Outsourcing hasn’t historically been linked to front-office activities and the buy-side trading desk, but the notion of outsourcing trading and execution is starting to turn heads at asset management firms, both large and small. Industry headwinds and changes in market structure due to increased regulation have seen the buy-side evaluate the tangible benefits of outsourced trading, while the future of the industry remains somewhat uncertain.
There are underlying issues with the front-office outsourcing industry, and these take many forms. To begin with, there is general confusion amongst market participants as to how these providers actually operate, primarily in terms of how they differ from agency brokers.
Alongside this, buy-side traders often view the outsourced dealing desk as a potential threat to the future of their careers. However, those asset managers venturing down the outsourced trading path are supposedly seeing a number of practical benefits.
Outsourced trading providers essentially act as a buy-side trading desk, with very similar operating models in terms of how they transact on behalf of clients. For a typical arrangement in the UK, the buy-side client has a single relationship with the outsourced trading provider, while the provider has individual relationships with the sell-side and trading venues, meaning that the client is transacting with the outsourced trading desk and they are the counterparty risk. Ultimately, the provider is standing between the market and the client.
Most outsourced trading providers will accommodate methods and arrangements in terms of anonymity based on the needs of the individual client because, as with most things in this industry, this is not a one-size-fits-all type of deal. There can also be differences according to region. Some parts of Europe, for example, have adopted a model known as RTO, or reception and transmission of orders, which has proved to be popular in major financial districts such as Paris.
With the RTO method, the outsourced trading provider deals in the name of the buy-side client, so the counterparty risk remains between the institutional investor and the broker. Focusing more on the typical UK model, anonymity is an aspect that providers of outsourced trading agree can bring huge benefits to many funds.
“Standing between the buy- and sell-side means that we can protect the end client by allowing them to remain anonymous, and conversations our clients would have previously had with the sell-side are now handled by us,” says Andrew Walton, head of European business development at outsourced trading provider, Tourmaline Trading.
“The sell-side is happy to have those conversations with us because they understand that we are not crossing orders or competing with them, and there is no potential for information leakage. If we were to get buy and sell orders in the same name from a bulk of clients, we aren’t taking that away from the sell-side table, we are taking it to their table.”
For smaller asset managers in particular, anonymity created through a typical UK outsourced trading arrangement could prove useful in terms of minimising market impact, reducing information leakage and preserving alpha. Such an arrangement also removes the need to establish separate and individual relationships with brokers, which can often be legally complex, costly, and difficult to both attain and maintain due to potentially lower business flowing from smaller funds.
But for the larger asset managers that most likely have the appropriate sell-side relationships embedded, anonymity doesn’t always provide a competitive edge. If a secondary relationship with an outsourced trading provider was established and that provider was trading on behalf of the larger asset manager, the market would likely see a sizeable shift in volumes and far less flow coming from that particular buy-side firm.
“CF Global has clients that want to trade anonymously, and others that want to be visible with their counterparties,” says Steve Blackburn, partner at outsourced trading provider, CF Global. “Anonymity can be helpful for some funds, whilst there are benefits to others of facing the street. It is a fluid situation that is constantly evolving as the sell side continues to change and as the market moves away from bundled commissions. The final outcome remains to be seen, but we are active in both types of workflow and the service is bespoke. Each client can have their own default, or change trade by trade, the flexibility is theirs.”
Buy- or sell-side?
Larger asset managers or hedge funds might not be as enthusiastic about outsourcing execution to a third-party. Speaking at TradeTech Europe in April, the head of trading at $975 billion asset management firm Invesco, David Miller, told delegates during an Oxford-style debate that, at this stage, his firm would not consider outsourcing its execution processes.
Citing Invesco’s expertise and in-house capabilities, Miller added that he doesn’t believe an outsourced trading provider could execute better than his traders can. “I would say some of the traders we have are best-of-breed anyway,” he said. “We’ve got the experience, the technological back-up as well, we’ve got the systems and the support, so, no, we wouldn’t consider outsourcing our trading.”
Where the front-office outsourcing provider could potentially add value for buy-side firms of all sizes is sourcing liquidity and market access, and this is where the difference between an outsourced trading desk and an agency broker emerges.
