Embracing the New Norm: Fixed Income Outsourced Trading

Featuring: Ryan Forberg, CFA, Senior Fixed Income Trader, Integrated Trading Solutions, AMRS and 
Dan Hines, Senior Fixed Income Trader, Integrated Trading Solutions, EMEA

Outsourced trading has gained momentum over the past few years. After starting as a niche service mainly for start-ups and hedge funds, outsourcing is now being adopted by asset managers of all varieties and sizes. As asset managers increasingly look for greater efficiency and reach, they are finding outsourcing is a way to help achieve their goals while enhancing the investment process.

Despite the growing popularity of outsourced equity trading, outsourcing fixed income has sometimes been perceived as less viable due to concerns about transparency and losing connectivity to the market. Like other outsourcing trends, however, this stigma has lost traction over time. Many asset managers that have outsourced all or a portion of their fixed income trading have experienced the realities of efficiency, flexibility and transparency in their search for greater alpha.

Misconception: By outsourcing our fixed income trading we may lose relationships, connectivity and information flow from the Street.

Reality: Combining the relationships and scale of the outsourced trading desk with those of the asset manager could in fact increase and enhance the total number of relationships and level of connectivity to the market.

Some asset managers may fear that the years spent building relationships, know-how and expertise when trading in fixed income markets could be lost, which in turn might impact client outcomes. Many outsourcing providers are sensitive to this and work hard to show clients that far from displacing this connectivity, they augment and often enhance their relationship to the Street. This is achieved by leveraging global teams of highly experienced traders, many with buy-side experience and a broad array of well-established relationships. Added comfort also comes from transaction cost analysis (“TCA”) that can measure trading performance. TCA reporting and regular governance meetings with the outsourced trader can provide transparency and an effective feedback loop on fixed income markets.

Misconception: We already have a designated fixed income trader; therefore, we don’t need to outsource that function.

Reality: An outsourced fixed income trading desk can serve as a backup to your current desk, eliminate key person risk, and enhance business resiliency, while also expanding your liquidity network.

The outsourced fixed income trading desk can be viewed as an extension of current capabilities and can provide additional capacity on heavier trading days. Additionally, the trade lifecycle of fixed income securities is often longer than equities. This is primarily due to the over-the-counter nature of fixed income trading which can lead to inventory and liquidity challenges, resulting in extended trade durations. As a result, fixed income trades can involve more steps before a trade even hits the desk, making an outsourced provider a valuable resource.

For example, a manager may be interested in a particular bond, but struggle to acquire it at a favorable price. In such cases, an outsourced provider with deep pools of liquidity can be beneficial. An outsourced provider can offer valuable insights by identifying alternative options or by taking on the price discovery role in illiquid markets. Outsourcing the fixed income desk can reduce managers’ time spent on the details, such as price discovery, to allow them to focus on the bigger picture.

Misconception: Outsourced trading is an all-or-nothing proposition.

Reality: Outsourced trading can be customized and offered as full or partial, depending on the specific needs of each manager.

Trading fixed income can be very nuanced and every manager may have a different goal in mind that outsourcing can help to address. Since trading is not a one-size-fits-all decision, managers can choose the level of outsourcing that fits their needs. A hybrid model helps to ensure that the operational infrastructure necessary to support the firm’s strategy is in place, adjusting trade execution to the ebb and flow of a given period. In addition to backup / business resiliency, some may choose to outsource for compliance reasons, including separation of trading from the investment decision-making function.

Additionally, for investment teams where the portfolio manager is also facilitating trading, outsourcing can bring a level of expertise to the trading function. When launching a new product in a different part of the market, outsourcing can provide them with a trade desk that offers additional bandwidth (for example, hiring or systems) and expertise. Outsourced providers have access to the major fixed income asset classes and can bring immediate connectivity to managers seeking expertise in non-primary asset classes.

Misconception: It is challenging to onboard an outsourced provider for fixed income.

Reality: The process can be as simple as putting the outsourced provider through a standard counterparty due-diligence review.

Relative to equities, fixed income does not have the same complexities associated with broker bundling or research budgets, thus simplifying the decision-making process. Furthermore, onboarding an outsourced provider can streamline operations by reducing the need for multiple trading counterparties. This approach provides access to a vast network of counterparties, offering many new opportunities for trading and market access while only needing to onboard the single outsourced provider. Since KYC requirements for onboarding and ongoing maintenance of relationships at sell side firms have become more stringent, barriers to entry have increased. Working with an outsourced provider eliminates this additional hurdle since they already have an established relationship with sell side firms given their reach and expertise.

Misconception: We have concerns over transparency, such as how our order flow would be treated, potential conflicts of interest and risk of internal competition in an outsourcing arrangement.

Reality: Transparency should increase in outsourced trading. By trading on an agency basis, and with detailed market insights from many different market participants, the asset manager will have better insight to seek out the best executable trade.

An outsourced provider that acts as an agent but does not maintain a principal desk or carry inventory helps to promote a conflict-free model. An outsourced provider's primary obligation is to impartially source the best trade possible within its extensive liquidity network. Furthermore, a provider’s values should consistently align with those of the managers they represent. For instance, if an outsourced provider secures better pricing than initially discussed, the improved level should be passed directly to the manager, rather than retained to maximize profits from the trade. This commitment to transparency prioritizes the best interests of the manager.

Misconception: We may be treated less favorably in primary markets.

Reality: Outsourced providers have worked to develop well-established relationships with investment banks in primary markets.

Outsourced providers emphasize the importance of building and maintaining relationships with a wide range of sell side firms by frequently trading in both the primary and secondary markets. With a multitude of clients leveraging the outsourced trading platform, outsourced providers represent many different pools of capital and can be a valued contributor to the new issue process.

The Reality of Outsourced Trading

Old myths about outsourcing the fixed income desk are being challenged as more managers choose to outsource. The focus has now shifted to the range of potential benefits offered when outsourcing fixed income – including supporting risk management, adding expertise, streamlining operations, enhancing governance and improving operational and business resiliency. Outsourcing fixed income trading is an increasingly proactive and future-focused decision. As a result, many asset managers view it as a way to create an optimal future state where all parties are focused on what they do best.