The pace of technological advancement this past decade has been staggering. From machine learning to distributed ledgers to cloud adoption to augmented reality to the advent of quantum computing, there’s no true way of knowing what the trading floor of the future will look like. Maybe it will resemble a scene out of the movie Minority Report, with traders swiping at the air to find information and execute trades. Or, it might appear like something closer to the exchange trading floors of the present, with computers whirring and a handful of humans making sure nothing goes terribly wrong. 

If it is the latter scenario, then the outsourced trading desks of today represent the first steps in that evolution. 

Despite being around for about two decades, outsourced trading desks have become popular over the past few years as asset managers—who are struggling to find alpha as investors switch from active to passive strategies—find themselves needing to cut costs. And as larger funds seek to outsource, the trend might be here to stay. 

Many smaller firms are outsourcing their trading desks, and as they grow, some will decide to stick with the model. 

“The first thing we asked ourselves is how many assets do we manage, what kind of instruments do we trade and how often do we trade,” says an executive at an asset manager that today has over $5 billion in assets under management (AUM). “We looked at that and determined how many traders we might need if we do this ourselves and what could be the salary and bonus for that person we hire. We wanted to have a centralized flow of our orders, sure, but at that time we just didn’t want to absorb the headcount.”

Some companies have concluded that trade processes can be non-core to them, so they can be outsoured.

Gary Paulin, Northern Trust

The source, who asked for anonymity because of the negative connotations associated with the word “outsourcing,” says that as the firm grew, it decided to stay with an outsourced trading desk—in this case, Jones Trading—as it saw the benefits of working with one, such as being able to tap into the expertise of the vendor, which was able to provide more color around its brokers and was able to determine the best ones through which to route flow. It is also able to get good deal allocations when it comes to initial public offerings because of its provider’s relationship with the investment banks, the source says.

Back to Front

Outsourcing usually deals with more process-heavy tasks like reconciliation, but it is extended to anything companies feel are not core to their work. Gary Paulin, head of institutional brokerage, EMEA and Asia-Pacific at Northern Trust Capital Markets, says outsourced trading is a natural progression of other outsourcing trends in the past decade in the back and middle offices. 

“Big outsourcing trends follow a pattern that occurs at the end of bull markets where you see years where costs go up but no one really noticed. Then when that ends, firms have to double down on core processes to cut costs,” Paulin says. “Some companies have concluded that trade processes can be non-core to them, so they can be outsourced.”

Northern Trust started its own outsourced trading desk offering just last year, one of the larger financial organizations setting up the service. The most recent entrant to the space is Wells Fargo, which announced its own service in mid-June. Other brokers are also actively thinking of offering the service, including the newly launched INTL FCStone prime brokerage. 

At its simplest, outsourced trading desks are extensions of asset managers—both traditional and alternative—that do business by trading and executing orders on behalf of their clients. The funds direct their outsourced trading desk service, usually offered by a brokerage, to trade a certain volume of securities, and it is the desk that chooses where and how to route the trade. Acting as the execution partner, a trader from an outsourced trading firm has the capability to route trades. Outsourced traders use their own order and execution management systems (OEMSs) and route orders to brokers in their community. 

Some outsourced trading desks offer more services to clients that can range from managing trades and commissions, to sourcing research requests and consulting on technology selection, integration, and support for OEMS platforms. 

Asset managers that look to outsourced trading desks have varied reasons for doing so, but the biggest driver of today’s current trend is a story heard over and over again: cost cutting. Paulin and others note that regulations and competition drive many asset managers to reconsider what they deem essential to their firm. 

Firms have to look closely at their activities and what they spend money on. Outsourced trading desk service provider Jones Trading estimates in a report that an internal trading desk for a $250 million AUM fund could cost around $590,000 per year. A larger firm with around $1 billion AUM may need to shell out $1.18 million yearly for an internal trading desk. 

Technology costs alone—the license to run trading software and other pre- and post-trade platforms—are already 15% to 20% of this cost. By moving to an outsourced trading model, however, it is estimated that trading costs for a $50 million AUM fund will go down to around $150,000 a year, and a $1 billion firm will spend $1.05 million annually. 

Peter Weiler, co-CEO at brokerage firm Abel Noser Holdings, says asset managers that want to stick to active investing will want to have the freedom to look at market signals and create strategies much in the same way financial institutions have largely moved operations that are not core to the business out to third-parties. 

“The trend really is that there is active management fee compression, assets under management are going lower, and there’s the move more toward passive. I think if you can go to a trusted partner that has all the pieces—the execution platform, commission management, trade analytics, etc.—in place, it can be an attractive option keeping in mind that one size doesn’t fit all,” Weiler says. 

Trading-as-a-Service

With the rise of passive investing in the US, active managers have tried to compete by bringing down fees charged to clients. Lower fees drive down the capital an asset manager may have to keep running their own desks, especially as costs are high. 

