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IMA White Paper as Response to FCA "Dear CEO" letter on Outsourcing Risks

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ISC's newest recruit, Julian Baines, has recently finished in his role as Chair of the IMA Working Group (Operations) leading to the publication of a white paper in response to the Financial Conduct Authority's (FCA) "Dear CEO" letter on outsourcing risks. The IMA white paper can be downloaded from the IMA website.

Background to Letter

Following the Financial Crisis of Q4 2008 the regulators recognised the reliance many Asset Managers had on their service providers, where operations had been outsourced. After a number of themed visits the conclusion of the regulators was that firms had not considered extending their Business Continuity plans to include the possibility of their service providers no longer being able to perform business critical functions along with the impact on their customers.

The responses from the Asset Managers visited did not show the existence of clear plans to cope with either severe prolonged service disruption due to a force majeure event, or the fact that many of the providers were an integral part of large banks that could be impacted by financial stress, if another Lehman's was to occur.

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The FSA issued a letter to Chief Executive Officers of all asset management firms in December 2012 stating that the options open to them in the event of a severe service disruption or the providers parent/owner falling into administration were not viable for continuity of service for clients of Asset Managers. It requested firms to consider the situations and risks for both events, in order to consider the compliance of contingency plans with the responsibilities of SYSC 8 (High Level Standards, Systems and Controls). This regulation is clear that although Asset Managers can outsource activities the risk of service provision still resides with them. The on-going oversight of the outsourcing risks by having sufficient plans in place is the area where the regulators expect the Asset Manager to focus with events planned that were planned for early Q2 2013 to share opinions and discuss possible solutions.

IMA Working Group

When the IMA became aware of the "Dear CEO" letter, the IMA acknowledged quickly the effectiveness of a collective response from the industry and formed a Working Group in January 2013 to enable discussion of the issues, look for the best approach and to give feedback to the regulators. A series of meetings took place with a cross section of asset management companies plus the major eleven service providers who have the lion's share of the industry's business. The Working Groups deliberated various options promoting some thoughts on solutions that would radically change the structure of the relationships between Asset Managers and Third Party Administrators. The meetings held further splinter groups to concentrate on factors such as business continuity planning, scope of outsourcing, agreement on naming of service provision and transfer timing real examples.

The group met regularly to form clear opinions of what was both practical and commercial in response to the 2 possible events. When the representatives of the working group met the FCA, the regulators were pleased that he letter had provoked a positive reaction and welcomed the role of the IMA in producing a collective approach.

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The 11 "Good Ideas" that had been established within the working group were presented as the options for the industry to consider in response to the "Dear CEO" letter. These ideas range from the asset manager having a strong internal knowledge regarding its outsourcing arrangements, across both parties having robust exit plans to the industry improving portability and standardisation. The Working Group included a lawyer to apply the legal opinion to the scenarios, passing on experience in dealing with these legal challenges plus previous experience of setting up outsourcing arrangements. The legal oversight resulted in the 2 scenarios being applied to the regulatory breaches that would occur if asset managers were unable to continue to serve their clients/customers. Using these breaches and risks a number of mitigations were considered along with the legal implications leading to the construction of the "White Paper"

Review of Portability of Service Providers

One of the early concerns raised by the Working Group was the possibility of needing to change providers at short notice due to financial stress or administration of any of the banks involved in this industry. The ability to migrate to another provider, although one of the options suggested by the regulators was felt to be an 18 month's to 2 year exercise due to the complexity of models' infrastructure.

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To substantiate these claims a number of recent migration projects were reviewed for examples of timeliness and issues encountered. These were included on a no-names basis in the White Paper to highlight this issue as a major risk that needs attention to help reduce these timeframes. The second generation of outsourcing is still very new with very few asset management firms taking on the task of migration away from their original providers despite the existing operating model complexity. This is different to the custody model which is now mature enough to allow large migrations in a 3 to 6 month period. It was felt by the working group that the custody model was the target and had evolved mainly due to adoption of a common standard for Swift messages enabling all providers to develop their interfaces using a standard protocol.

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Although this became the agreed approach to improve the portability and gain further support from the third party provider's community, this would need a huge industry initiative to make it happen. There are a number of industry groups looking at various industry initiatives such as FIX Protocols, LEI's, Data Standardisation, but there is no driving force ensuring that these are adopted by the asset management community in their dealings with service providers. Making the necessary changes would be costly with no easily visible return on investments.

Making it Real and Commercial

One of the first concerns of the working group was that the impact of all the suggested changes would prove too costly making the service provision less profitable for providers or too costly for Asset Managers. Both would likely lead to the slow death of the UK Administration Industry with parties migrating services to locations where these regulations would not apply, such as Dublin or Luxembourg. The need to protect the UK Industry sector was of great importance in the promotion of solutions such that they can be easily implemented, or if costly allow enough time for them to gradually evolve. Keeping it commercially rigorous was welcomed by the Third Party Administrators, who recognise the benefits of these changes, but also that the scale required needs to be over a longer period of time. The impact on service providers has been recognised by both groups and also the benefit of performing collectively. This has followed in the wake of the recent successful Solvency II Working Group formed by the IMA involving both TPA's and Asset Managers setting the standard for joint involvement in providing solutions. Each provider has met with their client base but also as a group to ensure the message given back to both asset managers and the regulators is consistent as this is an industry challenge with no competitive advantage for any provider to gain from trying to go alone.

Legal and Regulatory Impacts

The discussions during the working group came up against 2 major legal and regulatory issues.

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Firstly, the impact of Corporate Insolvency Law Response would likely preclude any pragmatic solutions being allowed to exist by any administrator looking after a bank post failure, as it would simply concentrate on what was best for the creditors and the administration clients would be well down the list of those receiving any attention, including any "lights on" provisions or sale of the part of the company.

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As has shown with Lehman's the process is still on-going over 4 years later and is likely to be another 6 years until resolved by administrators. Obviously a period that would be too long for any impact on service provision. Secondly, the recognition that although service providers are regulated at the parent level, the service function areas themselves are not. This would require a change to many rules across many regulations, an exercise the FCA and the other regulators are unwilling to perform. This exclusion has impacted the recent resolution and recovery plans provided by Banks to the regulators as the area performing the services were not required by the regulators review. Many Banks had included the area in their plans as they saw it as a business critical service, but as this is not regulated it cannot be taken into account as viewed by the regulator in any recovery planning. This highlights exactly why Asset Managers need to have their own sufficient planning and protection of their customers in place. One hedge fund has put in place a structure of shadowing across 2 providers their complete operations to mitigate their exposure to either relationship, but this is not a model being encouraged by either the FCA or IMA.

White Paper Evolution

The White Paper was drawn up by reviewing what was included in current Business Continuity Plans in an 'average organisation' and exploring areas that needed expanding.

UCITS Approved

Taking into consideration the possible breaches of the regulations as a result of either a severe service disruption or financial failure, this led to a table of risks/issues that were linked to various mitigations. The mitigations became the ideas for good practice which when presented to the working group was changed to Good Ideas in case they became too prescriptive as it is not a single solution appropriate to all firms.

It is hoped that the paper shows the recognition of the risks and suitable actions for the regulators to be able to satisfy themselves on a standard by which forms should operate. The FCA has hosted 2 meetings for Chief Operating Officers on 24th April and 1st May with a further IMA event being supported by the FCA on 18th June 2013 for all members. These events should hopefully lead to the regulators producing guidance on their preferred approach and anything else required beyond the "Good Ideas" detailed in the White Paper.

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