Buy-side firms can improve execution and save costs by outsourcing all, or parts, of their trading operations. Andrew Walton, head of European business at Tourmaline Partners, shares his experience and observations.
For many investment firms, managing their trading infrastructure can be a costly and complex challenge. Experienced trading professionals must be recruited, technology needs to be maintained and updated and brokerage counterparties must be reviewed on a regular basis. New regulatory requirements only add to the cost and compliance burden for buy-side managers.
For these reasons and others, it is becoming increasingly popular for investment firms of all sizes to engage experts to help with this challenge. Outsourcing some or all their trading can allow investment managers to concentrate on what they do best, relieving themselves of the growing pressures and challenges of running a trading desk.
The concept of outsourcing all or even a part of one’s buy-side trading functions to a third party might still be anathema to many firms. Nonetheless, this practice is growing, and its advantages are worth considering, regardless of a firm’s size, strategy or location.
Creating an Operational Advantage
If we consider the standard set-up of any asset manager, regardless of size or type, the core mission of the firm is to manage money. Portfolio managers (PM’s) analyse companies and markets, making investment decisions on their investors’ behalf according to agreed investment strategies and objectives.
To implement the strategy, orders are given to the trading desk by the PM’s. The next step is for the trader or a trading team to execute these orders in the marketplace as efficiently and cost effectively as they can. Historically, most firms hire the best trading talent they can afford. However, paying competitive salaries is just the tip of the iceberg when it comes to trading desk overheads. Traders need state-of-the-art order management systems and execution tools, as well as access to real-time data, analytics and connectivity. It’s easy to see how the costs and resources required to maintain a robust trading infrastructure can quickly spiral.
On a day-to-day basis, the trading desk manages relationships with numerous brokers and portfolio managers, analysing each incoming order and deciding the best path of execution. As the range of execution channels grows, so too does the scale of this task. Algorithmic tools must be weighed up and brokers and trading venues must be carefully compared using transaction cost analysis to identify the counterparty most suited to every individual order.
What if these weighty operational challenges could be outsourced—even in part—to an independent provider with trading expertise, state of the art tools and a best of breed operational infrastructure? We know from experience that significant savings and efficiencies can be delivered. And these benefits extend beyond pre- and at-trade processing. We have seen first-hand how using Tourmaline to face the sell-side solves the challenge of dealing with multiple brokers, clearing firms and other market participants, all of whom have their own disparate processes. Engaging fewer brokers also reduces the chance for errors and saves time and money.
It is worth noting that the historical growth of CSAs (Commission Sharing Agreements) and the recent implementation of RPAs (Research Payment Accounts) under the Markets in Financial Instruments Directive (MiFID II) have led many managers to eliminate their ‘long tail’ of execution counterparties. Outsourcing is a logical extension of this trend.
Outsourcing can also help to mitigate bandwidth challenges, particularly on small trading desks, when traders take time off for holiday or sickness, or even spend time away from the desk. Using an outsourced trading firm not only frees up operational resources and allows fund managers to concentrate on their core competencies, but it also means downtime on the desk can be virtually eliminated.
Delivering Best Execution
Providing an outsourced buy-side trading desk is not solely about relieving operational pressures. It can also deliver a superior trading service, facilitating access to the deepest liquidity and allowing firms to ensure they meet their best execution obligations on an ongoing basis.
A service provider offering 24-hour global coverage with a network of hundreds of brokers can source liquidity in ways many trading desks might barely imagine. Maintaining so many counterparty relationships would be an administrative nightmare even for the most sophisticated firms, but by using a third party that is solely focused on execution, they can tap into that broad coverage and independent expertise.
Not only are some outsourced trading providers better connected to a wider range of brokers, but they are likely also tapped into a much larger number of markets than the average buy-side firm, with visibility into the key drivers of financial markets all over the world. At Tourmaline for example, we closely monitor the research, market colour, news and liquidity across all geographies, and this market intelligence becomes one of our competitive differentiators.
Anonymity and market impact are other important concerns for many buy-side firms, particularly when looking to execute large orders. When calling up one or more trusted brokers and revealing an intention to trade in size, a firm might well leverage the power of those relationships, but by revealing its hand, it also risks the potential for leakage and reduces the likelihood of completing the order at optimal pricing.
One of the key tenets of outsourced trading as we define it at Tourmaline is the protection of strategy and the ability to execute large orders discreetly, without impacting the market. Such is the importance of anonymity that we see some firms specifically lean on an outsourced trading solution for those sensitive deals where anonymity is essential.
Adoption in Europe
As with any advance in market practice, outsourced trading is a discipline that is not always well understood and tends to be more readily adopted in some jurisdictions than others. In Europe, the benefits of outsourcing are often less well understood than in the U.S., where it is a well-established practice that has been widely used to reduce costs, improve execution and reap operational efficiencies.
Understanding that some European buy-side firms wish to maintain tight control of their relationships with a small pool of trusted counterparties, outsourcing can be provided as an extension to this; as a supplemental resource or a ‘tool’ to further empower their trading desk
Occasionally there has been a reluctance within the European sell-side to embrace the benefits of outsourced buy-side trading desks. Some brokers have viewed providers as competitors, offering similar services on an agency basis. This perception is shifting, however, as brokers come to understand that outsourced trading firms, particularly in the case of Tourmaline, are representing fund managers rather than competing for sell-side business.
From a regulatory perspective, MiFID II underscores the benefits of outsourcing, as it is incumbent on all firms to seek and evidence best execution while also complying with onerous reporting and operational requirements. By outsourcing trading and execution, firms can reduce the burden of compliance, trusting their providers to ensure that every trade meets its MiFID II obligations.
As MiFID II continues to bed down in Europe, new and established firms are coming to realise the benefits they can yield by outsourcing some or all their trading function to an entity that understands what is required and how to comply in the most efficient way.
A New Look at Outsourced Trading
Outsourcing elements of the trading desk will not suit every buy-side firm.
It has been standard practice for investment managers to keep trading in-house, investing in their own personnel and systems. Yet regulation, advances in technology and a growth in passive management - to name a few exogenous factors - have led many active managers to consider new solutions. Many are now realizing that leaning on an expert trading firm, in whole or in part, can be part of a best execution framework that improves performance and reduces costs.
In the US this is not a new concept to thought leaders on both the buy- and sell-side. At Tourmaline, we are seeing Europe and the rest of the world begin to take notice.