By Grant Johnsey, Head of Integrated Trading Services (ITS), Americas at Northern Trust
Recent trends in financial markets – including the impact from the pandemic, shrinking margins, expanding use of performance-based fees, and increasing regulation – have triggered the need for capital light, variable cost operating models. The ability to leverage another company’s assets and expertise not only provides margin flexibility in the face of volatility, but also offers business agility and scale as change accelerates.
Outsourced trading has gained traction not just because it helps reduce costs and increase efficiency, but also because it enhances expertise, scale, and capability. In other words, outsourcing is no longer recessionary but “future state”.
Outsourced trading is not a one-size-fits-all decision. There are different models that asset managers and hedge funds can implement. These include:
- full outsourcing,
- component outsourcing, and
- complementary outsourcing.
Component and complementary outsourcing are commonly referred to as hybrid, as the asset manager retains traders in-house.
How does an asset manager know which is the best model for them? When making a decision, start by considering your ideal future state. If you had a blank slate, how would you prefer to operate? From there, you can work backwards to find the right outsourcing solution and partner.
Full Outsourcing
With full outsourcing, the asset manager does not conduct trading internally, instead fully leveraging an outsourced provider. While this outsourcing approach is used extensively by start-up asset managers or new fund launches, it is also being adopted by larger, more established asset managers. Full outsourcing offers the greatest benefits because it transforms the operating model to one that is highly efficient, scalable, and combinable with services such as trade settlement oversight and foreign exchange execution.
There are multiple benefits to full outsourcing beyond cost reduction. Because full outsourcing can be readily combined with other services, such as middle and back office outsourcing, this approach significantly increases efficiencies. The asset manager also benefits from enhanced trading capabilities as the outsourced provider has more leverage and resource to execute trades, owing to more trading volume, larger investment in trading capabilities, and specialization. And asset managers that choose to fully outsource are able to redeploy trading staff in other value-added roles. For example, the head of trading may serve as head of trading oversight.
Component Outsourcing
With component outsourcing, the asset manager elects to outsource only certain types of trading (i.e. one component of their investment mandate) but does so completely. An example of a component relationship is a US-based equity manager that outsources trading in another global region but retains traders for the Americas. Another example is an income fund manager outsourcing bond trading, but retaining equity trading in-house. An asset manager no longer needs to staff a trading desk for every region and market in which they invest. Component outsourcing can provide many of the same benefits as full outsourcing and allows asset managers to retain a trading function.
Complementary Outsourcing
In a complementary model, the asset manager utilizes an outsourced trading desk to augment, or complement, their capacity and capability. In this model, the asset manager retains traders in each region and asset class in which they invest, but instead of staffing for their peak volume days, they staff for average days and outsource on higher volume days. While this model doesn’t offer the same efficiencies as the full or component models because few, if any, add-on services other than basic execution are included, complimentary outsourcing can reduce the overhead of the asset manager.
Making the Decision
How do you know which model is the right one? In each, expertise, cultural fit, people, and customization around specific needs are critical.
In the full and component outsourcing models, selecting the right provider matters the most, since you will rely heavily on the outsourced trading desk in these situations. The main consideration is the stability of the outsourcing provider. What is their ownership structure and how stable is the ownership? How much capital and insurance do they carry? How robust is their business continuity model?
A second consideration is alignment of interests and the potential for conflicts of interest. Does the provider trade on a principal basis or for proprietary accounts? Do they own execution venues that might be prioritized over others? How do they prevent information leakage? And, ultimately, how do they manage potential conflicts of interest?
Another consideration is expertise in managing the conversion to an outsourced model. A successful track record of transitioning to outsourced trading has increased significance in a full or component model.
One final consideration is communication. In any outsourcing application, communication is important. In a hybrid model, where the asset manager is spreading trade flow between internal and external trading desks, the interaction between the in-house and outsourced traders must be especially crisp.
