Exoé, Linear Investments and Tourmaline Partners may not be household names but they are quietly reshaping the way asset managers trade. Providers of outsourced trading such as these are enjoying fast-rising revenues and their prospects are sunny. One reason: an opportunity to venture deeper into fixed income from their traditional home of equities trading.
“There are more and more firms talking to us about fixed income and how that would work,” says Chris Hurley, director of institutional sales at Dallas-based Capital Institutional Services, another provider of a service that allows firms to hand over some or all of their trade execution to an outside desk.
Outsourcing trading typically lowers asset managers’ costs and, especially for small funds, can improve execution. These advantages, long exploited by outsourcers in equities, are increasingly opening up for bonds as well, as much of their trading is moving to subscription-only platforms.
But, unlike in stocks, much still remains over-the-counter, and outsourcers argue this too plays into their hands – because they can do all the work to locate the liquidity and the best price, and they can often do it better than the client.
Some asset managers remain unconvinced, though. They worry something will get lost in translation or that little-known outsourcers will not secure the kind of best execution a big-name fund can. They are also keen to maintain direct relationships with banks, rather than blend into the anonymous mass of an outsourcer’s clients.
Still, the balance of opinion is shifting in favour of trading outsourcing providers. Management consultancy Opimas estimates that the industry’s revenues will grow 20–30% annually over the next few years and that one in five large managers – those with more than $50 billion in assets – will have outsourced at least some of their trading by 2022.
Cheaper, easier, better
According to Opimas, the annual cost of maintaining a one-trader dealing desk can exceed $500,000 for a buy-side firm. This includes the trader’s remuneration, as well as the costs of market data, order and execution management systems, and connectivity to broker-dealer and execution venues.
“Subsequent additions of traders are significantly lower, but the substantial fixed cost associated with operating a trading desk means that certain volumes must be reached in order to justify the expense,” the consultancy says in a recent report.
For equities, that necessary minimum volume is about $1.5 billion a year per buy-side trader, the report notes. It does not provide a minimum level for fixed income.
Octavio Marenzi, the co-founder and chief executive of Opimas, says many asset managers do not have enough volume in fixed income products to justify employing a full-time trader.
And even those that do trade a lot in a given asset class may still benefit from outsourcing a portion of trading, suggests the Opimas report, pointing to “spikes in volume that the existing team is not able to handle”.
Another advantage of using an outsourcer is access to specialised traders, rather than generalists, if the asset manager itself does not have relevant specialists.
“They [clients] don’t want me trading credit,” says Jeff LeVeen, who heads up outsourced trading at US firm Jones Trading. “They want my colleague that trades credit here to be on the team to be handling that. Having experienced traders covering the various asset classes allows us to offer our clients the best service and quality execution.”
These points are not lost on asset managers. Andrew Walton, head of European business at US outsourcer Tourmaline Partners, says that at his firm partial outsourcing by large funds is growing much faster than full outsourcing and often applies to out-of-hours trading across different time zones.
Tourmaline handles equities, listed equity derivatives and exchange-traded funds but is receiving enquiries from potential clients about expanding into OTC derivatives in various asset classes, including fixed income.
The growing interest in outsourcing fixed income trading is partly driven by the increasing electronification of the asset class.
Research on European buy-side traders by Greenwich Associates shows that the share of investment-grade bonds trading electronically doubled to 59% between 2012 and 2018, and that more than a third of interest rate swaps traded electronically in 2018, up from 20% a year earlier. The figures are based on notional traded (see figure 1).
Another statistic reveals a similar trend in European government bonds: by the end of 2018, around 95% of all tickets, or individual trades, were done on an electronic platform, according to a senior rates trader.
In the European Union, the natural shift towards platform trading has been accelerated by Mifid II as among the directive’s many new rules is a requirement to disclose quotes and trades – a chore that falls on one of the counterparties in bilateral deals but on the venue for on-venue transactions.
The catch is platforms charge subscription fees, which may not be justifiable if an asset manager does only a handful of trades on a particular venue. Subscribing to a number of venues, such as MarketAxess, Bloomberg and Tradeweb, makes more sense for outsourcers, which can pay the fees on behalf of all of their clients.
But outsourcers also see a role for themselves in the other kind of fixed income trading: OTC deals.
“Quite quickly in fixed income, you get into fairly opaque markets where there’s not necessarily a standard reference price. There, there’s a lot more skill involved and the process tends to be a lot more manual than it would be in equities,” says Marenzi at Opimas, referring to the need to call around for quotes instead of simply checking prices on a screen.
Outsourcers say they can take that job off a fund’s hands and, what’s more, find better prices if they have a credit specialist while the fund doesn’t.
There is another reason trading fixed income is more laborious than trading equities and therefore, providers argue, ripe for outsourcing.
