Following the inflation shock of the past two years and the resulting gyrations in fixed income and equity markets, not to mention the wild swings we’ve seen in energy markets, investment funds have come to appreciate the value of being able to trade in asset classes other than their core areas.
By Massimo Labella, Head of Buy-Side Trading, Marex
This has been particularly the case for equity-focused funds more recently. When interest rates surged across the yield curve, upending many funds’ trading strategies, there was a sudden need for expertise and infrastructure for trading fixed income, money markets and energy markets with the experience required to navigate these new markets from both a trading and counterparty access standpoint.
The right outsourced trading provider can help here. These firms expand existing trading capabilities by adding resources directly to preexisting in-house teams. Yet even though outsourcing has been one of the fastest-growing trends in finance in the past five years, many fund managers are just now coming to appreciate the advantages of such solutions.
More to the point, the incentives for funds to be able to trade in multiple asset classes are as strong as ever, whether it’s for hedging, seizing one-off opportunities or developing a broader approach to their investment strategies.
The recent changes to the global macro environment have directly increased demand for non-equity trading capabilities. The Bank for International Settlements have underlined this point, with the head of the central bank umbrella group recently saying the global economy was on track for a soft landing, but warning of the possibility of more “bumps in the road”.
However, there is no crystal ball. Why build for a market that may never materialise when you can just add if and when needed via the right OT partner?
In practice, the prospect of more ‘bumps in the road’ means that funds have good reason to ensure they are as nimble as possible and to trade in whatever asset class is at their disposal. The question is, how can funds branch out into new and perhaps unfamiliar areas in an efficient and effective way? Hybrid trading solutions offer an answer.
The appeal of hybrid trading
Hybrid trading arrangements are sometimes referred to as supplemental outsourced trading or co-sourcing. Whatever term one uses, the idea is that an outsourced trading provider acts as a partner by adding trading capabilities to a fund’s in-house team.
In some cases, a fund may take this approach to simply add extra resource in an asset class in which it already trades, such as when funds have operational requirements or are simply looking to grow by expanding their activity. But I am focused here on a different kind of hybrid trading solution — when a fund wants to add new capabilities so that it can leverage global multi-asset class strategies.
To see why hybrid trading solutions make sense, it helps to consider a few examples.
Say a long-short equity fund suddenly sees a need to restructure its exposure dramatically because the market environment has changed. On the assumption the fund can access all asset classes operationally, bringing in an outsourced trading provider makes sense to help provide expertise and access to liquidity in both the credit and derivatives space (for example). For the firm to hire its own trader and open credit lines or derivative agreements, it may take time. Time that the fund may not have in the current macro environment. Plus, there are extra costs in terms of space and equipment.
Less dramatically, some funds want to just tiptoe into a new market. For instance, a fund may decide it wants to begin trading Treasuries, but its initial anticipated volume would only take up 50% of a trader’s time. Not only would the firm need to hire a full headcount to handle the trading, but also it would need to arrange for back-up for when the trader was on holiday or unavailable. By using an outsourced trading provider, those issues become moot.
The time issue also comes into play in this second example. A big difference between fixed income and equity markets, for instance, is that equity investors trade on exchanges, whereas fixed income trades will be via banks as counterparts. If those trading relationships do not already exist, it can take months to set them up – if at all. By using a trading service provider, which has an extensive global network of counterparts, a fund can start trading right away and know that it is accessing a wide array of liquidity sources.
These examples highlight that the fund does not need to take any expensive risks in terms of hiring new staff and investing in additional infrastructure, all of which adds to fixed costs. The fund does not need to worry about finding additional liquidity sources and establishing new relationships, such as the kind needed to trade in some over-the-counter markets. At the same time, a hybrid model leaves a fund the option of hiring its own in-house staff later on, or building a team gradually, if it decides to trade in the new market permanently.
Making the leap
Depending on the provider, on-boarding with an outsourced trading service can be a simple procedure. Look for a provider with a dedicated on-boarding team whose job is to work with clients throughout the process, from understanding what approach will work best for them through to final testing.
The process itself may only take weeks. Choose a provider equipped to work with most order management and execution management systems so there are fewer issues in terms of establishing connectivity.
Traders from an outsourcing service will be assigned to work with specific funds and ensure they get the service they need. They also can provide market colour that can inform a fund manager’s strategy and decision-making. Although the extra resources are not physically with the fund, the aim is for them to be part of the fund’s own trading team.
Funds will rightly want to make sure they can find a good fit. Does the provider have a strong track record? Is the firm flexible in what it offers, including the possibility of bespoke solutions? Does it offer added value beyond execution, such as market colour? Can the provider work with most trade execution systems and on-board a firm quickly?
Not every provider can say yes to these questions. Most of all, consider the provider’s own structure and business model. It’s vital to choose a firm that is well-aligned with your fund’s goals and objectives.
Learning more
For all the buzz that has been generated about the advantages of outsourcing and co-sourcing, we think there are many funds that are only just beginning to consider what it might mean for them. To that end, I’ve tried to give a high-level overview of the what, the why and the how of hybrid trading.
If you want to learn more, Marex will be hosting a workshop moderated by Global Trading at TradeTech Europe this April. We will be joined by a fund that employs hybrid trading, so the event offers a great chance to delve deeply into some of these issues. We’d love to see you there. If you are interested to hear more but unable to join, please reach out to me for a chat at the event.
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