LSEG Insights

Outsourced trading models and the importance of optionality

Brian Jepsen 

Managing Director, LSEG TORA

In my earlier insight, we looked at how the emergence of co-sourcing with execution consulting is becoming a key trend within the outsourced trading landscape. Another important trend for buy-side firms to consider is that of optionality, i.e. the ability to adopt whichever outsourcing model – ‘pass-through’, ‘agency’, or a combination of the two - is most appropriate to their business. Both models offer distinct advantages and potential drawbacks, depending upon different operational and strategic requirements of the firm.

  • As outsourced trading evolves into trading workflows, buy-side firms find themselves considering two options. The ‘pass-through’ model and the ‘agency’ model, or a combination of the two. 
  • Such optionality is important for firms with multifaceted operations across asset classes and regions offering flexibility, adaptability and scalability as trading needs change.

Comparing the models

The 'pass-through' model operates under the premise of seamless integration with the firm’s existing trading infrastructure. In this setup, the outsourcing provider acts as an extension of the client's own trading desk, executing trades in the client’s name. This model is designed to maintain the integrity of the firm’s established workflows, compliance frameworks, and broker relationships. It offers the advantage of consistency and continuity, replicating the firm’s internal processes while potentially expanding operational capacity. This is particularly beneficial for clients operating in regions with regulatory environments that necessitate unique identification protocols, for example. However, its applicability may be limited by the outsourced provider’s ability to accommodate such regulatory and compliance intricacies.

On the other hand, the 'agency' model simplifies the trading process by positioning the outsourced provider as an intermediary. Here, the provider engages in transactions under its own name but on behalf of the client, effectively acting as a traditional broker but with an expanded role. The main benefit of this model lies in its simplicity and the breadth of access it provides to various brokers, markets, and liquidity pools through a single counterparty. Additionally, it offers the strategic advantage of preserving client anonymity (if needed), which can be crucial for minimising market impact. This model is particularly suited for funds that either engage in trading infrequently or are constrained by their size from effectively managing multiple brokerage relationships. The potential downside is a dependence on the outsourced provider’s ability to manage those relationships, as well as questions regarding potential conflicts of interest (if the provider is also a broker in its own right).

Both models underscore the importance of a synergistic relationship between the outsourced provider and the client firm. Choosing the appropriate model hinges on the specific trading activities, strategic preferences, and operational constraints of the buy-side firm. For example, a firm trading in markets requiring detailed regulatory adherence might prefer the 'pass-through' model for its ability to maintain established processes. Conversely, a firm seeking broad market access without the complexity of managing numerous broker relationships might find the 'agency' model more fitting.

Why optionality is important

For buy-side firms with multifaceted operations across various asset classes and geographic regions, or for those anticipating changes in their trading requirements over time, the ability of the provider to offer a choice of models presents a strategic advantage for several reasons:

Flexibility Across Asset Classes: Different asset classes often demand distinct trading approaches due to their unique market structures, liquidity profiles, and regulatory environments. A provider capable of offering both models allows a buy-side firm to tailor its trading strategy to the specific nuances of each asset class, optimising execution and potentially enhancing returns.

Adaptability to Regional Variations: The regulatory and operational landscapes can vary significantly across regions. For instance, emerging markets may have specific identification requirements or regulatory hurdles that necessitate a 'pass-through' approach to comply with KYC rules. Conversely, in more developed markets where anonymity and broad market access are paramount, the 'agency' model may be more beneficial. A provider that offers both options can seamlessly adapt to these regional differences.

Scalability and Evolution of Trading Needs: As a buy-side firm grows or as its trading strategies evolve, its trading needs will likely change. Early-stage firms or those experimenting with new strategies may initially prefer the simplicity and market access provided by the 'agency' model. As they mature, develop more sophisticated strategies, or seek to exert greater control over their trading processes, they might shift towards the 'pass-through' model. An outsourced trading partner that offers both can support this evolution without the need for the buy-side firm to switch providers or overhaul its trading infrastructure.

Operational Resilience: Having the option to switch between trading models or to utilise them concurrently for different parts of the business enhances operational resilience by allowing firms to dynamically adjust their trading approach in response to market conditions, operational contingencies, or changes in internal priorities. This resilience is crucial in maintaining continuity and performance under varying circumstances.

Strategic Alignment and Risk Management: Working with a provider that offers both models ensures that the outsourced trading solution can be closely aligned with the buy-side firm's overall investment strategy, risk tolerance, and compliance requirements. It facilitates a more integrated approach to risk management, where trading execution is fully aligned with the firm’s strategic objectives and risk framework.

Cost Efficiency: Optionality may also lead to cost efficiencies. By having the flexibility to choose the most appropriate model based on the specific situation—whether that's driven by transaction costs, the need for anonymity, or regulatory considerations—firms can manage their trading costs more effectively.

In conclusion, for buy-side firms, the choice of an outsourced trading provider is not merely a tactical decision but a strategic one that can impact their operational effectiveness, regulatory compliance, and market performance. A co-sourcing provider such as LSEG TORA that can offer both the 'pass-through' and 'agency' models not only caters to the firm's current needs but also positions it to adapt to future challenges and opportunities.

For more on the emergence of co-sourcing with execution read our previous insight.

Disclaimer: This article is for informational purposes only, is not intended to be and should not be taken as legal or other type of advice. The opinions expressed are those of the author(s) and do not necessarily reflect the views of London Stock Exchange Group plc (“LSEG”), its clients, or any of LSEG and its’ respective affiliates.  Tora Trading Services, LLC is registered with the SEC and a member of FINRA, SIPC, NFA. TORA Trading Services Limited is regulated by the HK SFC. Not all TORA services and related services are offered via the regulated entities. In addition, TORA services are not available in all jurisdictions.

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