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 Matthew Nelson
Director, Market Intelligence
2008 was an incredibly turbulent year that has seen banks and brokers collapse, government bailouts and the nationalization of banks and lenders, massive asset write-downs, layoffs and huge financial losses for nearly all investors. No one will question that it was a year that reshaped the entire global financial services industry.
So what can we expect for 2009? We believe that a number of trends will dominate in the coming year. These trends will impact both the buy and sell-sides and will have broad implications for investors of all kinds. Most industry observers and analysts expect the current global recession to last well into 2009, so I’ll not postulate that the worst is over yet. Therefore, many of the changes currently underway are likely to last well into, if not throughout 2009. In summary, the year will be marked by the themes of safety, risk mitigation and doing more with less.
Flight to Safety for Risk Mitigation
Traditionally the term “flight to safety” refers to investors selling perceived risky assets and buying safe assets like cash and short term government securities. But what is happening today, which we believe will continue, is a flight to safety in a much broader sense. Not just to safer assets and asset classes, but also to safer trade counterparties and service and technology providers.
There’s growing evidence that institutional investors are fleeing risky assets. Recent news of poor performance at large endowments and pension funds has been coupled with news of their efforts to escape riskier asset classes like hedge funds and private equity through secondary market sales of their private investments at deep discounts. The same funds that benefitted during the good times by allocating assets to non-correlated investments have seen this bear market rip through all asset classes without mercy… historical correlations be damned. And as further evidence, one need look no further than the miniscule yields currently offered in short U.S. Treasury Bills, which investors around the world perceive to be among the safest possible investments. Clearly investors’ appetite for risk has decreased significantly.
Beyond asset classes, we believe that there has been and will continue to be a flight to safety in trade counterparties, service and technology providers. The pain that a number of UK-based hedge funds have felt from their involvement in Lehman Brothers bankruptcy touched off a large scale movement of hedge fund assets to prime brokers affiliated with large, diversified banks. Or beyond simply switching to a new prime broker, many hedge funds have taken the further step of shifting to the multiple prime brokers. Historically, only large hedge funds would employ multiple prime brokers and smaller funds would just use one. However, in today’s environment where confidence has vanished, hedge funds of all sizes are using multiple prime brokers. This has been a boon to the smaller prime brokers, mini-primes and so-called “prime-of-primes” and has upended the industry league tables. But switching from a single to multiple prime brokers is a major shift for the fund manager who is forced to take on significant new responsibilities in technology and operations. From trade processing to data management and reporting, the fund manager can no longer rely on a single brokers’ suite of tools and technology.
And this flight to safety spans both sides of the Street. It’s not just the buy-side that is concerned with trade counterparties; it’s equally the sell-side. Brokers are being forced to ask themselves which institutions they believe can survive this market and therefore, who they want to do business with. Brokers are turning away business that one year ago they would have taken on in a heartbeat.
The lesson learned that must be applied in 2009 and beyond, is to know exactly who you are doing business with. Know your exposure to those firms and know how you can mitigate any risk that may arise from that exposure. This isn’t just portfolio and counterparty risk that I’m referring to; this best practice must extend to service and technology providers as well. Know and measure the service level agreements with service providers and know the intimate details with technology providers, particularly the smaller vendors who may offer compelling technology, but carry with them more “vendor risk;” the risk that arises from a small vendor going out of business or being acquired.
Regulation and Global Cooperation
If there’s a positive outcome to this crisis, it may be in the new awareness that markets are truly global and therefore that regulation and oversight must be better aligned globally. As the crisis unfolded, European leaders took the lead role in acting to try to stave off further deterioration. Recall that it was only after European leaders (notably UK Prime Minister Brown and French Pres. Sarkozy) acted strongly that the Bush administration vigorously stepped up their efforts to restore confidence to the markets. Going forward, although we don’t expect to see a common set of rules or a single global regulator, we do expect to see global cooperation on principles for regulatory oversight, similar to the joint statement that arose from the November G20 Summit in Washington, DC.
It seems inevitable that there will be new regulation of financial services firms when the dust settles from this crisis in 2009. Risk management, derivatives transparency, ratings agency reform and hedge funds have been most often mentioned as the targets of future regulation. And although the Bush administration has been at odds with European leaders over regulating the hedge fund industry, the incoming Obama administration is expected to agree with the Europeans on increasing oversight of the US$1.6 trillion industry. We expect to see requirements for registration of hedge funds of a certain size as well as reporting requirements, drawing on the seemingly universal call for transparency into any investment vehicle or asset deemed “opaque.”
With regards to over-the-counter (OTC) derivatives and the complex structured products that many believe are at the heart of this economic crisis, it’s almost unquestionable that there will be some regulatory action. However, the calls for standardization and central clearing of OTC derivatives lie at odds with the fundamental concepts of the asset class that stress flexibility and customization. Further, some have speculated that in the current risk-averse environment, many investors will shift from OTC derivatives to exchange traded derivatives. Although this is likely to happen in the short term, we expect a migration back to OTC. Again, the appeal of the asset class is its flexibility and its bespoke nature. Investors who are not able to hedge their specific positions or portfolios via exchange trades will return to OTC and their brokers will welcome them back with open arms (and wallets). What will change in 2009 is the need to process OTC trades electronically, properly collateralize the positions and reconcile them on a more frequent basis, eliminating as much risk as possible from the process.
Do More With Less
Anyone not living in the deepest jungles of the world is barraged daily with news of massive debt write-downs, bank failures and job losses. The brokerage industry is reeling from the turmoil that’s swept the industry since March. The loss of two major players, plus the acquisition of others have reshaped many aspects of the industry. Those firms that have been able to make acquisitions will be faced with long and complicated integration projects. The rest of the industry is, in many cases, just glad to still be in business. Although the sell-side has received the biggest blow in terms of both financial and job losses, the buy-side is starting to feel more and more of the pain. Reduced assets under management and poor performance mean reduced fee-based and performance-based revenue for both traditional and alternative investment managers.
Clearly these are difficult times for all industry participants. Few firms are likely to be able to carry the mantra of “invest heavily in the future” through 2009 when the short-term outlook is so grim. However, this doesn’t mean that all investment in technology and operations ceases. Rather, we believe that there will be a shift towards “smart spending;” spending on projects with a short and significant return on investment. While there are sure to be tactical spending requirements on compliance with new regulation, projects that address critical weaknesses in high-focus areas like risk management will continue to get funding.
In 2009 firms will be forced with the need to do more with less, far more so than we saw in 2002 and 2003. However, it is important that the industry not lose its focus on the future entirely. This crisis will end, and when it does, the firms that have continued to invest wisely will be best positioned to revitalize their business quickly and emerge as the winners. All of the investments that the industry has made over the past years in automation need to be relied upon to handle simpler, repeatable tasks, allowing a smaller number of staff to focus on the most problematic tasks.
Back to Basics
Although 2009 is not set up to be a banner year, it’s difficult to imagine it being worse than 2008. However, firms that focus on the basics of the business; building expertise and reputation, servicing clients and making money, will always draw in new customers and will succeed. Behind the scenes, going back to basics by assessing operational soundness, risk management techniques and leveraging best practices will pay off in spades. We’re confident that the financial services industry will persevere and emerge stronger and fitter. It may be a bumpy road for the next several months, but history has shown us that all economic crises do end. Where will your firm be when this one ends?
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