The trend towards outsourcing of back-office administrative functions is likely to be accelerated by the requirements of the Markets in Financial Instruments Directive (Mifid), while asset managers who outsource will come under greater scrutiny.
Such is the view of Octavio Marenzi, chief executive officer and founder of consultancy firm Celent, which reported recently that Mifid would require significant IT investment by market participants, including asset managers, totalling €1bn.
He says: “Mifid will probably lead to a proliferation in the number of trade execution venues and therefore small and medium-sized asset managers are going to have a harder time ensuring that their orders are executed well and that they have fulfiled their best execution requirements.
“Also, in future, market data could come from any one of a number of different sources. So aggregating all that market data and figuring out what was the actual trade volume for a particular stock will become much more difficult. Fragmentation is going to lead to greater expense being incurred to connect to all these new end-points so asset managers will more likely outsource that connectivity either to a custodian or to a large broker/dealer or technology vendor.”
Wider range
Designed to replace the European Union’s 1993 Investment Services Directive, Mifid covers a wider range of services and asset classes including hedge funds, money market instruments, collective investments and derivatives. The directive, whose implementation has been delayed until April 2007, aims to expose Europe’s exchanges, which hitherto have enjoyed primacy in the trading of equities, to the fresh winds of competition from multilateral trading facilities (MTF) and investment houses internalising orders.
Mifid also aims to enhance pre- and post-trade transparency. Regulated markets, investment firms and MTFs are first required to publicise current bid and offer prices and the level of trading interest at these prices and subsequently to disclose the price, volume and time of the executed trades.
To further boost market transparency, investment firms are required to keep data on all trades, including tapes of client orders they have carried out, for up to five years.
In order to meet these provisions, asset managers will either have to invest heavily in updating their IT systems or else outsource the compliance functions to suitable third parties.
If asset managers choose the latter course, they still retain responsibility for the outcome and so will be expected to monitor the firm they have outsourced to.
Mr Marenzi says: “If, for instance, asset managers are outsourcing trade execution, they will have to ensure that their broker/dealers are fulfiling their best execution requirements. So there is probably going to be a greater level of scrutiny placed on outsourcers than we have seen so far.”
Alan Jenkins, head of Mifid at consultants BearingPoint, points out that on the question of monitoring outsourcing deals, the directive makes no distinction between intra-group and total third-party outsourcing.
“At present, people probably pay less attention when they outsource to a sister company, but now they will have to monitor intra-group contracts just as closely.”
He concurs that there will be greater scrutiny of outsourcing contracts which will have to be disclosed to the financial regulator where they are significant in the way set out in the new legislation.
Exit strategy
He adds that Mifid requires the outsourcing asset manager to have a carefully prepared “exit plan”.
“Some of the outsourcing problems that people have experienced in the past have arisen because they entered into a deal without thinking about their exit strategy. When you are doing a deal with an outsourcing service provider, you need a specific provision in the contract that allows you to repatriate the service or move it to a different provider after an appropriate period of notice,” he explains.
Mr Jenkins also envisages a bigger role for trade associations as small to medium-sized asset managers look to shift the burden of compliance.
He says: “It is hard to imagine, for instance, that smaller firms are going to want to engage their own lawyers to frame their client documentation. They might look to a trade association to come up with a template for them. And other co-operative type initiatives might result from outsourcing.”
He adds that the outsourcing market could witness an influx of new entrants providing value-added services in areas asset managers would not necessarily think of outsourcing today.
However, Phillip Kitto of Citisoft Consulting is not convinced that the implementation of Mifid will bring a new range of outsourcing service-providers to the market. On the contrary, he says the new directive might well have the opposite effect, contending that the costs of entry will increase due to the regulatory overhead.
