crash. It’s easy to see why. The first thing any business looks to do in a downturn is cut costs – and the asset management community is no exception. The issue is that as the years have come and gone, firms have seemingly accepted outsourcing services as an ongoing cost. This is perhaps why, according to a recent report from SWIFT, investment managers are now looking to cut their outsourcing relationships in a bid to reduce cost and complexity.
Turning to outsourcing is all well and good when the economy is weak, but we are entering a world where even small rises in interest rates will mean that the cost of certain activities, such as managing collateral, increases. A 2014/2015 study by the Bank for International Settlements states that just a 1% rise in rates could cost the industry more than $37.5 billion in increased funding costs on cash collateral alone. The trouble is that collateral management relies on pricing services which in many cases have been outsourced. If this situation materialises, it is likely to be more cost effective to maximise the allocation of available collateral by bringing these pricing services back in house rather than shifting the responsibility to someone else.
Cost, however, is just one part of the story. Similar to the UK public’s view of ‘Westminster’, the euphemism for all things political, a greater scepticism around third party services is understandable – particularly as the now delayed Mifid II technical standards requires asset managers to report on their risk exposure at any time. The challenge is that if a third party is supplying the information, it is harder for an asset manager to be fully confident of his risk exposure when the regulator comes calling. It is one thing to be able to monitor and report but ultimately, if all an asset manager is doing is collating information supplied by someone else, then a possible communication breakdown could lead to errors occurring. While in days gone by these errors may have gone unnoticed, today, everything needs to be logged, checked and then re-checked. A recent industry report by Deloitte stated that now more than ever, there is a need for asset managers to have effective oversight and supervision of the service provider’s operations. If this is the case, surely it makes more sense to bring these activities back in-house instead of shelling out yet more money to oversee the provider.
As well as keeping an eye on costs, the supplier selection process also needs to be assessed. European financial directive AIFMD clearly states that any relationship needs to be selected with due care and monitored efficiently and revisited frequently. Questions have to be posed as to whether the asset management industry has considered the latter – particularly as many of them have used the same two or three providers for certain services for some time now. Take fixed income, a market where one of the largest fund managers shares its risk management models, tools and controls with other asset managers. This creates a fundamental problem. If a large chunk of the market is all using the same models, even the slightest error can cause a ripple effect – creating a huge amount of systematic risk. Presumably, this is not the sort of situation the regulators had in mind.
This is why, with 2016 just around the corner, now is the time for asset managers to review their outsourcing relationships with a view to taking operations back in-house. Only then will they be able to deliver the change needed to meet evolving economic conditions. This is no easy task, but ultimately an asset manager’s primary focus should be delivering services that benefit their investors. Too much attention in recent times has been afforded to quick fix solutions in order to comply with regulations. Now is the time to take a step back and ask how all this change has affected the core business.
Some firms are already adopting systems that take the pain out of outsourcing relationships, whether that’s controlling and manage risk, or satisfying the reporting demands of regulators. Having an in-house infrastructure in place to handle this frees up fund managers to focus on devising the best possible investment strategies and be best prepared for the new economic environment. While certain firms are well prepared, others aren’t, and those that fail to act now may soon find themselves in the unfortunate position of to perform the investment management equivalent of a political U-turn, particularly if competitors start reaping financial rewards from taking back control.
Noel Montaigue is senior business manager at OpenLink