Equities GM & Editor, Jack Haddon
Last Thursday as part of the ongoing Hive Cafe series, I spent an hour on Zoom with ten head equity traders at leading asset managers discussing the merits and the pitfalls of outsourced trading.
Our members firmly believed that while there are scenarios where the model makes sense, the value of an internal trading desk to asset management firms cannot be underestimated, especially during periods of volatility and market instability. The group agreed that in the instance that a senior stakeholder at their firm began to have their head turned by an outsourced trading outfit, it was of vital importance that they were prepared, and fully understood the pros and cons. Below are their thoughts:
Reasons to outsource…
- If a firm is on the lower end of the AUM scale, then outsourcing can give them access to prime services. At low AUM levels, the costs and value-add capabilities of an internal trading desk cannot be justified due to the size and type of flow.
- Some outsourced trading firms can offer a specialist service, for example derivatives trading if a firm’s internal desk is primarily cash equity focused.
- Overflow services for when the trading desk has too much on its plate.
- The ability to switch execution from a fixed to a variable cost
- Extend your existing broker list through outsourced trading firms – you can use them as a “broker aggregator”
- Outsourcing can overcome conflicts of interests where investors impose restrictions that could be detrimental when trading for your other investors
But be aware!…
- If you wish to bring trading in house as your firm grows then you will need to start from scratch and have less historical data
- Overflow desks are unlikely to be familiar with your flow and the intentions behind trades, which will likely lead to worse performance
- A longer broker list does not necessarily mean access to deeper liquidity – the majority of their business may likely be with the same 6 brokers.
- Pre-arranging a trade with a specific broker not on your panel before handing to an outsourced firm to facilitate the trade can be a compliance concern
- Outsourced desks are less likely to have strong relationships with PMs and be able to act quickly and provide tailored feedback to them on timing and market insights – especially in volatile markets
- The onus of best execution remains with the asset management company not the outsourced trading firm
- If your flow is focused on alpha and being close to your PMs is important then outsourcing could be detrimental – you can’t outsource investment DNA!
- It can be hard to quantify the benefits of a having a trading team who are invested and incentivized for the firm to do well
- Trading desk innovation and performance is becoming more and more important to winning new clients
- Control of information leakage is very hard when outsourcing as the outsourcing firm may be less motivated by performance and more motivated by commission.
- There is a lack of clarity around how effectively you can access IPOs if relying on outsourced trading desks
Over the course of the conversation, it was agreed that if you can use trading analytics to demonstrate the value and alpha generating ability of your trading desk then the threat of outsourcing significantly reduces.