Trade desk outsourcing may be popular. But is it better for the buy side?

Buy-side firms are increasingly looking to outsource their trading and execution processes as they seek to exploit new and unfamiliar, unburden themselves from illiquid trades, or cut the fixed costs of trading in an environment of narrowing margins.

The outsourcing of trading is nothing new for asset managers; most hive off their FX trading to their custodian. However, contracting out execution in primary asset classes such as equities and fixed-income is an emerging trend. According to the consultancy Opimas, about 20 percent of firms managing more than $50 billion will outsource some or all of their trading activities within the next two years.

Initially, startups, hedge funds and smaller setups sought third-party trading capabilities. But as financial and regulatory pressures mount, larger firms have also begun spinning off parts of their front-office or in-house desks.

As the trend nears a tipping point a slew of surveys and studies suggest there is, however, no one-size-fits-all approach for buy-side firms and that for every benefit, there’s a potential pitfall.

In or out?

Proponents argue that outsourcing brings efficiencies in costs and operations, and enables money managers to concentrate on the things they do best – earning a decent return on their clients’ capital.

“We have heard time and again that if outsourced trading results in lower overheads, but does not impact execution performance, some managers would rather reallocate to other parts of the firm,” says Dean Gray, Senior Vice President of Outsourced Trading at global investment bank Jefferies International.

The growth of exchange traded funds, passive investment vehicles and other low-cost strategies has compressed fees so much that money managers have been forced to seek efficiencies to stay in business. At the same time, stricter regulations, especially MiFID II, are placing costly obligations on firms, forcing them to open up to greater scrutiny of execution quality and how commission payments are spent.

Additionally, the search for alpha in a low-rates environment means many firms are casting their nets into markets they’d not previously considered. Appointing an outsourcer, often with a live trading presence in new regions, would dispense with the need to hire a new trader and team for a foray into risky new waters.

“When a fund has a full-on 24-hour trading desk, it’s an expensive, fixed-cost proposition… and not easy to achieve,” says Scott Chace, Co-Founder and CEO at CF Global.

Future growth

The shift to third-party trading and execution providers was underlined by a recent Tabb Group study, which found almost half of outsourced firms expect their outsource revenues to grow between 50 per cent and 100 per cent in the next few years. The momentum has been accelerated by the emergence of large outsourcing specialists, such as CF Global and Jefferies, and the migration of business to them. Broker-dealer JonesTrading estimates that for small firms with less than $50 million under management, the trading budget would be $375,000 in the first year and $357,000 annually after that. To outsource that business would cost between $25,000 and $150,000, it calculated. The cost differential decreases as assets under management increases, but even for a firm overseeing a $1 billion or more, the trading budget would be $1.18 million annually, compared with $1.05 million if it was outsourced.

Sceptics, however, say that the cost argument is not so clear-cut. Cathy Gibson, Head of Dealing at Royal London Asset Management, believes the logic behind ceding a huge and strategic part of a firm’s order flow is flawed because it means potentially losing vital intangible benefits such as market insights and customer relationships. Such concessions would eat away at revenue over time, eventually eclipsing any savings from outsourcing, she says.

“We see execution as a value-added service to the business and would not be comfortable outsourcing it,” Gibson says. “Our traders are motivated and incentivized to ensure that they get the best possible outcome for our clients. I don’t believe any third party would be.”

Balancing of costs

From a hardware point of view, the attractions of outsourcers are many. Technology is expensive and always requires updating. Larger outsource firms can achieve economies of scale that enables them to buy in larger data feeds and update their infrastructure. That also affords them a greater level of platform neutrality and gives them the muscle to connect to a wide array of client workflow management systems.

Also, they can buy in algorithms from specialists and offer clients both low-touch and high-touch trading options, an important factor as the “juniorization” – the loss of seasoned, experienced traders – at sell-side desks makes systematic trading more attractive.

“Interestingly, as the outsourcing business has grown, with larger clients using the model, so the investment in technology has increased both at the outsourced trading firms and the execution system providers,” Gray says. “Scalability of systems helps outsourced trading desks to grow, [giving]  access to greater technology than one may receive in house.”

Both Jefferies and CF argue, also, that their size means they can tap into a larger pool of liquidity providers. Jefferies relies on the bank’s broader operations for robust risk, client onboarding and other functions and CF already has more than 300 counterparties and 50+ electronic destinations with whom it can trade.

“You have to be an active desk to sign up all the counterparties you deal through,” argues Chace. If you have a “very small in-house set up, you might not get much of their time”, he adds.

