The V word: How an outsourced trading desk makes volatility manageable

There are many lessons we can draw from how markets have behaved in the past year and a half. One of the most important is that in times of uncertainty, it truly pays to have an experienced, reliable trading desk that knows how to cope with extreme volatility.

The pandemic sent volatility up to its highest levels since the global financial crisis of 2008. Of the five highest-ever levels for the CBOE volatility index (the VIX), four of those occurred in 2020. Executing trades in such an environment is one of the greatest challenges that asset managers will ever face. They need traders who can find liquidity, deal with massive price swings and see through the noise.

It would be tempting to think that the volatility witnessed last year is firmly in the rear-view mirror. Afterall, markets in 2021 appear to have got firmly back on track. The World Bank says the global economy is set to experience its strongest post-recession recovery in 80 years. And the VIX has settled back into the range it stayed in for most of the 2010s.

But the prospect for more tumultuous trading remains a lingering question. Scarred by the events of 2020, many asset managers are more wary at this stage of the recovery than they have been during previous rebounds from major market crises.

Given that wariness, it is worth thinking about volatility in two distinct ways. First, there is the question of why outsourcing or supplementing a firm’s trading makes so much sense during market meltdowns. Second, there is the question of how likely it is that we will face another bout of extreme instability.

A range of benefits

The value in using an outsourced trading desk, or in adding to a firm’s capabilities by co-sourcing trading requirements, became abundantly clear during the early stages of the pandemic.

Simply being able to get in and out of markets became a daunting task, particularly for smaller to mid-sized funds which might employ one trader or a handful of traders. Firms with outsourced or supplemental trading desk solutions enjoyed the benefits of having a large team of experienced traders at their disposal, all of whom knew how to navigate choppy waters. For those firms that had less seasoned teams it was, at times, a white-knuckle ride that they would not want to repeat.

There are many opportunities that an outsourced trading solution provides during volatile times, including the following:

Liquidity

When markets are stressed, finding buyers and sellers, even for some of the more liquid of assets, can be difficult. Asset managers who do not have a broad array of liquidity sources will invariably face wider bid/offer spreads or be forced to adjust their trading strategies. In worst-case scenarios, they may not even be able to get in or out of positions until markets calm down again.

Outsourcing or supplementing the trading desk offers a kind of operational insurance policy during chaotic times. It allows a fund to focus on strategy, safe in the knowledge that its trades will be executed and value captured.

Insight

A second benefit is based on the wisdom that comes with experience. Traders who have witnessed acute market stress in the past will have a better understanding of what is achievable or sensible. That translates into better judgement in terms of split-second trading decisions or determining how indicative or firm market quotes really are. At Cowen, our Outsourced Trading team consists of more than three dozen traders, the majority of whom have had extensive experience dealing with market turmoil.

Coverage

A third benefit comes from the reliability and 24-hour coverage that an outsourced trading desk provider offers. In times of volatility, markets will be prone to sudden movements at any time of the day. Having an outsourced desk with a physical presence in all three major trading hubs, means that an asset manager can respond to market gyrations 24/7 across the globe.

The prospect of more upheaval

Judged purely from the way that volatility has subsided in 2021, it is understandable that many asset managers might feel a little less anxious about an immediate return of turmoil. But the potential for more upheaval is very much on the minds of some in both the equity and credit markets.

Barring unexpected geopolitical events, some in the market say that resurgent inflation is the most likely source of any newfound volatility, as runaway consumer price growth would immediately unnerve credit markets and that would then ripple through to other asset classes.

Fuelling the inflation thus far has been the massive monetary stimulus that governments have injected to keep the world economy afloat during the pandemic. Economists have voiced concerns about the possibility of a wage-price spiral being ignited and that has led to nagging worries in the government bond markets.

The chief economist at Goldman Sachs, among others, so far believes the inflation we’ve seen is transitory, but he does see risks. It will take months of accumulated data to form a view as to just how successful monetary authorities have been at supporting economic growth without stoking too much inflation. Governments meanwhile are expected to stay fiscally loose, and as long as that is the case, markets are likely to have residual worries about inflation taking off.

For now, the consensus view, based on current economic signals, is that markets are not in a danger zone and poised for a spike in volatility. But many are keeping a closer eye on the VIX and other indicators than during past recoveries.

Ready for any scenario

No one can predict when the next bout of volatility will be. But whenever it happens, asset managers will face the same obstacles – and potentially the same pain – as what they went through in the early months of the pandemic.

It is that uncertainty which makes outsourced trading desk solutions such an attractive proposition. Asset managers can tailor their trading activity to fit with the prevalent conditions. When markets are healthy, they can take advantage of Cowen’s expert outsourced trading team. When markets are weak or unstable, firms can cut back on activity without having to worry about maintaining all the overheads associated with having an in-house trading team.

We all know that financial markets can be fickle. The environment can go from summer to winter in the blink of an eye. One moment, it’s the best of times, and the next it’s the worst of times. But working with an outsourced trading desk provider can help firms weather these unanticipated shifts, whenever they might occur. In other words, just because a sudden downpour occurs, it doesn’t mean you have to get drenched.