Outsourced Trading – Questions to Ask and Pitfalls to Avoid

According to a recent study from Greenwich Associates, around one third of US buy-side firms are now actively looking to outsource some or all of their front office trade execution activities to third parties.

Outsourced trading has also become increasingly attractive to the buy side, and it’s not just smaller or start-up funds who are moving towards outsourced trading models.

One issue that funds are trying to address, as are all businesses, is that of costs. This can be particularly problematic when funds are looking to expand, either through accessing new markets or extending asset class coverage. Outsourcing your trading allows a firm to do this without committing large amounts of capital (both human and $$$).

Regulatory pressures are in some respects accelerating the trend towards outsourcing the trading function. Keeping up with ever changing trading regulations in multiple global jurisdictions incurs significant time and expense, and many asset managers are keen to remove that burden.

The recent pandemic massively shifted the normal working environment, where almost 100% of financial industry employees were working from home, at one stage An outcome which has proven that it is no longer necessary for traders and portfolio managers to be in close proximity to each other.

The point is there are many reasons to outsource, way beyond those points including such things as holiday or sickness cover. There isn't one size fits all so it's important your provider is flexible in the extreme.

There are varying brokerage models which I will discuss, but it's also important to be aware of the pitfalls and issues that need to be addressed.

Outsourcing models

Typically, outsourced trading is conducted in one of two ways.

The ‘pass-through model’ (in the client's name) where the outsourcer essentially operates as an extension of the client’s internal dealing desk, transacting in the client’s name, replicating as far as possible the client’s existing workflows and compliance controls and preserving the client-broker relationship. The outsourcer acts solely as the buy side trading desk and not in any principal capacity. Orders are essentially routed the same way as they would be if the client was conducting its own trading and the post-trade operations are unchanged. This type of workflow is interesting as it is not always offered by all trading desks. This could be because of geographical market requirements - such as emerging markets where IDs are needed within the regulatory landscape. Or it just doesn’t simply fit with the outsourced providers operating model.

The agency model (which tends to be the most common) is where the outsourcer operates an external dealing desk or a traditional broker, transacting in its own name on the client’s behalf, acting in an agency capacity to provide a conduit to brokers, with commission attribution. The appeal of this model is the simplicity of transacting with one counterparty while gaining access to multiple brokers, markets and liquidity sources. It also allows the end client to remain anonymous to the street since the outsourced provider sits in between the client and the executing broker. This model is especially common with funds that either don’t trade frequently or their size prevents them from having multiple brokerage accounts.

Regardless of which model is adopted, it is important that the outsourced provider’s objectives are aligned with its clients, and that it is able to provide unconflicted execution.

Questions to ask

Many providers of outsourced trading services are sell side firms such as agency brokers, broker dealers, banks, custodians and fund administrators, who see the potential of outsourced trading as an additional revenue stream. When working with such providers, clients will want to ensure that they receive satisfactory answers to the following questions.

Is the outsourced trading provider being compensated to pitchtrade ideas? Are there potential conflicts of interest? Will they be forthright when sharing information? Order management and trade execution should be the sole focus, not order solicitation for users wanting to outsource their trading function.

It is also important for users to consider, is the provider internalising and crossing order flow, and could it potentially be sitting on both sides of the trade? If so, then that could also create an incentive conflict.

Is the outsourced provider truly broker-neutral? If the outsourced trading desk is being run by an agency broker, do other sell side firms on the street view that firm as a competitor? Brokers are less likely to be fully forthright when sharing information if they have concerns about how the information might be used.

Is the outsourced trading provider reliant upon third-party technology to run its trading desk? This is an important issue, because if the provider licenses third party software, in effect, the outsourcer is itself outsourcing its technology.

Who controls the trading technology?

A fundamental requirement for a firm offering outsourced trading is to be able to completely replicate its client’s setup. But this is not just a ‘set and forget’ exercise. Client implementations are constantly evolving, with new trading books, new swap accounts, new broker connections, and so on. Workflows that need to be mapped are often complex, particularly around compliance.

A client might, for example, have specific rules around limits and offsetting that need to be factored into the trading workflow. If both the client and the outsourcer have to sit in a vendor’s queue when implementing this kind of functionality, it can seriously impact their ability to trade.

Whereas, if the outsourced trading provider is also fully in control of the design, development, implementation and support of the trading technology, not only does it foster a deeper understanding of the client’s requirements, it allows much more flexibility and significantly improves implementation response times.

Every buy side client has its own specific requirements when it comes to trading, so if the outsourced trading provider can accommodate those requirements without having to rely on a third party software vendor to make the necessary changes, it can rapidly improve speed to market.

Final thought

So there are many questions the buy-side needs to ask before thinking about outsourcing their trading. It’s also clear that there are many benefits that outsourced trading can offer. It is equally clear that there is no ‘one size fits all’. Investment firms looking to outsource some or all of their trading therefore need to consider all of the options available and pay particular attention not only to areas where potential conflicts may arise, but also to how responsive the outsourced trading provider is likely to be when accommodating their specific needs.