Opinion from David Berney and Michael Broadbent, principal consultants for Ergo Consultancy.
The sun rises on outsourced trading
Outsourced trading is a concept and a sub-sector of the financial markets that has long awaited its day in the sun. It has always been just around the corner, sometime in the future, or the next great thing but, could it be that this is all changing right in front of our eyes? The industry has always faced a fundamental problem in that getting a Head of Trading at a buy-side firm to choose to outsource some of his or her executions, has been likened many times to “turkeys voting for Christmas” meaning that more often than not, it is not going to happen!
‘In front of our eyes’ well perhaps not, but underneath the radar certainly. 2018 has seen growing interest in the Outsourced Trading industry from across the full spectrum of the Asset Management industry and pushed along by multiple business drivers that all seem to be heading in the same direction. The Heads of Trading have not changed their vote, some things do not change, but the business leaders, decision makers, executives, CIOs, CEOs, COOs and senior portfolio managers are all starting to think differently. The reasons for this change are examined below in detail, but the landscape never stands still, the status quo never remains, and as the Asset Management industry adapts to this post-MiFID II world and moves forward through 2020, Outsourced Trading is about to have its day in the sun.
Traditional out of hours work
Traditionally Outsourced trading has found a receptive audience for out of hours trading and out of time zone. The so-called “follow the sun” trading model has always made complete sense because all heads of trading know that to give all your out of hours trades to the same few or even one broker is a mistake regarding execution quality. Handing them to your Prime Broker and then returning in the morning for a progress report will not provide you with access to all of the available liquidity in the market and will almost certainly not generate the best price for the fund. The best Outsourced Trading operations have each of the significant worldwide trading areas covered by offices on the ground and staff on hand to execute orders and provide flow and market information whenever needed.
In a similar vein to out of hours trading and execution, is local and worldwide market fragmentation. The access to diversified markets and products is fragmented and requires dedicated skills, infrastructures and connectivity setups. It is almost impossible for an in-house trading team to stay focused on every new and opening liquidity venue, electronic broker, non-incumbent exchange and crossing network while continuing to execute their existing business to a MiFID II standard of best execution. An Outsourced Trading partner could navigate these fragmented markets more efficiently and with enhanced results.
The on-going and long-term trend of compression on fees continue across the Asset Management industry as a whole. It is size dependent, and small and mid-sized managers have been hit the hardest, although no one is immune in the long term. There is no sign of this compression abating and, if the market takes a prolonged down leg, then it will gather pace again remorselessly. In the face of this compression on fees, managers have to review all of their costs with a particular eye on fixed costs in the case of a falling market.
Industry estimates are that in London a three-person dealing desk costs somewhere between 1 and 1.5 million pounds a year to run. Total price includes real estate, insurance, compliance, pay, bonuses, technology hardware, Bloomberg and software, and data feeds and storage. This cost by definition needs to be paid entirely out of the management company, and not by the fund. The items the fund can pay for has reduced drastically over the years, a trend that is set to continue.
Outsourced Trading allows a manager to convert what has always been considered to be a fixed cost into a variable cost that can be managed on a pay as you go basis. This variable cost, of course, still has to be met but it raises the question of who pays the bill. By paying an agreed basis point commission on the trades that are executed by the Outsourced Trading firm, the fund that is most active and trades the highest volume pays the most for the execution services received: the fund is paying for its executions.
The result is not always a significant increase to the total commission bill paid by the fund, especially in the case of medium-sized funds and smaller because the Outsourced Trading firm benefits from economies of scale itself, and these savings can be passed on to their clients. If calculated in terms of commission versus better execution, then the savings to the fund can sometimes even outweigh the costs.
Outsourced Trading has become an extremely cost-effective method for management companies to execute the trades that their funds need.
MiFID II regulations state firms must ensure that they “take all sufficient steps to obtain the best possible result” for the orders they execute on behalf of their funds and therefore clients. With this in mind, it is still extraordinary how many funds view themselves as “single” asset in respect of market regulations and rules. A long-short equity hedge fund, for example, could view themselves as Equity only, despite the use of derivatives in hedging the portfolio, the use of Fixed Income products in allocating cash away from their Prime Broker, the use of forward and spot FX trades in balance sheet management and hedging of unrealised stock P&Ls. The obvious question on these non-core trades is, of course, who is monitoring the best execution and how is best execution being obtained?
If the fund or fund manager has got themselves into the habit of always using the same broker or Prime Broker to execute these trades, then real fears must be had on the execution quality. It is not surprising that these are given to a small pool of brokers, by definition they are non-core to the business and in many cases not even put on by the same trader that executes the vast majority of the firm’s orders in the core markets of the fund. Despite the relevantly infrequent nature of these orders, it does not excuse the fund its best execution responsibilities under MiFID II. It would make infinitely more sense for the fund to give these non-core trades to an Outsourced Trading firm for them to execute in the market. With more counter parties, better market access and more sophisticated technology in these non-core areas an out performance in execution quality is inevitable, while an increase in total trading slippage is not.
