It goes without saying that the topic was met with quite some contrast at our 2020 Innovation Forum. It is however a stark reminder of the rate of change the global ‘buy side’ sector is facing. Outsourcing trading, is nothing sacred?
In today’s blog we will look to unravel the options and implications.
Regulation and other industry pressures have driven an increasing number of asset managers and asset owners to use or seriously consider the use of outsourced trading services. However, many managers consider the execution process too critical to outsource, either due to trading being an alpha generating activity or essential to the ongoing quest for liquidity. These firms are in turn enhancing their internal capability and taking advantage of development in trading technology, through fintech, disrupters and brokers looking to provide an edge.
We live in a world of outsourcing, where todays providers are increasingly becoming a standard part of a business’s operating model. Outsourcing can deliver not only cost savings; it can also address capacity issues and introduce strategic flexibility. Both organic and inorganic growth becomes easier under an outsourcing model. But what does that mean for trade execution and why the spotlight?
The Cost vs. Value Debate. Is it really that black and white?
Fee compression is certainly a key factor driving this debate. Asset managers are continually looking at different ways to increase profits. On one hand trade execution is considered by some as an area for potential cost savings, but at the same time it is also considered to be a way to generate alpha.
For the smaller players, the opportunity for cost savings is obvious. There are barriers to entry in establishing and maintaining an internal trading desk. Technology, data, regulation, compliance, oversight, key person dependencies and market coverage all stack up to an estimated 1.5 million cost of a 3-person desk.
For the larger players they have the scale and leverage of all of the above to overcome these barriers. With costs not being as big a barrier, they tend to shift their focus to alpha generation. This can be achieved through optimisation of process, use of technology and broker relationships to achieve best execution and actionable transaction cost analysis. The portfolio manager may also see trading as an important part of the life cycle, the market insight provided by their trader considered value add to the generation of alpha. The broker relationships can be leveraged to assist with liquidity challenges, and anonymity can be better managed.
The Challenges
Outsourcing in general will always introduce a challenge for the people and culture of the organisation. However, outsourcing does not necessarily mean job losses for traders, but rather an evolution of the role. By shifting the day to day operational tasks to a service provider, this will free up the trader’s time to focus on value-add activities.
Comfort or confidence with the outsourcing service will always be a concern. Conflicting interests, competing with the sell side, acting as agency or principle, information leakage. Does the value of the service provided actually stack up? Has the provider been around long enough or have considerable flow in order to realise real value from the broker community? There are upward of 20 providers in this space with four entering in 2019 alone, how do you pick the right partner, do you use multiple providers to hedge any risk? Firms will need to be very clear on their due diligence to ensure these types of questions are answered on the way in. A successful model does require partnering with a trusted provider, ensuring the service level agreements are tight, along with upfront effort in establishing the relationship. Ongoing management will certainly be required to ensure the relationship is delivering value.
For the insourcing model, the challenge will be to keep the jaws open and growing. Keeping on top of technology and innovation will assist with generation of trading alpha. Use of tools to provide artificial intelligence and complement the market insight, technology enhancements to optimise the process. Separation of the EMS from the OMS/s to introduce broader asset class optionality and hence execution scale to the process.
Who pays for the outsourcing, the fund or the fund manager? The traditional inhouse model keeps it simple by being able to easily apportion direct costs incurred through trading. This becomes a bigger problem to solve with the outsourcing model.
Alongside an increasing move to global markets and offshore trading means the internal desk may not have the required coverage (traders, data, broker relationship, market access). This is where outsourcing of these particular trades, and hence a combination of Internal and outsourced operating model, may provide for the ideal solution.
So maybe we need to rethink the value proposition. Financial markets have always worked in shades of grey rather than black and white. The evolution of the trading operating model, in particular outsourcing of execution, is certainly opening the door. Is it time the model shifts slightly from a broker provision to an extension of your own trading function?
The Supplemented Trading Model.
Has a certain ring to it.
Barnaby Edmunds
Director
Front Office Practice Lead