In the fall of 2020, right as the second wave of the Covid-19 pandemic was hitting, Frontier Road opened its doors (virtually) in London.

As is true of any startup, the asset manager had to decide whether to buy or build. For Martin Bercetche, the choice was simple: He is running an investment firm that focuses on the niche sector of emerging markets credit; it’s not a tech company, so why not leverage the expertise of an outsourced trading provider? That led the firm to New York-based Cowen Group.

“Financing Angolan government bonds isn’t everyone’s cup of tea,” says Bercetche, Frontier Road’s chief investment officer. “A long–short strategy needs good financing and repo abilities. There aren’t many specialists in emerging markets credit from an outsourced trading desk perspective. But Cowen has some experienced emerging markets credit traders who understand how the game is played. I’m confident I can get the best price in the shortest time.”

Cowen Group has 45 traders on its outsourced buy-side desk, with connections to 152 brokers worldwide, across multiple asset classes. All Cowen’s outsourced traders use a combination of SS&C’s Eze OMS and RealTick EMS, and has built its own security master in SS&C’s Advent Geneva back-office platform, in which it has also built workflow tools to generate and distribute automated reports to clients. The firm also built a client-facing prime brokerage portal, and a “lite” version of its own P&L monitoring system for clients who don’t want to build or buy their own.

While most adoption of outsourced trading has so far centered around equities and gaining access to international equities market, emerging markets credit is heavily reliant on expertise and manual processes. As such, Cowen has been investing heavily in its fixed income capabilities—and human capital—over the last year, says Michael Rosen, managing director and global co-head of prime brokerage at Cowen Prime Services.

“The equities markets are very transparent and easy to navigate, but fixed income is still more opaque and voice-brokered,” he says. “So, having a desk that’s connected to between 40 and 45 liquidity providers globally gives clients the reach that they couldn’t have achieved themselves. There’s a lot more value there than, for example, in the equities market.”

That expertise—coupled with the execution—has made getting Frontier Road off the ground much easier than it would otherwise have been. Bercetche notes that in emerging markets credit, you can’t simply call five banks and expect to get a price: “You have to find a real buyer.” He struggles to put a return on investment on the cost savings or performance gained, but the fact that Cowen has opened the firm up to 10 times the counterparties he would have had access to on his own has helped to jumpstart the firm’s trading activities.

“For a startup fund in its first year of existence, outsourced trading is very attractive because it lets me gain access to lots of different players—and to their research and expertise—that I wouldn’t otherwise have access to,” he says. “I wear a lot of hats, so this saves me a lot of time. Usually, I use Bloomberg chat to tell them the bond, size, price band, and what I want to do, and they go and work the order.”

Another bonus feature is that Cowen also caters to Frontier Road’s financing and regulatory operations needs. “So, it’s a one-stop shop,” Bercetche says.

Slow burn

The drumbeat for outsourced trading has been growing for several years now—and that only got louder during the pandemic. But while there’s a lot of talk about outsourced trading, only a small proportion of the buy side appears to be taking advantage of those benefits so far.

“Outsourced trading is a topic that gets a lot of attention and comes up pretty frequently: Both buy-side firms and outsourced trading desk providers call us up and ask what we see their peers doing. But, based on the results of our studies, it seems like outsourced trading is still quite nascent,” says Brad Tingley, research manager in Coalition Greenwich’s Market Structure and Technology practice.

According to Coalition Greenwich’s 2020 Market Structure & Trading Technology Study, only 10% of buy-side firms already outsourced their trading desks—specifically, that figure was for international trading, one of the most compelling use cases. For other areas and asset classes, that number was even lower.

And Greenwich’s latest report on buy-side spending, released in Q2 this year, reveals that the budgets for trading desks on the buy side increased by 5% overall in the last year, with the average firm spending $2 million per year on technology and staff, making for $10 billion per year spent on this area by the buy side overall.

But the research also shows that the increased spend was mostly driven by fixed-income desks, where budgets increased by 12%, whereas equities desks increased by 4%, and budgets assigned to currency trading desks decreased by 2%. If one assumes that firms spend more on the areas that make money and less on areas where they perceive less advantage, then these figures might provide a hint of which areas are more or less likely to be kept in-house or opened up to outsourcing arrangements.

“For most buy-side firms, their FX trading is just hedging their currency risk. It’s not a source of alpha, so they’re probably happy to outsource that execution,” Tingley says. “As it becomes more time-tested and outsourced trading desks can show a longer track record and that they help firms’ investment management requirements, and as more buy-side firms start using it and report positive experiences, then we’ll see it expand into other areas.”

