THE OUTSOURCING CONUNDRUM.

It is not an easy one to solve for those in the front office, according to Heather McKenzie.

Outsourcing has been a slow burn in the financial services industry. For around twenty years the benefits of handing over ‘non core’ activities to a third party have been strongly extolled by outsourcing service providers which typically include global custodians. Gradually financial institutions have moved from dipping a toe into the water, with functions such as personnel management being handed over, to much more extensive outsourcing arrangements including middle and back office operations.

The benefits are most often identified as the ability to move from fixed to variable costs as a service provider with scale and expertise that can deliver the same functionality at much lower costs. Those who outsource are told they will be paying only for what they use, rather than having to maintain systems and staff for both the peaks and the troughs of their business activities.

So established is the outsourcing trend in the asset management community, that in December 2012, the then UK Financial Services Authority raised concerns about the risks. The financial regulator was uneasy that in an industry where outsourcing of operational activities to external service providers was increasing, not enough attention was being paid to recovery and resolution plans should an outsourcing service provider fail. The regulator was also concerned that oversight of outsourcing providers was inadequate.

The outsourcing undertaken by the buyside has to date been squarely in the middle and back offices; outsourcing actual trade execution has not yet taken off. Those in favour of it argue that asset managers should focus on their core activity of stock picking and then hand over the execution of trade to the experts.

In November 2012, Norwegian broker Christiania Securities outsourced its trade execution activities to independent agency brokerage Neonet. For some commentators, the move was the beginning of a new trend but few other sellside, or buyside firms have followed its lead.

Based in Oslo, Christiania Securities, which focuses on technical stock analysis in Nordic markets, decided to outsource in order to focus on its core business, according to chief executive Oddbjørn Hollen at the time the deal was announced. Under the terms, Christiania uses Neonet’s execution services on a pay as you go basis. The firm taps into Neonet’s connections to markets and also employs its algorithms. Christiania does not have to pay for exchange memberships or maintain in-house resources dedicated to execution technology.

Putting the case forward

Firms that offer outsourced trading facilities argue that they have the infrastructure as well as the expertise required in order to focus solely on trade execution which frees investment managers to identify new opportunities and manage current investments. Such organisations operate global networks of buyside and sellside relationships and can execute large value trades while maintaining the confidentiality and anonymity of their clients.

Bradley Wood, a partner at London-based capital markets consultancy GreySpark Partners, says a “few” buyside firms are contemplating outsourcing execution but he does not think it is a trend or will happen “in a wholesale way”.

Wood says the main question firms must ask when considering such an arrangement is whether the function they propose to hand over is critical or not. “Is execution critical? The answer will depend on the nature of the trade activities being undertaken by a firm,” he says. An asset management firm trading only once a day, with a long investment horizon may decide outsourcing is appropriate. However, firms that are more active and trade in and out of positions regularly are likely to find that keeping the trading function in-house is more worthwhile.

Paul Rowady, principal, director of data analytics research at TABB Group characterises discussions about outsourcing execution as “more talk than walk”. While the outsourcing of technology to managed services providers has been ongoing among buyside firms for some time, outsourcing the actual “human capital” including financial traders and portfolio managers is not happening.

He agrees with Wood that if a firm does not have highly sensitive execution needs, it may well consider outsourcing execution. However, firms whose strategy is in pursuing alpha via rapid execution and are sensitive to short-term slippage, outsourcing execution is not yet a viable approach.

Rowady is sceptical about whether firms will save headcount costs by outsourcing execution. “Possibly some firms that have a large number of traders may look to outsource execution. It is a theme that is being tested at present, so I wouldn’t debunk it totally just yet.”

Outsourcing has not been a smooth ride for all firms. There are challenges that have to be overcome and that may prove significant for areas such as execution. Wood points out that there are numerous examples of firms that have outsourced call centre operations to low-cost locations only to bring them back into their home countries after ‘disastrous’ effects on their businesses.

“In outsourcing any area of business, a firm needs to be able to closely manage the relationship it has with the party to whom it is outsourcing,” says Wood. “This is non-trivial; if you outsource execution how will you know whether the service provider is executing properly? What will the implications be on costs and slippage? How will you know that outsourcing is worth it?”

Best execution

Given regulatory requirements for best execution, firms that outsource execution will have to deploy reliable, trustworthy transaction cost analysis processes in order to measure their third party provider’s performance. “This is not something that is done on any sort of scale today,” says Wood. “It would be quite difficult to ensure that there is value in the relationship and to manage that relationship.”

In addition, questions of security should be high on the checklist, says Rowady. “Confidentiality is very important. Firms must determine whether or not their provider will leak their orders. They also need to know what will happen if an order is wrongly executed.”

Trading where liquidity is plentiful, highly fragmented, with low-touch trading via smart order routers is sufficiently commoditised, says Wood, and may be a suitable candidate for outsourcing. However, trading in areas such as fixed income are unlikely ever to be suitable for outsourcing as there is so little liquidity, so a trader has to work very hard to execute trades. “Buyside firms should not let a third party conduct its trade execution if there is a large chance of slippage shortfall if the trade is executed poorly.”

Rowady says execution remains one of the more sensitive functions within any trading firm and therefore he is unsure how widespread the outsourcing of execution will become. “It is important in the current environment for firms to seek cost savings, but I cannot imagine execution outsourcing will become widespread.”

In fact, he believes trading strategies will become more complex and sophisticated across all asset classes and regions, making alpha much more difficult to find. In such an environment buyside firms will need new skills and better trading tools. There may be niche execution outsourcing offerings for basic trading strategies but not for the highly automated, high turnover strategies.

The confidentiality required by Rowady may be reflected in how many firms admit to having outsourced execution. He believes it is unlikely many buyside firms, tasked with managing investments for their clients, will admit they have outsourced what may be considered a core function.

© BestExecution 2014