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 Matthew Nelson
Director, Market Intelligence
In the first quarter of 2009, Omgeo interviewed over a dozen of our largest U.S. clients, representing all segments of the industry. The purpose of these interviews was to better understand how institutions are coping with the current conditions, how they are planning for the future and to gather their opinions on the future of the industry. Six common topics emerged from these interviews; planning and prioritization, the changing role of operations, relationships, risk and regulation, changing business models and emerging as a stronger industry. This series of articles will discuss each of these topics and our discussions with the participants.
Relationships between business partners have changed dramatically as a result of the current crisis. Following the collapse of Bear Stearns in March 2008, there’s been a heightened concern over the viability of major global financial institutions. Our industry, politicians and many in the public have come to realize that the modern financial services industry is massively interconnected and truly global in its reach. At the same time, the notion of “too big to fail” has been shattered, leaving many questioning the relationships that their business has developed along with the stability of these business partners.
It wasn’t until Lehman Brothers collapsed in Sept 2008 that this issue took on a truly prominent role. Bear Stearns, despite ceasing to exist as a corporate entity, had been “rescued” by the U.S. government and JP Morgan. Lehman on the other hand was allowed to fail entirely by filing for bankruptcy. This left many firms in a state of limbo; brokers and asset managers with trades that would never settle, exposure to debt and derivatives issued by or backed by Lehman and hedge funds with assets held (and in some cases rehypothecated) by Lehman. The pain was felt more acutely in Europe, where bankruptcy laws made recouping assets from Lehman Bros. International much more difficult than the U.S. entity.
As a result of the pain felt in the Lehman collapse and the belief that in the current environment this same event could occur at another firm, counterparty risk has taken on a far more prevalent role in almost every financial services firm. But, the concern over the viability of partners has extended well beyond this somewhat limited scope. The seemingly endless string of failures to protect the clients’ best interests (Madoff and other “Ponzi”-schemes, PwC as auditor for Satyam, etc.) has spread concerns over business partners deep into the industry.
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. Further, when establishing legal contracts with partners, financial services firms are scrutinizing every line of the contract, assessing and mitigating any risk exposure that could leave them in a perilous situation should the partner firm fail.
From the service provider’s perspective, they are also concerned with who they do business with. Although technology providers show no signs of becoming more selective (in this difficult sales environment, they cannot afford to), 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. While the crisis has given most firms reason to carefully analyze what parts of their business are core versus ancillary, the challenge of coming up with the money and staff to execute on an outsourcing arrangement in the current environment is not insignificant. 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. In many cases, they felt that the only possibility would be to expand existing outsourcing relationships, but not to establish new ones. 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 U.S., even if the long-term cost savings to the firm are significant.
It’s clear that this is also a time to leverage partnerships. Particularly for technology providers who are faced with longer sales cycles and difficult sales to institutions who are under pressure to reduce costs and also have fewer staff, the ability to build a strong network of partnerships and leverage them for sales opportunities is critical to the providers’ survival.
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