Funds urged to scrutinize outsourcing models to reduce data leakage

Asset managers go to great lengths to protect their trading data and techniques, using a combination of surveillance and threats of legal action, not hesitating to act against staff or competitors suspected of stealing confidential information.

Yet despite the secretive nature of the industry, many funds have opted to tap into outsource trading solutions. Last year, a Northern Trust survey of 300 asset managers found that 85% had either outsourced or were interested in outsourcing their trading desks. (Northern Trust, it should be noted, provides outsourced trading services.) Those numbers come way down, according to a recent study by Greenwich Associates, which found that fewer than 10% of institutional investors currently outsource their trading desks, though 33% said that they see outsourced trading desks as a good solution to help buy-side firms manage their trading flow and achieve best execution.

Outsourced trading providers, which take on some or all of a buy-side firm’s order execution, have picked up business in recent years as asset managers have sought to reduce the costs of hiring traders, transacting in various time zones, and maintaining their own trading technology infrastructure.

At its simplest, outsourced trading desks are extensions of asset managers—both traditional and alternative—that do business by trading and executing orders on behalf of their clients. The funds direct their outsourced trading desk service, usually offered by a brokerage, to trade a certain volume of securities, and it is the desk that chooses where and how to route the trade. Outsourced traders use their own order and execution management systems (OEMSs) and route orders to brokers in their community. 

There are several reasons for this shift in thinking, though cost-cutting is one clear driver. Outsourced trading desk service provider Jones Trading estimates in a report that an internal trading desk for a $250 million AUM fund could cost around $590,000 per year. A larger firm with around $1 billion AUM may need to shell out $1.18 million yearly for an internal trading desk. Technology costs alone—the license to run trading software and other pre- and post-trade platforms—account for between 15% and 20% of this cost. By moving to an outsourced trading model, however, it is estimated that trading costs for a $50 million AUM fund could drop to around $150,000 a year, while a $1 billion firm would spend $1.05 million annually. 

Asset managers also turn to these offerings as a way to quickly and affordably expand into new asset classes, regions, or markets. There has also been a push because of the Covid-19 pandemic and subsequent surge of remote work. 

Trade-offs

There are detractors, though, as outsourcing providers are not one-size-fits-all. Different categories of providers work better with different funds, depending on their size and structure. For instance, some providers specialize in certain types of trades, such as structured derivatives, while others work better for particular regions because of trading hours that would not suit a fund that does not have its own traders based in that location. Some outsourcing providers are good for overflow services—for example, if a trader is absent due to sickness or vacation. And some funds choose to outsource to their custodians that also offer brokerage desk services. 

Before entering into an agreement, funds must closely scrutinize the approaches these providers take to handling and sharing data around a trade, to minimize the risk of information leakage, says Neil Bond, former head of trading at London-based Ardevora Asset Management.    

“Beware of some outsourced trading providers that overshare your order information to find the other side of your trade and subsequently encounter higher market impact costs. Most buy-side trading firm​s will drip-feed that information out to the market,” says Bond, who left the investment firm last year after it decided to shut its trade desk and outsource.

There are different levels of information leakage. For example, a trader could tell a broker they want to buy $1 million worth of a particular stock. If the first contact in the market the broker talks to turns out to be a seller, there would very little leakage. But if the trader does not find that seller immediately, they could be telling other buyers, which leads to the more harmful type of data leakage.

“If they go and tell 10 of their clients, and all 10 of them are buyers as well, those people might use that information and say, ‘There is another buyer out there; I am going to be more aggressive with my order.’ And you see the price moving without having executed anything. You do not have to execute in order to have market impact. So that is why you have to be careful about information leakage,” Bond says.   

He believes that many outsourced traders do not care about market impact for a trade they are planning to execute, particularly because under an outsourcing agreement, they are not competing for each trade: they know they will continue to receive trades from the same fund manager, and will continue to make money, regardless of price impact.

‘Every portfolio manager believes they have an edge’

Outsourcing providers, however, obviously see things differently. “Every portfolio manager believes they have an edge in their investment process. The problem is that when trades are put into the market, that manager’s purchase or sale of a particular security at that time most often has little to no impact in the context of a market in which huge volumes are traded via electronic algorithms,” says Jack Seibald, managing director and global co-head of prime brokerage and outsourced trading at Cowen, which offers multi-asset trade outsourcing services, including for equities, options, foreign exchange (FX), and fixed income.

He says the majority of the firm’s clients use it not only for trade outsourcing, but also for operational support and shadow books and records. In such cases, the outsourced traders will have a clients’ entire portfolio live on their desktop.  

“It means that we are super careful about data protection. The broker-dealer from which we perform the outsourced trading service is a separate entity from Cowen’s institutional broker-dealer. So we are not just walled off by a floor or by a different desk; we are literally walled off by a different legal entity,” he says.