Business continuity is not a new argument in favour of Outsourcing but has been re-evaluated in light of the increasing burden of due diligence questionnaires in the Asset Management industry. Single point of failure risks, such as a Head of Trading, is always a significant worry for potential investors but also management and executive level concern. Whether just providing holiday cover for a trader or providing permanent replacement solutions Outsourced Trading neatly provides a solution to these needs.
Business continuity takes many forms, and not always obvious ones. Many hedge funds, for example, use a Portfolio Manager as a backup trader when the principal trader is out of the office or away from his desk. As well as dramatically increasing the risk of an error, and being no one’s first choice, it also comes with a very hard to quantify opportunity cost – the cost of a Portfolio Manager not doing his day job.
Returning to due diligence questionnaires, the answer to the question “what happens if you lose a trader or Head of Trading” in the section on key personnel, no explanation is not an acceptable answer in today’s investment world. However, a contract to provide Outsourced Trading in the case of just such an emergency would satisfy any client question and offer a real and workable backup plan.
Compliance and regulation dominate the landscape and have done since 2010 and will continue to do so for the foreseeable future. Compliance and control add a layer of cost to the execution process for the fund and the management company, over and above the costs investigated above. Executing orders also have a hidden risk or loss to the business as a whole in the case of a breach or failure to meet the regulations which are almost impossible to quantify. Using an Outsourced Trading firm does not remove regulatory responsibility, however many of the tasks associated with regulation would be addressed by the partner in question.
Most of the existing Outsourced trading firms offer pre-trade compliance and constraints tests included in their offering, alongside allocations and post-trade checking too. Trade support and middle office functions can also be significantly reduced for the management company under an Outsourced arrangement. Transaction reporting, RTS 28 reporting and consumption of RTS 27 data are also easily handled by the Outsourced Trading firm, and in a lot of cases at no additional fee. All providers offer comprehensive Transaction Cost Analysis and best execution reporting and can repackage this in any format needed for the end clients of the fund or funds. Outsourcing these sort of regulatory functions has minimal or zero cost but saves actual money for the fund as well as considerable hours of labour.
In the last six months, we have seen the first trend towards outsourcing as a solution that is viable for a post-Brexit world. Almost all long-only fund managers and pension funds have been active in the creation of investment vehicles inside the European block, largely through the setting set up of SICAVs in Luxembourg or elsewhere – to prepare for the new brave new world to come.
The majority of funds and management companies have been content to stop with the creation of these vehicles. However, some funds’ legal councils have been considerably more bearish. The question arises that if in the case of a hard Brexit or even a hardening of European regulation post-Brexit will it become prohibited for these funds to market and distribute themselves within the European Union? If this does occur, then the funds will need to be more than just a PO Box fund, they will need dealing desk facilities inside the European Union and possibly even Portfolio Manager presence as well, they will need a European business to operate in Europe. Outsourcing dealing to a partner inside the European Union is a credible, quick and efficient method for achieving this, and fortunately, the market for Outsourced Trading is highly developed on the Continent and the choice of providers large and of very high quality.
The final problem is of course how to navigate the search for the perfect Outsourced Trading partner? A complicated question to answer for any buy-side firm, regardless of size, asset class owned and traded, from any regulatory regime or in any physical location. Even generating a list of all the outsourced trading providers is a challenging project to undertake, so much so, that when asked most of the outsourced providers in Europe can only name between eight and nine of their competition, when in fact there are more than 25 in Europe alone. Understanding the different execution and operating models can be frustrating, and getting the best pricing model for trading your assets just a lottery.
In conclusion not only outsourcing your executions may be the answer, but what about outsourcing the search for your ultimate execution solution? This year alone we here at Ergo have had 25+ conversations on the subject, conducted four beauty parades, awarded two current and live mandates, analysed and met with over twenty outsourced dealing providers in this space alone. We have worked on Outsourced Trading for insurance companies, boutique hedge funds and tier 1 global asset managers that are genuinely household names. We have run standard and accelerated RFPs, prepared and planned implementation road maps and advised on dealing and best execution practices that are not only MiFID II compliant but will also stand up to the planning and development of the oncoming and inevitable MiFID III. Outsourced Trading is here, and it is now time to evaluate and consider it for some or all of your execution needs. We are uniquely placed for Outsourced Trading to have its day in the sun and firmly believe that the day has come.
David Berney and Michael Broadbent are the principal consultants for Ergo Consultancy. Specialising in finding solutions for your Trading Desk’s needs, putting your Front Office on the front foot.
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