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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.
It’s clear that the very fundamentals of the securities industry have changed as a result of this crisis. The demise of the independent broker/dealer, the demotion of hedge funds and proprietary trading and changes to the prime brokerage industry are just some of the ways in which the core of our industry has changed.
After Bear Stearns and Lehman Bros. collapsed, the writing was on the wall that the independent broker/dealer was going the way of the lemming. This pressure forced Goldman Sachs and Morgan Stanley to change their respective corporate structures to that of bank holding companies, effectively ending their ability to take on the considerable amounts of risk that had fueled their strong growth and earnings over many years. Although it’s unclear whether this change will be permanent or temporary (bull markets and profits often can make us forget the difficult times), for the time being, firms’ roles have changed. But simply because some firms are able to take on less risk, doesn’t mean that investors will never wade back into risky waters again. Therefore someone will undoubtedly emerge to fill the void left by the demise of the independent broker/dealer.
Many industry participants interviewed by Omgeo believe that this role is being assumed by 2nd tier brokers, boutiques and in some cases, the larger hedge funds. It seems that there is daily news highlighting the departure of key bankers, analysts, traders and portfolio managers from bulge-bracket firms to join or start their own boutique firm. A key reason for these departures is the pressure of government intervention on the bulge-bracket banks, particularly those that took (or were forced to take) TARP funds. Along with that capital came scrutiny over staff compensation and a public flogging of the compensation system that’s served Wall Street well for decades. To the public, this compensation system seems lavish and extravagant, but in reality, it’s how the industry attracts and retains highly talented, educated and experienced staff to the. Imposing punitive taxes or capping compensation on Wall Street will only weaken the U.S. financial services industry as staff will be more likely to work for non-U.S. companies not subject to government oversight, or will seek out jobs in altogether different industries.
Couple the boutique-ization of the industry and the compensation handcuffs facing financial services firms, and it suggests a bleak future for big Wall Street firms.
But this is not the only changing paradigm in the securities industry. On the contrary, the crisis has caused several other metamorphoses. It’s no secret that there was a stampede away from any asset class considered “risky.” Many hedge funds were forced to close due to significant redemptions and those that survived were forced to look carefully at their product lines with an eye towards making changes. As a result some larger, more diverse managers have consolidated funds, or closed funds that were ted to riskier strategies where market opportunities have dried up due to lack of participation (liquidity). If a funds’ strategy is too difficult to explain to an investor, it’s not likely to draw assets in the current environment.
Similarly, many banks were forced to scale back or cut altogether their proprietary trading desks, desks that in many cases contributed significant profits to the firm. However, despite having the potential to generate revenue, proprietary trading can increase the firms’ risk (as measured by leverage and trading value-at-risk), which is either undesirable in the current environment or outright banned by regulation.
Another shift that’s occurred is in the prime brokerage industry. After Bear Stearns, one of the top 3 prime brokers at the time, collapsed in March 2008 hedge funds scrambled to find an alternative prime broker or in many cases, multiple prime brokers to mitigate their risk. The “multi-prime” trend was furthered when Lehman Bros. collapsed later in the year, leaving many hedge funds in a far more perilous position; the creditors line. Add to the complexity of dealing with multiple prime brokers the fact that the prime brokers, now banks, have become more risk-averse and are therefore less inclined to provide capital to hedge funds and to finance exotic trades and it’s created a difficult situation for the entire hedge fund industry. Hedge fund managers’ fundamental needs still exist; they require execution, clearing and custody, capital and access to liquidity, however finding suitable service providers who are willing to provide these services has become a much larger challenge.
With all that’s going on in the markets and industry today, it’s difficult to forecast what the industry will look like tomorrow. On top of worrying about risk management, cost containment and volatility, firms need to worry about relationships and the very nature of their own business. This has significant impact on competitors and services and it will be critical for firms to have a firm grasp on the new business models across the industry.
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