The EU regulatory framework on outsourcing – where are we now?

In recent years, in pursuit of cost reduction and efficiency improvement financial institutions around the globe have been increasingly interested in outsourcing their business activities to other institutions and specialised service providers. From asset management, where delegation of certain functions was a standard practice since decades, to small payment companies relying on specialised regulatory compliance service providers, there is almost no area of the financial services sector nowadays that has remained immune to the ever-increasing use of outsourcing arrangements. Moreover, rapid digitisation of the financial service sector, featured by more frequent use of cloud technology and specialised providers of IT-related services to financial institutions has just added more complexity into the game which immediately triggered the attention of financial regulators in the European Union.

ESA’s Guidance Framework

In attempt to bridge these gaps (to the certain extent) the European Supervisory Authorities (ESAs), European Banking Authority (EBA), European Securities and Markets Authority (ESMA and European Insurance and Occupational Pension Authority (EIOPA) have issued guidelines on outsourcing arrangements that stipulate standards and requirements that financial institutions under their respective supervisory remit need to fulfil when entering into outsourcing arrangements.

These include:

  • EBA Guidelines on outsourcing arrangements (EBA/GL/2019/02), see our explanation thereof here
  • ESMA Guidelines on outsourcing to cloud service providers (ESMA50-164-4285), see our blog post thereof here.
  • EIOPA Guidelines on outsourcing to cloud service providers (EIOPA-BoS-20-002)

What applies to whom?

Whereas EBA Guidelines apply to all types of outsourcing arrangements that financial institutions under its supervisory remit enter into, ESMA and EIOPA Guidelines are focused solely on one specific type of outsourcing arrangements that has attracted much of regulatory scrutiny lately, outsourcing to cloud service providers.

Outlook

It is unquestionable that ESA’s Guidance framework on outsourcing has provided a valuable set of standards and requirements that financial institutions can follow when ensuring compliance with applicable requirements on outsourcing they may be a subject to under applicable sector specific pieces of EU and national legislation. However, there are small divergences between ESA’s Guidelines and such lack of full alignment brings financial institutions that find themselves under the supervisory remit of more than one European Supervisory Authority in front of significant challenges. Furthermore, given that ESMA and EIOPA Guidelines apply solely to outsourcing to cloud service providers, there is a great number of standard outsourcing arrangements that will still need to be structured in accordance with high-level regulatory requirements on outsourcing stipulated by applicable EU legislation that frequently falls short of providing clear guidance for financial institutions.

Nevertheless, the process of harmonization of rules on outsourcing and operational resilience of financial institutions in general seems to be far from over. As part of its Digital Finance Package published on 24 September 2020, the EU Commission has published a proposal for Regulation on digital operational resilience for the financial sector (commonly known as Digital Operational Resilience Act “DORA”) that aims to harmonize EU regulatory requirements on digital operational resilience in financial services. In the same vein, beside requirements on management of ICT risks, DORA aims to bring certain requirements on outsourcing arrangements, onto a legislative footing. Despite the fact that DORA may harmonize a number of questions related to outsourcing arrangements until it becomes operational (which from today’s point of view is hard to expect before 2023) financial institutions will have to ensure compliance with requirements on outsourcing in accordance with ESA’s Guidelines and applicable sector specific pieces of EU and national legislation.

Final ESMA Guidelines on cloud outsourcing

At the end of December 2020, the European Securities and Markets Authority (ESMA) published its final report on its guidelines on outsourcing to cloud service providers (CSP). The purpose of the guidelines is to help firms identify, address and monitor the risks that may arise from their cloud outsourcing arrangements. Since the main risks associated with cloud outsourcing are similar across financial sectors, ESMA has considered the European Banking Authority (EBA) Guidelines on outsourcing arrangements, which have incorporated the EBA Recommendations on outsourcing to cloud services providers and the European Insurance and Occupational Pensions Authority (EIOPA) Guidelines on outsourcing to cloud service providers. This ensures consistency between the three sets of guidelines. The ESMA Guidelines on cloud outscoring apply to MiFID II firms such as investment firms and other financial services providers indirectly but they describe the market standard and set the supervisory framework for the National Competent Authorities (NCAs) in Europe such as the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin).

