Half-time, swap sides
It was inevitable
investment managers would need to change their trading processes and
counterparty management procedures in the wake of the sweeping reforms in the
Dodd-Frank Act. But it now seems entire business models may require considerable
change in order to survive and excel in the new market order.
A number of recent announcements have hinted
at the possibility of buy-side firms offering fellow buy-siders new services.
In February, State Street launched its SwapEx initiative as an expansion of its
end-to-end derivatives solution to include an execution platform for the
trading of derivatives products. The launch of State Street’s swap execution
facility (SEF) coincides with the 2012 implementation of significant regulatory
changes in the US.
And earlier this month, the US$3.7 trillion
assets under management buy-side behemoth Blackrock revealed the launch of a new
bond trading system for clients. Blackrock chief executive Laurence Fink said
the new platform was aimed at filling any gaps which might be left by major
banks reducing their bond trading participation due to new capital standards
and the Volcker rule’s ban on prop trading.
“We are responding to the regulatory regime
that is transforming the future ways of the business,” said Fink in a call to
Fink has insisted the new platform won’t
change Blackrock’s relationship with the sell-side but many industry pundits
aren’t buying it. And the move may signal more buy-siders taking traditional
sell-side liquidity roles.
To John Jay, a senior analyst at financial
consultancy Aite Group, the Blackrock platform makes a lot sense and should
“I can see benefits for Blackrock because
the firm is enormous and will likely be able to keep the book tighter but this
isn’t a game-changer,” says Jay, explaining only the very large firms can hope
to build such a platform.
in the buy-side
Jay worries more about the potential
unintended consequences of exchange trading and centrally clearing OTC
derivatives and what that could mean to buy-side business models.
In line with G20 mandates, Dodd-Frank aims
to bring transparency and accountability to OTC swaps markets and the new rules
require reporting swap data throughout the lifecycle of the trade, providing
real-time dissemination of price and volume. Credit default swaps and interest
rate swaps will fall under the new rules in July 2012, while equities,
commodities and FX swaps will follow later this year.
“Central clearing causes a change in
relationship for the buy-side that goes beyond simply a new contract with a new
counterparty,” says Jay. “Mutualising risk can also mean concentrating risk.”
If a central counterparty (CCP) goes under,
explains Jay, counterparties would most likely look to the CCP’s member firms.
But if it is the member firms which cause the failure, then this wrong way risk
would ultimately find its way to the buy-side.
Sean Owens, director of fixed income and
derivatives at US financial consultancy Woodbine Associates, points out that
Blackrock had likely been considering the viability of its own fixed income
platform for a long time and that it was likely established not for reasons of
“When you’re as big as Blackrock, one would
think it was best practice to offset flows and channel trading to a centralised
desk before going to market,” says Owens. “It’s more natural and they will save
on execution costs.”
Owens says the large impact regulation such
as Volcker, Basel III and Dodd-Frank is having particularly on OTC derivatives
and fixed income will undoubtedly lead to a reassessment of buy-side business
“Liquidity will get more expensive, so the
buy-side will look for different sources,” Owens says. “This might mean more
electronic trading and firms looking to access a wider range of dealers.”
Owens says he has already seen the buy-side
pulling back from their relationships with dealers and ready themselves for
more cost efficient business models.
Mark Israel is prepared to go one step
further in his assessment of the buy-side’s intentions: “The real question is:
What will this do to the sell-side? Every industry eventually gains
efficiencies from cutting out the middleman. Long term, why would trading be
any different? Institutional investors don’t like paying commissions and I
don’t blame them – the broker is not holding the assets.”
Israel, vice president at advisory firm
Sapient Global Markets, believes while the dramatic regulatory overhaul
permeating from Washington will not per se effect changes in buy-side business
models, the tipping point may be the costs passed on from brokers.
“We’re seeing clients look at regulatory
changes and how they affect their processes – particularly how to deal with
costs and collateral,” says Israel. “Investment managers are beginning to
understand that there are more than just the obvious transaction costs that
drag on the portfolio, including margining, collateral and risk. These costs,
which stem directly from changing regulations, are coming into sharper focus.
And the buy-side is looking at its business models accordingly.”
Israel says the next stage of development
for the buy-side will be to discern how to effectively measure these costs and
create a strategy that also incorporates futures, options, derivatives traded
on SEFs and collateral management in the new environment. Sapient is helping
firms face these new challenges, helping them understand the effects of
collateral and deal with it in their processes.
But Owens says it is one thing to pay
greater attention to costs and another to completely change business models to
offer services to a new client base.
“Traditional long-only asset managers will
continue to conduct their business as usual but they are likely to change the
way they execute,” says Owens. “Firms looking for liquidity will either reduce
the size of their trades or they will take on more execution risk over longer
He says the buy-side will become more
creative in sourcing liquidity and that it will trade more and more
electronically, but save for the rare remaining long-only giants – like
Blackrock – the buy-side will not radically change their offerings.
“There are a lot of moving pieces over the
next couple of years and the buy-side will be thinking more about how they
execute and how their business models can be modified or streamlined,” says
For the sell-side, an unintended
consequence of the reforms designed to reduce systemic risk may be that only
the biggest firms will have the resources to compete effectively in the new environment.
While facing new guidelines and oversight, brokers,
dealers, market-makers and other securities firms are racing to find
appropriate new business models. But they are hard to identify and even harder
to grasp with traditional revenues dwindling and new costs spiralling.
At the arguably more adventurous end of the
buy-side, one source says there is chatter about hedge funds transforming into
swap dealers and leveraging existing technology investments to pursue new
business opportunities, although it is likely only the most well-resourced
firms will take this path.
Woodbine’s Owens agrees: “Any non-bank
broker/dealer could increase their share of business if they are willing to
risk capital and make markets and this is an avenue also open to
well-capitalised hedge funds or even smaller, innovative prop shops.”
The source, who asked to remain nameless
because he works on the sell-side developing business opportunities, says
steeper capital charges under Basel III mean the traditional sell-side model of
transferring and repackaging risk for clients to make it attractive and
saleable to other market participants, might be too expensive for many brokers.
If they can’t make markets in as many instruments as they used to, larger sell-side
firms with well-established flow-based agency franchises will be able to source
prices from droves of new trading platforms and counterparts. To begin with, there
will likely be half a dozen SEFs for each asset class, and even after
concentration, many industry pundits expect three or four platforms to thrive
in the most liquid instruments.
But smaller firms without substantial
budgets or infrastructures may struggle to compete when the costs of
connectivity, clearing and collateral management will cut deep into margins.
And the resulting concentration of derivatives volumes in the hands of the
biggest firms, is the very opposite of what the G20 had in mind.