The pandemic marked a seminal moment across the capital markets, effectively drawing a line between the old world and the new. One of the greatest revelations across the financial services sector (and beyond) was that mantra of ‘we don’t have to do things the way we used to’ as office hours turned to hybrid work-from-home setups and video conferencing and instant messaging became the norm.
For some asset managers and hedge funds, the seemingly impossible notion of all traders not physically sitting together on a centralised desk and communicating face-to-face was all but wiped away overnight as the hybrid working setup was forcibly tested and passed with flying colours. This realisation became one of the catalysts which has sparked more of an acceptance of outsourcing parts of the trading desk among buy-side firms, something which many once considered – though some still do – an unthinkable concept.
But the acceptance turned out to be just one element in a perfect storm of factors pushing many firms towards outsourced trading, including increasingly complex markets, regulation, rising costs, declining profits, fee pressures, market structure changes like T+1, and the war for talent.
The C-suite and heads of trading may have originally had opposing views on the matter, but perhaps those views are beginning to converge as the misconception that the umbrella term ‘outsourced trading’ refers to a full send, rather than the possibility of a hybrid model, falls away. Suddenly the longstanding narratives of ‘giving up control’, ‘loss of information’ and ‘replacing jobs’ have been replaced with the realisation for some fund managers that you can supplement your trading desk with an outsourced trading provider by turning to them for a particular geography, asset class or cover for holiday periods or busy times.
It’s no longer all or nothing. It’s no longer relinquishing control. It’s no longer just a defensive play. And soon, it may no longer be just a service that applies to smaller fund managers.
“Outsourced trading is no longer a taboo topic. In fact, it is now firmly a part of the institutional trading ecosystem,” says Dragan Skoko, head of outsourced trading and xBK at BNY Mellon. “Hedge fund launches now often choose outsourced trading over building their own capabilities. And larger clients will choose targeted solutions with trusted providers, to close key gaps and complement their own capabilities.”
But that’s not to say it’s going to be for everyone. Here we look at where the space has grown from and what lies ahead on the journey.
The backstory of outsourced trading
Outsourced trading is not a new concept – just a rapidly evolving one. It was born out of servicing smaller hedge funds post-financial crisis and represents a natural evolution towards front-office outsourcing, after the back- and middle-office migrations which had come decades before it.
It is not, however, a service loved and/or to be adopted by all and remains a contentious topic among trading desks around the world. For a truly balanced view of the space, we must remember that there is an entire population of the fund management industry at the top end of the pyramid who don’t – and may never – use the service. It’s worth noting that in many cases, a switch to outsourcing would inevitably replace some internal roles.
Back in 2019, The TRADE became the vehicle for a back-and-forth between an anonymous buy-side trader and a provider, with the former stating that the noise around outsourced trading was being “perpetuated by providers and consultants who are directly incentivised by the proliferation of outsourced trading”, adding “just because the media is saturated with articles stating how marvellous something is, doesn’t necessarily mean that it is”. The rebuttal from Aaron Hantman, CEO of Tourmaline at the time called the article “a misrepresentation of what outsourced trading does, and what its benefits are, particularly for the buy-side”.
Remembering the articles, Outset Global’s founder and CEO, Raymond McCabe, opines that we’re “way past that now,” adding: “I genuinely didn’t think that was a democratic feeling across the industry. And for the record, I don’t believe I’ve ever taken anyone’s jobs, it’s all about efficiencies.”
This distain has somewhat eroded but has not entirely disappeared. Some trading desks bring up the matter of conflict among the larger providers, fears of losing their trading DNA and the ultimate liability still resting with the fund. Other traders who have outsourced also have quite severe grumbles and have told The TRADE they would like to insource again. However, overall, this was not seen across the board according to our inaugural survey results, where satisfaction among those who have made the decision to outsource was exceptionally high.
So balance is key here: there are obviously benefits to an internal trading desk within an asset manager or hedge fund, but the same is true of the opposite for many in 2023. The largest players have the sophistication and resources to ride out the mounting headwinds and maintain the traditional model if they choose, but smaller funds simply do not.
