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Ins and Outsourcing

No-brainer decisions aren't what they used to be in the brokerage industry, and outsourcing is a case in point. Broker/dealers have long understood that third-party service providers can handle processes, such as transaction clearing, more efficiently and more cheaply than the b/ds could themselves. For smaller b/ds who often lack for scale, the range of outsourcing services that make obvious sense

No-brainer decisions aren't what they used to be in the brokerage industry, and outsourcing is a case in point.

Broker/dealers have long understood that third-party service providers can handle processes, such as transaction clearing, more efficiently and more cheaply than the b/ds could themselves. For smaller b/ds who often lack for scale, the range of outsourcing services that make obvious sense is expanding all the time — from mortgage processing to continuing education to producing client account statements.

“When there are things we don't want to build ourselves, things our market wants, the only choice is to find the best possible outside provider to meet that need,” says John Wyllys, executive vice president of Ryan Beck in Florham Park, N.J., which outsources such functions as trust and mortgage broker services.

But like a lot of business decisions that used to be taken for granted, outsourcing is turning into an increasingly complex affair. The primary complicating factor, unsurprisingly, is increased regulatory scrutiny of the practice, but there are other factors that should keep b/ds of all sizes on their toes.

Strong Attraction

The primary allure of outsourcing, of course, is its ability to deliver cost savings. For example, for the past 10 years, Lon Dolber, head of American Portfolios, a 400-broker b/d in Holbrook, N.Y., has used a company called Albridge Solutions to aggregate client account information and to produce reports for reps. He figures it would have cost him $2 million to build the system to do the job himself, plus another $1 million a year to maintain it. He pays Albridge a fraction of that amount to do the job.

But there are other considerations, as well. For one thing, outsourcing permits smaller players to provide services they might not otherwise have been able to afford. “Outsourcing gives you the opportunity to level the playing field with some of the big guys,” says Rob Hackel, managing director of RF Lafferty, a 28-broker b/d in New York that specializes in options trading. He points to his recent introduction of a bond-trading platform, allowing the firm to tap into multiple electronic communication networks.

Over at Ryan Beck, it's the same sort of situation with the trust services — the firm not only retains more client assets but also has a way “to continue to have a hand in managing for the next generation,” says Wyllys.

One of the great advantages of outsourcing arrangements is that they shed the costs associated with keeping compliant with ever-changing regulations. In the low-margin b/d business, keeping up with the costly systems needed to meet the onslaught is sometimes simply not feasible.

Says Dolber, “I don't think it's possible to have the money to build this stuff in-house.”

Drawing the Hairy Eyeball

As you might expect, regulatory agencies are taking an increased interest in outsourcing. In March, the New York Stock Exchange released a new rule filing about outsourcing among its members b/ds. That filing was the result of a survey, conducted last spring by the NYSE and NASD, that found a rise both in the number of companies using outsourcing arrangements and in the specific functions involved. While they can't provide the precise increase in outsourcing, “I know it's much more prevalent,” says Grace Vogel, executive vice president of the NYSE.

The ruling isn't intended to curb outsourcing, according to Vogel. Instead, it requires that b/ds notify the NYSE in writing if they intend to outsource core business functions.

“We want to be aware of it when we conduct our examinations of firm policies and procedures,” says Vogel. In addition, it nixes the outsourcing of any function performed by a b/d employee that requires registration or passing an exam. Plus, it lays out a due diligence standard for working with vendors. The NASD is still considering what it intends to do with the findings, according to a spokesman.

Not surprisingly, one of the primary areas of interest for outsourcing among b/ds is in the area of compliance. While few b/ds are willing to turn the lion's share of their compliance activities over to an outsider, many are looking to third parties for help with a few parts of the puzzle. Adam Antoniades, president of Advanced Equities Financial in Chicago, which owns Round Hill Securities, First Allied Securities and Advanced Equities, with a total of about 600 brokers, recently hired an outside compliance group to audit the company's internal policies and procedures and to validate the fact that they meet regulatory requirements. That's not because he lacks the capability to do the job in-house, but rather, because he thinks it may provide an extra stamp of credibility. “The evaluation of a third-party arms-length relationship is more powerful than one done internally,” he says.

