Opportunities Beckon Amid Economic Turmoil
Bear Stearns has crashed, assets are being written off by the boatload and positions are being slashed. But it is never as good as it looks on the top, and it's never as bad as it looks when things are down. While many companies are shoring up their balance sheets, realigning staff and cutting initiatives, there are opportunities for those firms that aren't afraid to act.
During a dislocation there typically is a flight to quality. While many fixed-income products (e.g., mortgage-backed, asset-backed, auction rate notes, etc.) are defibrillating, assets need to go somewhere else. Much of the fixed-income challenge stems from the inability to obtain transparency and pricing. This has and will continue to cause assets to flow to more-liquid and more easily priced assets, such as sovereign debt, equities and listed derivatives.
In addition to product quality, large investors also are looking at the quality of their trading partners and diversifying counterparty risk. As brokers shore up their balance sheets, their proprietary trading and the risk capital that they are willing to extend will decline, and the pricing of that capital will become more expensive. This provides opportunities for smaller brokers with good execution capabilities to regain ground they've lost over the past five years.
This risk-capital reduction will have other impacts, including the faster implementation of automated trading across traditionally manual markets, the migration of OTC derivatives products toward exchange-traded derivatives and, hence, the increasing power of exchanges or automated matching mechanisms. These three aspects come into play as banks and brokers reduce their risk and investors need to go elsewhere for quotes.
Over the past 10 years I have been very bearish on fixed-income electronic matching platforms. Other than the Tradeweb/MarketAxess-type request-for-quote platforms and interdealer broker platforms, it has been difficult for ECN-type fixed-income platforms to succeed. Fixed-income ECN-style platforms need liquidity providers to prime the pump. Bulge-bracket brokers are the main liquidity providers. But ECNs and trading desks are in conflict as ECN platforms take flow away from the trading desks where brokers make their money. So there has been little incentive for brokers to provide liquidity to platforms that threatened their franchise.
As traditional fixed-income markets seize and brokers become more leery to extend credit and capital, however, an agency market begins to make more sense. This way it becomes easier for brokers to move in and out of the market without taking risk.
Hand in hand with the development of fixed-income ECNs, exchanges also will prosper. Exchanges enable efficient risk transfer. Besides being central counterparties, they force firms to confirm trades, mitigate risk, manage margin and focus liquidity across a smaller number of more actively traded products. As brokers look to reduce their risk exposure, and the buy side looks to move into positions with greater transparency and liquidity, there will be an opportunity to concentrate OTC-type products into a more select and liquid selection of exchange-traded products. Investors may not get products with the exact characteristics they want, but they will get liquidity and transparency, two things gravely missing in dislocated markets.
This is exactly the time to be aggressive. During times of challenges, markets across the board are oversold. Of course, some assets deserve to be sold; however, many don't. So while the natural tendency during a crisis is to pull up the covers, it is exactly the wrong time to hunker down. Take some calculated risk. After all, when things are down, so are prices.
Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio
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