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One thing is clear, standing still is not an option
Recently we have seen a series of announcements from firms promoting outsourced trading. For example, AXA Investment Managers has begun to offer outsourced trading to smaller firms, JonesTrading and Meraki Global Advisors have been hiring traders, and WallachBeth Capital is expanding their service.
However, countering that trend, Railpen, which looks after over GBP 30bn on behalf of 350,000 workers in the UK rail industry, announced that it was bringing its trading function back in-house – reversing the outsourcing model it established in 2016.
WHAT’S THE SIGNIFICANCE OF THE RAILPEN ANNOUNCEMENT?
Pardon the pun – what ‘signal’ is Railpen sending other asset managers?
BUYSIDE TRADING IN FIXED INCOME HAS HISTORICALLY SHOWN TO BE SLOW TO EVOLVE.
Recent research by The Desk indicates that, for active funds, high-touch is still the preferred method, with desks using voice or messaging for 37% of their activity. (The percentage of traders continuing to hold their dealer’s phone number in a Filofax was not revealed.)
ARE WE SEEING INSTITUTIONAL RESISTANCE TO CHANGE?
“If your senior management only wants you to not mess it up, then you are likely to stick with the status quo.”
AGAINST THIS BACKGROUND, OUTSOURCING TOOK A WHILE TO GAIN TRACTION.
Pre-pandemic, the trend started among startups, hedge funds and smaller funds. But larger investment firms have apparently, in the last year, begun – slowly and cautiously – to think the unthinkable. Faced, suddenly, with having trade large volumes in short bursts, firms needed to know that they could do so flawlessly. Could an outsourced trading firm provide more peace of mind than in-house traders are able to?
IN MAKING THAT DECISION, THREE FACTORS LOOM LARGE: an increasingly complicated trading environment; increasingly rigorous regulatory demands; and increasingly sophisticated developments in technology.
THE FIXED INCOME TRADING ENVIRONMENT HAS GENERALLY LACKED A CENTRALISED INFRASTRUCTURE.
The market landscape is notoriously fragmented, frustrating attempts to source liquidity and establish prices. Historically, buyside firms have relied on the sellside for liquidity and pricing; now, traditional broker-dealers are being challenged by a growing number of trading venues – some of of whom offer versions of all-to-all trading. And, when some bonds remain untraded for months, why should any trader rely on just one dealer for a quote?
EVIDENCING BEST EXECUTION IN SUCH A BYZANTINE LANDSCAPE CAN NEVER BE A QUESTION OF PRICE ALONE.
In a market as illiquid as fixed income, any broadly accepted form of Transaction Cost Analysis (‘TCA’) means factoring in the nature of the instrument being traded, market conditions and impact, speed of execution, the limits of the investment mandate and the firm’s execution policy. Traders can’t adopt a one-size-fits-all approach.
MEETING THESE TWO CHALLENGES DEMANDS ACCESS TO REAL-TIME DATA THAT’S BOTH COMPREHENSIVE AND SUFFICIENTLY GRANULAR TO BE USEFUL.
“Trusted data is the lifeblood of the fixed income trading desk, traders also need the right tools to make sense of vast quantities of incoming information if they are to make sound decisions with accuracy, speed and precision.”
UPGRADING LEGACY SYSTEMS WILL ALWAYS BE EXPENSIVE.
Off-the-shelf solutions from big vendors such as Blackrock, State Street, SimCorp and Bloomberg – “might seem like cost-effective solutions,” says Mark Watters, CCO and co-founder of AxeTrading, “but you’re generally locked in and have to embrace the workflows they offer.” Cloud-based web services might offer a more open data ecosystem, and makers of the third generation of OMS claim that it will offer even more integrated functionality. But when existing systems can’t be easily customised, some firms are hiring in-house IT expertise to optimize whatever black box the firm has bought or troubleshoot when it falls down.
THE IMPACT OF TECH ON THE MARKET IS PATCHY AND UNPREDICTABLE.
True, machine learning is coming online, able to evaluate and manipulate vast data sets; and the European Commission is currently discussing the idea of developing a consolidated tape of bond market data. But if AMs want to survive and compete, they need to do something to improve trade execution.
OUTSOURCING MIGHT BE PART OF THE SOLUTION.
With more platform neutrality, outsourcers can connect to a wider range of workflow management systems. They can operate in 24-hour markets, network with more brokers and access hard-to-find pools of liquidity. The larger players can buy in larger data feeds and update their technology.
OUTSOURCED TRADING ITSELF IS EVOLVING INTO DIFFERENT MODELS.
It can be a full-service desk or a specialised service: trading large positions in small cap names, for instance, or in less traded markets. Outsourcers can also create hybrid solutions, operating case by case or asset by asset.
THE BEST OUTSOURCED TRADING DESKS OPERATE AS AN EXTENSION OF THE BUYSIDE FIRM.
They can help smaller firms, in particular, to minimize market impact and reduce information leakage. They can even offer anonymity when an AM needs it.
SCEPTICS, HOWEVER, REMAIN SCEPTICAL.
Some point to the intangibles that could be lost through outsourcing: market insight, customer relationships, operational skill. Others fear losing control or creating conflicts of interest. Some buy-side firms are still struggling to understand the concept: the distinction between outsourcing and agency brokerage is not, it seems, always clear.
MEANWHILE, THE WORLD TURNS.
The global bond market has suffered its worst start to a year since 2015, as investors increasingly believe that central banks’ QE measures and governmental stimulus packages might fuel inflation. Some are muttering about higher interest rates; and a significant number, perhaps even most of today’s traders have never operated in a rising interest rate market. How to price dynamically in a shifting environment? Can we rely on AI to do that for us?
ONE THING IS CLEAR: STANDING STILL IS NOT AN OPTION
Traders can no longer see themselves as static price-takers, relying on limited contacts and limited information. And they can no longer rely on simply carrying out their portfolio managers’ instructions.
THE SMARTER TRADERS ARE BEGINNING TO UNDERSTAND THE NEED TO BE MORE PROACTIVE
“They’re upping their game, and behaving more like the sellside. They’re looking for liquidity pretrade and increasingly becoming not just price-takers but price-makers.”
There’s an increasing view that the trading process should be considered as integral to the value chain within investment firms. That’s why this decision whether or not to outsource ,matters.
THOSE TRADERS WILL NEED TECHNOLOGY THAT’S CUTTING EDGE AND FIT FOR PURPOSE
They will need to be able to plug in the relevant information sources at the point of pricing, as well as at the dealing point. They will need to be able to see diverse, comparable and accurate information, in one place. They will need, above all, to be able to trade efficiently and respond rapidly where needed.
AND WHERE WILL THOSE TRADERS BE?
If their firms invest in them, they’ll likely stay. If not, the opportunities elsewhere are proliferating. The critical question for any firm, large or small, is how to marry rapidly evolving technology with human ingenuity and skill.
THE TRUE SIGNIFICANCE OF RAILPEN’S DECISION WAS THAT THEY ANNOUNCED IT.
They knew they needed to show themselves as proactive buy-side players, investing in their traders rather than being at the mercy of industry headwinds. They’ve decided to build a house of bricks to weather whatever storms the future may bring.
THEIR ANNOUNCEMENT ALSO SERVED TO EMPHASISE THAT EACH FIRM MUST MAKE ITS OWN DECISION.
The question is not whether to outsource; the question is how a firm aligns its investment objectives with its operational intelligence. Make no mistake: smart ideas without smart execution will lose you alpha.