In other cases, b/ds are farming out continuing education activities. For example, Robert Dearman, assistant vice president of b/d systems at Jackson National Life in Lansing, Mich., recently hired a company to provide training to help reps meet new California certification requirements for selling variable annuities.

Hold on Tightly

At the same time, for some b/ds, certain compliance-related activities are exactly the type of function they don't want to entrust to outsiders. For Dearman that includes anything that falls into the category of “Elliot Spitzer triggers” — areas that company compliance officers deem too sensitive to give over to anyone else. “Their necks are on the line,” says Dearman.

No matter what the specific function you're outsourcing, though, you have to tread carefully — really carefully — when using outsiders to perform key company functions. The potential for problems was, in fact, a reason for the NYSE and NASD's recent probe.

“Companies may outsource a function and then feel they no longer are responsible,” says Vogel. She points to one typical example in which a b/d that had hired a vendor to provide proxy information failed to institute an effective review process and wound up with information that was riddled with inaccuracies. What's more, even when b/ds stay on top of the situation, they still might encounter unacceptable service. Consider Dearman. Five years ago, he ended an outsourcing arrangement with a company that was providing a managed account platform for fee-based reps because the information had too many errors.

For that reason, the service agreements you sign have to spell out clear methods for measuring acceptable service. In other words, specify what constitutes success or failure — the quality of the data, say, or the time it takes to prepare reports. Then, include a schedule for required, regular status reports.

“Think about potential failure points and build in protections,” says Antoniades. And be creative. With one vendor, for example, Antoniades' agreement stipulates that if, after 20 days, service remains unacceptable, he can get access to a copy of the source code, which is held in escrow.

In general, keep contract time commitments for as short a time as possible — a year, or even less. “You have to be able to walk away from the agreement in the event they're not delivering,” says Antoniades. Hackel points to two vendors (he won't say what services they were providing), both of whom proved to be unsatisfactory. One insisted on a pricing structure Hackel found to be unfair, the other delivered inadequate service. Because he had signed month-to-month agreements, however, when the vendors weren't able or willing to make the changes he needed, he was able to drop them easily.

B/D, P.I.

You should also evaluate the business to make sure it has staying power. Obviously, the last thing you want is to entrust the functioning of part of your business to an enterprise that either can't deliver or, worse yet, can't survive. Dearman held discussions with five companies interested in providing a variable annuity system several years ago. After analyzing their financials, he decided not to go with any of them. “We were very skeptical of their business models,” he says. “We didn't think they had a sustainable cash flow.” Only one of the companies is in business today. Due diligence should include visiting the company offices, looking at their books, even talking to customers, not just to assess their experience, but also to see how viable their business is, as well.

At the same time, you also need to bend over backwards to make sure the vendor's security systems are foolproof. Antoniades conducts on-site inspections of a company's processes. If he finds a vendor isn't doing things the way he wants, he requires that they make the necessary changes before going any further in their discussions.

Ultimately, the more you outsource, the greater the onus to tie everything together with technology. Dolber, for example, outsources six functions, including a fixed-income platform, processing of commissions and aggregation of client information. But, he developed a way to link all that information into his own core system containing information about reps and employees, and to build an interface permitting reps to view client material.

The effort has been so successful that he has turned his system into a profit center. He recently signed contracts with other b/ds that want to outsource their back-office systems to him.

An outsourcee turned outsourcer — it's not for everyone, but it's one sign that you're approaching the process the right way.


Tips for ensuring an outsourcing arrangement fulfills its promise.

  • Spell out clear methods for measuring acceptable service.
  • Make sure you can integrate the services of multiple vendors.
  • Specify what constitutes success or failure — the quality of the data or the time it takes to prepare reports, for example.
  • Create a schedule for required, regular status reports from the vendor.
  • Think about potential failure points and build in protections.
  • Keep contractual commitments as brief as possible.
  • Make sure the vendor's business condition is stable.
  • Talk to other customers of the same vendor prior to signing a contract.
  • Make sure the vendor's security systems are solid.
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