Any evidence that outsourced trading desks are the way of the future for the buy side is largely anecdotal. Today, the sector feels a bit like the movie Field of Dreams—if you build it, portfolio managers will come. It’s this thinking that has led to something of an arms race among established outsourced trading providers and newcomers, alike.

The pitch in favor of outsourced trading largely revolves around cost savings, fewer (manual/human) errors and streamlined workflows. Shifting that cost burden onto third parties who already have infrastructure and licenses in place is one way to take costs out of the industry overall, says George Black, a partner at Capco and US head of the consulting firm’s capital markets domain. In his view, the rationale for outsourcing at any firm should be that if something is not differentiating your business, you should be willing to pay someone else to do it for you.

“In the past, traders were seen as a value-add. But as liquidity and electronification in the equities markets have increased, and spreads and commissions have decreased, it has begun to be less of a differentiator, so trading has become more about expense management,” Black says. “You have portfolio managers who decide what a portfolio should consist of, and the traders just act on those instructions. So firms are asking whether they should be investing in those roles.”

The mere suggestion that any portion of the buy side is ready to shift to using outsourced trading desks is creating intense competition among those offering outsourced trading services. These include custodians such as Northern Trust, specialists such as Tourmaline, firms like Cowen Group, large banks like UBS, and startups like Meraki Global Advisors.

The analytics angle

Proof that there’s a tipping point emerging in the outsourced trading space perhaps can be seen by the entrance of UBS. The Swiss bank had been providing a similar offering to around 300 sell-side clients across the US, Europe and Asia for years, but at the start of 2021 the bank decided to expand its service to the buy side.

By December 2021, it had constructed a new trading portal, covering equities markets. UBS will add fixed-income coverage at the end of June and plans to add listed derivatives capabilities in Q4 of this year.

“There’s a conversation on the buy side about what is your core business, and what core capabilities do you want to keep in-house vs. what can you benefit from outsourcing? For example, if you mostly trade in the US, but also want to trade in Asia, you can meet that capability,” says Mark Goodman, head of UBS Execution Hub and platforms in London. “By using an outsourced desk, you get exposure to that expertise.”

For its trading platform, UBS partnered with FlexTrade and with Virtu’s ITG division for the broker’s transaction cost analysis capabilities, both of which are already well used by buy-side firms. By buying systems off the shelf and customizing them rather than building something from scratch in-house, UBS was able to move quickly to take advantage of the growing opportunity, while offering broader capabilities to clients. For example, it is using FlexTrade’s API to plug machine-learning models, external data sources and capabilities into the platform.

“The API was so important because we wanted to take algorithms and apply them to the outsourced trading desk,” Goodman says. “Our aim in using the flexible API was to build out our machine-learning capabilities to optimize trading. So, the buy side doesn’t just have access to experienced traders, but we also have a very large dataset, which we can use to optimize a trade. For example, if, on a specific Friday in August, you want to trade a small-cap Swedish stock, how is best to execute that trade, and with which broker?”

Goodman believes UBS will entice the buy side by incorporating its data analytics capabilities to drive insights to the buy side. By running machine learning—rather than standard statistical analysis—against the dataset, which comprises all orders placed and trades executed by UBS, as well as data from clients, the bank can spot patterns and make sense of the large datasets.

“We’re in the early stages, and are starting to experiment with how to make it useful,” Goodman says. “But as the dataset gets bigger, we expect the quality will improve.”

UBS has staff serving this specific space in New York, the UK and Singapore, and will have a dedicated team in Frankfurt up and running in July. “We wanted a single, global order management system so we could provide a follow-the-sun service across our global team,” he adds.

Growth ‘supplements’

That idea of global coverage is one of the key drivers of interest in outsourced trading desks among buy-side firms, most of which tend to trade in their domestic market. But as clients’ portfolios become increasingly diverse and international, those managers may need to execute trades in asset classes where they have limited expertise, and in regions or on markets where they don’t have a physical presence or a trading membership.

For Atla Capital Management, a San Juan, Puerto Rico-based startup investment fund focused on listed emerging market real-estate investments, the global coverage of an outsourcer—in this case, new entrant Meraki Global Advisors—to provide access to far-flung emerging markets “where trends around urbanization are most pronounced” was a no-brainer, says John Haskell, chief investment officer at Atla.