“Covid was an accelerant, not a catalyst,” adds McCabe. “We don’t actually tell people that we’re going to save them money – of course, we’d like to think we do – but there’s other reasons for outsourcing. Some people treat the trading desk as an alpha generator, some people treat it as a cost centre.
“Most people who treat it as a cost centre would be definitely more open to the idea of outsourcing their trading as they don’t see it as core to their investment process. It’s a portal to markets to express their investment thesis. But it’s not for everyone, there’s certain people who should keep the trading desk. For them, it’s about building a brand with the sell-side, ensuring that they get all the resources they require.”
No two fund managers are the same and the concept appeals to some and not others. One obvious sensitive point is that providers will often be talking to the C-level suite about the decision which could ultimately cost jobs, making them less than popular on the circuit.
“There was always the argument of ‘I need my trader next to the fund manager’ and they were some of the hardest people to convince,” says Glenn Poulter, global head of brokerage and integrated trading solutions at Northern Trust. “The C-suite gets it because they look at the numbers, but it then becomes more of a political and sensitive play. I understand that if a fund manager has worked with a trader for the last 10 or 15 years there’s that level of trust there and if they lose that control there’s a fear they lose something. But over time with data and metrics we can prove out.”
On the rise
Outsourced trading – an umbrella term commonly used for both full outsourcing and all kinds of hybrid approaches – is really snowballing. The more that external, macro and internal pressures steer funds to outsource, the more that investment is being made from service providers – which are growing in numbers. Those investments bolster their technology, scale and the level of talent and experience on their desks, to the point where the sales pitch becomes unavoidable for some.
“It’s part of everyone’s conversations now as it goes mainstream, and it’s almost incumbent on them to explore,” says David Berney, founding partner of ERGO Consultancy. “Our view is that it should be the trading desk that’s having this conversation though, rather than the trading desk who’s desperately trying not to.
“Everyone knows that almost every firm has got something they are less optimal at, and for the majority of them – in the small- and medium-sized camp, those shortcomings are probably costing the fund money.
“Rather than having the CEO or the COO mandate that they’re going to look at outsourcing, what should be happening is the trading desk saying, ‘Look I’m doing the very best I can in the stuff that I specialise in, but we are leaving money on the table with stuff we’re not,’ and that’s why co-sourcing is the growth area.
“It’s not to replace every trader, because that’s not the aim, but to be able to create something that is better, and if you do it correctly it is managed by the trading desk.”
If you need data points to back up the growth, look no further than the provider landscape. Coalition Greenwich points out that from 2018 to 2022 the number of outsourced trading providers grew from fewer than 10 to more than 40. The number now – in 2023 – is said to be well over 50.
Jefferies explained to us that it was seeing 25% of new launch managers looking to outsource in 2019 versus almost 80% in 2022. Northern Trust said it added 20 new clients over 12 months and believes a further eight-to-twelve clients could be onboarded in the next six months. Subsequently, we are seeing new entrants into the space, while others significantly invest in their offering.
Meanwhile, take a pick from the data of research firms, but one Opimas report predicted a 45% year-on-year increase in revenues in 2023, to the tune of $1.7 billion.
The sector has evolved from servicing smaller hedge funds, to potentially capturing the attention of a variety of buy-side firms as the percentage of those who outsource all, or part of, their trading increases with each passing year.
“Over the last few years, we have seen wholesale change and increased adoption and engagement from the buy-side toward outsource trading,” says Dean Gray, senior vice president, prime broking, Jefferies. “Where hedge funds were the traditional users, we now see a far more diverse group of players, including managed accounts, allocators, insurance firms, family offices and sovereign wealth managers, to name but a few.”
In The TRADE and Global Custodian’s inaugural Outsourced Trading survey, we discovered more about the profiles of participants that outsource by asking 16 of them about their client base. Around 72% of clients had less than $5 billion in assets under management, 15% had between $5-10 million, 8% were in the $10-50 billion category while 2.5% were in $50-100 billion and another 2.5% in the $100 billion-plus range. Outset Global was not featured in the survey; however, McCabe points out that the firm has “double-digit clients” over $100 billion. So it very much is a space taken up by smaller funds – but with some large funds also turning to these solutions.
