FTK and LDI make strong case for outsourcing

For many years, global custodians have been trying to convince their clients that outsourcing is the solution to the processing of increasingly complex investment products and more strenuous compliance obligations. They have argued that handing over functions such as regulatory reporting and fund and investment accounting to securities services providers will reduce costs and improve efficiencies.

It's been a long, hard road for custodians and outsourcing didn't take off as anticipated more than a decade ago. However, in the Netherlands outsourcing has become flavour of the month, driven in large part by the introduction of the Dutch government's Financieel Toetsingskader (FTK), a new financial framework that came into effect on 1 January this year.

FTK has dominated discussions in the Dutch financial services market for the past few years. Among its many requirements are that both assets and liabilities are valued on a marked to market basis, that the minimum funding requirement is 105%, and that there is a risk-based solvency for investment risks and long term continuity analysis.

One of the consequences of FTK has been growth in the number of liability driven investment (LDI) mandates. In a survey published in June this year, SEI, the US manager of managers, found that Dutch respondents had "the most advanced understanding of LDI, defining it as an approach in the context of the risk management of the overall portfolio". Respondents from Canada, the UK and the US were more likely to define LDI as "matching duration of assets to duration of liabilities".

The Netherlands also demonstrated that it is further ahead when it comes to considering investment strategies tied to LDI strategies, said SEI.

"Almost three quarters of Dutch schemes are using interest rate derivatives and approximately two thirds are using emerging market debt and high yield bonds."

Mark van Weezenbeek, associate director, institutional investors Europe at KAS Bank, says Dutch pension funds have issued a growing number of LDI mandates during the past few years. The use of derivatives has also grown dramatically, with the number of swaps and credit derivatives processed on KAS Bank's accounting platform now in "thousands ".

Along with this change in investment style, there has also been a change in reporting. "We are doing more reporting on the liability side as well as the asset side," he says. "We now report on the return of liabilities, doing risk analytics on the difference between liabilities and assets."

Under FTK, pension funds are required to report on a quarterly basis and van Weezenbeek says many have outsourced that reporting. "There has been an enormous boost to outsourcing due to FTK," he says.

Pension funds' asset managers are investing in more regions and asset classes than ever before and are making use of derivatives that are difficult to administer. "Calculating the value of an instrument like a swaption is very difficult, compared to the more traditional instruments because interest rate volatilities have to be taken into account. So not only do you have to calculate the value of the derivative, you also have to calculate its sensitivity to shocks. That makes the process very complex," says van Weezenbeek.

Jan Bart de Boer, global commercial director brokerage, clearing and custody at Fortis Merchant Banking, says outsourcing is being driven by sponsors seeking more efficiency and the greater demands placed by regulators on schemes.

"Traditional service providers like Fortis are receiving requests from clients to enlarge their product ranges. As a result, we are getting into performance measurement, investment accounting, valuation of OTC derivatives and risk analysis," he says. "Ultimately, unless you are a truly big pension fund, you cannot do all of these functions in-house."

In order to service pension funds, says de Boer, custodians can no longer be "one trick ponies". He adds: "These areas are opportunities for service providers and are a logical extension of the custodial role, which is pivotal in all of the information flows that go from the market to the pension fund and back again."

Marco Homburg, head of business development, Netherlands at BNP Paribas Securities Services in Amsterdam, says LDI is becoming more complex in the Netherlands, with structured products tailored for pension funds: "As a result, the role of custodians in administering these products is also becoming much more complicated. Valuation is particularly tricky and we have tools to ensure we deliver the right valuation and manage the collateral around these products. Before the advent of FTK we hardly did this type of business."

Van Weezenbeek says KAS changed its accounting platform in 2005 in anticipation of a growth in derivatives and more complex instruments. "The volumes on the new platform have doubled in size over the past few years because of the enormous growth in these instruments," he says.

He also notes the bank experienced a rush of interest at the end of last year as clients looked to the bank to take over their accounting and reporting business.

"I think despite the vast amount of information about FTK in the market, some pension funds were taken by surprise by just how much they had to do themselves," he says.

"With the Dutch government continuing to change rules these tasks are even more complex and pension funds need more and more people to manage their business," he adds.

De Boer admits to being a cynic when it comes to some of the wider implications of FTK: "There have been so-called seismic changes in the market during the past few years, including the euro, Y2K, Sepa, Mifid and FTK. Every time one of these comes along we are told it will be a watershed and there will be a big shakeout and people will exit the pension business. But there are still so many pension funds in the Netherlands that need to consolidate. It has been surprising to see the slow speed of the consolidation, if it is even happening at all. Institutions have reacted, but in a different way from what people expected a few years ago. Instead of consolidating, they have outsourced."

On the other hand, Homburg says there has been a decline in the number of pension funds because of the complexity of administration and reporting. "Given the investment requirements of FTK, some of the smaller pension funds [of up to €1 billion] are trying to link up with industry pension funds. The smaller funds are looking for partnerships that can deliver advice, asset management and administration."

Van Weezenbeek says the FTK legislation "has changed the entire market and we are seeing a number of pension funds that have had enough; they feel the pensions business is becoming too complex and are looking for solutions either by appointing fiduciary managers or outsourcing to other organisations."

Like de Boer, he recognises the expanding role of global custodians in the Netherlands.

"Securities services providers must ensure we have all the information required, that it is the right information and that it is sent to the regulator on time. We are not only doing the number crunching but are also monitoring the entire process. Making sure everything is coordinated is like solving a giant jigsaw puzzle."