By Benjamin Arnold, Founder and Managing Partner at Meraki Global Advisors and Michael Ashby, Head of Strategy at Meraki Global Advisors.
What's Driving the Growth?
Asset managers are facing compounding pressures, including ever-increasing costs associated with operating a fund. To find ways to stay profitable and drive efficient growth, managers have significantly reduced the size of their trading desks in the last 20 years, replacing traders with software. Even so, desks and their systems are still expensive.
At the same time, increasingly complex and fragmented markets alongside regulatory and compliance challenges are driving the need for more software and expert traders. These issues only make creating alpha harder, especially for small funds. With many asset managers struggling to justify a million-dollar desk, outsourcing has become a compelling strategy, delivering superior trading services in a cost-effective way.
In addition to lowering costs overall, outsourced trading creates the opportunity for asset managers to turn a fixed cost into a variable cost.
All outsourced trading services are not alike.
In the broadest sense, outsourced trading replaces some or all of the functions of an internal buy-side trading desk with a third-party provider—but as this fast-growing industry continues to establish itself as a critical part of the asset management landscape, it becomes increasingly important to differentiate between the various service offerings within the space. Here we take a closer look at three predominant models for outsourced trading, assess the strengths and weaknesses of each, and discuss several key considerations for asset managers working to identify the optimal choice.
3 types of outsourced trading service models
Services can be separated into three models, defined by their core characteristics.
1. Prime Brokerage / Custodian Model
To enhance their prime brokerage and custodial services in an increasingly competitive environment, custodians and smaller investment banks are offering outsourced trading. The buy- side client has a single relationship with the provider. The execution broker housed inside the provider, a.k.a "outsourced trading desk", executes trades for the client and passes the execution to their settlement and clearing group. The clients are provided with research, corporate access and other services. The outsourced desk may also have relationships with other sell-side firms for execution, meaning the client is transacting with the provider. Ultimately, the outsourced service provider is the executing broker and stands between the client and other sell-side firms.
Strengths
Lower explicit execution costs. Outsourced trading commissions are bundled as revenue for prime services.
Weaknesses
Limited execution capability and expertise across asset classes and geographies.
Limited integration with investment teams' idea generation and portfolio management process.
Entire desk may see orders, not just assigned trader and backup.
Model may create incentive misalignments based on parent organization priorities.
Outsourced desk may be in close proximity to institutional sales trading desks.
Intermediates a fund’s relationship with its brokers and resource partners.
Traditional broker-dealers often treat this model as competition.
Non-directed order flow may be mishandled, e.g., internalized or routed to payment for order flow (PFOF) parties.
2. Traditional Agency Model
Agency broker-dealers offer outsourced trading services by executing client orders with traditional sell-side brokers. The agency outsourced desk typically acts in an introducing broker capacity and maintains the relationships with the sell-side resource providers. In effect, the outsourced trading desk acts as a hub for client orders to be further executed by one of the outsourced desk’s counterparties. The client faces the outsourced desk’s broker-dealer division for settlement of all trades.
Strengths
Hub and spoke model provides clients easy access to a wide broker network. The client does not need to be onboarded directly with other broker-dealers.
The outsourced desk may be able to provide written research reports from its broker relationships
Weaknesses
Limited execution capability and expertise across asset classes and geographies. The trading desk may be serving a large number of clients.
Limited integration with investment teams' idea generation and portfolio management process. Intermediates a fund’s relationship with its valued brokers and resource partners.
Client’s traditional broker-dealers often treat these providers as quasi-competition.
Non-directed order flow may be mishandled, e.g., internalized or routed to PFOF parties.
3. Pure Buy-Side Model
Providers act solely as authorized traders for asset management clients. This structure allows the outsourced desk to be a truly independent, conflict-free extension of the client's investment team, thereby operating in a pure buy-side capacity. In contrast to the models above, the provider does not have a clearing arrangement, conduct traditional brokerage activities, nor have any competing lines of business with clients’ broker-dealers. Clients settle all of their trades directly with their sell-side counterparty which ensures all trades are booked into the funds account and all commissions and/or spreads paid to the sell-side are from the fund.
Meraki has pioneered the pure buy-side model, a unique offering that is more akin to “co-sourcing” than traditional “outsourcing."
Strengths
Ability to trade any asset class including global equities, credit, FX, rates, structured products, commodities, and derivatives. Funds are matched with seasoned traders according to their specialization.
The client maintains direct relationships with their executing brokers and the fund name remains the focal point for resource providers.
Low client to trader ratio ensures a bespoke high-touch service. Traders monitor portfolios, understand themes important to the manager, and provide him or her with opportunistic flows and market color.
Full access to capital markets teams, stock loan desks, IOIs, and buy-side only liquidity pools. Complete integration with both the investment and middle office teams. Traders accept orders in shares, $, or % of AUM and can facilitate settlement of securities and cash management.
Weaknesses
The client must have trading accounts with execution counterparties to trade and settle directly.
Key considerations when selecting an outsourced trading firm
Building upon an understanding of the different outsourced trading service models, asset managers should ask themselves:
Which firm offers the greatest value for our needs? Some funds are looking for high-touch, experienced trading; others are focused on growing their broker network. Another way to approach this is to ask, which model would your desk most closely resemble if cost weren’t a consideration? Start by establishing core values—from here, it’s easier to weigh the advantages and disadvantages of the outsourced trading models.
What am I giving up by narrowing down the offerings to a single focus? If the sum of the lost values is greater than the value of the single focus, then you may want to reconsider your focus. If, for example, you choose the prime brokerage model, are you limiting your resources and creating concentration risk? If you chose the agency model, are you limiting the products you can trade, forfeiting credit for your commission dollars, or receiving subpar execution? And if you chose the pure buy-side offering, do you have the ability and willingness to set up prime brokers, ISDAs, and execution accounts with your preferred counterparties?
Here's an associated podcast: Podcast - Pierpoint Perspectives with Roy Zimmerhansl (merakiglobaladvisors.com)
Original article source: https://merakiglobaladvisors.com/outsourced-trading-with-meghan/
About the Authors:
BENJAMIN ARNOLD: As the Managing Partner of Meraki Global Advisors, Benjamin Arnold is responsible for running all facets of the business. The concept of Meraki Global Advisors was a direct result of Ben’s rebellious determination to deliver conflict-free outsourced trading services to asset managers with an overriding objective of excellence.
Mr. Arnold has over 15 years of experience in the hedge fund and financial services industry spanning across the globe. Previously, he spent three years at Fillmore Advisors (acquired by INTL FCStone) where he was instrumental in growing the outsourced trading desk. Prior to his move back to the United States, Ben was an Executive Director on the Equity and Equity Derivatives Sales-Trading desk at Goldman Sachs in Hong Kong and Mumbai, India. Before joining Goldman Sachs, Ben was a Vice-President on the Equity and Equity Derivatives Sales-Trading desk at BNP Paribas in Mumbai.
Ben began his career as a hedge fund trader with roles at Intrepid Capital Management and Asian Century Quest Capital in New York. He graduated from American University’s Kogod School of Business with a Bachelor of Science Degree in Finance.
MICHAEL ASHBY: Before joining Meraki, Michael was Operational Partner at Thunderbird Partners in London, where he co-ran all non-investment functions of the fund, including trading, treasury and data science.
Prior to Thunderbird, he was a trader at Ziff Brothers Investments and Jabre Capital in Switzerland. He has also held roles at Krom River Trading, a commodity hedge fund, and GLG Partners. Michael holds a BA in economics and an MBA from Rollins College, as well as a MSc in Financial Sector Management from SOAS.