| With the demise of Lehman
Brothers and the subsequent upheaval among bulge-bracket
firms on Wall Street, buy-side traders are scrutinizing
their exposure to sell-side counterparties and reassessing
their reliance on sell-side trading technology. After
living through the collapse of Bear Stearns, the bankruptcy
and disappearance of Lehman Brothers and the hasty sale
of Merrill Lynch to Bank of America, followed by the
concerns over the stability of Morgan Stanley and Goldman
Sachs, buy-side firms are more cautious about relying
on the top investment banks for serving all their needs,
including access to liquidity and financial systems.
Now that some of the industry's storied brands have
disappeared, been sold or transformed into banks, buy-side
firms are reassessing their exposure to counterparties
-- and not only in the execution space. Buy-side firms
also are examining their relationships with clearing
firms, depositories and trading systems that could expose
them to risk if a counterparty were to default.
"We are spending a lot of time thinking about
counterparty risk -- not just thinking about our immediate
counterparties but looking at the markets we're trading
in and drilling down to the depositories that the equities
we trade settle at," reveals a buy-side trading
veteran who requested anonymity.
The question is: How will the turmoil on Wall Street
impact the actions of traders at investment managers
and hedge funds? Will they shift order flow to agency
brokers to avoid counterparty risk? Is the buy-side
going to look more closely at third-party technology
vendors as alternatives or backups to bulge-bracket
execution management systems (EMSs)?
Keeping Clients' Money Safe
While buy-side traders agree that the immediate danger
of brokers defaulting has been stabilized now that both
Morgan and Goldman have transformed into bank holding
companies and received capital from outside investors
(i.e., Mitsubishi UBJ and Warren Buffett, respectively),
there still is a lot of uncertainty in the financial
markets. "The buy side has so many concerns right
now; I don't know how they are keeping their heads above
water," says John Comerford, EVP and global head
of trading research at Instinet, a global agency brokerage
firm whose parent is Nomura Securities International.
"No. 1, you have to make sure that your money
and your clients are safe. You also have to worry about
the trading, and you have to make sure that if you make
a trade, someone is going to be there to settle it,"
Comerford continues. "So there is counterparty
risk. It is a very challenging problem that everyone
is facing right now."
The fast-moving financial crisis certainly has made
buy-side traders more apprehensive about doing business
with sell-side firms, confirms Brian Baker, manager
of trading at BB&T Asset Management in Raleigh,
N.C. "It's made us more diligent to assure that
our process of evaluating brokers is as it should be,"
he comments. "We're constantly re-evaluating the
brokerage landscape. We're doing this on a weekly basis."
According to Baker, prior to the credit crisis, BB&T
analyzed and reviewed its brokerage counterparties on
a quarterly basis. "Now we have more informal dialogue
and ad hoc committee meetings to discuss counterparty
exposure," reports Baker, who oversees equities
and fixed-income trading and confers with the firm's
chief investment officer.
Even after the collapse of Bear Stearns in March,
a lot of people didn't expect Lehman to go under, notes
Baker. But with so many household Wall Street names
in the news, Baker adds, he had to pay attention to
the "little whispers and hints and rumors that
started surfacing this past May or June, some of which
had some degree of merit." With the fate of brokerage
houses changing direction so quickly, "You really
have to be forecasting," he adds.
As concerns mounted, Baker says, he curtailed trading
with certain firms. "Nobody wants to stop doing
business with anybody, particularly if you don't have
a real good reason for doing so," he comments.
"On the other hand, I don't want to say that we
had counterparty risk exposure with XYZ yesterday and
today they're out of business."
While the buy side has paid attention to counterparty
risk for many years, it is applying increased vigor
to the process, adds Navin Sharma, VP and director of
risk management at OppenheimerFunds in New York. "The
analysis of counterparty risk in great detail is here
to stay, and firms have gone to great pains to make
sure they have a good handle on counterparty risk,"
he emphasizes. "We actually have multiple levels
of credit analysis that consider, review and opine on
new counterparties."
Multiple departments -- from risk, legal and compliance
to fund operations/accounting and investments -- scrutinize
OppenheimerFunds' counterparty risk, Sharma continues.
"All of these areas are working together as part
of a counterparty risk committee to make sure we don't
leave any stone unturned in reviewing counterparty risk
and related credit analysis," he says.
The Agency Advantage?
To avoid counterparty risk, buy-side firms are likely
to look more closely at executing through agency brokers.
