In a survey of buy-side equity traders in the US and Canada, recently published by Greenwich Associates, one third of respondents described outsourced trading desks as a good solution to help buy-side desks manage their flow while achieving best execution.
This might not sound like a ringing endorsement of outsourcing until you consider that only 20% of equity traders surveyed for the firm’s Market Structure Trading and Technology Study a year earlier, in 2019, expressed a similar view.
Benjamin Arnold, CEO of Meraki Global Advisors, says that a notable percentage of the product enquiries his firm has received during the past year were for structures that were either linked directly to FX or had FX components.
“Understanding the inherent risk in these complex products and how best to navigate and then execute the trade can make a significant difference to an asset manager’s performance,” he says.
Emerging managers continue to be a typical client for the industry, but not all emerging managers have the same needs
Benjamin Arnold, Meraki Global Advisors
Many of these requests have come from sophisticated mid-size hedge funds that trade global markets across multiple asset classes with assets under management (AuM) ranging from $250 million to $5 billion.
“Emerging managers continue to be a typical client for the industry, but not all emerging managers have the same needs,” says Arnold.
“Their success rate can be lifted by partnering with multi-asset buy-side experienced traders and this characteristic is often overlooked by outsourced trading providers when their models are templated from and staffed the same as agency sales trading desks.”
According to Arnold, if an outsourced trading firm has a business structure that encourages it to execute most of its order flow with one or two venues, it is likely that those venues are the brokerage arm of their clearing or custodial firm that requires the trading firm to meet financial minimums.
“This practice, while not explicitly payment for order flow, should raise questions not too dissimilar to those being asked in the recent GameStop controversy,” he adds.
Fee compression
As equity asset managers continue to face fee compression, pressure has increased to reduce costs and dedicate resources to their core competencies.
Equity managers who outsource FX trading are realising improved FX execution through netting and competitive bids, simplicity of operational interface and transferring the increasing regulatory/reporting requirements to a specialist, suggests Michael Zehfuss, head of client management at Mesirow Currency Management.
“Outsourced FX services can be customized to meet client requirements relating to trade communication, execution venues, customized reporting or client-imposed restrictions,” he explains.
“Execution quality is monitored in real time by our 24-hour trading desk and is then assessed by an external third-party transaction cost analysis (TCA) provider and transparently reported to clients.”
Access to a rules-based menu of execution options is important to managers, as is pricing flexibility in terms of rate sources, execution times and methodology that allows them to meet intended investment objectives and benchmarks.
“Being able to provide measurement of execution quality includes price information, market characteristics and any market impact from the execution,” says Ed McGann, global head of FX program and platform sales at BNY Mellon.
“We can also provide data to a client’s consultant in order to provide an analysis of our execution.”
In the past, there were two ways an equity manager could handle FX related to their global equity trades. They could either use a custodian standing instructions programme or implement and manage an active FX trading desk in-house.
With the former, they could be giving up execution quality and losing netting and aggregation benefits if they had multiple custodians – as many managers do.
With the latter, the execution benefits had to be weighed against the requirement to have trading expertise in-house, own the currency and trading risk, manage relationships with liquidity providers, and support pre- and post-trade operational tasks.
The early adopters of outsourced FX solutions were looking to move away from custody standing instructions and there are still many managers with that profile.
However, Brendan Burke, vice-president, foreign-exchange investor services at Brown Brothers Harriman, refers to growing interest from managers with global dealing desks who are looking to optimize their resources and keep core, strategic FX in-house while offloading operational, transactional FX.
“There are various flavours of outsourced FX,” he says. “We see managers who have deployed a best-of-breed model, for example using an active dealing platform to handle freely traded markets with a panel of banks, but partner with a specialist for some of the more restricted currencies.”
Burke observes that spikes in market volatility early in the coronavirus lockdown increased the pressure on managers’ operating models.
“For equity managers, FX is generally operational and related to settlements of their global security trades,” he adds. “For these reasons, it is generally an uncompensated risk that has the potential to add unexpected costs.
“This is consistent with an industry-wide theme of managers looking to mitigate costs and risks wherever possible and FX is no different.”
