In recent years the popularity of outsourcing in financial services has swung like a pendulum, and while to some it is still a ‘dirty word’ others see fresh opportunities. Best Execution spoke to Linear Investment’s chairman, Jerry Lees, and managing director Richard Lilley, about the rationale for outsourcing trading operations for buyside firms.
There is much discussion in the market with groups such as Alternative Investment Management Association (AIMA) around the subject of outsourcing trading and operational services due to increasing demands from regulators for proof of best execution, operational risk management and cost management. Is this leading to European funds embracing outsourcing and how will it be different from the past arrangements?
Jerry Lees: This is exactly what is happening. There are a series of regulatory requirements including proving best execution that smaller and medium sized fund managers are obliged to provide and it makes more sense to outsource these requirements to specialist entities that can offer a bundled package of services and economies of scale. The change that it is happening is in the front office, although the trend is more established and more prevalent in the US. I think it will take time for European buyside firms to follow suit because of the multiple regimes, markets and currencies.
What type or size of organisation can benefit from outsourcing their dealing desk and/or middle and back office operations?
Richard Lilley: It is across the board and the drivers are different. However, all funds are under greater pressure due to regulation in terms of trade reporting, risk analytics, risk management and proving best execution. Outsourcing of, particularly the front office, will also depend on the frequency of trading. For example, large long-only firms who trade infrequently do not have the flow to justify having an in-house trading team so may well decide to outsource the function. The same is true with small to mid-size hedge funds which only have one or two people on the trading desk and are looking to reduce the costs and improve the bottom line. As for small or start-up hedge funds it makes more sense to outsource the dealing capability from the beginning versus taking on a dealer in-house. Hedge funds that are not running high volume trading strategies will also be better off to outsource.
Many global prime brokers have recently announced staff and operational cuts and intended increases in fees while at the same time asking smaller funds to find an alternative broker in order to address internal capital and profitability targets. What impact is this having on the industry?
Jerry Lees: Regulation such as Basel III has had a massive impact and there are balance sheet implications for all banks. Most hedge funds have tiny balance sheets and a lot of assets under management but it has become expensive for banks to rent out their balance sheets. They are no longer willing to do this for nothing but are now looking for a higher return. The benefit of a service like ours is that we can act for several relatively small and medium sized hedge funds and bundle them up as one account. We will do everything for them, ranging from know your customer (KYC) documentation to on-boarding, risk and compliance management and reporting, and they benefit from the economies of scale. The larger prime brokers cannot afford to look after this segment of the market. We can because we do not have the same type of overhead.
Do you believe that by outsourcing trading, funds will ultimately enhance their performance and profitability?
Richard Lilley: Yes absolutely. Since soft commissions are no longer acceptable, research, previously obtained from sellside brokers, is just one of the many products that the buyside now pay hard dollars for. We offer full commission sharing agreement capabilities and are able to direct the flow to the broker research of their choice. Setting up an in-house dealing desk is also expensive. For example a firm with two to three traders will, in addition to the personnel costs, have to license three Bloomberg terminals, or similar, in order to trade effectively. Add in IT support, rental of extra office space and before you know it the total costs are anything up to £1m. By outsourcing trading this figure is directly removed from the bottom line, without impacting the service. Funds are unable to cover these costs, so they are paid from their standard management fees. By outsourcing, the problem goes away and the bottom line immediately looks better. Fund managers are also able to focus more on their core business of investing and can have higher execution quality if, for example, they use a specialist team of traders. We are an agency-only business with no proprietary positions. We have access to liquidity in a disguised way and can allow the fund to trade anonymously.
How are the deals being structured – are they on a component basis or lift out?
Jerry Lees: We do not see any broad discernible trends. We have general discussions with funds and they may buy components or decide to outsource everything from back and middle to front office. One of our main messages is that best execution is achieved by specialist traders.
What are some of the biggest challenges?
Jerry Lees: Changing the cultural mind-set and the decision making process of the CFO and CIO are the biggest challenges. There is a perception that outsourcing is like asking turkeys to vote for Christmas in terms of losing jobs and internal controls. That is not the case.
Richard Lilley: There are numerous buyside dealers who do not trade electronically, but use a broker. They can be paying unnecessary and inflated dealing commissions. One of the benefits of outsourcing the execution is that we are able to capitalise on our higher volumes and offer a more attractive rate. The brokers will not lower their rates to individual funds because there is no incentive to do so. I think over the next two to three years, there will be a major transition, mainly due to the regulatory changes. This will create more interest and an increase in the number of firms who will outsource their execution desks. It will not happen overnight, but once funds recognise the benefits to their current dealing process and see the increase in their bottom line, I expect the demand for outsourcing trading to increase dramatically.
© BestExecution 2014