One of the objective requirements of the modern asset manager is to identify and mitigate conflicts of interest in the work they do. Of course, ‘the work they do’ is to invest wisely and deliver a return to their underlying clients. The requirement to avoid or mitigate conflicts of interest is codified in various rules and regulations in force in different jurisdictions and the need to avoid conflicts of interest often applies to activities at every level of operation. That means there can be a ‘look-through’ duty of care with respect to conflicts too.  Investment firms need to mitigate conflicts of interest on behalf of their own underlying investors, who are not able to manage and mitigate such risks themselves.

Why is that? In simple terms, it’s to avoid any suggestion that a firm, or individuals in a firm, have a financial or other incentive to favour the interest of another client or group of clients over the interests of a client. 

An area in which there has been particular focus in recent years is securities trading. Avoiding conflicts of interest at every step in the lifecycle of a trade is important and the choice of execution route to market needs careful thought and consideration.  

Background

In recent years, regulators have addressed this by focusing on two widely used execution models for listed securities.  

One model became known as ‘proprietary trading’ or ‘trading on risk’. A ‘prop trader’ would take an order from a client and fulfil the clients order using the prop trader’s own capital. You might ask why – one significant reason for doing this is the express intention of profiting inside their own portfolios from price appreciation.  

For a period after the 2008 financial crisis, prop trading in some circumstances was banned. Concerns about the inherent conflicts of interest in the model lead to the implementation in the US of what’s known as the Volcker Rule (named after former US Treasury Secretary Paul Volcker). That US legislation generally prohibits US regulated banking entities from engaging in short-term proprietary trading and limits their investing in or sponsoring hedge funds or private equity funds. 

Over recent years, and especially following some changes to the Volcker Rule in 2019, the ‘prop trading model’ has come back into the market, albeit there are still restrictions on such activity inside the US. Therefore, sending trades to prop desks has reintroduced the risk of conflicts of interest, alongside other risks inherent in that form of trading. 

Agency Trading

The other model, agency trading, is substantially different to proprietary trading. Agency traders act only on explicit instruction from a client and only generate revenue (commissions) when a client’s order is traded in a market. For asset managers and asset owners, using agency traders brings the following key benefits: 

1. Objectivity:  There are no financial incentives generating conflicts of interest between their activities and the objectives of the client because agency traders are rewarded by executing trades only. There is generally no other way for an agency trader to earn a return. This helps ensure that trades are executed in the best interest of the client. 
   
2. Access to liquidity: Agency traders often have access to a wide range of market participants, which can help them find the best prices for their clients' trades. 
   
3. Cost and transparency: In a world measured by best execution and trade cost analysis, agency traders provide a fully transparent execution process. There are usually no hidden or non-explicit costs embedded in the agency model. It’s clean, clear, simple and efficient.
   
4. Protection of confidential information: Agency traders do not have access to their clients' trading strategies or confidential information, which can help protect clients from the risk of information leakage and consequent unhelpful price action in the market. 
   

Mitigating the risk of conflicts of interest is clearly important, for managers and for their own clients. Making good choices when selecting execution counterparts can be a key part of this mitigation. There may well be good, sensible reasons for choosing to trade with non-agency brokers but it is important to bear in mind ALL considerations when doing so. In the past, regulators were concerned enough about such conflicts of interests as to impose restrictions on such activity.

Managers will need to remain vigilant and consider all the variables in this respect for themselves and for clients who trust them with their assets.

ABOUT NORTHERN TRUST CAPITAL MARKETS

Northern Trust serves the evolving needs of asset managers and asset owners around the globe. As silos of the past give way to synergies of the future, Northern Trust’s flexible, customized solutions work together to drive performance by driving down costs – connecting the pieces across the investment lifecycle.

Our outsourced trading capability – Integrated Trading Solutions – combines worldwide trading expertise in equities and fixed income, exchange-traded derivatives, futures, and exchange-traded funds (ETFs) across global markets. It provides coverage from multiple trading locations, access to high-quality liquidity and an integrated middle- and back-office service. The Integrated Trading Solutions platform helps asset owners and asset managers to lower costs, reduce risk, manage regulatory compliance, and enhance transparency and operational efficiency.