In Europe, the revised Markets in Financial Instruments Directive (Mifid II) drove much of the interest in outsourced trading as commissions and payments became unbundled. European traders traditionally handed the payment processes to brokers, but with Mifid II and the unbundling of fees from services like trading, this function has been taken away. This has forced companies to look at how they handle trading and fees. 

In either case, many asset managers decide to focus on creating strategies and looking for signals, rather than the actual act of trading. Many of these firms have concluded that trading is not a core function. But asset managers do have concerns over the prospect of moving an important—if not core—function of the business, particularly around the protection of their information, Paulin says. 

“If a function adds value, then it’s probably not going to be outsourced. Take quant funds: They’re mostly data scientists rather than relationship traders, so their focus is on the analysis. They may not see trading as a function that adds value for them, so they’re more willing to outsource that,” he says. “Hedge funds are sometimes resistant to the idea of outsourced trading, because they view trading as a core function. They get insight on flow, liquidity and macro events that may impact market timing. But for those funds that don’t trade so much, which rely more on analysis than market timing, it doesn’t make sense to have a full-time trading desk. They might be better off outsourcing and swap a fixed [cost] for a variable cost. Think of outsourced trading as ‘trading-as-a-service.’”

Funds may be concerned, however, about the security of their order flows. Some are comfortable with their orders being routed into internal trading systems, but many are not and would prefer orders be routed away from internal dark pools. These firms fear there might be conflicts of interest and their order flows might get contaminated. Security around these orders is also of particular concern as some funds may want to prevent others from knowing how much they have to trade. 

I wouldn’t be surprised if in 10 years, 90% of the market is outsourced.

Jeff LeVeen, Jones Trading

And sometimes it’s the other way around. The asset manager executive says the biggest concern was that the firm wanted other traders to know the orders were coming from them. They worked with their provider to have the ability to tag trades that orders were being traded on their behalf. As with any outsourced relationship, compromises have to be made and the asset manager has to be willing to have slightly less control over their orders. 

“I really trust [Jones Trading]; they’ve been really great partners. If I wanted to set up a trading desk where I am, I’d have to hire at least two people and absorb that headcount. But if we’re just trading equities, our book is not that complicated. I don’t foresee any time in the near future that we’re going to hire in-house traders,” the asset manager says.  

There is also a fair amount of pressure on the service provider. As outsourced desks mainly deal with executing orders on behalf of clients, proving best execution is key. Aaron Hantman, CEO of outsourced trading provider Tourmaline Partners, says outsourcers have to prove they follow best execution on behalf of their clients and do not at all use their investments for internal dark pools. 

“A big concern for asset managers is the ability to maintain a level of control at the client level. You solve for that by creating bespoke trading solutions for each client so that they realize they are able to shape the outsourced service the way they want. Much of their influence is on workflow and operational factors, less so than on trading itself,” Hantman says. “Another concern is protection of information, and we ensure that first by being unconflicted and unbiased, by not being tied to a greater entity. Information is further protected in the way you handle order flow. We don’t advertise flow or shop it out to other clients.”

Tipping Point

As technology costs rise, the ability to spread those costs to outsourcers becomes crucial for asset managers. Andy Volz, Jones Trading managing director and head of prime services, says that 10 years ago, OMSs were unwieldy and had to remain on premises. But with the cloud, OMSs and EMSs can now be deployed anywhere. The optionality the cloud offers, as well as more sophisticated trading tools and post-trade platforms, mean funds have more options for how they enter the market, and it can be switched on and off, as needed.

But it’s not just on the trading side that technology has improved. Advances in analytics allow more firms to hone their strategies to find alpha without having to take time away to execute trades. And as the low-fee environment is likely here to stay, outsourced trading may have hit a tipping point where it becomes a viable option to many types of funds. 

Northern Trust’s Paulin says outsourced trading is not just temporary, but will continue as a viable option for years to come. 

“The biggest reason, though, why I say we’re at a tipping point is that we’re seeing a change in the size of funds that look to outsourced trading. It used to be funds that were sub-$10 billion looking at the service, but now we’re talking to firms with multiples of that,” Paulin says. 

Smaller asset managers gravitate toward outsourced trading as they are more affected by the need to cut costs. Larger firms have also begun to look at where they can save some money or be more efficient, and increasingly this means tapping an outsourced trading desk service to do so. Outsourcing providers like Jones Trading, Abel Noser, Tourmaline and others report they are pitching their services to funds whose AUM can reach north of $100 billion. 

And it is not just the size of the funds, but also the types of funds looking to outsource and different assets being traded. Jeff LeVeen, head of outsourced trading at Jones Trading, notes the next five years of growth for outsourced trading will likely come from pensions, family offices and endowments. The company has also seen strong interest in possibly opening up outsourced trading for asset classes like fixed income, futures and derivatives as these become more electronically traded. Outsourced trading works best in terms of electronic trading, particularly of equities and equity derivatives. 

“I think outsourced trading is the fastest growing element of the sell-side execution business,” LeVeen says. “I think there are cost savings of hundreds of percent. I wouldn’t be surprised if in 10 years, 90% of the market is outsourced.”