At first glance, the week starting 15 September should have been a difficult one for the buy-side. Some of its biggest and most important trading counterparties either went under completely, were bought, or were severely weakened. While counterparty risk was kept under control, the ride has been far from smooth.
On Monday, the market was hit by a double-whammy. The holding company of investment bank Lehman Brothers filed for Chapter 11 bankruptcy protection, casting the future of its still-operational broker-dealer units around the world into doubt. Then Bank of America, at one time a potential buyer of Lehman, acquired Merrill Lynch for $50 billion.
The following day, the share prices of two more global investment banks, Goldman Sachs and Morgan Stanley, fell sharply following the release of their Q3 results, prompting speculation that both needed rescuing. Both banks have subsequently converted their legal status to bank holding companies from investment banks, granting them access to Federal Reserve funding if required. They also attracted additional investment from Berkshire Hathaway and Mitsubishi UFJ respectively.
Despite the weakening or loss of some of its biggest trading partners, however, the buy-side has emerged relatively untroubled – largely thanks to prudent counterparty risk management practices and careful monitoring of the condition of troubled banks. Although Lehman Brothers was declared bankrupt, anecdotal evidence suggests the buy-side has avoided significant exposure, because it heeded warning signs and took precautions before disaster struck.
“When Lehmans declined the approach from Korea Development Bank [on 9 September], we decided we did not want to have any exposure to them so we reduced everything we were doing with them, which was mainly on the government bond side, and stopped trading,” said Adrian Fitzpatrick, head of investment dealing, Aegon Asset Management UK, adding that Lehman Brothers is not a major counterparty for his firm in the equity markets. “We didn’t think they were going to go under – we thought a deal would be put together and they would carry on as an entity. But we didn’t want to be exposed until all the facts were clear.”
Other firms were similarly cautious. “We are keeping an eye on share price movements and credit default swap spreads to try to give us an idea of who is considered to be at risk by the marketplace, and we are taking a scaled approach,” said Peter Baillie, senior equity dealer at Martin Currie Investment Management. “For example, earlier in the year we were treating Lehman Brothers pretty much on a ‘we’ll only trade with them if there’s a compelling reason to do so’ basis, and by June, as they got closer to the eventual collapse, they went onto a total bar, where we wouldn’t trade with them at all.”
Some buy-side firms reported that, thanks to the strict counterparty risk management practices they already had in place, any changes to their procedures were only slight. “Naturally, when dealing with clients’ money, we are very diligent regarding our counterparties,” said Daemon Bear, head of European equity trading at J.P. Morgan Asset Management. “We were probably more diligent about rumours, but essentially what we did that week was no different from the way we would normally behave.”
The buy-side is continuing to keep a watchful eye on any potential future failures or difficulties to ensure they do not expose their clients to another bank collapse. Some have ramped up their existing procedures. Like many buy-side firms, Baring Asset Management has a counterparty credit committee which, among other things, approves all brokers and trading venues before the firm can use them. It usually meets every two weeks but, according to Brian Mitchell, Baring’s head of dealing and portfolio control, frequency has increased to every two days. “We have historically and are to an increased extent further minimising gross and net exposures to some brokers and in Q3 are currently using execution-only agency brokers more than our H1 2008 average, which was itself was up on 2007,” he said.
Although the continuing turmoil may result in changes to executing brokers lists, this is unlikely to cause big headaches. “There are a lot of ports of call open to us, so it is fairly easy to move from one place to another or diversify and move around,” said Baillie.
Another reason why counterparty credit risk is not the issue it once was on the equities side for some buy-side firms is their use of modern settlement mechanisms such as delivery versus payment (DvP). These mechanisms mean buy-side equity traders are really only exposed to the risk of having to try to execute the trade again another day if a bank fails and the transaction cannot be completed. “The shorter time span of DvP settlement also reduces risk compared with the longer settlement periods on certain other transactions,” adds Martin Currie’s Baillie.
However, hedge funds using banks’ prime brokerage facilities will have to tread much more carefully. “The prime broking side is more of a risk because you have significant amounts of assets held by your prime brokers,” said Baillie, whose firm also manages hedge funds. “Funds will need to look at diversifying cash holdings and splitting counterparty risk over a number of brokers. We have had to look very carefully at all of our relationships and take certain actions over the last week or two.” He added, “Two brokers are currently suspended because of assumed short term risk.”
While brokers’ troubles may not have greatly taxed the buy-side from a counterparty risk perspective, they have made traders’ jobs more challenging in other respects. The news that apparently stable banks were failing or in need of rescuing made global stock markets highly volatile, making trading more difficult.
“It was probably as volatile a market as we will see in our lifetimes, I suspect,” said Aegon’s Fitzpatrick. “The extremes of last week were just stunning – and totally unpredictable as well.”
For example, there were big swings in the daily closing value of the Dow Jones Industrial Average index in the US. It closed at 10,917.51 on 15 September, rose to 11,059.02 on 16 September, then fell again to close at 10,609.66 on 17 September.
Algorithmic trading in particular has suffered. “When a market is as volatile as it was [in the week beginning September 15], one thing you have to make sure you do, which some people hadn’t done, is put proper limits on your orders,” said Fitzpatrick. “We virtually stopped using algorithms on the basis that when you are trading via algos in fast or volatile markets, it can blow up in your face.”
He added, “In that situation, it’s best to go back to phoning brokers and send orders electronically to them so they can trade it in line with volumes with what ever parameters you want to set. That gives you an element of control.”
At a time when large banks’ finances are under pressure, the crisis has also made it harder to get capital commitment from brokers in some cases. “Brokers will make you a price depending on the institution, but it will be nothing like the size before; they can’t unwind the position because the market could move against them very quickly,” said Fitzpatrick.
The higher cost and greater scarcity of capital commitment is prompting more restraint in its use. “It has increased our efficiency around trying to use capital and brokers’ balance sheets,” said Bear at J.P. Morgan Asset Management.
Despite this, there is a silver lining for the buy-side. Although brokers may be more reluctant to offer a risk price now, their priorities may change as they begin to stabilise their businesses and set themselves on the road to recovery. “Broking houses are making quite a bit of a play about getting back to basics and offering a good quality equity trading service,” said Baillie at Martin Currie. “Facilitation is an important part of that. Those that survive, by simplifying or pulling away from some of the other parts of the business, might find that their best route to recovery is focusing on a more plain vanilla service, and they may be quite happy to offer a bit of capital to facilitate that.”