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Walking the Walk of Good Governance with Outsourced Trading

What started as a cost-efficiency endeavor has now become a primary method of enhancing governance required by regulators.

There’s no escaping ESG in investing today, whether you’re the asset owner, the asset manager, or an intermediary. Governance (the G) may be the most pervasive of the three in the day-to-day business of investing, particularly when it comes to transparency. Regulators have made it mandatory to some degree, and asset owners press asset managers for ever greater amounts of it beyond that demanded by law. Intriguingly, the most profound effects of governance could be those on outsourced trading.

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Outsourcing in general is a trend among asset managers, driven in part by an increased emphasis on governance and transparency, that in turn contributes to fee compression. Index investing is usually cited as the key contributor to the lower fees asset managers now charge, but requirements for transparency around fees have played a part as well. It’s a bit of a circle – less revenue in fees means a search for greater cost efficiencies, which leads to outsourcing. But here’s the twist – increased benefits in terms of fulfilling governance requirements are evolving to become an equally compelling reason for managers to outsource their trading function.

“If the savers demand that our money is put into companies with good governance, then the guardians of those savings must be able to display really good governance,” says Gary Paulin, Global Head of Integrated Trading Solutions, Northern Trust. “And unless you have your own trading functionality, you need to outsource to an appropriate third party – a counterparty without conflicts and with outsourcing in its DNA, along with deep liquidity that clients can interact with to meet trade execution requirements and maintain a global presence.”

Increasing importance of governance

Transparency, accountability, and fairness are the cornerstones of good governance, and if there is a lasting legacy of the global financial crisis it’s that those watchwords continue to ring out loud and clear.

“Regulators all around the world are trying to improve those aspects within their industries,” says Paulin. “As I’ve traveled the world and spoken with regulators, I’ve concluded that regulators tend to listen to each other, and they always seem to be looking at which regulations produced good customer outcomes in one jurisdiction and how they might apply in their own. I’m not suggesting that MiFID or the Senior Managers Regime from the UK will wholly be incorporated into the U.S. regulations, but that doesn’t stop those regulations from entering those industries via competition. The aspects of MiFID that govern research are now widely viewed as a best practice in the U.S. Why? It provides cost transparency but also lowers research costs at a time when there is huge cost pressure and everyone is questioning value for money.”

Northern Trust

The Senior Managers Regime in the UK is particularly relevant to why governance help is now seen as a key aspect of outsourced trading – and why outsourced trading is growing. In a nutshell, the regulation makes senior managers accountable for the activities of their firm, and the people performing those activities. More than cost pressure, more than the need and expense to keep up with technology, accountability is the biggest driver of change in terms of asset manager operating models.

“If you’re a senior manager, and there is a steward’s inquiry, you have to show you have taken all reasonable steps to prevent misconduct or whatever is at issue,” says Paulin. “You can’t just say you did X, Y, and Z – you have to prove it. Almost invariably, the senior manager for the trade activity doesn’t come from a trading background. It’s more likely they have an operations background. In my conversations with some of these folks, they have shared similar concerns: operation resiliency, conflation of roles, and overnight orders.”

Paulin says he’s hearing “more and more about overnight orders, and it comes right down to governance and control. For a lot of funds – and this could be if you’re a U.S. fund trading in Japan or a European fund trading in Hong Kong – a senior manager who is responsible for all reasonable steps to prevent any misconduct might naturally feel uneasy about the fact they might have $100 million of risk going on in Japan but their trader has gone home to bed. Do they have sufficient control over their order flow? Do they have a line of sight? For many managers it’s a significant burden to have their own traders in Japan controlling order flow.”

It is solutions to such global challenges that inspired Northern Trust’s Integrated Trading Solutions (ITS) in the first place, and which motivate its constant pursuit of solving new problems as they arise for asset managers and owners alike. In addressing the accountability issues around trading, Paulin says the degree of enhanced governance can be a game changer, especially in conjunction with other aspects of ITS’ front- to back-office integration, significant liquidity capture and scale, and reporting functions, embedded compliance and oversight, transaction cost analysis, and rigorous business continuity planning.

For example, Paulin says, consider the footnote requirement for transaction reporting. Northern Trust can assist its clients through its third-party provider of transaction reporting software. In other words, the process can be automated to a large degree, and free up resources and streamlines processes as a result.

“It’s a good thing for everyone that a lot of firms and individuals within them are thinking about how they can enhance governance,” says Paulin. “We can help as an outsourcing partner with boots on the ground, with sole interest in our clients’ goals, and knowing that our interests are aligned with theirs. The outsourced trading story has fully evolved from one that was about cutting costs to one that can improve controls and oversight across functions. And it’s not just about regulation or clients – ESG is the fastest growing category of funds in the world, and any time you demonstrate that you walk the walk in that regard, it’s a plus.”

Stay ahead of the unprecedented pressures falling on buy-side trading desks by building an efficient, cost-effective, and compliant execution solution.

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