Trading Out of the Box ⁠— Best Execution


In the past, outsourcing the trading function was the preserve of the hedge fund community. Fast forward to today and the trend is gaining traction in mainstream circles with fund managers considering their options. There is of course no one-size-fits-all solution so the challenge is finding the right fit.

A recent study by consultancy Opimas predicts that by 2022, around 20% of investment managers with assets under management (AUM) greater than US$50bn will outsource at least some portion of their trading desks. While that may not sound like a big figure, it is significant given that historically buyside firms were loath to relinquish control of this activity. They were much happier to contract out back and middle office functions but over the past decade a confluence of factors has focused the collective mind on trading.

This not only includes regulation and the increased compliance burden but also a steady march of assets from active to passive funds which is eating into fund managers’ margins. In addition, a separate study by Oliver Wyman reveals that globally, assets under management dropped around 6% last year compared to 2017, with just US$3 trillion of flows into the industry. This is the first time since 2008 that AUM and valuations of asset managers have dropped.

Asset owners are also evaluating their options for the first time. “They used to delegate their investment management to their asset managers but they are re-internalising and need to become better equipped,” says Thomas Castiel, head of dealing services at BNP Paribas Securities Services. “For many, even the larger firms, do not see the trading function as core.”

The MiFID II burden

In Europe, MiFID II has also caused a great deal of soul searching. The regulation has had a particular impact on the buyside because of the increased focus on best execution and compliance as well as surveillance costs, according to Octavio Marenzi, founder, CEO, and author of the Opimas report. “Asset managers are under pressure and commissions have been compressed,” he notes. “This has led buyside firms to look at their organisational structure and to evaluate how much value the trader is adding, especially as trading has become much more commoditised in the past five to 10 years. The cost savings will vary though, depending on the nature of the firm and type of assets they choose to outsource.”

For example, Opimas research shows that smaller and medium size funds with low turnover velocity in a particular asset class can whittle down operating expenses by outsourcing, although it can still be cheaper for larger funds to run their trading operations in-house. Execution quality can also vary. At the smaller end of the spectrum, firms could experience improvements of between 15 to 20 basis points per trade because they do not have the necessary scale to deploy highly professional traders and systems themselves. By contrast, their larger counterparts who have deep pockets and trading prowess, are unlikely to see any discernible enhancement by moving to an outsourced trading desk.

Gary Paulin, global head of integrated trading solutions at Northern Trust Capital Markets, also notes that quantifying cost savings is also difficult because the activity is still relatively new and it depends a lot on a fund’s size. He points to the Opimas study that estimates each buyside trader costs an asset manager at least US$500,000, and to Oliver Wyman which shows that firms can save 25% on the execution side compared to keeping it in house, and significantly more in a few cases.

“The rationale for outsourcing trading will differ between firms,” he adds. “One reason is that they want to remove the fixed costs of running a desk, such as the monitoring and compliance systems, as well as the people themselves. There are also the opportunity costs of not focusing on their core competencies as well as the transaction cost savings they can pass to the fund.”

While the depth and breadth of a firm will influence the outsourcing trading decisions, industry experts believe that should not be the only motivating factor. “I think it will appeal to small to medium sized firms that have assets up to US$75bn, but size is not the best way to judge whether a firm should outsource the dealing function,” says Clare Vincent-Silk, partner at consulting firm Sionic (formerly Catalyst). “It also depends on the asset class they are trading, locations where they have a dealing function and whether they want to outsource part of the dealing desk or one of the geographies where they do not have coverage.”

She adds, another issue to consider is where the dealing desk sits within the organisation. “For example, does it report to the chief operating officer and if that is the case, they are more likely to outsource.”

Take your pick

There are of course different models on offer ranging from the full range where trading is completely farmed out to a third party, to the so-called hybrid approach which was adopted by Hermes Investment Management seven years ago. It handed over trading of emerging markets and non-Japan Asia equities to CF Global. The fund manager retained its own in-house traders for all other instruments, including US and European equities and fixed-income products.

Opimas notes that this model is gaining traction particularly in cross-border activity, where the asset manager is below the critical scale, or finds it operationally difficult given time-zone differences. “It is an expensive proposition for fund managers to have desks everywhere and offer 24 hour coverage,” says Scott Chace, chief executive officer and managing partner at CF Global. “We also have funds give us the harder trades, or they use us because they want an alternative way to execute trades in an unbiased and anonymous manner while disguising their footprint in the marketplace.”

Given the growth prospects it is no wonder that the number of providers continues to mushroom. In fact, the buyside is spoilt for choice with the Opimas report showing that they hail from all walks of financial service life – agency brokers, custodians, investment banks, as well as asset managers, that make their own trading desks available to their compatriots.

Surprisingly perhaps, a large number of firms are based in Paris including Amundi, a subsidiary of Crédit Agricole and Societe Generale created to regroup their asset management operations, BNP Paribas and Exoé. They tend to focus more on fixed income trading due to the dominance of money market mutual funds in the French asset management arena. The trading of equities is the asset class of choice to outsource in the US and Europe.

Regardless of the location or asset class, buyside firms should do their homework before choosing an outsourcing provider. The basic checklist should include corporate structure, whether it is independent or part of a larger broker-dealer, and the breadth of trading tools and services that they offer. “One of the challenges is that asset managers have to ask the right questions,” says Andrew Walton, head of European business at Tourmaline Europe. “They have to understand the different propositions on the market and the differences between services being offered, for example, by an agency broker or custodian, from a prime broker and the conflicts of interest that may exist.”

Asset managers should also look at the activity in context. “The outsourcing of the trading function is part of a larger discussion about outsourcing in general,” says Castiel. “The challenges for clients are to think about their own internal models, what is core, what they want to focus on and what they want to externalise across the front, middle and back office.”