As outsourcing moves increasingly towards the front office, Nicholas Pratt looks at the various options for outsourced dealing services.
Outsourcing is no longer confined to back-office grunt work and has been moving gradually towards the more glamorous end of operations, including the buy-side dealing desk. A survey conducted by asset servicer Northern Trust showed that 85% of asset managers had either already outsourced some part of their trading function or were considering doing so.
Furthermore, the reason for outsourcing the dealing function is no longer exclusively cost-based. There is the pursuit of greater operational resilience and risk reduction and even the idea that a third party might do a better job.
Provided they can get over some of the stigmas that come with outsourcing a front-office function like dealing, the next challenge for asset managers is to decide who they should outsource to – the asset servicers such as Northern Trust that offer a complete front-to-back outsourcing option that includes dealing; the independent specialists that offer a dedicated dealing service and allow firms to trade in their own name; or the large asset managers offering their own dealing desks to third parties and promising independence and a buy-side perspective.
Analogue anorak
One of the biggest catalysts for the increased demand for outsourced dealing has been Covid-19, says Gary Paulin, Northern Trust Capital Market’s global head of integrated trading solutions. “Even the most ardent analogue anorak has been dragged into the digital age thanks to Covid forcing us into remote work locations. This has big implications for the dealing desk.”
Aside from intensifying existing cost pressures, the pandemic has also highlighted the inadequacies of traditional business continuity plans, with their big back-up trading floors that have remained unused during the pandemic, as well as operational resilience issues.
Firms have also assessed other risks and shortcomings when running their own dealing desk – such as their exposure to key person risk if the head of dealing is off sick, or the number of duplicate roles, for example, where the portfolio manager is also the dealer.
In addition, some firms are uneasy about the lack of control and oversight when it comes to offshore orders, say where a London-based firm is trading in Japan overnight, but with no boots on the ground – so relies on a sell-side broker or a network of brokers to transact on their behalf, but with little way of knowing if they act in their best interests, says Paulin.
Consequently, a growing number of firms are now comparing these costs and complexities to what they would face from an outsourcing vendor.
Where costs were once the sole reason for outsourcing, things have evolved, says Paulin. “Outsourcing has moved from being seen solely as a defensive or reactive measure to cut costs to one that resembles a more optimal future state and a way to streamline efficiencies, provide for cost-contained growth and enhance systems of governance and control.”
This is not to say that every firm is going to move to a fully outsourced model overnight, he says. “There are still some firms that get value from their dealing function, but wherever a firm perceives gaps or weaknesses in their operations, there are now credible alternative providers of those services who can perform those functions better and more cheaply than if they were to be kept in-house. And that’s a big change.”
Nor do firms have to take an ‘all or nothing’ approach to outsourced dealing, says Paulin. “It’s about flexibility and not every firm will want to outsource their entire trading stack. Instead they may look to outsource their overnight dealing function.”
That said, he is seeing a growing number of managers wanting to outsource all post-decision functions to a single, hyper-scale vendor who can do everything, everywhere – something that tallies with Northern Trust’s strategy to deliver platform solutions for the ‘whole’ office rather than just back, middle or front-office functions.
“Those overarching trends we have discussed earlier are likely to continue and we will see a move from front-office to whole-office outsourcing, where even greater cost synergies can be provided by asset services by bringing more of their internal processes to bear in a single platform solution,” he adds.
Despite the apparent direction of travel, some stigmas still need to be overcome for outsourced trading to thrive, says Paulin. For example, many firms may feel that by outsourcing the trading function, they will lose their connection to the street.
“If you have spent years building up relationships with street-side brokers, there is no reason to give these up simply because you are moving to an outsourced model,” says Paulin.
“Indeed, it makes more sense for the vendor to support and enhance these relationships, for then everybody in the eco-system wins. That’s a stigma based on an outdated view of the vendors, which for the bigger vendors no longer exists.”
There is also the sensitive issue of headcount and what happens to roles like the head of trading. Do they simply become the head of trading oversight instead? “As the oversight function in any outsourced relations is critical, who best to provide that but someone who intimately knows the role of a dealer and best placed to ensure the vendor shows continual improvement,” says Paulin.
“The regulator will like that from a control perspective, funds will like it from a transaction cost analysis perspective, managers will like it from a risk perspective and asset owners will like it from a P&L perspective. We are even finding more and more heads of dealers approaching us to discuss this very point, from the perspective of improving operations, not displacing them. That’s a big change.”
And what about concentration risk: should the outsourced trading market be dominated by a handful of providers, as has been the case with global custody? Given the sheer number of providers that currently exist, it is unlikely any concentration risks will emerge in the short term, says Paulin.
“When or if those risks do materialise, they will be weighed against the value they bring to the end customer who demands greater transparency, value for money and lower costs,” says Paulin. “For example, there are virtual monopolies in the tech sector, but regulators so far seem reluctant to act due to the benefits it provides consumers in terms of removing cost barriers and allowing firms to compete on alpha and on value, which in turn promotes a thriving and competitive industry.”