For example, a fund wanting exposure to 10-year debt from a company may have upwards of 40 bonds to choose from, says Tim Nersten, head of liquidity partnerships at Liquidnet. The bonds would vary by coupon size and maturity date depending on when they were issued.
In that situation, it would be necessary to explain the fund’s desired exposure to the trader, who can then recommend the specific bonds it could buy easily and cheaply. While some asset managers may worry an external trader might misunderstand their needs, outsourcers respond that the buy side should think of them as just another trader on their own team.
“We are telling [portfolio managers] that we are bringing alpha to their fund in finding good bonds, cheaper bonds, and we can screen the market for them,” says Steve Mosseri, the head of fixed income dealing at Paris-based Exoé.
Whether it is bonds or equities, some outsourcers point out that by trading at scale they have both greater purchasing power and closer relationships with liquidity providers in their respective asset classes than their fund clients – amounting to a better ability to “find where the bodies are buried” as two outsourced traders put it.
Not won over yet
Despite all the apparent benefits, some funds are still reluctant to outsource any of their trading.
One reason commonly cited by outsourcers is a fear of losing control or, in other words, lack of confidence in the ability of a third-party provider to secure best execution.
Some well-known funds are unwilling to give up the advantages of their brand and trading know-how by handing over trading to an outsourcer.
“Thanks to the size of our assets under management and our broad range of products traded, we can source liquidity directly with investment banks in a more effective way than using an outsourced trading facility,” says Antonio Pilato, the head of trading at the asset management group of insurer Generali.
But in other cases, outsourcers have more heft than their clients. One such example is the outsourcing service provided by a leading European asset manager Amundi, which opened its centralised dealing desk to external clients in 2014 offering trading in all asset classes.
“When we come to the market, we come to the market with the firepower that comes from $4 trillion that we can trade every year. So we are not the unknown. We have bargaining power,” says Gianluca Minieri, head of Amundi Intermédiation for the UK and Ireland.
Amundi’s brand may be particularly valuable in less liquid markets as it helps it obtain competitive prices for clients, Minieri adds.
However, even the outsourcer’s renown may not be enough to convince some funds to start using external traders. Their concern is that doing so would threaten the relationships they have established with banks and eventually impact execution quality.
“You will lose that direct link with investment banks, and maybe this will prevent you from getting additional benefits from a liquidity standpoint,” says Generali’s Pilato. Other benefits could include informal access to the banks’ traders and their views and insights, or invitations to exclusive conferences organised by the banks.
But, at least in Europe, the importance of those relationships has become less clear since the introduction of Mifid II, which requires asset managers to seek out best execution – as defined by factors like price and speed – for their clients in each and every transaction.
Another possible barrier to the spread of outsourcing is the potential for information leakage at the providers that also have brokerage arms (see box: What’s in a name?). The worry is that details of outsourced trades could become known to brokerage traders at the same firm, even if internal policy forbids information sharing. Brokerage traders are meant to give their clients as much information as possible about market activity but any leaks could hurt the outsourced traders’ ability to get best execution for their clients.
What’s in a name?
At first glance, an outsourced trading service appears identical to a traditional agency brokerage. But there are differences, as a recent report by consultancy Opimas explains: “With a traditional agency brokerage relationship, decisions are made on an order-by-order basis in terms of which brokers to use and how much of the order to expose to them. This can change on a daily basis, depending on the asset manager’s broker selection practices.
“In the case of an outsourced trading desk, on the other hand, all of the order flow is sent to the provider, and the trader sitting on the outsourced desk liaises directly with the portfolio managers in terms of priorities for the order, market colour, fills and execution quality. The outsourced trading desk is deeply embedded in the workflow of the asset manager, with the traders at the outsourcing provider treated very much as if they were part of the in-house team. Indeed, the outsourced trader typically participates in the asset manager’s broker votes.”
LeVeen at Jones Trading counters that the firm’s outsourcing desk is separate from its brokerage business, geographically and in practice. “While we will execute some of our orders internally, we also direct a large number of trades outside the firm, and we need to ensure that as few people have visibility on our client orders as possible,” he adds.
Likewise, other firms are quick to point to Chinese walls between their businesses but, according to market sources, there are also those that are less fastidious about the separation.
Walton at Tourmaline Partners suggests that any outsourcer targeting EU funds would be wise to address such concerns from potential clients, given Mifid II’s emphasis on best execution.
“In view of the heightened scrutiny surrounding best execution now, if you’re looking to pitch a true outsource product, it should be utterly independent,” he says.
So, there are still obstacles to greater outsourcing, be it in fixed income or equities, but none seem insurmountable.
Perhaps more importantly, asset managers are increasingly open to the idea.
The question of whether trading and execution should be a core part of funds’ offering is now “up for grabs”, says Marenzi at consultancy Opimas. “It’s quite a change in mindset that’s occurred in the last 18 months or so.”
Editing by Olesya Dmitracova
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