Our thinking Quick reads Why are you still trading in-house?
 
Regulatory Refreshment
February 2020
5 min read

Why are you still trading in-house?

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We think now is a good time to evaluate whether an internal dealing desk is a good use of resources or if focus would be better placed on core business activities.

Why should you reevaluate? 

Regulatory, market and financial pressures continue to erode traditional asset management industry margins. These pressures have promoted many to consider how their businesses are structured and which functions remain core and which can be outsourced.

Our recently launched Outsourced Trading paper discusses long term trends around the themes of regulation, market dynamics and financial pressures.

Why now? 

In our view, the FCA’s 2020 supervisory strategy for investment managers is a key driver for firms to consider outsourced trading. This edition of Regulatory Refreshment picks up on last month’s (January 2020) release by the FCA of a series of “Dear CEO” letters to investment managers in two portfolios: alternatives1 and asset management2.

The letters explained the FCA’s supervisory priorities for 2020 and the themes included (not exhaustive):

  1. Product governance, investment and liquidity risk management: How are you ensuring that your product is doing what it says on the tin and that investors can get their money back inline with their expectations? Are you complying with the new product governance sourcebook?
  2. Market conduct: You have a role to detect and prevent market abuse and ensure that there are appropriate controls when the trading strategy may present risks for other market participants and the wider market as a whole (i.e. manage market integrity risk). Are you doing all that you should be?
  3. Governance: Effective governance is critical to the success of your firm in delivering long-term returns for investors – have you got it right?
  4. Operational resilience: Asset managers are heavily reliant on robust and reliable technology, which underpins the smooth operation of their businesses and the protection of client assets. Have you got appropriate controls to mitigate risk to investors?

There is an argument that outsourcing trading will help firms address the themes above and this is explained in more detail below.

Theme 1: Product governance, investment and liquidity risk management

The core role of investment managers is to be stewards of capital and not used-car salesmen. Significant time and resources go in to managing product, investment and liquidity risks and this fits well within the core competencies of most investment managers.

There has been an increased emphasis on the management of trading costs and the risk of poor trading strategies on the portfolio. Whilst this responsibility lies ultimately with the fund or delegated investment manager, we question, given these increasing obligations, if there is sufficient time and resources within the business for those charged with governance to manage this part of the business effectively? Outsourcing trading activity to a partner that is looking after your best interests may assist in this regard.

Theme 2: Market conduct

Outsourcing trading creates an additional “buffer” between the investment manger and the market which may assist in reducing the risk that an investment manager is said to be engaging in market manipulation behaviors that are inconsistent with the Market Abuse Regulations. In addition, sending orders directly to an external party reduces the risk of information leakage internally which may assist with demonstrating robust controls around the use and dissemination of inside information.

Theme 3: Governance

Core trading competencies at most mid to small tier investment managers reside in one person or a small team overseen by a single person. In our experience the team is generally left to their own devices and outside of the team there is limited scope to effectively interrogate their trading activity other than perfunctory compliance checks against certain benchmarks. It is often the case that the team is performing well but in the absence of robust checks and balances how can this be demonstrated? Outsourcing to a specialist provider , with greater knowledge, experience and resource, may improve the ability to supervise whilst more effectively demonstrating, those responsible, are taking “reasonable steps” to reduce their SMCR liabilities as Senior Managers.

Theme 4: Operational resilience

Trading is operationally complex. However, unless you are also outsourcing other functions (e.g. back and middle office) there is limited marginal impact (reduction) on regulatory risk – indeed, it may be more difficult to outsource a small slice of the pie. If you are undertaking an outsourcing exercise, we think it is important to not only consider how you will monitor the outsourced provider’s trading performance, but the related technology and controls used to achieve best execution for the benefit of investors.

Key message

Our key message is that firms should consider the value added provided by the in-house trading function against the costs (internal and client/investor) and the regulatory risks. If the value added doesn’t stack-up against the costs/risks then it is time to seriously consider alternative solutions – please chat to us about what these could be.

[1] FCA authorised firms that predominately manage alternative investment vehicles (for example, hedge funds or private equity funds) or alternatives assets directly, or advise on these types of investments or investment vehicles
[2] FCA authorised firms that predominantly directly manage mainstream investment vehicles, or advise on mainstream investments
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