Unlike the bulge-bracket brokers, agency brokers match
customer order flows, so they do not act as a counterparty
on trades. Whereas many bulge-bracket firms relied on
trading for their own accounts and used mortgage-backed
securities and other esoteric instruments combined with
leverage to boost their returns, agency brokers mainly
trade exchange-listed instruments (equities, futures
and options), charging a commission on trades as their
main source of revenues. Typically, they don't get involved
with OTC derivatives such as credit default swaps.
"We have no proprietary trading," explains
Instinet's Comerford of the company's agency model.
"Basically, we have no exposure to the counterparty
risk that some of our large bulge-bracket competitors
have."
On the other hand, bulge-bracket firms provide a broader
range of services -- including proprietary research,
capital commitment to faciliate a trade when there is
no liqudiity and access to IPOs -- than agency brokers.
The bulge bracket also serves as market makers in fixed
income, foreign exchange and commodities; and designs
OTC derivatives to hedge portfolios.
Often, it is these services -- particularly the research
-- that keeps buy-side clients engaged. But the advent
of client commission agreements (CCAs) has only fueled
concerns regarding counterparty risk.
As Lehman teetered on the brink of bankruptcy, asset
managers with CCAs at the firm became extremely concerned
that their commission dollar balances for paying research
providers would be tied up with the bankruptcy filing.
Some buy-side firms were not sure if they would ever
receive their money back. According to some sources,
these balances can reach as much as a few hundred thousand
dollars.
"We have been particularly vigilant about that,"
says BB&T's Baker of the firm's position with regard
to soft-dollar accounts or CCAs with bulge-bracket brokers.
Fortunately, Baker says, BB&T, which has $17 billion
in assets under management, did not have large balances
with any one broker. "It's your clients' money,
and you want to protect it, and you want to be smart
about how you are using it," Baker notes.
In addition to the security of their CCA balances,
buy-side firms are highly concerned about exposure to
credit default swaps, which contributed to the overall
financial meltdown and the near collapse of insurance
giant AIG, in particular.
"It's reaffirmed my view that you should be trading
as much as you can with exchanges and not with over-the-counter
transactions," emphasizes Stephen Davenport, director
of equity risk management at Atlanta-based Wilmington
Trust, which has $46 billion in assets under management.
Wilmington Trust, Davenport relates, runs a call-writing
options program with all listed options (FLEX options)
at the Chicago Board Options Exchange. "You basically
define your price, your expiration date and trade on
the exchange, so you don't have [the other side of the
trade] with one counterparty," he explains.
"This market has really reaffirmed the benefits
of trading with exchange-traded options," adds
Davenport. He notes that prices for exchange-traded
options are published on an exchange and the Options
Clearing Corp. (OCC) guarantees settlement, so the buy
side is not depending on the creditworthiness of a single
counterparty to ensure that the trade settles.
Technology Risk
The situation is all the more complicated because the
buy side relies on large brokers for various kinds of
trading platforms, algorithms and analytics in return
for order flow that could expose them to technology
risk should a brokerage default. Some examples are Lehman's
Townsend Analytics (now owned by Barclay's Capital),
Morgan Stanley's Passport and Goldman Sachs REDIPlus.
According to Dave Quinlan, executive managing director
and head of strategy at BNY ConvergEx Group, while these
systems continue to operate, buy-side firms are concerned
about the viability of the brokers themselves. "The
balance sheet concerns have nothing to do with the legitimacy
of the technology," Quinlan adds. "The solidness
of Rediplus or Passport or any other EMS technology
provider hasn't changed. Those systems are still there.
... It's just a matter of whether the buy side has the
confidence to do any transaction with the counterparty
because they're fearful they won't be around to settle
the trade."
That fear was particularly acute in September. "We
scaled back on Redi in light of the concerns over Goldman,"
says the veteran buy-side trader who requested anonymity.
But after the turmoil subsided somewhat, "We turned
them back on," he notes, adding that the upheaval
on Wall Street has impacted his view of technology risk.
"To the extent that technology is dependent upon
one broker, it really concentrates our counterparty
risk to a degree that we're not comfortable with, and
that's something that we may look at at some point,"
says the head trader, who uses both Redi and Citi's
Lava on the trading desk for access to markets.
Other buy-side traders stress the importance of using
broker-neutral trading platforms so that they are not
locked into a single broker. "One of the things
that is important to me as the head trader is making
sure there is broker neutrality," says BB&T's
Baker.