Lightbulb moment
A second option for asset managers is to consider the independent specialists offering an outsourced dealing service. UK-based BTON Financial was started in 2018 after founder Dan Shepherd had a ‘lightbulb’ moment during his time working on a MiFID II trade reporting product for the London Stock Exchange.
“Talking to asset managers, I found that the associated costs with trading were continuing to go up – a trading desk, unbundled research, regulatory reporting and audit trails and technology advancements – while fees are going down,” says Shepherd.
One of the barriers to the outsourcing of dealing has been the idea that it is part of a firm’s DNA and a differentiator that allows the traders to sit together and communicate directly with portfolio managers about market events.
Shepherd says that his model allows firms to maintain their connection to the street or to the market. “We augment the head of trading by being an additional channel and to automate trades where possible. If a trader is executing an equity VWAP algorithm over the course of the day, it is difficult for them to argue that they are adding any value.
“But for those trading more esoteric instruments, they can still use voice trading. We refer to it as an in-house outsourced solution. The head of trading still retains the option to trade or use BTON Financial as opposed to throwing everything over the fence. It also allows smaller fund managers to scale up.”
Shepherd accepts that outsourcing does inevitably lead to a reduction in staff numbers across all industries and “it is a difficult conversation”. But outsourced trading does give some people the opportunity to change their role rather than lose it altogether, says Shepherd. “We are seeing heads of trading look more at the research space and the dissemination of information to the rest of the company.
“Previously you needed a really good justification to outsource trading,” says Shepherd. “I think that will flip and you will need a really good justification to keep trading in-house.”
A number of providers in the market now offer an outsourced trading service, says Shepherd.
“Some are independent like us, but are essentially offering to do things the same way but at a cheaper cost. Some brokers are offering outsourced trading, but that means asset managers are relying on only one provider and I don’t see how that meets best-execution requirements.
“There are also some asset servicers offering front-to-back office outsourcing. It is a compelling idea, being able to outsource everything to one provider and the data normalcy that brings. But I invest a lot in the maxim that you should keep the main thing as the main thing.
“Finally, there is the asset manager model where some large firms have spun off their trading desk as a commercial entity on offer to other asset managers. I wonder if there is a conflict of interest, even though firms are using other asset managers’ technology. It seems a less independent and less clean model.”
Dedicated dealing desks
One of those large asset managers is Amundi. It includes outsourced dealing as one of the functions it provides to other asset managers, as well as internal clients, via its Amundi Services offering. The service has been running since 2005 and has about 40 clients, 15 of which are external.
“The difference between us and other outsourced dealing providers is our competence and our coverage,” says Gianluca Minieri, deputy head of the trading desk. “We have dedicated dealing desks in each time zone and we have a mix of local and global counterparties across all asset classes. This gives us access to more liquidity pools.
“As a buy-side asset manager that has been doing this for many years, we know the business inside-out. And we have a set of policies and a governance model that can’t be bettered by independents.”
Access to liquidity is another driver that has arguably become more pronounced as a result of Covid-19 and the market volatility it has created. The ongoing fragmentation of liquidity has been a challenge for buy-side dealing desks for more than a decade. Equity trades that would have been executed on a single venue are now commonly executed on several venues. And then there are more emerging market trades where liquidity can be even more elusive.
All of this complexity has intensified since Covid. “It is easy to trade when liquidity is abundant,” says Minieri. But when liquidity is disappearing from screens, it becomes a much bigger concern. Added to that is the challenge of setting up your traders to work from home with all the equipment that comes with it.
Another change that has materialised in the past two months, says Minieri, is an interest in a hybrid model. Rather than outsourcing the entire trading function, some firms are interested in just outsourcing their Asian orders, for example. While this is a model that Amundi supports, and which may give some firms comfort in terms of a more gentle introduction to outsourcing, it may also create additional complexities such as the need to run two different front-office software systems, says Minieri.
As an asset manager offering an outsourced dealing service to other asset servicers, he recognises the challenge of having clients that are also competitors. “We have to address their concerns about segregation of data and the fair treatment of clients by showing what controls and processes we have in place to ensure good governance and total independence.”
There is also the size issue and the concern of some clients that by outsourcing to one of the world’s largest asset managers, with more than $1.7 trillion (€1.45 trillion) of assets under management, they might not get the attention they would like. But Minieri says that the ability to leverage Amundi’s capability and standing in the market, including access to liquidity and bargaining power with the sell-side, should be seen as strong benefits.
He also says that asset managers should not be worried about losing their connection to the ‘street’ by outsourcing. Much of this concern derives from a time before unbundling when buy-side dealers were dependent on their brokers for research, corporate access and other benefits.
“At Amundi, we pay for research from our own P&L, so clients can still buy whatever research they want from brokers or meet with analysts. Furthermore, we only provide execution services on their behalf, so it is always their name on any trade. So, unlike with an agency desk, the client maintains their visibility with the market,” says Minieri.
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