“I came to the decision to outsource my trading very early. The resources required to spin up a trading desk with the same quality and reliability were beyond my scale. And I didn’t want to bootstrap it internally because it’s an important function, and I don’t have time to do it myself—I have many other demands on my time. It’s a question of what to do yourself and what to outsource—and outsourced trading was one of the more obvious decisions I had to make because the economics were obvious,” Haskell says.

Haskell has used Meraki since the inception of the fund, and describes the workings as being just like having an internal desk. His resume includes stints at larger buy-side firms that had internal trading desks, where he communicated with traders exclusively by phone or email. The relationship with Meraki is no different, he says.

Meraki was founded three years ago. The firm has offices and 16 clients spread across North America, Asia, and Europe, and is adding new clients at a rate of one every two months, says the company’s COO Michael Ashby. Meraki has found a sweet spot providing multi-asset outsourced trading for hedge funds with between $1 billion and $5 billion under management.

What makes Meraki somewhat unique, Ashby says, is that the firm sets up a desk for each client, and its traders handle a maximum of three to five clients. They don’t share any resources, and—unlike other firms that can use their scale to gain an advantage with the broker-dealers with whom they trade—the sell side sees exactly which fund they’re trading with, getting them a level of recognition with those firms that has declined under existing agency-broker models, he says.

A contributing factor to Meraki’s growth during the Covid-19 pandemic is that new funds found it hard to raise funding over this time, which substantially increased the importance of firms like Meraki that can help facilitate capital introductions, Ashby adds.

Muddy waters

Rob McGrath has spent three decades in senior trading roles at buy-side firms, including as global head of trading for Abu Dhabi Investment Authority and as global head of trading for Schroders Investment Management, where he led a team of 42 traders with over $500 billion in assets. He was also head trader at Oppenheimer & Co.

For much of that time on the buy side he believed trading functions didn’t add value and should be outsourced. The problem, he says, is that age-old distrust between the buy side and brokers.

“For 15 to 20 years, I’ve firmly believed [outsourcing] is the way to go, but I don’t think you can solve this by just having an asset manager give a trader an order,” says McGrath, who today runs fintech consultancy ZigIQ. “When I was on the asset management side, I would give a trader an order to execute, but I wouldn’t want to give them too much information that would give away my strategy—and yet I would still expect them to do a good job. How can they do that? The problem is, there’s one piece of data at the asset manager, there’s another piece that they share with the broker, then there’s the data that the broker has—how can you expect to get the best outcome if you don’t share data?”

Getting the best result, he says, requires access to all the data that an asset manager has—specifically, their models, strategies, portfolio data, and so on—rather than a single order, given with no context around it.

“I don’t see buy-side firms giving that to a broker. But they might give it to a technology provider,” he says.

That’s where McGrath sees the next opportunity: to build a solution—initially targeting buy-side firms outsourcing their execution, but with the potential to expand to serve other market participants also—that can capture data from all sides and use it to set strategies, then monitor and adjust them in real time, in response to changes in the data. He’s currently talking to potential partners, and hopes to have a product available in the fourth quarter of this year.

There’s certainly room for more players on the outsourced trading court. Cowen says its own business in this space has doubled over the past three years, and expects to continue experiencing double-digit growth. That may not be the same for everyone.

“Whenever there’s a ‘shiny new toy,’ you get a lot of firms hanging out a shingle,” says Cowen’s Rosen. “There might be brokers with excess capacity who think by saying they’re in outsourced trading that they’ll be a miraculous success. So, I think there will be a wave of new entrants—but I also think there will be a number of those that aren’t able to meet clients’ needs.”

Looking to the future, the distinct forces driving different types of firms toward outsourcing their trading desks create interesting decisions for firms in a few years’ time: Those choosing it to save money over existing resources will have to decide whether outsourcing has met their cost and performance expectations, and whether to continue or deepen those relationships. Meanwhile, those using it to gain broader reach during their startup phase will have to decide whether there’s any advantage to bringing the function in-house—and whether they could replicate the same levels of service, coverage and reliability as those offered by an outsourcer.

Those drivers—and that decision—may depend on the size of the firm in question and what they’re trying to achieve. And while outsourcers claim to be attracting larger clients, smaller and startup funds seem to stand to gain the most benefits.

“In the asset management industry, those with scale have a natural advantage. But there are countervailing trends, such as outsourcing, that give smaller firms a shot at success,” says Atla’s Haskell. “Those who break down the barriers to entry will help breathe life into the industry and drive innovation.”