For the German jurisdiction, BaFin published guidance on outsourcing to cloud providers back in 2018. Please note that the amended MaRisk include outsourcing requirements for investment firms and other financial services providers and already reflect the EBA Guidelines on outsourcing, including cloud outsourcing. For more information on the MaRisk amendment, please see our previous Blogpost.

The guidelines in more detail

The following gives a brief overview of the main content of the ESMA cloud outsourcing guidelines.

  • Guideline 1: Governance, oversight and documentation

Firms should have a defined and up-to date cloud outsourcing strategy which should include, inter alia, a clear assignment of the responsibility for the documentation, management and control of cloud outsourcing arrangements, sufficient resources to ensure compliance with all legal requirements applicable to the firm’s outsourcing arrangements, a cloud outsourcing oversight function directly accountable to the management body and responsible for managing and overseeing the risk of cloud outsourcing arrangements, a (re)assessment of whether the cloud outsourcing arrangements concern critical or important functions as well as an updated register of information on all cloud outsourcing arrangements. For the outsourcing of critical or important functions, the ESMA guidelines include a detailed list of information which should be included in the register.

  • Guideline 2: Pre-outsourcing analysis and due diligence

ESMA provides information on what is required for the pre-outsourcing analysis (e.g. an assessment if the cloud outsourcing concerns a critical or important function). In the case of outsourcing of critical or important function, firms should conduct a comprehensive risk analysis and take into account benefits and costs of the cloud outsourcing and perform an evaluation of the suitability of the CSP.

  • Guideline 3: Key contractual elements

The guidelines provide a detailed list of what a written cloud outsourcing agreement should include in case of outsourcing of critical or important functions. Such agreements should include, inter alia, provisions regarding data protection, agreed service levels incident management, business continuity plans, termination rights and access and audit rights for the firm and its competent supervisory authority.

  • Guideline 4: Information security

Firms should set information security requirements in its internal policies and procedures and within the cloud outsourcing written agreement and monitor compliance with these requirements on an ongoing basis. In case of outsourcing of critical or important functions, additional requirements apply regarding information security organization, identity and access management, encryption and key management, operations and network security, application programming interfaces, business continuity and data location.

  • Guideline 5: Exit strategies

In case of outsourcing of critical or important functions, firms should develop and maintain exit strategies that ensure that the firm is able to exit the cloud outsourcing arrangement without undue disruption to its business activities and services to its client. Exit strategies should include comprehensive and documented exit plans, the identification of alternative solutions and provisions in the written outsourcing agreements that oblige the CSP to support orderly transfer of the outsourced function from the CSP to another CSP.

  • Guideline 6: Access and audit rights

Firms should ensure that the cloud outsourcing written agreement does not limit the firm´s and competent authority´s effective exercise of the access and audit rights on the CSP (see also Guideline 3). However, the Guideline also includes provisions aimed at reducing the organizational burden on the CSP and its clients when exercising access and audit rights: firm may use e.g. third-party certifications and external or internal audit reports made available by the CSP. However, in case of outsourcing of critical or important functions, the guidelines stipulate additional requirements that must be met in order to be able to rely on third party certifications or assessments.

  • Guideline 7: Sub-outsourcing

In case of sub-outsourcing, the firm should ensure that the CSP appropriately oversees the sub-outsourcer. In addition, ESMA provides information on the provisions that should be included in the written outsourcing agreement between the firm and the CSP in the case of sub-outsourcing critical or important function. This includes the remaining accountability of the CSP, a notification requirement for the CSP in case of any intended sub-outsourcing allowing the firm sufficient time to carry out a risk assessment of the proposed sub-outsourcer, the firm´s right to object to the intended sub-outsourcing and termination rights in case of such objection.

  • Guideline 8: Written notification to competent authorities

Firms should notify in writing its competent authority in a timely manner of planned cloud outsourcing arrangement that concern critical or important functions. The notification should include, inter alia, a description of the outsourced functions, a brief summary of the reasons why the outsourced function is considered critical or important and the individual or decision-making body in the firm that approved the cloud outsourcing arrangement.

What´s next?

In a next step, the guidelines will be translated in the official EU languages and published on the ESMA´s website. The publication of the translation will trigger a two-month period during which the national competent authorities must notify ESMA whether they comply or intend to comply with the guidelines (comply or explain mechanism). For the German jurisdiction, it is to be expected that BaFin will comply with the ESMA guidelines.