“In the past it was mostly small start-ups or small hedge funds, but if you look at our stable of clients I would say – by and large – it is buy-and-hold long only asset owners, asset managers with significant billions under management,” adds Poulter. “Now they are not necessarily outsourcing everything but they’re looking at component outsourcing – whether it is outsourcing their US and APAC business because their London desk is handling that at the moment with traders sitting there until 9pm at night or through the night, which is just outdated.”
The 800lb gorillas
In the provider questionnaire which outsourced trading firms submitted to The TRADE and Global Custodian, the majority pointed to the migration of larger funds as one of the biggest trends in the industry. Many noted how they were using the service for supplemental overflow and as part of their business continuity plans.
“The growing trend towards larger, more sophisticated managers using outsourced trading means that when viewed by revenue generated, the market share from co-sourcing, defined as those managers who use an outsourced provider to complement their existing trading desk, has significantly increased, with these larger managers typically benefitting from the flexibility offered,” adds Gray.
Dan Morgan, global head of portfolio solutions at State Street, sees the outsourced trading journey as a marathon, not a sprint, but says larger managers are certainly asking questions.
“If the concept is new to them, the natural progression is to start small with the supplemental relationship which may turn into a more fulsome one over time, whether it be within an asset class or a geography and then if they get comfortable with the workflow that you’re providing, they’re more apt to consider expanding the relationship,” he explains.
There are many different tiers of asset management sizes with some untouchable behemoths at the top, but the trend is certainly creeping into new sub-sets of bigger funds. When it comes to – as one commentator puts it – the 800lb gorillas (the big players), there may be a tipping point where one player can spark a domino effect.
“I don’t think it will be a big bang,” Poulter continues. “But I do see this component outsourcing piece working. If you look at the average trade size on lit markets now, they’re around $5,000. To get proper blocks done, you need to have that high touch. You either want to trade algos anonymously or you want to be away from the lit market and in order to do that you need high-touch executions, you need people with relationships with institutions or you know the top 10 shareholders.
“If those macro drivers continue and there’s no sign that they’re going to change in the near future, then it does become a profitability play.”
Why are firms outsourcing?
When we asked why firms outsourced their trading in the survey, the most commonly cited reason was operational efficiencies, followed by pursuing growth while controlling costs, and regulatory change and compliance challenges. Technology limitations and concerns about hiring relevant experience and talent were also prevalent.
We’ve touched on the growth and costs element, but if we group regulatory change, compliance challenges and market structure as one category for assessment, there is a lot going on.
The shift to T+1 in the US is a challenge which stretches far outside of North America, significantly impacting FX, pre-funding for those in different time zones, along with having a knock-on effect on securities lending, the need for a robust operating model between execution and settlement – and a landmark shift in people, processes and technology for all.
In addition, regulation including upcoming Mifid II reforms, the Fundamental Review of the Trading Book (FRTB) and proposed due diligence rules from the Securities and Exchange Commission (SEC), all continue to lump greater operational burden on fund managers. The SEC also appears particularly intent on introducing more reporting rules across asset classes while also reviewing market structure for equities. Meanwhile, the UK looks to be introducing a new research platform and moving away from unbundling rules, while the no action letter in the US expiring this summer disrupted how European managers are able to pay for US research.
“It’s not just the trading piece, it’s everything else that goes with it and us future-proofing our clients from regulatory changes further down the line,” explains Poulter. “When the no action letter expired in the US, we engaged with a consultant who has been working with the Treasury in terms of policy, because if the regulation changes – and we do think that the FCA will adopt the Treasury’s views – then the landscape for paying for research changes. T+1 is another great example where our clients expect us to support them.”
Under pressure
If you look at the financial pressure on asset managers, it’s also clear to see why some are looking to pivot and seek operational efficiencies along with reduced costs. A report from Boston Consulting Group in May 2023 stated that “if asset managers simply stay the course, their annual profit growth will be approximately half the industry average of recent years (5% versus 10%)” and that “to get back to historical levels of profitable growth, asset managers will need to cut costs by 20% overall”. While the report doesn’t discuss outsourced trading, it does highlight the need for drastic change as an industry somewhat on the ropes and consolidating at pace.
