Many fund managers still exist who prefer to handle middle- and back-office work with in-house staff.
But complying with the requirements of the financial reform bill may prompt them to consider outsourcing a lot of work. It's the ripple effect of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires careful attention to transaction records of all types. As a result, fund managers must evaluate their operational and regulatory risks, which in turn, will raise the bar on the data collection and reconciliation they will have to conduct.
"Fund managers will need to keep track of dozens, if not hundreds, of transactions daily, which means aggregating data from multiple internal systems, then do the necessary recordkeeping and reporting to regulators and investors quickly," said Ronan Brennan, chief technology officer for MoneyMate. The Dublin firm aggregates and cleanses product data from fund providers and third parties such as Morningstar and Lipper for websites, summary prospectuses, client reports and other fact sheets, while providing an audit trail not only for the fund but regulators as well.
Concerned about the potential for error-and costs-investment firms are either expanding their existing agreements with service providers or starting from scratch in deciding to outsource middle-office functions. This loosely includes such post-trade but pre-settlement functions as confirmation of trades, allocation of purchases or sales to different accounts, position reconciliation, investment accounting, collateral management, performance metrics and data management.
"It's not an overnight decision and requires a lot of thought on whether the work can be done not only at a lower cost but more efficiently by another party and with little risk," said Holly Miller, a partner at Stone House Consulting, a Thornton, Pa., consultancy specializing in investment management operations.
The more commoditized the service the more likely it is to be outsourced. "The services with a higher customer touch such as client reporting and performance metrics are the last ones fund managers will outsource," Miller said.
Two common candidates for outsourcing: sending post trade- allocations and settlement instructions to be matched with a broker-dealer and custodian bank as well as reconciling positions and balances with multiple third-party prime brokers or custodian banks.
"The fund manager may decide that it doesn't want to maintain its own message formatting or connectivity to the SWIFT network to send post-trade messages," Miller said. "The fund manager might also decide to allow the service provider to find the breaks-or discrepancies-between the managers' records and those of prime brokers while allowing the fund manager to further research and correct the problems."
Hedge fund advisors are particularly concerned about whether they can meet the requirements of registering with the Securities and Exchange Commission by July 21, without the proper office infrastructure in place.
Sol Zlotchenko, chief technology officer at Paladyne Systems in New York, a hedge fund technology firm that offers a hosted platform for buy-side firms, said that over the past few months his firm has been receiving dozens of calls from hedge funds that want to ensure they can provide regulators with daily portfolio level reporting, counterparty and sector exposures. The same applies to hedge fund administrators that want to be ready to offer more middle-office services to their hedge fund clients.
"Fund managers don't want to tell the SEC they are still working off of spreadsheets or manually create reports and it would be easier for administrators to step in to provide reporting and other regulatory services if both organizations shared the same technology platform," Zlotchenko said.
A narrower area of interest: Managing of records on over-the-counter derivatives. As institutional asset managers and hedge fund managers diversify their investment strategies, they are moving away from their historic comfort zone-processing exchange-traded equities or even liquid fixed income instruments. They may not have either the specialized staff or the necessary technology particularly if an over-the-counter derivative contract needs to be cleared through a clearinghouse, as required by the Dodd-Frank legislation.
"There will be a range of functions to perform such as trade confirmation, valuation and collateral management, which go beyond the minimal recordkeeping," said Paul Fahey, director of product management for global fund services at Northern Trust in Chicago.
The bank's OTC derivatives processing unit offers services as simple as providing connections to clearing agents to the far more complex service of valuing hard-to-price assets and collateral management. When it comes to pricing, Northern Trust will use vendors such as Markit, SuperDerivatives and Numerix.
Finding the right service provider can take anywhere from a month to close to a year depending on the number of services outsourced and the number of decision-makers involved. The chief operating officer, the chief executive officer, technology director and even director of operations should be part of the team which creates a list of potential candidates for review.
"The fund manager needs to set up an infrastructure for how it will manage the relationship on a day-to-day basis and how any errors or potential problems will be escalated at both the investment firm and the service provider," said Ben Keeler, director of Citisoft, an investment management consultancy in Boston. "Evaluating the feasibility of outsourcing and finding the right provider requires the involvement of a host of key executives at investment management firms even if the buck stops with the chief operating officer."
Among the questions fund managers should ask: is the service provided on a real-time or batch process, at what time in the morning are essential reports generated and how easily those reports be accessed over the web and customized.
"Many of the providers will likely fall out of the running because of poor technology and reporting," said Vernon Barback, president of GlobeOp, a London-based hedge fund administrator. "It's a clear red flag when the fund manager is told that the daily P&L statement will be sent via an Excel spreadsheet instead of delivered on a desktop inside a secure system."
Although third-party firms typically don't allow fund managers to do a test using live data, they can get close. "We show fund managers our production system using sample dummy data, and we will offer them an understanding of how we value hard to price securities using live case studies," Barback said.