Fixed Income Liquidity: Is outsourced trading the answer?

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Article 3 of 3:  This is the final article in Cowen’s three part series discussing the fixed income trading landscape for the year ahead. Innovative technology and workflow management tools, covered in part one, will continue to be increasingly important. Part two explored the importance of skilled traders, whose acumen and insight remain essential to accessing global liquidity pools.

For this third article, I held a conversation with David Berney and Michael Broadbent of ERGO Consultancy, I explore how outsourced trading can help you to navigate the complex fixed income ecosystem, while maximizing overall operating efficiency. ERGO Consultancy is a specialist firm which works with hedge funds and asset managers to increase the effectiveness of trading and execution desks.

The rise of outsourced trading

Outsourcing is not a new trend, but gained increased prominence during the pandemic when both buy and sell side firms moved to remote work environments. This put to rest the concerns that people had to be in the same room to trade in an effective manner.

It has become even more important today as fixed income trading has become more complex, especially over the past year due to shifting monetary policy and heightened geopolitical risks.

Rising inflation and interest rates were already hanging over markets, but the Russian invasion of Ukraine added a layer of volatility that reinforced the need for experienced traders. Markets will be more unpredictable as the impact of sanctions on Russia is likely to translate into increased energy costs and loftier inflation for much longer than anticipated.

The US Federal Reserve, ECB and the Bank of England have already started to normalize monetary policy. The result is that many pockets of fixed income markets will be under pressure and finding the best prices will be much more difficult.

Best execution, it’s all about scale

In the current environment, experienced traders are at a premium, but very few have seen the volatility that is currently disrupting fixed income markets before. With events moving at record speed, they need both the acumen to deploy technology, but also the long-standing relationships to find liquidity.

“Yes, the technology is there to help make your job more efficient, but you need seasoned traders with the skillset and experience to navigate today’s fixed income environment. Who can not only observe a price on a screen, but is able to transact at that price as well – relationships are key,” says David

The behemoth asset managers may have this combination, but the majority don’t, which is why outsourcing trading is increasingly on the agenda. It offers a seamless and efficient trading experience that frees up space to focus on the core competencies of investment.

“When it comes to accessing either primary or secondary markets or flow information in fixed income, it’s all about your size and presence in the market. If you’re not one of the huge players and you want to feature prominently on a broker dealer list, outsourcing gets you a bigger seat at the table and the best possible execution,” says Michael.

Outsourced trading desks expand reach and influence because there is a much wider network of experienced traders working on behalf of many firms nationally, regionally or globally. Firms can leverage well-established connections to access deeper pools of liquidity across the different market segments – effectively engaging with liquidity which they would otherwise not have access too.

At Cowen, we have the ability to aggregate our clients’ volumes and present them to the street or to platforms as a single larger order. After all, it is one thing to see a price on the screen and a completely different matter to transact at that price in size.

“The one thing you can do, as a fund, is you can pretend to be bigger. How can you pretend to be bigger? The person giving your order is bigger. That’s the way to do it,” adds Michael.

The fixed income conundrum

Unlike with equities, it is not that easy to send a fixed income order through the pipes. Electronic trading may be making inroads, but it is at the more liquid end and much of the bond market still operates on a bilateral basis. Negotiations are conducted via phone or chat between people and having those trusted, strong connections are crucial.

This is particularly the case for the more complicated or difficult trades, where there are no shortcuts. It takes time, effort and skill to work the order without moving the price. It is also especially true in volatile markets.

“The risks of not being able to act in a timely manner have never been higher. You almost certainly will not get best execution unless you have sufficient routes to market. This increases a) your access to liquidity and b) access to a potentially better price. Both are prime parts of best execution, along with a skilled trading desk that can pick up the phone and negotiate directly. Many funds do not have these capabilities,” comments David.

Accessing every piece of liquidity

The human component needs to go hand in hand with technological prowess. By outsourcing, asset managers can tap into the latest tools and solutions to streamline processes, enhance operational efficiency and reduce cost.

“I think that fixed income is an asset class to drive outsourcing, because it is about the relationships, the axes, the counterparties and the available liquidity – more critically than other asset classes,” says Michael.

Outsourcing also avoids firms having to invest in upgrading their infrastructure or new technology. Instead, they can concentrate on honing their strategies and investment decisions that will yield the greatest returns.

“We hear a lot of traders, PMs and CIOs say they’re frustrated because they don’t have the resources to take advantage of the tech that’s out there. Another reason to leverage the tech stack of an outsourced trading partner like Cowen,” adds Michael.

Making the right choice

“There isn’t, of course, a one-size-fits-all outsourcing model. It depends on the type of firm, its investment strategies and geographical reach. Some asset managers prefer hiving off their entire trading operations to a third party while others opt for a hybrid approach,” concludes David.

This is where an inhouse team may cover core activities while an outsource provider will handle the areas that it doesn’t cover such as certain asset classes (for example keeping equities in-house, but outsourcing fixed income), geographies (for example, a US based firm that may not want to staff a team in Europe), the more illiquid or difficult trades that require anonymity for minimal market impact ,or outsource the trades they don’t do electronically, such as high yield or emerging market.

Regardless of the path they choose, the benefits of the outsourcing model are the same – a more proficient, effective way to navigate fixed income markets to generate returns and reduce costs. It enables asset managers the time and space to concentrate on the strategies that will help them to outperform.

Final thoughts

In this series we have delved into the key drivers in the fixed income space and concluded that it takes a carefully concocted blend of technology, experience and relationships to access global liquidity in an environment where many pockets of fixed income markets are under pressure.

There are a number of very large players that have the resources to leverage all these capabilities, but where does that leave the rest of the market? At best, working furiously to keep up, at worst missing out.

The answer? The expertise, scale, influence and reach of an outsourced trading desk. One underpinned by best-of-breed technology and resourced by highly experienced fixed income traders.

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