Key Takeaways
- Outsourced trading is a practice that financial institutions employ to outsource trading operations to a third party that specializes in it.
- Hedge funds, pension funds, asset managers, and mutual funds commonly employ outsourced trading companies services/
- Outsourced trading lowers costs, improves overall operational effectiveness, and lets professionals deal with the assignments they are best in.
People are often unaware that many financial institutions including, hedge funds, asset managers, pension funds, and family offices outsource their trading activities to the third side. This practice gained momentum because of the numerous benefits that come with it. However, to understand what is outsourced trading and what are their principles, we need to dig a bit deeper.
Outsourced trading or third-party trading is a practice of hiring external firms or individuals to conduct trades for a financial company. External providers of trading services are called trading agencies and have extensive knowledge and experience which recommends them for these operations.
Why would financial companies outsource trading to a third party? There are several principles behind it, but the common ones are to reduce operating costs, increase efficiency, and potential to scale operations. Also, passing off these operations to a professional also ensures regulatory compliance, reduces operational risk, and allows the core company to redirect its operations.
Who Uses Outsourced Trading
Outsourced trading today is a whole market where financial companies of different structures employ trading agencies. Common users of outsourced trading are:
Hedge funds
Hedge funds often have smaller teams and one of their ways to keep operations efficient is to use third-party agencies. Trading operations are on the top list of agencies that hedge funds turn to. By using them they gain access to traders and technologies without maintaining a trading desk in-house.
Pension funds
Pension funds often construct large portfolios with different asset classes. Maintaining a team of traders to maintain it is costly and reduces overall effectiveness. This way the fund can focus on its core specialties and at the same time reduce costs.
Asset managers
The core competencies of asset managers are asset allocation and management. Trading is often a large task for these often smaller companies. Passing these activities to outsourced trading providers leaves them with enough space to focus on the operations that are in their focus.
Family offices
Family offices use outsourced trading solutions for similar reasons to pension funds. These offices are often small organizations dealing with a limited number of clients. Monitoring different markets and conducting trades often proves to be a challenge, and they offset it to trading agencies.
Another benefit of using these third-party agencies is a high level of confidentiality. Family offices manage wealth for generations of notable families which demands a certain degree of privacy.
Registered investment advisors
These professionals sometimes outsource trading activities so they can streamline their operations and get access to improved trading approaches.
Broker-dealers
One of the main missions of broker-dealers is trading, but sometimes they employ trading agencies to supplement their capabilities.
Insurance companies
Since trading is not among the key operations of insurance companies they often seek expertise in third-party professional companies.
Why Use Outsourced Trading
Several reasons are behind opting for outsourced trading services, but essentially companies aim to lower costs, combat risk, and focus on their core functions. These are in-depth reasons explaining why relying on outsourced trading providers.
Cost efficiency
If a company wants to have an efficient in-house trading desk, it needs to hire traders, invest in technology, and be careful about regulation compliance. Organizing this operation can be costly and that is why companies often rely on outsourcing their trading desks. Outside traders bring in top-line technology, and trained professionals at a lower price.
Hiring top experts from the industry
When hiring an outsourced trading provider companies choose to go with professionals in their business. Managers and traders who work in trading agencies are professionals who are focused on these operations.
Scalability of operations
Every outsourced trading firm offers their client to adjust the scale of operations based on their needs. In case the company has a busy trading period, additional outsourced traders can be hired to carry the additional weight of the operation. Also, if the need for traders drops, the company can reduce the number of traders. In case the company had a trading team, they would need to adjust the workforce to their current needs.
Breathing room for core functions
Companies like hedge funds, asset management firms, and pension funds often do not primarily deal with trading. By outsourcing trading operations they can move their resources to other core operations like investment research and portfolio management.
Access to advanced trading technologies
Implementing current trading technologies is not cheap, but it delivers the best results. When choosing to outsource it to a specialized firm, you will most likely get all the advanced tech from the industry that helps in achieving the best trading practices. Those include advanced trading infrastructure, order management systems, and access to multiple trading venues.
Regulatory compliance
In a world where regulations are regularly updated, staying on top of everything can be a tricky task. Outsourced traders are focused on updating their practices to the newest regulatory practices, minimizing potential regulatory issues.
Reducing trading risk
Different trading risks demand the use of robust risk management processes and control. By offloading trading operations to a third party, the company is reducing not only trading but the overall operational risk of the whole process.
Using outsourced trading solutions allows companies to focus on their core functions, reduce costs, and mitigate risk.
What Services Are Outsourced
Depending on the company’s needs a trade outsourcing firm can take on three groups of services:
Executing trade
Opting for outsourcing trade is the most common demand that companies like hedge funds and pension funds choose. This is also a core function of every outsourced trading provider.
Research and analysis of the market and companies
Outsourcing research and analysis is also a common function that is outsourced to trading companies. Outside traders offer to conduct both fundamental and technical analysis with the aim of identifying the overall condition of the company, its potential growth, and its positioning in the market.
Middle-office activities
Executing trades comes with a handful of administrative tasks. It includes order management, trade confirmation, settlement with counterparties, and record keeping.
Depending on the company’s needs they can choose what services they will outsource. This depends on the resources that the firm has and its strategy.
How Outsourced Trading Works
The outsourcing process starts with the fund or the financial institution choosing the outsourced service provider. Choosing the provider of these services is essential for future success.
The outsourced trader market is highly developed, and companies can make their choice after browsing through a number of factors. Every outsourced trading firm has its reputation, level of expertise, technology that it provides, what services it can handle, and cost.
The next step in the process is to integrate the systems and processes of the outsourced trader with the companies. Depending on the system it can include connecting the company’s order management system or execution management systems.
When the company generates a trade order for either selling or buying, it sends it to the trading provider. With the use of their infrastructure and system, the trade provider executes the trades.
Outsourced traders choose the most efficient way to trade the security. To achieve this they employ sophisticated trade execution algorithms. With it, they can achieve maximum trade results, with low market impact. Order slicing, smart order routing, and algorithmic trading strategies are just some of the techniques that algorithms use.
While the trade is executed, both the company and the outsourced trader are monitoring the operation done in compliance with all regulatory requirements. If the companies agree on this, the trader can provide trade reports for record-keeping purposes and eventual reviews by the company.
Companies usually have benchmarks that are used to analyze trade results. After the trade, they compare the results with the benchmarks and look for potential room for improvement.
After the trade is completed is it necessary to transfer ownership of the securities between counterparties. For these purposes are hired custodians, clearing houses, or other intermediaries.
When the two companies signed the deal they agreed on trade execution quality, the responsiveness of the provider, and following through on service-level agreements. The hiring company periodically reviews the overall performance of the hired company to ensure that outsourced trading arrangements are followed.
Final Thoughts
Financial companies and institutions often outsource their trading capabilities to get the best execution. Outsourced trading solutions offer integration of the whole trading and research process which can generate an operational cost shift. This can allow strategic extension into other crucial operations of the company.
Compliance challenges, and cost pressures, are passed on to the professional which offer the best execution of trades. However choosing an outsourced trading solution, and which elements will they take on has the largest impact on the success of this process.
Choosing an outsourced trading provider needs to be based on its reputation, offered services, price, and execution success. Like with any business opting for the lowest cost can result in new problems instead of increased current trading capabilities. Companies are advised to outsource their operations to a third-party company if it will result in overall operational improvement.