The collapse of Lehman Brothers 51 weeks ago had numerous painful repercussions across the financial markets. For many buy-side traders, it was the final nail in the coffin for risk pricing. But as Lehman endures its anniversary autopsy, there are signs that capital commitment is coming back to life.
In August last year, at least a year into the US sub-prime crisis and its aftermath, The Trade conducted a straw poll on buy- and sell-side attitudes to, and appetite for, securing a risk price.
More than 85% of respondents said that the sell-side enthusiasm for committing capital to client trades was declining, while around 60% claimed that buy-side appetite was waning. This change of sentiment had a predictable impact on price. “Premiums are up, but it is negotiable. It depends on how desperate you are to trade,” said one buy-side trading head.
Within a few weeks, the poll – and capital commitment – was history.
As traders attempted to take in the ramifications of the failure of so many pillars of the financial establishment and the Chicago Board Options Exchange Volatility Index reached unprecedented levels, risk pricing was soon beyond the pale. Intraday volatility in even the most liquid stocks was so extreme that buy-side traders knew there was no point picking up the phone as they would not be able to pay the rates the banks judged necessary to protect themselves. Trading in London was hit particularly badly due to the reliance on risk pricing by many institutional investors operating out of the UK.
After the tap was switched off, the tactics of the buy-side adjusted. Self-directed trading and agency brokerage enjoyed a boost as many buy/sell-side relationships that had been based on capital commitment foundered. With balance sheets and staff morale in bad need of repair – and electronic trading tools offering the buy-side a much wider range of execution options – a key revenue stream for bulge-bracket firms seemed to be off the agenda for good.
But even as they made hay, a number of agency brokerages recognised that their window of opportunity might close fast. “Investment banks will regroup quite aggressively, toward the end of this year or early next,” said one agency broker.
Right on schedule, a small number of sell-side firms have indicated that they are open for risk business. The return of appetite for risk comes from a number of sources. First, there are the banks that have engineered a remarkable return to profit and balance sheet health during 2009. Second, there are a small number of banks that have rationalised and centralised their risk activities in order to take on more business. Third, some banks that have used taken the opportunity to boost their cash equities franchise are offering capital commitment to support franchise growth.
Recovery is fragile – and patchy. By no means are all banks are prepared to commit capital and those that are remain selective. Risk pricing for program trades is at pre-Lehman levels, according to a number of buy-side traders, but continued high volatility in individual stocks means most brokers remain risk averse. Risk pricing may never reach the level of importance it enjoyed prior to the credit crunch – but reports of its demise appear to have been exaggerated.
To register your vote in our monthly poll on risk pricing, click here