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A-Team Insight Blogs

Cutting Through the Noise: How to Identify True Outsourced Trading

By Andrew Walton, Head of European Business at Tourmaline Partners.

More than 18 months into the era of MiFID II, it is now clear how this key piece of European regulation has fundamentally changed the business models of both brokers and investment firms. Buy-side firms in particular are required to have greater systems and controls around most aspects of their core business, including pre-and post-trade transparency, best execution, costs and charges and regulatory reporting.

It should therefore be of little surprise that many asset managers, actively looking for solutions to help ease their regulatory burdens, are evaluating what they should be doing themselves versus what they could potentially outsource. In response, we have seen a marked rise in the number and variety of ‘outsourced trading providers’ entering the market over the past year, with a recent report produced by Opimas focusing on comparing and evaluating the very different services offered by no fewer than 19 outsourcing providers, fifteen of which have operations in Europe.

While this presents the investment management community with a greater degree of choice, the growing number of providers claiming to offer some version of outsourced trading is also creating additional noise and confusion. The result? Despite a marked increase of interest in outsourced trading due to the tangible benefits it can offer, the lack of clarity around the services actually being provided is resulting in continued inertia on the part of the buy side in Europe.

This lack of understanding is often characterized by the belief that the only form of outsourced trading available to the market is the sell-side interpretation of the model. It is this this misunderstanding that we wish to address. We want to draw specific attention to the differences in outsourced trading models, such that the noise is removed and absolute clarity prevails. With clear distinctions in place, we believe that the benefits become more readily understood and therefore adoption of the service more easily accepted.

Investment firms need reassurance that, despite the overpromising being made by some providers, they are actually going to be partnering with a robust, institutional grade provider that will address their specific outsourced or supplemental trading requirements.

Only one way to outsource

So how do buy-side managers cut through the confusion and make an informed decision around real, verifiable outsourced trading services? Towards the end of last year, we wrote about the rising interest in outsourced trading. With the arena becoming even more saturated with offerings since then, now is an important time to take a step back and highlight the core features that outsourced trading should offer, so that firms can make an informed choice when engaging a provider. Here’s how to do that:

Find a specialist who is independent and non-conflicted. Within the wide range of new entrants to the market, not all the services being touted as ‘outsourced trading’ truly fit that description. Outsourced trading has been commonplace in the US for quite some time, but the concept has only really taken hold in Europe post-MiFID II. And as a host of custodians, prime brokers and other institutional providers now claim to also offer outsourced trading, as a buy-side firm, you need to be more aware than ever of the potential conflicts of interest between a provider’s core business and your dealing desk activities.

Focus on the new paradigm of best execution. Best execution has rapidly evolved since the onset of MiFID II and is now more than merely a checklist of components that need to be met to satisfy regulatory requirements. Firms are now more aware of and conscientious about what execution-related costs are and how to create efficiencies to keep them low. The right outsourced trading provider should work as a partner with firms in order to fulfil their best execution requirements, while also tailoring services to enhance trade execution quality and manage costs. The vast majority of players in the space are actually unable to do this given the conflicted nature of their operating model.

Understand the true cost of trading. It is imperative that firms observe the full lifecycle of the trade when assessing costings. Focusing purely on the front-end basis point charges for the service (bps) misses both the point and the opportunity of engaging a true outsourced provider. The true cost of a trade runs much deeper, and firms need to fully grasp what the impact of their trades are and how well they were executed – which is often far greater than the upfront cost of just their trading activities alone.

An institutional grade outsourced trading provider with extensive operational expertise, and deep concentrated trading knowledge, will have a deep understanding of all the associated costs and will be able to work with firms on how they can optimise and reduce these significantly. In addition, that partner should be fully independent and have the tools to trade in a variety of ways, operating anonymously in order to significantly reduce the market impact of execution. By changing their focus from simply looking at the cost of a service, firms using a true outsourced trading provider are able to focus on how much they are saving through the improvements in the quality of the trading activities.

Making the right decision

With this in mind, we are seeing that the impacts of MiFID II are maturing and, as a result, the investment management community now has a better understanding of the space. The fog surrounding those just using the label ‘outsourced’ and the true providers has started to clear and managers are now able to see how to enhance specific parts of their trading workflows by engaging with the right provider.

As this conversation advances, it is important to note that outsourced trading is not an all-or-nothing proposition. A frequent misconception on the buy side is that ‘outsourcing’ implies turning over all control to an outside source, but this is simply not the case and never has been. While some firms do choose to have all trading activities handled by an outsourced trading provider, many opt for a ‘supplemental trading’ model in which the provider oversees just a portion of their trades – to leverage specific broker relationships, access non-local markets, trade specific asset classes or for many other reasons. In any case, whether all trading is outsourced or only some, the client retains full control and works with the provider to set a specific strategy.

Bottom line: the goal of outsourcing is to optimize workflows, processes and costs, and that’s going to look different for every firm. An independent provider of outsourced trading solutions can easily adapt to the needs of its clients, including those who wish to retain control of some or even most of their trading operations.

We are also seeing how big data is driving the augmentation of trading behaviour. ‘Real’ or institutional-grade outsourced trading desks will be able to prove consistently better execution via means of evidence-based (data-driven) trading. Increasingly sophisticated data sets offer valuable information and patterns that enable to user to enhance execution quality markedly. By engaging a desk with institutional independence and scale, this data can be harvested easily. The potential cost savings and trade optimisation opportunities from this point are exponential. This level of co-operative partnership can only be garnered with providers who are wholly independent, agnostic and genuinely unconflicted.

By offering a completely agnostic view and a greater number of options, the cost benefits are clear, while helping customers adhere to MiFID-mandated best execution policies. Buy-side firms are now very much aware of the outsourced trading message, but need to proceed with caution in order to cut through the current noise and find a provider that enables best execution and best practice in addition to improving their P&L, whilst honouring their regulatory commitments.

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