Sell-side providers offering an outsourcing service need to ensure there is no conflict of interest with their own institutional trading desk.

Seibald says his firm protects client data by offering full transparency to its buy-side clients and executing brokers. “When the client sends the trader an order, the client will not only see that the order was received, and routed to a designated broker, but will also see that the broker received it and started to execute it. Effectively, the client will see every portion of the trade that gets executed, as it’s routed back electronically to their systems. The client has full transparency all the way through,” he says.

If a client wants to retain some anonymity because they are trading a relatively illiquid stock or are building a position over a number of days, Cowen can be their counterparty or broker. Seibald says Cowen will go out into the marketplace and transact as needed on a broker-to-broker basis and then transfer the trades to the client’s account.

“The best thing I can point to is when clients have engaged us and have turned us on for full view on their live portfolios—which means our trading systems are updated daily by feeds from their prime brokerage or custodian accounts and our traders have the same view of the client’s portfolio as the client does, much as an internal trader would. That is the best indicator of trust I could ever imagine. It negates the notion of secrecy that some people have articulated,” he adds.

Cowen’s outsourcing business has built its entire platform on buy-side trading systems, not sell-side trading systems, whereas the institutional side of the business runs completely on sell-side trading systems, and the two sides are not connected, he says. 

Andrew Walton, head of European business at Tourmaline Partners, another trade outsourcing provider, says there are different spectrums within outsourcing. On one end of the spectrum, he says firms like Tourmaline offer a trading environment that mimics a buy-side trading desk. The unit is connected globally to over 50 electronic routes “in addition to the more than 450 high-touch broker relationships,” that the company maintains.  

New players, similar concerns

And even as there are worries amongst some buy-side traders about the encroachment of outsourced providers, a rift is forming between the ranks of the outsourced providers. Walton contends that providers on the sell-side end of that scale cannot—and do not—operate the way that Tourmaline does. While those firms may have electronic lines into banks because under Mifid II the banks are obligated to see that liquidity,  Walton says they are never going to show the banks their high-touch flows or information as they are direct competitors.

Walton contends that firms like Jefferies, which started up an outsourced trading desk in 2018, have a conflict of interest here, because of its investment banking arm, which opens up the potential for data leakage between groups. 

Paul Covello, global head of outsourced trading at Jefferies, says that Warren is incorrect in his assessment of Jefferies’ services.

“Our outsourced trading business is fully segregated from our execution business, similar to the separation of our investment banking, research, and sales and trading divisions,” he says. “We operate as a separate entity that’s part of a global bank. We partner with a broad range of brokers in sourcing liquidity as well as information. Our traders have an average of 15 years buy-side experience and work orders for clients with a wide range of brokers in the same manner as we have our entire careers. Our clients are provided third-party TCA analysis that show all best execution metrics.”

Jefferies is just one recent entrant in this fast-growing space. Last year, Northern Trust added European listed options and derivatives to its outsourcing offering, and State Street integrated the Charles River OMS and BestX TCA platforms into its outsourced trading service. In 2019, high-frequency firm Potamus Trading expanded into outsourced trading.

Bond, the former head of trading at Ardevora, says that even though many see an opening to win new clients and build sticky relationships, he does not anticipate that all of these entrants will have staying power, even if the popularity of outsourced trading is still growing right now.

“I remember when a lot of the investment banks opened up transition management desks because it was considered to be a very profitable growing market—they don’t have those desks anymore,” Bond says. “I suspect that while outsource trading will stay, I think it’s going to stay with the specialists in that area, like the Tourmalines and CF Global’s and Cowen’s. I don’t think that all the broking houses that set up outsourcing desks will still have outsourced trading desks in five years’ time that are of any significant size.”

Walton says it is important to understand that outsourcing can be a hugely valuable resource and does not have to be seen as a threat, assuming the fund has partnered with the right provider and understands the process. He says the C-suite cares about costs, while the trading desk cares about data. “Those two things are not connecting, and that adds to an ongoing misunderstanding of the space. It adds to this sense that conversations are being had by outsourced trading firms with C-suite executives who don’t understand trading,” he says.

Bond says he would encourage senior management responsible for any outsourcing decision to first engage with their trading desk.

“If you don’t understand trading, you may make the wrong decision about whether it should be outsourced or not. If you do not know what a periodic auction is, or a systematic internalizer, why would you make the right decision about whether in-sourced or outsourced trading is better?” Bond says. 

If a fund does decide to proceed with outsourcing, it must look carefully at a providers’ models for handling client data before inking an agreement. “Some of the questions you have to ask of your outsource providers are, how do they find the other sides of your trades? How do they share your trading information with their other counterparties? In what order do you do it? What do they do to protect you from conflicts of interest?” Bond says.