Establishing – or even maintaining – trading desks can be costly, and at the same time as fee pressures and revenues weigh on fund managers, the costs of staffing – i.e. a trader, back-up and ops teams – can be costly, along with technology, software, Bloomberg Terminals, data feeds, storage, and all the other elements required to operate an efficient desk.
“Desks and management are looking at what alpha actually adds to performance – or rather what lost alpha takes away from performance. It doesn’t really matter what asset you’re trading, whether it’s the thing you’re good at or the thing you’re not good at,” says Michael Broadbent, principal consultant at Ergo Consultancy. “If anyone, anywhere, can trade anything you trade better than you, then you have given it to the wrong place and at that point, whether that’s a trading desk or a dark venue or a matching system, it doesn’t matter.
“If you know that that can be done somewhere else, then you have an obligation to do it there and you should want to because it all leads to performance growth, which leads to marketing growth, which leads to everything that compounds up inside of an asset management firm. If you’re not doing those the best you can, that is actually alpha out the door.”
As The TRADE has pointed out previously, when entering into outsourced trading arrangements the cost impact for the buy-side, regardless of size, is significant, albeit in an unexpected manner. Costs are not necessarily realised in terms of hard dollars or pounds, but in terms of who, or which part of the business, is paying for the outsourced service. Through an agreed basis point commission on trades that are executed by the outsourced trading provider, the fund that is most active and trades the highest volumes within an asset management firm foots the bill. The bottom line is that it is the fund that pays for the outsourced trading service.
This is particularly interesting in relation to European regulations which prohibit buy-side firms from using funds to pay for a number of internal costs. The impact of this has seen the majority of operational costs shift from the fund to the management company. But buy-side firms that have outsourced trading and execution could hypothetically remove in-house dealing desks – along with the associated costs – and pay for outsourced trading out of commission that is in the fund.
Scrutiny and the future
One provider noted in our survey that “the growing call for disclosure of the use of outsourced service providers by investment managers could prove a temporary headwind, though from what we’ve observed thus far, we don’t see this as an intermediate to longer term obstacle”.
In addition, the biggest risk to the business will be internalisation, and one case of this can be found in the decision reversal at Railpen. Ergo Consultancy was chosen by Railpen – which manages £37 billion of assets – to bring its trading activities in-house from an outsourced service provider.
The provider noted in a case study on the move that as the level of assets managed internally by Railpen increased following its Investment Transformation Programme in 2015, the fund built its trading capabilities to a point where revisiting the merits of bringing the trading function in-house made sense to enable more agile and efficient trading on behalf of the members it supports.
As the industry grows, there will likely be more scrutiny around outsourced trading providers, meaning service and execution levels will have to remain high, with costs competitive. Hopefully the newly launched survey by Global Custodian and The TRADE will also continue to shine a light on service levels and where current clients see room for improvement.
“The industry is evolving and maturing, hence providers having to come up to speed with institutional client needs,” says Skoko. “The industry is more competitive now than ever before, and providers that don’t keep up with the needs of their institutional clients risk putting themselves at a disadvantage.”
While the survey showed an overall satisfaction from more than 200 users of outsourced trading – we did have one off-the-record conversation with an asset manager actively seeking to insource because their provider had a “lack internal expertise and broker relationships” had a “conflict of interest with best execution” and “didn’t have their own algos”.
What the survey will show in the coming years is annual comparisons of satisfaction and areas which are slipping in the eyes of clients. However, an overall survey score of 8.98 out of 10.00 – with 9.13 for coverage, 9.31 for execution and 9.33 for client service and relationship management – is high, high praise.
Ultimately, outsourced trading as a service is in a great position with demand set to continue rising, breadth of asset classes increasing and a new sub-section of larger managers coming to the fore. For the C-suite it might be an obvious economic decision, whereas for the trading desk, they will always question whether they are being replaced by outsourced trading or supported by it. But the rise of co-sourcing, supplemental trading or the hybrid model – depending on how you refer to it – does allow a halfway point where everybody can win in the current environment.
The pandemic represented a period of time bridging the old world and the new in many ways throughout our everyday lives, and this has been no different for the trading world which is learning to live with its own new norm – the fact that outsourced trading, for many, is here to stay.