Investment managers need to ask the right questions when engaging an outsourced trading firm. Here are four key considerations that will help to identify the most comprehensive and compliant offerings.
In any commercial transaction – from buying a new car to upgrading your laptop – consumers like to know that they have chosen the best possible option. Whether that means touring dealerships and taking test drives or spending hours online at Best Buy or your local Apple Store, some form of due diligence is part and parcel of every transaction.
This principle holds true for institutional trading, as well. The greater the challenge, the more carefully you want to consider your options, and the engagement of an outsourced trading provider is a decision where advanced due diligence will serve you well down the road. Once a niche business that appealed largely to emerging hedge funds, outsourced trading has become increasingly popular with larger firms looking to supplement their reach, enhance performance and efficiency or better manage costs.
The level of service that is being delivered by outsourced trading firms varies significantly, however, and investment firms need to look under the hood before committing, making sure that what is being offered can actually be delivered.
Functionality checklist
As with any procurement exercise, a clear checklist can help you size up providers, ask the right questions and determine which firm is best suited to meet your unique needs. While there is an extensive series of questions that should be asked, here are the four high-level questions that you absolutely must have an answer to:
1. CORPORATE STRUCTURE
Is the firm independent or part of an investment bank that competes with the sell-side?
The corporate structure of the provider should be carefully reviewed to determine whether it is entirely independent. If the business resides within a bank or competes in some way with other sell-side firms, further questions must be asked to determine whether there are any conflicts of interest. Are they delivering a buy-side trading solution, or do they have preferred trading venues or routes? Are they required to internalize flow? Does their structure limit pathways to liquidity?
The ideal scenario is that your provider is positioned as an independent, agnostic firm with no businesses that directly compete with the sell-side, such as research, banking or prime brokerage.
2. EXECUTION CAPABILITIES
Does the firm have experienced traders, the latest technology and global reach?
The providers execution capabilities should be analyzed so that the investment manager can have confidence in the trading expertise it is buying. Seasoned, experienced traders are core to a quality service proposition. Additionally, the firm should have the necessary scale to be pertinent with the sell-side, have access to the latest algorithmic tools, dark pool and ATSs, as well as global high-touch coverage and a broad scope of trading intelligence, timely information and news. Again, independence and flexibility remain important here as well, as providers should not be biased towards their own proprietary tools
3. RESEARCH ACQUISITION CAPABILITIES
Can the firm truly operate like a buy-side trader would, managing and funding research budgets using CCAs, CSAs, aggregation and attributed trading?
Research acquisition capabilities will need to be considered to ensure that the provider has sufficient experience in commission management and a comprehensive and flexible suite of offerings. This is of paramount importance in an unbundled world. This should include technology to provide detailed reporting and transparency along with up-to-date advice on best practices and global regulatory requirements.
4. OPERATIONAL INFRASTRUCTURE
Does the firm have a global operational infrastructure, and can it manage the full trade lifecycle?
Investment managers must scrutinize the providers operational infrastructure to make sure it can manage the full trade lifecycle, from execution through to clearing and settlement. If a firm is offering an outsourced trading function, it should be transparent about where its capabilities start and end. An outsourced trading firm needs to be clear about whether they are only operating as an authorized trader or if they are handling all of the back-office operational functions, creating efficiencies that help a fund to better manage their counterparty list and reduce both costs and risk.
While these four main questions should provide a broad framework for assessing an outsourced trading provider, there are additional considerations to take into account as well. A full checklist comprising many more specific questions under each of these core themes can be accessed here.
Caveat Emptor
While a wide range of firms might claim to offer outsourced trading today and others will seek to enter the business, we expect that effective due diligence will help investment managers narrow the scope of their search. When an investment manager chooses to engage outside expertise to supplement their trading, the broker they choose should have the right answers to all of our key questions.
What will the outsourced trading landscape look like down the road? For our part, we expect that ultimately investment managers will gravitate toward the pure-play, independent providers, as the buy side recognizes the inherent conflicts that arise when more traditional brokers look to diversify into outsourced trading as they seek new areas of growth.
Tim OHalloran is a Managing Director with Tourmaline Partners.
