The Lehman Brothers collapse, a year ago today, “took risk pricing off the board” for many buy-side traders. Long-only asset management firms with deep and longstanding relationships with global brokers moved substantial trading volumes to an agency execution model over the final three months of 2008 and maintained that approach for the first three months of the next year.
But the absence of capital commitment wasn’t the only reason for change. During Q4 2008, many bulge-bracket broking businesses, especially those reliant on public money for survival, were very uncertain of their future. As such, a lot of brokers made aggressive cuts to their sales trading resources. “This had quite a significant impact on our ability to execute,” recalls one buy-side head of trading. “Trading might be an increasingly electronic activity, but you still need that market intelligence from human counterparts who can advise about matters like which venue to post liquidity on. This all disappeared.”
The phones weren’t being answered, but the lights did not go out.
Meanwhile, the agency brokers made the most of their opportunity. With capital commitment not part of their business model, the agency-only providers made their appetite known in other ways. Incentivised to get business through the door ‘cleanly’, agency sales traders delivered high-quality service through their mastery of electronic trading tools and understanding of liquidity dynamics in a rapidly fragmenting market environment. “They were very helpful at a time when execution was getting difficult,” another trader observes.
Since March, coinciding with an extended bull run in many of the world’s major equity indices that has lifted investor confidence, larger brokers and investment banking businesses have had their confidence restored too. These firms hired sales traders to replace the ones they let go last year, often at inflated salaries. They have also been willing to quote risk prices. And the buy-side is biting.
In many cases, the return of risk pricing appears to be a function of the need of brokers to win (back) market share. The firms that were hit hardest in Q4 2009 by collapsing headcount and trading volumes are among those keenest now to commit capital to client trades. And firms like Nomura and Barclays are reportedly using capital commitment as part of their strategy to grow their newly acquired franchises.
So everything back to normal then? Not quite.
Capital commitment has always been a function of supply and demand to some extent. “Very quickly a risk price can go from five basis points to 45 bps to a broker refusing to even quote. The aggression is rarely sustained. It’s all about inventory,” a buy-side source comments.
Both sides are now much more discriminatory in how, why and who they deal with on a risk basis, both for single stocks and program trades. “It only takes three or four dogs in a basket to wipe out the profit on a program trade,” a buy-side user of capital commitment says. It’s not called risk pricing for nothing.
And not everyone on the sell-side is coming back into the market. “Some brokers lack the ability to unwind trades effectively. There have been some uncomfortable conversations about loss ratios,” another head of trading notes.
As such, neither capacity nor demand for capital commitment has yet returned fully to pre-Lehman levels, and perhaps never will.
“The new trading environment doesn’t really lend itself as well to use of capital,” a buy-side source notes. “The decision-making process has changed. I’m likely to try a dark pool or use a combination of algos to source liquidity before going to a broker for a risk price.”
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