In Q1 2009, Omgeo interviewed over a dozen of our U.S. Advisory Board members to better understand how institutions are coping with the current market conditions and how they are planning for the future. This article focuses on the key theme of business relationships and on the importance of operations as a result of the economic crisis.
Business relationships - a sharp eye turns toward managing counterparty risk with financial services firms, asset servicers, and technology vendors.
Relationships between business partners have changed dramatically as a result of the current crisis. Every firm is looking at asset servicers, technology vendors and other business partners with a cautious eye on these firms’ viability. This is not to say that anyone was lazy with their due diligence before the crisis; on the contrary no firm interviewed by Omgeo said that they were not carefully scrutinizing business partners before. However, the current environment is causing firms to analyze the details more carefully.
From the service provider’s perspective, firms are concerned with who they do business with. Although technology providers show no signs of becoming more selective, some providers like prime brokers are becoming more selective. We expect that this may flow down to brokers for traditional asset managers and perhaps even custody banks. Brokers are highly concerned with client profitability and are analyzing the fully-loaded cost of servicing a client versus the risk and revenue associated with that client. For prime brokers who are now limiting the risk they take on and the capital they are willing to commit to their hedge fund clients, this may mean outright firing clients who no longer make sense to the prime broker’s business.
For brokers to traditional managers the analysis takes on a slightly different structure, a key component of which is the client’s post-trade automation level. Where a lack of automation makes the economics unfavorable for the broker, there may be a change in pricing that would make it punitive to continue providing post-trade information to the broker via fax or email. The goal would be to incent automation or push the managers who insist on manual methods to another broker, but the fringe benefit to the broker would be to rid themselves of unprofitable clients.
Outsourcing has been a consistent theme in the industry since the early 2000’s, but the debate over whether to outsource or not is heating up as a result of the tremendous cost pressure that firms are under. However, the challenge today is to weigh the benefit of long-term cost savings, versus the short-term implementation costs. Investment managers are more likely to be able to execute on outsourcing arrangements in the current environment, which will benefit custody banks, fund administrators and other specialized outsourcing providers.
Brokers interviewed felt that they had less ability to execute in the current environment as their purse-strings are drawn even tighter than the buy-side’s. Further, when off-shoring is involved, all sides of the industry are treading very carefully. No one wants to deal with the likely public and political backlash of moving jobs to another country when so many jobs have been lost in the own country, even if the long-term cost savings to the firm are significant.
Heightened visibility and the importance of operations
Operations’ has, in many firms, taken on a new level of visibility and importance as a result of the economic crisis. Operations executives were the focus of the interviews conducted during this project and although very few of the interviewees suggested that their departments were ever considered “second class citizens” in their respective firms, most did indicate that Operations has achieved a heightened role within the organization.
Several factors have contributed to this change. In some firms, Operations’ has gained in notoriety because they were proven in a trial-by-fire. When Bear Stearns collapsed, Lehman came under fire and eventually filed for bankruptcy and AIG stood on the verge of ruin, it was Operations that was able to steer the firm through these major counterparty failures by providing concise and timely risk exposure reports to the organization.
Second, most firms are realizing now more than ever, that data is indeed the lifeblood of their organization. Operations’ role as the owners and stewards of critical client, counterparty and security data means that they are responsible for the bulk of the data that feeds the hundreds of mission-critical downstream systems. Perhaps highest among these systems in terms of importance and visibility to firm management today are risk systems.
Hedge funds are being forced to increase the importance they place on Operations in light of industry scandals and expecting future regulation addressing the hedge fund industry. Many believe that these will require transparency, which will in turn, require more robust operational and reporting capabilities. Further, thanks to sweeping mandates for independent third-party providers from large institutional investors and fund-of-funds managers, many hedge funds are being forced to outsource their middle and back office operations.
Finally, every firm has been forced to focus on mitigating the risk from failed trades. Firms are more thoroughly analyzing trade errors and “near misses” to better understand how they occurred and who was involved. A new era of accountability seems to have dawned on the industry which is being tied to incentives and compensation.
When significant price swings and volatility have become the standard, not the exception and we question whether our trade counterparties will be in business tomorrow or next week, ensuring quick settlement of trades is the best possible protection against one side failing and the other side getting in line with the rest of the creditors. An open question that came out of many of these discussions was around the permanence of this change; is it just temporary while the industry is at a heightened level of concern, or is this a permanent change to the DNA of our industry?
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