For example, if a UK-based asset manager sent an order to an agency broker for execution in Asia, that order will only interact with the flow that the agency broker sees in Asia. An outsourced trading provider, on the other hand, will have access to broader parts of the liquidity spectrum through various relationships, including with the agency broker.
“In most cases, we actually have better access to the sell-side than asset managers building those relationships on their own because of the sheer volume of our desks globally,” says Daniel DiSpigna, chief operating officer at Tourmaline Trading. “We’re trading with more than 350 brokers in the world now. We use broker electronic trading tools and access high-touch desks and so we are considered an algorithmic client as well as a cash desk client.
“When you put that altogether, that is effectively one massive buy-side desk because we are acting in that capacity, far greater than most trading desks. We use our economies of scale to access liquidity on the street, and for a fund to get that kind of access to a bulge bracket there’s usually a large price tag attached. The large banks aren’t going to reveal their flow to anyone for free and commission budgets can be unclear because funds won’t know until they get access to the liquidity they need.”
Some providers are indeed registered as agency brokers, mostly those that are part of larger institutions offering other financial services such as investment banking, custody or prime broking. But ultimately, the outsourced trading desks are acting as buy-side trading desks, not agency brokers, and they are deeply embedded in the workflow of the asset management client.
There has been reluctance from European sell-side firms to embrace outsourced trading desks due to this misunderstanding, with many brokers identifying outsourcers as competitors offering similar services on an agency basis, but this perception is shifting. Ultimately, and providers continue the battle to clarify this, the outsourced trading desk represents the fund managers rather than competing for sell-side business.
Giving up control
There is an element of fear when considering outsourcing front office activities, referred to by some funds as ‘giving up control’, that it could potentially leave them in the dark in terms of market insights.
Heads of desks, and even portfolio managers, are intrinsically linked to the execution element of asset management. Execution is a key part of the business for most firms, from dealing right through the trade lifecycle to settlement, so carving out that piece and handing it to another firm can initially seem troubling.
Border to Coast is a UK asset manager established by local authorities to manage pension funds as part of the move towards the pooling public sector pension schemes. It chose to outsource its dealing after contemplating the monetary resources needed to establish a trading desk in-house and determined that the outsourced model was operationally more efficient for the firm. This is a typical case for many long-only funds that already outsource execution to a provider, but for Border to Coast, taking a step back from the execution and relying on an outsourced trading provider certainly left some members of the team with concerns.
“The portfolio managers were worried they would lose market flavour by not being as close to it,” explains Mark Lyons, head of equities and alternatives at Border to Coast. “But now they say they haven’t lost anything, and in fact, they probably have more market insight than they previously had. I imagine this is because they were sourcing insights from various individual brokers, but having outsourced our trading, they are getting the information from one central counterparty that is seeing the wider market and feeding that back to us.”
For other asset managers, it’s the lingering potential for conflicts of interest that dominate concerns when handing flow to a provider. UK equity fund Fundsmith was seeking expertise in execution and access to liquidity pools when it outsourced its dealing following its launch in 2010 to a well-known, although no longer operational, provider.
Similar to Border to Coast, Fundsmith opted to outsource its execution having considered the costs of running an internal dealing desk. But Simon Godwin, partner and chief financial officer at Fundsmith, says that when the firm engaged with outsourced trading, removing any potential conflicts of interest was of paramount importance.
“It’s imperative that outsourced trading providers do not trade as principal,” Godwin says. “They need to have clarity of strategy, and I think that’s why some prime brokers will struggle to get into this space because they will have to leave trading in principal behind. You have legal agreements in place and tonnes of oversight, but for me, it’s about telling me that you are a house that is never buying as principal, never unknowingly on the other side of a trade from me.”
There can be no doubt that managing costs has played at least some part in almost every fund’s decision to outsource front-office activities. At a time when regulatory upheaval has substantially increased costs and squeezed resources for the buy-side, fee compression in the asset management industry has created a perfect storm of unease about the profitability of running an active trading business.
