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A message to the buy-side on
outsourced trading
A senior buy-side head trader has penned a stark warning on the rise of front-office
outsourcing, and its potential impact on the trading community.
T
here have been multiple articles and thought
pieces on outsourced trading over the past
year. Many of these have been perpetuated
by providers and consultants who are directly
incentivised by the proliferation of outsourced trading,
but earlier this year, The TRADE itself published
an in-depth feature on the subject, which was
commendably sober. Just because the media is
saturated with articles stating how marvellous
something is, doesn’t necessarily mean that it is.
The Financial Conduct Authority’s Conduct of
Business Sourcebook (COBS) clearly states that
outsourced trading is a service. The question that
the end client needs to ask is: ‘who is paying for that
service?’ An internal trading desk is paid for by the
fund management company, but an outsourced trading
desk is generally paid for by the fund, as The TRADE
has confirmed through its own research.
From my own personal experience, I have witnessed
outsourced trading desks approaching the CEO, CIO
and COOs at asset management firms, essentially
suggesting they can transfer the cost of trading to the
funds. How does a fund management company explain
that to their investors if this is the case?
FOR EXAMPLE:
Internal trading desk execution rates currently stand at
3.5 bps for low-touch, and 5 bps for high-touch execution.
If an outsourced trading desk proposes a rate of 3 bps to
fund managers, they are essentially undercutting this.
But if the cost of execution for the outsourced desk is 1
bps, which is often the case, the outsourced trading desk
keeps the 2 bps margin.
One possible outcome of the incentive to maximise
the margin could be lower execution quality, as
outsourced trading providers may avoid certain
trading methods which command a higher execution
rate in favour of low-touch algorithms. As far as I am
aware, many outsourced trading desks also have very
different broker networks compared to internal buy-
side trading desks.
Most asset managers I know employ highly
educated, experienced professionals who have seen
several market cycles. In comparison, it is often the
case that outsourced trading desks are staffed by sales
traders, some with less experience of buy-side trading
or working with a fund manager as a collaborative
process. This is important as the skillset of a buy-
side trader is very different to that of a sales trader.
Furthermore, as referenced by The TRADE in its own
research on outsourced trading, clients of outsourced
trading could lose market insight by giving up control
of execution.
What happens when there is a big market
correction? How will an outsourced trading desk with
multiple clients deal with it? If you had multiple fund
managers per asset manager trying to give orders with
instructions to an outsourced trader at the end of a
telephone – I’d pay to be a fly on the wall on that day.
Then, there is the question of liability. What happens
if the fund manager sends the wrong order? The
outsourced trading desk can’t see the underlying
position. What happens if the outsourced desk has a
dealing error? Who pays for that? Do all outsourced
trading desks have the necessary balance sheet to rely
on?
Remember, it is not possible to outsource the
obligation to demonstrate there is a process in
achieving best execution.
My advice to the buy-side:
If you drop your low-touch execution to 1 bps this could
take away some of the appeal for C-suite executives at
buy-side firms to turn to outsourced desks for cheaper
execution.
My advice to buy-side C-suite executives:
You need to be able to demonstrate that outsourcing is
better for the underlying clients in terms of cost, service
level, experience, liability, risk and quality of execution.
My advice to the sell-side:
If you continue to offer 1 bps to the outsourced trading
desks, you may increasingly face outsourced trading
desks only.
Issue 62 // TheTradeNews.com // 23