ASPs Bite At The Banks

Introduction

In Ancient Egypt, it became fashionable to outsource ritual killing to another species. Cleopatra, "working in partnership" with her asp, is possibly the best known example. The benefits were equivalent to those boasted for classical IT outsourcing: · an undesirable job (in Cleo's case, killing) was transferred to a third party (the asp); · minimal human intervention was required to get the desired results (death of Anthony and Cleopatra).

Similarly, some 2030 years later, the use of outsourcing services and shared utilities in the financial services industry is nothing new. New York banks were outsourcing their security guards to Pinkertons Detective Agency in the 1910's. In the payments and securities arena, shared services such as SWIFT, Euroclear and CHAPS have been around for a number of years. In fact, huge businesses have been grown in the bank-to-bank market with the emergence of global custodians and cash clearers.

But investment banks (with some notable exceptions such as JP Morgan's deal with the Pinnacle Alliance) have largely ignored the outsourcing trend for their systems development and operations functions. This, despite the fact that in other sectors, outsourcing has spread in waves. For example, in 1987 in the UK, each health authority had its own systems development group. Within 10 years, all of these had either been outsourced or commercialised through management buy-outs. Throughout these sectors, the key question that management has been asked has changed from "How will you best run your department?" to "Have you thought about outsourcing?" to "Why haven't you outsourced yet?"

Our suggestion is that 2030 years later, the ASPs are starting to bite again in the outsourcing market. With the advent of web-enabled e-commerce, investment banks are looking hard at new-style outsourcing through the e-business utility or application service provision (ASP) model. And if there is a better way through e-business ASP utilities for investment banks, what are the implications for other sectors, steeped in conventional outsourcing?

The argument for outsourcing

Many people believe that the wave of outsourcing will hit the financial services sector in the next few years. There are a number of pointers that back this assumption:

• high staff costs;
• commonality of processes between different organisations;
• scope for automation to make a large reduction in unit costs (and thus differentiate between competitors effectiveness);
• the requirement for huge spends on technology;
• commoditisation of products leading to reduced margins and higher volumes;
• historical management focus on business growth rather than efficiency on product delivery.

But there still need to be a number of credible outsourcing suppliers to make outsourcing in financial services take off. Then we realise that outsourcing financial services has its own "Catch 22".

1. You'd almost certainly have to be a bank to have the systems, people and processes capable of supporting another bank;
2. banks are most reluctant to outsource from other banks because of reasons of confidentiality and competitiveness.

This Catch 22 has stunted the growth of outsourcing in financial services. The big outsourcers such as EDS and Andersen Consulting cannot get in at the high value end, because they do not have the systems etc. The banks who have the resources have other priorities and do not wish to help their competitors. Only a handful of large scale providers have made inroads into this area, e.g. Bankers Trust (now Deutsche Bank), Bear Sterns and JP Morgan (Arcordia).

The advent of e-business Utilities

In the past two years or so, a number of e-business utilities have been initiated in the investment banking arena, particularly in the OTC Derivatives market. Three of these are:

• SwapsWire.com - a collaborative venture within the interest rate derivatives community. It intends to deliver e-solutions for the negotiation and trading of Swaps products to the whole interest rate derivative dealing community at a utility price.
• Londex - Londex is a highly automated trade matching service currently focused on the matching of over-the-counter (OTC) Derivatives trade confirmations.
• SwapClear - London Clearing House's SwapClear was launched in September 1999 to provide settlement and clearing for plain vanilla interest rate swaps of up to 10 years maturity in US Dollars, Euros, Japanese Yen and UK Sterling.

These e-business utilities are in effect large-scale application service provision (ASP) suppliers. Whereas most people still seem to consider ASPs to be solutions for small and medium-sized enterprises, we suggest that these e-business utilities for banks are leading the way towards larger-scale ASP provision for organisations of various sizes across all sectors.

An investment banking example

Lets take it step by step with a simple example, a "plain vanilla" interest rate swap. Although this is considered an OTC derivative product, it has become a commodity with the largest banks having over 100,000 such deals on their books with 10's of thousands of new trades each year.

The processing of a swap has three main stages:

• trading - where two parties agree on financial terms either between each other or via a broker
• confirmation - where the legal agreement is drawn up and matched
• settlement - where regular "coupon" payments are calculated and made by both sides to each other

Effectively, these are three sets of bilateral functions that go on in parallel on both sides of the deal. All can sometimes involve a series of manual processes and all require dedicated teams of people and systems at each bank.

So how will using the e-business utilities change these processes?

The benefits that can be expected

The benefits are not just financial:

• by using a trading utility such as Swapswire.com, the trader will have the ability directly to match up to all the market needs of all other counterparties bypassing the existing brokers; 
• use of an electronic trade matching utility such as Londex will enable confirmations to be matched immediately and accurately reducing data errors and operational risk; 
• use of a clearing utility such as Swapclear, will reduce settlement risk and enable end-of-day funding positions to be calculated more easily and accurately.

And more, when you link these three services together, you hugely reduce the need for an internal operations team at all as most of the work is done by the Utilities. See Diagram below.

So will conventional outsourcing still be needed?

In a word, maybe. Because these e-business initiatives are new, there are still ongoing issues over linkage and take-up at each of the banks. These will take some years to resolve and for some banks, conventional outsourcing may yet still become a favoured approach to replace the need for expensive new technology.

However, for the majority of jobs who opt-in to these new initiatives, as the e-business utility ASPs get off the ground, costs will reduce and cost-effective conventional outsourcing will become much harder to achieve.

So what does this mean for the investment banking sector in general

Since most investment banks have shunned outsourcing in the past, they are still completely in control of their own destinies. This means that they can opt-in to using utilities without having to rely on external outsourcing suppliers. Assuming that the e-business utility ASPs have sufficient resources to handle the growing level of demand, watch out for a huge step change in the sector with rapid reduction in the need for operations and operations technology staff.

In general, is this new e-business utility ASP model really different?

The e-business utility ASP style of outsourcing differs from conventional outsourcing in several key respects. The table below sets out those key differences.

TABLE TWO: KEY DIFFERENCES IN OUTSOURCING MODELS

Implications for other sectors

The IT software and services sector is rapidly waking up to the opportunities this new model provides. There are new announcements almost daily from enterprise resource planning (ERP) providers, call centre management software providers, human resource management software vendors, sales and marketing systems providers etc.

Organisations of all shapes and sizes can consider this type of model, especially in the following circumstances: · desire to break into new area of activity quickly; · urgent need to replace crumbling software application; · cherry picking a mixture of conventional outsourcing (e.g. facilities management for IT infrastructure) with new-style model for key applications outside the skill set of chosen party for the facilities management outsourcing.

Within the IT software and services sector, suppliers who are not considering this type of service need to wake up. Think back about 2030 years again. Anthony and Cleopatra hopelessly underestimated the strength of the advancing upstart Octavian. Result: Octavian became the Emperor Augustus, while Tony and Cleo got fatally bitten by the asp.

Jeremy Smith and Ian Harris are Directors of Z/Yen Limited. Z/Yen specialises in risk/reward management, an innovative approach to improving performance in strategy, systems, people and organisation. Z/Yen clients to date include blue chip companies in banking, technology, charities & business to business services companies.

[A version of this article originally appeared  as "ASPs Bite at the Banks", Conspectus, Prime Marketing Publications (December 2000) page 29.]