The industry is at a point where small funds seem to pay disproportionally more for having an in-house dealing desk than larger funds, which in turn pay disproportionally less relative to their assets under management. The all-in costs to establish and maintain a three-person dealing desk, according to industry estimates, are up to £1.5 million per year, including compensation, technology, software, Bloomberg Terminals, data feeds, storage, and all the other elements required to operate an efficient desk.
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 fact may come as a surprise to some, particularly 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.
One might call this a ‘rebundling’, or reverse of unbundling under MiFID II, bringing about huge cost savings for an asset manager. With competitive rates offered at outsourced trading providers, and the most active fund at an investment firm paying for the service, it’s not as dubious as it perhaps initially sounds. Outsourcing advocates point to a potential positive impact for buy-side firms grappling with increased costs under the regulatory burden.
“Prior to MiFID II, we had been relatively low cost because we had low transaction volumes and our research didn’t really cost that much given the transactions we were doing, but moving to a new model post-MiFID II we realised it would be a much bigger cost to us, so we were looking for the most efficient way of reducing our dealing costs,” Border to Coast’s Lyons explains.
“We aren’t making a saving per se, we still have to pay for execution and research, but under MiFID II it’s more expensive for us to run the business. Although we are paying more for research now than we used to, I would say we are probably getting broader coverage. But we avoided that additional cost by outsourcing our trading, rather than making a saving.”
Movement under MiFID
MiFID II has resulted in a downward trend for commissions and counterparty numbers are being slashed at a time when buy-side firms need to see more liquidity and more information to appease the best execution mandate. Providers of outsourced trading say that now even larger asset managers are turning to them for assistance in navigating the new European trading landscape, as well as a managing costs and market access.
“Historically, larger funds have considered their asset size as a reason not to use services like ours, building out in-house desks. But now, funds are getting much more pragmatic about the explicit and implied cost of trading and firms are more open about their internal priorities and how they allocate resources and cost,” says CF Global’s Blackburn.
Scott Chace, co-founder and managing partner at CF Global, says that the firm has seen a steady increase in interest from prospective clients, with MiFID II playing a key role in raising the standards for best execution.
“It’s a difficult operating environment for both the buy- and sell-side, where most institutions are looking to reduce costs,” he explains. “There has been a lot of focus on the research side of MiFID II since it came into force, and we think taking further steps to ensure best execution will become more important to regulators as the cost of poor execution is effectively an additional fee that the underlying client pays.”
Where outsourced trading providers are already beginning to make headway, particularly with the larger investment firms, is in the hybrid trading desk model. Referred to by some providers as supplemental trading, the model differs from fully outsourced trading that smaller funds tend to lean towards by integrating in-house dealing desks with an outsourced trading desk.
The idea behind this is that the buy-side client can use the outsourced trading desk, integrated into the buy-side workflow under the hybrid model, to cover geographies that its internal desk does not currently trade, access parts of the liquidity spectrum out of the internal desk’s reach, or deal with difficult transactions that require anonymity for minimal market impact and to preserve alpha.
Hermes Investment Management, a UK-based asset manager with just under $50 billion in assets under management, has long-been an outspoken advocate for the hybrid trading desk model after entering into an agreement with CF Global to form a desk focused on emerging market and non-Japan Asia equities.
According to Hermes, the decision to outsource was taken primarily for the investment teams trading outside of UK times zones. Equity transactions related to Asian and emerging markets portfolios are executed by CF Global and all other transactions are dealt with by Hermes’ in-house dealing team.
It’s this approach that is expected to spearhead the rise of outsourced trading and those on the buy-side will perhaps breathe a sigh of relief to learn that providers are focused on empowering in-house dealing desks. The historically negative aspect of front office outsourcing, often associated with being a threat to buy-side traders or general confusion around how they operate, appears to be changing, while fees continue to decline, as costs continue to surge.
Technology will help with this battle, but it will only get firms so far. Change is in the air for outsourced trading, with industry estimates that by 2022 at least 20% of investment managers with assets under management more than $50 billion will outsource some portion of their trading operations. Perhaps it’s the outsourced trading route that could prove to be a key differentiator among buy-side firms in the future.