Outsourced trading?

Where have you gone Gordon Gekko? Bud Fox?

Outsourcing – it has happened in so many industries. Much like manufacturing, customer service and staffing, trading is no longer a holdout but rather joining the list of industries seeing this phenomenon.

In the fourteen months since it went into effect, MiFID II has proven to be a disruptive force for the financial services industry, upending existing business models and ushering in a new era of scrutiny in how firms spend their money. In Europe, trading and research can no longer be sold together as one service; even in the U.S., the global impact of MiFID has led many firms to explore full unbundling, leading to difficult questions about which costs are necessary and what it means to seek best execution.

Where there is disruption, however, there is also opportunity for growth. In this case, that opportunity can be seen as buy-side traders and hedge fund managers are increasingly enlisting outsourced trading firms to help them navigate this new normal.

A recent survey of Traders Magazine readers, representing a broad spectrum of buy-and sell-side professionals, found that 28% work for firms that have either already outsourced some of their trading and back-office operations or are actively considering doing so. That may not sound like a big number, but given outsourced trading’s longstanding reputation as a niche service for hedge funds only, it qualifies as a significant figure.

Also, research consultancy Opimas noted that though outsourced trading desks have existed for some time, interest in such offerings has increased in recent years as the asset management industry faces increasing pressure in terms of fees, fund performance, and regulation. Octavio Marenzi, researcher at Opimas, said this is leading even larger asset managers to outsource at least part of their trading desks. He forecasts that by 2022 about 20% of investment managers with assets under management greater than US$50 billion will outsource some portion of their trading desks.

Marenzi also noted several things when it came to outsourced trading:

• The majority of small, start-up funds have long outsourced their trading desks to their prime brokers. There are clearly exceptions to this: Some new hedge funds‘ strategies are heavily dependent on trading, and these funds tend to establish trading desks and hire traders from the very beginning.
• A newer phenomenon is that large, established asset managers are considering outsourcing all or part of their trading desk to an external provider. This reflects tougher cost pressures, as changing economic realities force asset managers to weigh which functions are essential and which can be outsourced at a potentially lower cost.
• The basic rationale for outsourcing revolves around reduced operational costs and improved execution quality. While improvements in execution quality in the range of 15-20 basis points have been demonstrated, this is typically only for very small funds that do not have the necessary scale to deploy highly professional traders and systems. Execution quality improvements for larger trading operations are very limited, if discernible at all. In practice, Opimas has found that the reduction in operational costs is far more important than execution quality.
• A large number of outsourced trading desk providers exist. While most outsourcing providers are registered as agency brokers, they frequently are part of larger institutions, including custodian banks, other asset managers, prime brokers, or investment banks. The future for these offerings looks bright, and we expect to see revenue growth in the range of 20-30% annually for the next few years.
• Asset managers looking at providers to outsource their trading desks to should consider regional coverage, instrument coverage, number of traders and experience in instrument class, number of similar clients, number of connections to relevant brokers and execution venues, systems architecture, including review of the order management and execution management systems in place, system used for transaction cost analysis, review of historical execution quality, commission management program, trade allocation policy, and any conflicts that the provider may have, including proprietary trading or asset management.

One firm that is focusing resources and assisting institutions with outsourced solutions is Dallas, Texas-based Capital Institutional Services (CAPIS). An independent agency broker offering global execution services and commission management solutions for institutional investors, CAPIS also has an outsourced operation and services it offers to clients, said Chris Hurley, Director of Institutional Sales, who is charged with leading CAPIS’ Outsourced Trading sales effort.

“CAPIS has acted as a de-facto outsourced desk for decades” Hurley told Traders Magazine. “The difference now is technology enables an outsourced desk to direct commissions to other brokers on the manager’s behalf.  Our independent research and agency-only brokerage model was a natural fit for expansion to dedicated Outsourced Trading.”

Hurley said that he finds clients are drawn to an unconflicted trading model where incentives are aligned with the goals of clients, who recognize the value of technology, high-touch trading expertise, and stealth in sourcing liquidity while offering a high level of engagement and customer service.

“An effective outsourced trading provider has the process, relationships, and resources to efficiently manage each client’s unique needs and provide best execution beyond U.S. cash equity and into the international equity, fixed income, and derivatives markets,” he said. “Managers looking to maximize their resources gravitate toward partnering with an outsourced provider who can seamlessly facilitate their current needs and growth plans while minimizing disruption and costs, and who can also consult on projects such as outsourcing middle and back office functions.”

While outsourcing is gaining steam in both the U.S. and Europe, the growth has progressed in different ways. In the U.S., where the practice has a longer history, larger funds have followed the hedge fund vanguard and are now choosing to supplement their established trading desks, while in Europe, the interest began with the largest firms adapting to the shifting regulatory landscape, with the smaller firms then following that example.

But no matter why they make the decision, firms that choose to outsource some or all of their trading operations are seeing strong results. “Given all the mounting costs and complexities around reporting and best execution, outsourcing all or parts of trading may increasingly makes sense for some firms in the industry,” Ryan Larson, Head of U.S. Equity Trading at RBC Global Asset Management, said at the Equities Leaders Summit in Miami last December.

And in the 2018 report “Outsourced Trading: Helping the Buy Side Improve Execution and Enhance Operational Efficiency,” Greenwich Associates found that among participating institutional investors using outsourced trading desks, 71% were extremely satisfied with the service.  Among the study participants were 10 firms with at least $10 billion in assets under management.

Tim O’Halloran, Managing Director at Tourmaline Partners, another outsourced trading firm, said that today’s landscape increases the benefits of outsourcing for large and small managers alike.

“Historically, outsourced trading has been popular with emerging managers at launch, because those firms are less likely to have the resources to support an in-house trading desk,” he said. “As a result of new regulation, changes in technology and a host of other factors, we are now seeing larger funds experience some of these same cost pressures. In addition, larger firms that do employ traders are starting to realize our global scale and expansive network of sell-side relationships can supplement their in-house trading activities. The result is that outsourced trading has become a much bigger tent.”

Whatever forces are driving firms to outsource their trading operations, one thing is clear: running a full desk internally, with no outside help, is no longer a prerequisite for being a large manager. The buy side is facing tremendous pressure, and if present conditions persist, outsourced trading’s transformation from a specialized service to a standard practice may have only just begun.

And its not just limited to the front office or trading desk. A cottage industry is being born at the middle- and back-office as well. Stephen Dora, Director at Conformity 360,  explained how his firm fits into the outsourced trading ecosystem.

“Our platform is focused on small and midsize hedge funds, where traders may take on multiple roles and responsibilities,’ he began.” An independent compliance managed service like us can be an affiant while being cost effective way to adhere to the stringent requirements that Funds must comply to.”

Due to the increased demand for soft dollar relationships and the pressure builds to lower costs, Dora added he felt this is a great opportunity for his firm to be able to partner with outsourcing desks to be able to offer a valuable service at a significant lower cost within their platform.