Building walls

The migration of technology may, however, create barriers and offer little visibility into a firm’s key trading strategies. That’s especially true with algorithms. Having input into what those strategies look like is vital, says Gibson, as is knowing who’s providing that technology.

“If I give my trade to an outsource company, it is possible that they will use their own algorithm for execution but it’s also possible that they’ll use another company’s,” she says.

Sceptics are also concerned that third-party providers cannot always guarantee there will be no barrier between the two parties. One of their chief concerns in this regard is that information flows between market and trader – data that can be strategically valuable and add value in terms of relationship management – will be lost to the buy-side firm. Outsourcers point out that connections to far more counterparties than a single buy-side desk can maintain will mean their clients benefit from more, not less, market intelligence. The conflict is resolved by having geographically disperse offices, different systems, different reporting lines and so on Nevertheless, Gibson argues that an in-house trading team will be able to capture and monetize all of that and that under an outsourcing model such intel will be lost to the vendor who may even be able to leverage it for the benefit of their other clients.

“Traders are more than just execution traders, they go out into the market, they see what’s available to trade, they know their portfolio managers, they know what they like,” argues Gibson. “If you outsource your execution you create a gap of knowledge flowing back to your portfolio. And when you’re trading in niche markets and they’re usually where you get the alpha, that information just isn’t there anymore.”

Additionally, there are fears that separating the trading desk from the rest of the firm would prove troublesome at times of market stress or even during a natural or man-made disaster. When markets crash, can a third-party provider put orders through quickly enough?

“If push came to shove and my systems don’t recover as quickly, then I get to make the decision how and when we access the market,” said Gibson. “Once I’ve outsourced that, that decision is taken away from me because you can’t suddenly materialize a couple of traders who are deemed appropriate. You are reliant on somebody else for your execution and yet you’re liable to your clients.”

Separation may also create delays in trade executions, it’s argued. Managers may find themselves waiting in a queue to have their trades executed if a third-party vendor chooses to prioritize some clients over others. For their part, outsource firms argue that they treat all of their clients the same. Gray at Jefferies says his team works like a buy-side desk.

“All orders are treated the same to ensure a consistent outcome,” Gray said. “This approach is essential to providing comfort to managers of all sizes that we do not prioritize one client over another.  We are broker agnostic and use a variety of methods to execute clients’ business to ensure best execution and unlike some other providers are not limited to using algorithms.”

CF Global goes as far as auditing its execution results to demonstrate that no one client gets an advantage over another. “The buy-side ‘DNA’ of our high-touch independent team is key to our model,” says Chace. “Clients simply treat our traders as part of their investment team.”

Regulations in focus

The fast-changing regulatory landscape is giving every aspect of the industry headaches, not least buy-side firms. This is one part of the in-or-out argument that both sides seem to find agreement; if you can safely unload the cost of it to a third party, then do so. It still raises some compliance questions, nonetheless.

In the same way that scale is enabling third-party providers to bring down execution costs, it’s also allowing them to offer an abundance of regulatory expertise. Although MiFID II is a European regulation, its increasingly global application means US-based managers may not have the necessary expertise should they wish to exploit overseas markets. In such a case, a vendor with global reach would be of help. Similarly with regulatory expectations that traders offer best execution service to their clients, the outsourcers argue that the breadth of their network enables them to find the best prices.

“If you’re a global fund and you don’t operate 24 hours and you’re just handing off orders to banks, that’s not a good way to go about business,” says Chace. “The slippage and opportunity cost is huge.”

Gibson warns, however, that there may be compliance issues with the way in which some outsourcing services are paid. Generally, a portfolio manager will be expected to foot the bill for his or her trading activities. However, when those activities are hived off, it’s not uncommon for managers to pass the costs of the third-party’s services to the funds they manage, a practice she warns may be regarded as transfer pricing.

“This is probably my key point around one of the pitfalls of outsourcing,” she said. “There is a possibility at some point later on that the regulator turns around and says, ‘hang on a minute, you as an asset manager must pay the cost of the execution’.”

As the financial system faces a global slowdown and cost and regulatory pressures mount, it seems likely that more money managers will follow the outsourcing route, if only to keep down their overheads. That may be good news for the third-party providers. If that’s the path buy-side firms take, however, they’ll need to weigh more than the simple benefits of cutting costs. The loss of corporate memory, expertise and order-flow control that would necessarily accompany such a move could prove damaging in the longer term.