Innovative ideas tend to go through a process of ridicule and rejection before they become self-evident. Take cloud computing – as recently as 2014, the idea of entrusting critical infrastructure to third parties sounded outlandish.
Today, even conservative-minded organisations recognise the cloud’s role in helping drive down cost, enhance efficiency and provide scale without compromising security or responsiveness.
The idea of outsourced trading has faced similar suspicion but, at Northern Trust, we see multiple factors converging and driving adoption, to the extent that it is likely to become an industry norm.
Big outsourcing waves have followed a fairly consistent pattern over the last few decades, beginning in mature bull markets rife with cost inflation, then accelerating as they end, and costs become magnified.
This is today’s context; extreme margin pressure from decreasing fund flows, competitive pressure on fees and stalling AUM growth. What is different, however, are the challenges presented by passive competition, digital innovation and new regulation.
Renewal of focus on accountability In Europe, the greatest of these factors is regulation. To rebuild the trust lost after the global financial crisis, regulators continue to pursue initiatives to promote transparency, fairness and good governance.
A notable example is the UK’s Senior Manager and Certification Regime (SMCR), which seeks to change corporate culture by making individuals personally accountable. We believe this type of regulation is already having a profound impact on decision making and similar legislation is already appearing in other regions.
Outsourcing activity, no responsibility
Our experience is that senior managers often feel uneasy about being held directly responsible for trading, especially with regulation so focused on operational resilience. They have concerns around key person risk, business continuity, overnight orders and the conflation of portfolio manager and dealer roles.
Often, allocating in-house time and cost to remedy these concerns is hard to justify. As a result, firms are looking to outsource trading to a third-party – one that is suitably large and secure, ideally with access to broad liquidity and global presence – so no breaks arise in oversight and control processes.
However, it’s important to remember that asset managers can outsource activity but not responsibility. For this reason, the oversight function gains even greater importance, as does the person performing it.
Augmentation and evolution, rather than displacement
A common criticism of outsourcing has been that it is essentially an exercise in reducing staff numbers. However, we have found that, unlike traditional outsourcing – which replaces like-for-like at a cheaper unit cost – outsourced trading removes fixed costs and can involve greater staff retention.
Head of dealing and third-party vendor relationships
In light of increased regulatory obligations to ensure sufficient oversight and control exists over third-party vendors, the person in charge of the relationship gains greater significance. A strong argument exists that the best person to assume this role – and satisfy the regulator – should be someone who understands trading.
Dealers are well placed to challenge the service quality of outsourced vendors and, in so doing, ensure continual improvements and better execution quality. Moreover, they are best placed to understand and communicate the outcome of transaction cost analysis (TCA), the intricacies of client queries and interactions with regulators.
An opportunity to become part of the solution
Outsourced trading offers dealers an opportunity to become part of the future. Using their unique skill-sets and market experience, dealers may be able to help shape their firm’s outsourcing model.
They can potentially create roles for themselves that not only remove complexity and risk but also enhance operational efficiency, simplify the application of regulation and lower cost – something to be welcomed by regulators, shareholders and investors alike.
This article was first published in Issue 61 (Fall 2019) of The TRADE magazine.