For example, BB&T accessed an agency broker through
former Lehman subsidiary Townsend's RealTick Platform.
But Baker questioned whether there was counterparty
risk involved in accessing another broker via the RealTick
platform. "That's a good example of the lengths
that people are going to," he says. "They're
crossing their t's and dotting their i's to make sure
that any trades they're doing do not become problematic
after the fact."
Joseph Ward, VP/equity trader at RidgeWorth Capital
Management in Atlanta, says his firm takes precautions
by using multiple ECNs that connect to multiple brokers.
"If one broker had gone out of business or one
platform had gone out of business, we would have had
redundancy, and we do not believe it would not have
interrupted our trading style," he explaiins.
But multibroker platforms are not a panacea if the
firm operating the platform files for bankruptcy, Ward
notes. "What if the broker that owned the broker-neutral
platform goes out of business?" he asks. In fact,
that's exactly what happened in the case of Townsend
Analytics, which was an independently operated, wholly-owned
subsidiary of Lehman Brothers. Fortunately, Barclays
Capital bought Townsend along with Lehman's U.S. trading
operations and other assets.
Continued Sell-Side Support?
Another concern on the buy side is whether the major
investment banks will continue to invest in these EMS
platforms given the IT budget cuts and pressures they're
facing. "With all the turbulence in the brokerage
market, it is unclear whether brokers will be able to
offer the same execution service via these front ends
that they did in the past," wrote Dusyhant Shahrawat,
senior research director, investment management, for
TowerGroup, in a research note published in September.
Like other industry observers, he predicts the upheaval
on Wall Street will create an opportunity for agency
brokers to step in as buy-side firms seek to diversify
their trading counterparties and EMS providers.
"Other brokers that are relatively unscathed
-- mainly the large agency brokers (e.g., BNY ConvergEx),
Fidelity Capital Markets, Jefferies, Investment Technology
Group (ITG) -- will take this opportunity to step up
their execution service," stated Shahrawat in the
report. But he warned that agency brokers "still
may not make up for the decline in service from the
bulge-bracket firms."
Shahrawat also questioned whether commercial banks,
such as Bank of America, which acquired Merrill Lynch,
would make the long-term commitment to continue investing
in their brokerage subsidiaries' EMS platforms considering
all the other competing investment priorities that will
be on their plate. He suggested the buy-side will veer
toward independent EMS providers -- such as FlexTrade,
Portware and TradingScreen, and third-party OMS vendors
(i.e., Linedata, Charles River Development and SunGard)
that will look to exploit the narrow opportunity opened
by the Wall Street upheaval to court the buy side.
Turning to Tech Vendors
Amid the turmoil and uncertainty, third-party technology
vendors stand ready to help their customers. There's
a "tremendous amount of uncertainty now on the
part of all market participants," not just on the
buy side but the sell-side as well," comments Alan
Mangelsdorf, VP of marketing at SunGard. As buy-side
firms watched brokers "struggle and cease to exist,
it changed the relationship they had with other counterparties,
with clearing partners, algo providers and EMS providers.
They've had to make changes and address it."
SunGard, for instance, has seen an uptick in firms
considering its clearing capabilities. "If you're
a firm, you don't want to start looking for a clearing
partner the day after your primary partner goes under,"
says Mangelsdorf.
Buy-side firms have also approached SunGard as a backup
or alternative to their algo trading providers, he says.
"And we've seen some that are moving off their
tier-one providers and moving onto our algos,"
Mangelsdorf relates. "It's really important in
the current environment that you have more than one
approach to how you are going to access liquidity, how
you access clearing providers, and who you are going
to leverage for algo trading if you're tier-one algo
provider goes under."
In the end, buy-side firms will need to diversify
their counterparties and technology providers. "Buy-side
institutions should reassess their trading relationships
on a continuous basis," says Ian Domowitz, managing
director responsibile for analytical and research products
at agency broker Investment Technology Group. "And
I also believe that changes in the corporate structure
of their counterparties should be part of that reassessment."
Indeed, after the turmoil of the past few months,
buy-side traders have become more proactive in assessing
their counterparties. "As a buy-side trader, it
is a balancing act of paying for research needs and
ensuring best execution, while understanding the environment
is dynamic and your brokers need to be analyzed in a
way that we have taken for granted in the past,"
says BB&T's Baker. "Sometimes we find ourselves
being especially cautious so we are not the last one
sitting down in this game of musical chairs."
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