Lynn Strongin Dodds looks at the changing attitudes towards outsourcing and the different paths markets participants are considering including a look at front-office activities in addition to middle and back-office functions
Letting go is always difficult but during the pandemic ladened year, sell and buy-side firms have had to take a cold hard look at their organisations. The switch to remote working along with increasing competitive and margin pressures highlighted operational frailties as well as revenue generating opportunities. The result is that everything in the derivatives world is on the outsourcing table and not just the traditional back and middle-office activities.
This is quite a change from the pre Covid-19 days when execution would never feature in the discussions. It was seen as sacrosanct and the preserve of the financial institution. This is especially true on the buy side where many portfolio managers insisted on having traders in close proximity. MiFID II and the emphasis on best execution only reinforced this view but the prolonged virtual working environment has with many things served as an inflexion point. Suddenly, the location of the trading function is less relevant as long as the fund manager continues to add value.
Cost savings is definitely a factor but so too are the potential benefits of a fewer broker relationships, better market access and deeper liquidity with more reliable exposures to counterparties. In Northern Trust’s paper – Niche to Norm, Gary Paulin, Global head of Integrated Trading Solutions at Northern Trust Capital Markets and author of the report notes, the outsourced trading model has evolved from a cost-efficiency exercise to one that offers diverse benefits in terms of efficiency, operational resiliency, governance and managing technological complexity.
To date, equities has been the main target area due to the advancement of electronic trading, broad fragmentation of liquidity, and the ubiquity and speed of information access, according to Paulin. This has meant that the ability of dealing desks to extract value or find edge has diminished which in turn has altered the perception of dealing as fundamental to the decision-making process of an asset manager.
However, derivatives are coming into the frame because “increasingly clients are attracted via electronic platforms instead of bilateral conversations, and pricing processes are highly automated, even if the models and market data remain proprietary,” says Mark Aldous, CEO Structured Products for Delta Capita.
Even in the OTC space, “there are more traditional long only asset managers who use derivatives but realise they do not have the experience and are looking to outsource their trading,” says Paulin. “This will provide them with efficiency gains, and they can also plug in the expertise of the outsourced trader in the OTC area while reallocating their resources to their core competencies.”
While some firms will hive off trading of derivatives as a standalone proposition, it is more likely to be part of a multi-asset class offering. “What we are seeing is that there is a migration to solutions covering asset classes across the spectrum including fixed income, foreign exchange and futures and options including listed derivatives,” says Massimo Labella, European Head of Outsourced Trading at Cowen. “Clients are cherry picking what they need but what they are really looking for is expertise and the ability to replicate the relationship that the portfolio manager has with the trader.”
Unsurprisingly, there is no one size fits all solutions. “It depends on the asset manager,” says David Berney, founding partner of Ergo Consultancy, “There are basically two models – agency and RTO (reception and transmission of orders). The agency predominately exists in the UK and there is one point of contact and relationship with the Street. RTO which is used in France and on the continent is where the counterparty relationship, is between the investment manager and the executing broker.”
Post trade landscape
Although outsourced back and middle office functions are well established, change has also been a foot in the post trade processing world. The spikes of volatility wrought by the pandemic placed significant strain on these systems many of which still run on legacy architecture and manual systems, according to a recent report by Acuiti and sponsored by Broadridge Financial Solutions – Investment in derivatives post trade space set to soar.
As Will Mitting, founder and managing director of Acuiti, notes “the pandemic acted as final warning to many firms that they needed to modernise and upgrade their technology because their systems were not talking to each other, Many had been putting off investment into their post trade technologies and giving higher priority to other investments.”
However, as Paul Clark, Head of International Post-Trade Pre-Sales, Broadridge, notes, respondents were more willing to engage in conversations about outsourcing and to look at the different models. “In our study, we saw greater emphasis on the client relationships and differentiating activities while looking to outsource what was non-differentiating mission-critical core and peripheral,” he adds.
In the past, sell and buy-side firms may have turned to their asset servicing firm or a tech vendor to help with the reporting as well as the reconciliations, trade data matching, initial and variation margin, legal documentation, trade capture and allocation. Today, there are different models and service offerings in the market.
As Bernard Fripiat, Director for Simcorp’s Channel Play division notes “outsourcing will be on the agenda, although not as we’ve previously known it, because asset managers want to reduce costs, but also de-risk operations create more scale and greater efficiencies. Asset managers are now looking for more flexible services that go beyond data quality and reporting.”
He adds, “At the same time, the asset servicing and custodial space is undergoing much of the same changes and challenges as the buy-side, with costs pressure being the main one. To stay competitive and meet the rising expectations of their clients, asset servicers are looking more at activities that can help them differentiate and add value into the investment process.”
There is also more interest in the fully managed back-office outsourcing, where providers are integrated into the institution’s wider service architecture but provide autonomous services on their own technology. “Banks involved in derivatives business are adapting to a more complex but more prescribed regulatory environment and an increasingly electronic distribution model, “says Aldous. “External specialist providers bring deep expertise to specific areas of the process alongside specialist technology developed for use at scale.
Depth and breadth
Although more conventional, adoption varies typically in relation to the size of the institution. As the Acuiti report points out, the larger sell-side firms are digging deeper into their pockets while smaller and medium sized players tend to look externally. It found that around 40% of tier 1 and 2 banks were planning to increase spending in post trade systems while 37% were already going down this route.
Only 8% of respondents had outsourced their post-trade operations to a fully outsourced third-party managed service while just 2% were actively considering doing so. However, 22% of overall respondents would consider doing so if there was a wider choice in the market and for non-bank future commission merchants (FCMs) this figure rises to 40%.
The report attributed the reluctance of banks to outsource to the quality of service standards, insufficient cost savings as well as concerns over the lack of control over the development of services and the operational resilience of the providers. In addition, there were question marks as whether a fully outsourced service would deliver the requisite competitive advantage. For non FCMs, client service standards were also a worry as well as exposure to operational risk and data leakage.
“Banks are very conscious to avoid dependency on external providers in their value chain and need to ensure that services remain transparent and under their supervision,” says Aldous. “In practice many service providers offer increased levels of transparency and accountability for their services than internal teams often provide.”
