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On 4 November 2013 the FCA published its review of outsourcing in the asset management industry.
This review follows on from the FCA’s “Dear CEO” Letter of December 2012 and the subsequent meetings that the FCA held with the industry. Although this review is directed at the asset management sector, it has relevance to all financial services companies that outsource an activity that is important for their business since it shows the steps that the FCA considers should be taken by companies in managing the risk of supplier failure and how outsourcing contracts are managed.
The FCA’s rules on outsourcing are contained in chapter 8 of the Senior Management Arrangements, Systems and Controls sourcebook (SYSC 8). The review examines how these rules have been actually implemented by the asset management industry in relation to:
In relation to contingency plans for the failure of a service provider, the FCA examined the actual plans of 17 asset managers. The FCA found that the industry believed it could deal with this risk in four ways. In the majority of cases the industry said it would move to another service provider to deal with this risk.
However, the FCA was not convinced that the industry had considered the practical steps required, how the service would be run during the interim period (which could take many months) or whether the concentration on a few service providers meant that it would be difficult for the remaining service providers to take over all the affected contracts.
The FCA also found that some asset managers considered that exercising step in rights would be an effective way to deal with service provider failure. Again, the FCA was not convinced that this had been considered carefully and questioned whether the operational difficulties could be overcome. In particular, the FCA noted that no asset manager was able to show how it would deal with data privacy issues when stepping into a shared platform.
The third method proposed by asset managers involved insourcing the affected activities. With the exception of hedge funds which replicate their outsourced activities, the FCA did not consider that asset managers had the necessary in-house expertise, technology and data to take over these activities at short notice.
The final response of the industry was that since most service providers were divisions of large international banks, the risk of service provider failure was mitigated by the “too big to fail” argument and that national regulators would ensure the survival of these banks.
The FCA rejected this view on the basis that international groups could be wound down in a controlled way and in any case, not having contingency plans to deal with a risk was in breach of SYSC 8. Having found the four answers inadequate, the FCA was encouraged by the industry’s response since its Dear CEO Letter. This included the formation of an Outsourcing Working Group which has proposed standardised contracts and making it easier to switch service providers.
The FCA believes that if more of the service definition documents could be standardised, this will reduce the time it takes to switch service providers. The FCA also approved of the concept of “standby” service providers where plans are already in place to move a service to a chosen provider at short notice without the need to go through a procurement process. The FCA recommended that exit plans are tested regularly and that priority is given to identifying core services and how they can be moved quickly and safely from an existing service provider.
The FCA then looked at how effective the industry was at overseeing service providers since without adequate oversight customers could be exposed to losses and considerable risk. The first area of concern for the FCA was their view that most asset managers did not retain staff with sufficient expertise to be able to oversee their service providers. The FCA considered that a well resourced and trained governance team was essential.
Using service levels effectively also requires good management information and the FCA considered that too many asset managers were entirely reliant on the information provided by their service providers and did not take sufficient steps to check the accuracy of the information. The FCA recommended that internal audit and compliance should play an active role in oversight since they had the right expertise to understand the risks involved and to make improvements to service levels.
As part of analysing oversight capabilities, the FCA looked at four functions which are essential in the asset management industry: reconciliations with custodians, pricing and valuations, corporate actions and trade processing. In each case, the FCA was concerned that asset managers were too reliant on information provided by their service providers and were not taking steps to replicate information and to check for errors themselves.
The overall thrust of the review is that asset managers need to plan more effectively and spend more time and resources on managing their outsourcing agreements. This will increase the cost of outsourcing and means that companies need to retain more in-house expertise to manage service providers.
For the wider financial services sector, we now have more guidance on what the FCA requires from regulated companies to demonstrate that they have sufficient controls in place to manage their outsourcing contracts. It is no longer sufficient to point to the exit plan or step in rights.
Instead the FCA will require companies to demonstrate that its plans are more carefully tested and that it has in place a strong governance team to manage the outsourcing service provider.
For more information please contact Paul Kay, Partner
T: +44 (0)20 7427 6504