July 7, 2011 – Fund managers are widely cited by consultants and analysts for outsourcing their middle- and back-office operations.

But they’re not alone. Broker-dealers are also finding themselves driven to seek outside help. The same rationale applies: Having someone else handle administrative work reduces operational risk and cost.

"Outsourcing provides a way to manage processes in a predictable and controlled manner," says Alberto Corvo, managing principal for financial services at eClerx, a capital markets and investment management consulting and outsourcing company in New York. "Operational risk is managed through service level agreements while costs are fixed at an all-inclusive rate."

Yet another benefit: Competitive edge. Brokers can enter new markets and offer new products and services without the expense and time needed to hire and train staff. The outsourcing agent can often do it in a matter of weeks

That doesn’t mean broker-dealers are entirely off the hook. They are still responsible for meeting regulatory requirements and must closely monitor their outsourcing agents.

“Broker-dealers must ensure that the process follows their guidelines through strict service level agreements and is auditable for internal controls and regulatory requirements,” said Rodney Nelstruen, a director of research for Tower Group. “They can also price the contract based on their level of satisfaction and the level of guarantees offered by the outsourcing agent to prevent any errors.”

Here are five of the top processes which broker dealers are most likely to outsource to either a bank, another broker-dealer or a technology firm such as eClerx, according to a survey of 50 broker dealers conducted by eClerx and Tower Group.

  1. Valuations. Broker-dealers want to test their pricing models and methodologies to ensure they have accurately marked their securities accurately. Such third-party valuations will become critical when over-the-counter derivatives are cleared though a clearinghouse. That is because broker-dealers must be able to validate any marks calculated by clearinghouses, and understand any discrepancy, so they can ensure they post the correct collateral and in turn request the correct margin from clients, said Corvo.
  2. Processing corporate actions. Broker-dealers need to make certain that they have paid the correct dividend and interest to beneficial shareholders. Therefore, they need to match up the amount they receive from their custodian bank to the amount paid by the issuer. They may also want to ensure they have received accurate corporate action announcements to forward to their investors. Errors in either the amount of payments made to investors or information on reorganizations and tender offers could easily spell a few million dollars in costs to reimburse their investors. "To ensure the best quality service broker dealers are often tying their liability to service level agreements," said Rodney Nelsestuen, director of research for Tower Group. "The third party will agree to pay for any financial losses resulting from errors."
  3. Managing reference data. Although broker-dealers may think it's easy to keep track of basic information on the securities they trade and process. As data is distributed in multiple silos it’s often inconsistent leading to plenty of errors in payments to counterparties or trades which fail to settle on time. It will also be difficult to understand the exposure to a client stemming from multiple asset classes housed in multiple systems.
    "Ensuring accurate static information on securities and derivatives sounds basic but it’s the one area often neglected which can have the greatest number of ramifications," said Corvo.
    In the case of securities, errors will be caught either at settlement or at the time an interest or dividend payment should have been made. For over-the-counter derivatives, the mistakes could take days or even years to find because contracts are multi-year. Mistakes can result in not only charges to replace securities but interest penalties for delay in the use of capital.
  4. Reconciling portfolios with third parties. “Nowhere will the need become more important than in over-the-counter derivatives where they will have to match up the transactions they completed with counterparties," said Corvo.
    Any mistakes will mean errors in valuing portfolios which will result in mistakes with initial margin and margin calls. Broker-dealers need to match up their positions and cash balances with their clearing agents, fund managers and counterparties. Otherwise they will make mistakes.
    As part of the central clearing requirement, details held by the following players will need to be reconciled: the broker dealer, the client, the central clearing firm and Depository Trust & Clearing Corp. It will be the broker-dealer’s responsibility to reconcile positions with the client, the central clearinghouse and DTCC, and potentially the position will be spread across multiple clearinghouses.
  5. Complying with know-your-customer regulations. Broker-dealers are legally required to verify the potential or any of their clients to engage in money-laundering activities. They must also understand the customer’s financial condition before extending any credit or starting to trade on its behalf. It’s best to know as much about clients when they open their account and any circumstances which might change afterwards.
    Too often broker-dealers either don't have the necessary information, don't update it when required or don't even know what to look for. Although compliance departments are held legally responsible for any errors, operations executives are often the ones left doing the work. With little experience and not enough guidance from management—“high-risk” customers can be categorized as “low-risk” or concerns may not find their way to upper management before transactions are executed or funds are wired.

Technology alone doesn't help. Data needs to be correct and procedures need to be tight and followed strictly. Some banks don't have clear procedures in place, due to the fact that such procedures were developed over time and as a response to new systems and products being brought in and developed, and even when they do, there is a risk of falling short of following them.
Firms such as eClerx can help ensure they restructure their processes to achieve best practices, monitor them in order to follow their own policies and be alerted when a potential problem emerges such as the inability to verify information given by the customer or eliminate inconsistent information, said Corvo.

This column originally appeared on Securities Technology Monitor.

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