More than 20 years after its introduction, ‘outsourced trading’ has become an umbrella term, with no single operating model. As the service options mature and governance considerations increase, however, buy-side firms searching for an outsourced trading partner are often left with many unanswered questions. TABB Group senior analyst Michael Mollemans sheds light on this rapidly growing segment of the brokerage industry.
Outsourced trading started from humble beginnings more than 20 years ago as an option for start-up hedge funds that could not afford their own in-house trading teams. Today, it has become an umbrella term, with no single operating model. Traditional sell-side brokers, prime brokers, clearing and custody banks, boutiques, and technology firms are entering the outsourced trading service space with their own unique brands of offerings. As the service options grow and governance considerations increase, however, buy-side firms searching for an outsourced trading partner are often left with many unanswered questions.
Historically, growth in outsourced trading services was tied to the rate of new start-up hedge funds, the typical users of the service. During the past few years, however, demand for outsourced trading services has started coming from all sides, including larger investment managers trying to cut costs and raise efficiency across the trade lifecycle. Alongside this growing demand, providers of outsourced trading services have expanded, from boutique specialists to large, full-service firms. This expansion of the outsourced trading industry to larger-scale firms is expected to help drive up growth rates further.
[For more on outsourced trading, check out part 1 of this article, "Inside Outsourced Trading: The Buy-Side Perspective."]
Forty-seven percent of outsourced traders interviewed for TABB Group’s latest research report expect 25%-50% annual percentage growth in outsourced trading industry revenues over the next few years; 38% of firms expect annual growth numbers to exceed 50%, while 15% of firms expect growth to come in below 25% over the next few years (see Exhibit 1, below). Factored into the growth rate estimates is an unprecedented number of firms launching their own brands of outsourced trading services, with major sales initiatives and infrastructure build-outs to support these businesses (see Exhibit 2, below).
Exhibit 1: Outsourced Trader Annual Industry Growth Estimates, Over the Next Few Years
Source: TABB Group
Exhibit 2: New Entrants into Outsourced Trading, By Accumulated Number of Firms
Source: TABB Group
Beyond the basic features of outsourced trading services, many firms try to differentiate themselves by emphasizing services such as technology and analytics, access to a wide broker network, regulatory reporting, flat monthly fee pricing options, prime brokerage services, and more. While the firms that have been providing outsourced trading services for many years argue that they benefit from experience, newer entrants in the space say they gain from leapfrog effects in trading and process technology (see Exhibit 3, below).
Exhibit 3: Main Differentiated Services Offered by Outsourced Desks
Source: TABB Group
TABB Group believes that governance will be an increasingly important aspect of the outsourced trading relationship as the industry continues to grow. Risks around selecting and managing outsourced trading desk relationships only will rise as clients, and their trading businesses, get larger. The need for clearly outlined operating policies and reporting procedures in outsourced trading agreements is increasingly critical.
The buy side is dealing with significant margin pressure and many firms are looking to outsource all, or part, of their trading functions to cut costs. Many firms in the brokerage industry are adapting to their clients’ changing service requirements by entering the outsourced trading service space. As the service options expand, client expectations are growing accordingly. Performance in the outsourced trading service model today goes well beyond execution against any benchmark – it goes all the way up the alpha chain to the portfolio managers’ core strategies.
To learn more about the expanding universe of outsourced trading services, please contact TABB Group for details on our latest report, “Outsourced Trading, Part 2: Outsourced Traders’ Perspective,” by Michael Mollemans.