Agency Brokers Take Role in Credit Markets Recovery

A new market structure is emerging in fixed-income trading as entrepreneurial sell-side firms with less recognizable names move into debt trading to capitalize on the pullback by the big banks and bulge-bracket broker-dealers, which appear less willing in the wake of the credit crisis to risk capital to make markets in bonds.

The collapses of Bear Stearns and Lehman Brothers, the major bond dealers, and the sale of Merrill Lynch to Bank of America created an opportunity for agency brokers to search out counterparties for the buy-side institutions that traditionally relied on the bulge bracket for fixed-income trading. The emergence of agency broker fixed-income desks is a sign that Wall Street is reinventing itself in high-grade, high-yield, distressed debt, and mortgage-backed and asset-backed securities following the credit freeze.

Pointing to the significant head count reductions at the big banks and broker-dealers, Chris Zingo, SVP of SuperDerivatives, notes that boutique sell-side firms now can bring in talent with deep existing relationships on the buy side and start generating order flow quickly.

Meanwhile agency brokers recognize that they need to cover both equities and fixed income to serve hedge fund clients whose strategies span multiple asset classes. JonesTrading Institutional Services, for example, has many hedge fund clients doing capital market structure arbitrage, according to Will Geyer, the firm's president. "They may sell the stock and buy the bonds," he says. "That means knowing it across the asset classes."

But what does the agency model mean for the institutional investors? According to Neil Decker, director of fixed-income trading at Capital Institutional Services (CAPIS), an institutional agency broker in Dallas that has executed fixed-income trades for the past 20 years, institutions that depended on the large dealers to make a two-way market in corporate bonds no longer can count on that. "[Institutions] need to access liquidity when they want it, not when it suits the bulge-bracket firms," he comments.

Since the credit crisis gripped the markets, Decker adds, when a money manager needs to sell a bond, it may have to call 20 to 30 shops to execute a trade. "They don't have the contacts or the time to make all these calls, so that's why you'd need a broker intermediary," he explains.

The large dealers are "all very situational-oriented," Decker continues. "If they're not involved [with a position], they're not looking for a reason to get involved."

In addition to more-attentive service, the agency brokers also can provide competitive pricing in today's market, according to SuperDerivatives' Zingo. "Because we're in a deleveraged environment, [the big banks] are taking in less inventory, so their ability to be price- competitive is somewhat diminished," he explains. So, "There's value in being able to find the other side of the trade for clients," Zingo says of the agency model.

Zingo adds that for the agency brokers adding fixed-income desks, the next move likely would be to add the ability to sell derivatives. "If their clients are buying the interest-rate instruments, the natural extension is to execute the interest-rate swaps," he says.

And with the Obama administration's proposed financial reforms seeking to push trading of standardized OTC derivatives contracts onto exchanges and centralized clearing facilities, Zingo contends, agency brokers are more likely to pursue trading of credit derivatives, which can be used as hedges for their clients. In fact several agency brokers indicated to Advanced Trading that they were considering such a move.

But it's not clear that buy-side firms can entirely rely on agency brokers for their fixed-income needs, either. The issue of how much capital these firms have and what kind of technology platforms they can afford to develop to compete with the bulge-bracket dealers is not clear.

Nonetheless some of the agency brokers are expanding rapidly and making inroads into fixed income. Only time will tell whether this is a short-term trade or a permanent change in the market structure.