Outsourced Trading: Buy-Side Questions Answered

Outsourced Trading: Buy-Side Questions Answered

By Dan Shepherd, CEO of BTON Financial

Dan Shepherd, BTON Financial

The popularity of asset managers outsourcing their trading desks to third parties and execution providers is on the rise. Well documented now, consultancy Opimas estimates that a fifth of investment managers overseeing more than $50 billion will outsource at least parts of their trading by 2020. In addition, almost half of outsourced firms expect their outsource revenues to grow between 50-100% in the next few years, according to a recent study by Tabb Group. Yet some investment management firms are still hesitant about whether they should move some of their trading functions over to third parties. In order to help asset managers weigh up the pros and cons of outsourcing, we have taken a look at some of the key benefits in the context of maintaining a healthy marketplace and answered some of the most commonly asked questions posed by asset managers before making a decision.

Improving performance and maintaining a competitive advantage remains a top priority 

The rise in popularity of outsourced trading is due to an increasing number of pressures faced by asset managers including regulation, fee compression and performance. Asset managers have had to cut prices in order to compete with the popularity of low-cost passive funds and outsourcing is a way firms can achieve economies of scale related to brokerage costs as well as maximising technology advantages.

Technology keeps improving in the meantime, symbolised by the fact that today asset classes are becoming increasingly automated. The information extracted by digitisation of trading can provide a competitive edge for trading desks. Firms with access to a greater data set of executions are using this information to improve trading performance, a task that has previously been considered as cost-prohibitive for smaller firms.

The rise of the machine cannot be ignored

Further, volumes in European closing auctions (currently rising by 3% to 4% each year), are expected to reach 50% of all European trading activity within eight years, according to Liquidnet. This is thought to reflect the growth of passive investing, which Tabb Group claims has begun to account for as much as 25% of a stock’s average daily trading volume because funds are benchmarked to the close. In these scenarios it is not only hard to justify the value-add for a human trader, but in order to compete against these passive funds, firms need to automate to reduce costs.

This sentiment is echoed by Asita Anche, Head of Systematic Market Making and Head of Data Science at Barclays’ Investment Bank who argues that: “We are already getting value from smart machines in the Investment Bank – most obviously in the efficiencies that machine learning is driving on the trading floor. It is taking repetitive jobs off our traders’ hands, freeing us up to spend more time focusing on delivering high impact results for our clients and our business.”

But is there a cause for concern?

Regardless of the promises of cost-savings and increased opportunities to improve trading performance whilst out-smarting passive investment strategies, there are still some asset managers that fear outsourcing can lead to a loss of corporate memory, expertise and order-flow. We examine these issues by answering some of the more prevalent questions below:

1. Is there a risk of losing customer relationships?

Customer relationships require scale which cannot be achieved by smaller firms on their own. In the meantime, technology and machine learning are improving exponentially which is presenting the buy-side with an opportunity to capitalise on economies of scale and smart data usage. MiFID II and the exemption of soft dollar benefits has meant that today’s dealing desk is really only about best execution. And when dealing with a large broker list and thousands of firms, automation is simply the best way of assessing that level of data. By using an outsourcing firm that focuses solely on technology and data, trading desks can utilise the information gained from anonymised, non-proprietary, consolidated data sets to improve future executions. For smaller firms trying to compete, the sheer scale and strength of this data trumps relationships.

Notwithstanding, there are other more complex strategies that cannot be handled by automation alone. A hybrid model may be needed for these scenarios so that asset managers can retain complete control over their broker and execution relationships, yet still outsource their management and rate negotiation.

2. Are outsourcing firms as incentivised as in-house traders?

In these days of tightened margins, it should be the end investor who gets rewarded for the best possible execution rather than in-house traders. Because algorithms don’t require incentivisation, costs are not increased simply on the back of a trader’s success.

3. Will an outsourcing desk use its own algorithms?

We don’t believe in reinventing the wheel, but rather in maximising the potential of suites of algorithms previously developed by the sell-side. For best results, outsourcing firms should only use proven execution algorithms selected on the basis of a machine-learning analysis of best performance for a particular type of trade. In essence, having technology utilise past performance to improve future results.

4. What will happen to information flow gained between the trader and the market?

It should be recognised that information gained is also information lost on behalf of another asset manager – information leakage not being a friend of the asset manager. Automation via technology, on the other hand, only reduces the risk of information leakage and predatory market participants.

5. Do outsourced desks prioritise one firm over the other?

They shouldn’t. All clients should be considered equal, with no preferential client status. Automation means that an order is placed into the system the minute it hits the servers with no exception, unlike in days of old when a broker wouldn’t pick up the phone on a busy day.

Helping healthy competition

In order to successfully compete in a post-MiFID II trading environment, small and mid-sized asset managers need to closely consider the competitive benefits that technology can provide. Independent outsourced trading desks with no existing ties to brokers provide an important role by helping firms comply with best execution policies and audit trails. In addition, those third parties that are paid via a subscription fee are much more aligned with their customers than the commission-led model.

Ultimately, firms need to compete in order to ensure the continued existence of multiple participants contributing to a healthy marketplace. One of the more successful ways of competing against larger firms and passive investing is by outsourcing trading to modernise and implement the  latest technologies. The prosperity of the market may depend on it.