Buy Side Reevaluates Counterparty Risk and Reliance on Sell-Side Trading Platforms
With the demise of Lehman Brothers and the subsequent upheaval among bulge-bracket firms on Wall Street, buy-side traders are scrutinizing their exposure to sell-side counterparties and reassessing their reliance on sell-side trading technology.
After living through the collapse of Bear Stearns, the bankruptcy of Lehman and the hasty sale of Merrill Lynch to Bank of America, followed by concerns over the stability of Morgan Stanley and Goldman Sachs, buy-side firms are more cautious about relying on the top investment banks for serving all their needs, including access to liquidity and technology. In addition to rethinking their exposure to counterparties in the execution space, buy-side firms also are examining their relationships with clearing firms, depositories and trading systems that could expose them to risk if a counterparty were to default.
"We are spending a lot of time thinking about counterparty risk -- not just thinking about our immediate counterparties but looking at the markets we're trading in and drilling down to the depositories that the equities we trade settle at," reveals a buy-side trading veteran who requested anonymity.
The question is: How will the turmoil on Wall Street impact the actions of traders at investment managers and hedge funds? Will they shift order flow to agency brokers to avoid counterparty risk? Is the buy side going to look more closely at third-party technology vendors as alternatives or backups to bulge-bracket execution management systems (EMSs)?
While buy-side traders agree that the immediate danger of brokers defaulting has been stabilized now that both Morgan and Goldman have transformed into bank holding companies and received capital from outside investors (i.e., Mitsubishi UFJ and Warren Buffett, respectively), there still is a lot of uncertainty in the financial markets. "The buy side has so many concerns right now; I don't know how they are keeping their heads above water," says John Comerford, EVP and global head of trading research at Instinet, a global agency brokerage firm whose parent is Nomura Securities International.
Keeping Clients' Money Safe
"No. 1, you have to make sure that your money and your clients' [money] is safe. You also have to worry about the trading, and you have to make sure that if you make a trade, someone is going to be there to settle it," Comerford continues. "So there is counterparty risk. It is a very challenging problem that everyone is facing right now."
The fast-moving financial crisis certainly has made buy-side traders more apprehensive about doing business with sell-side firms, confirms Brian Baker, manager of trading at BB&T Asset Management in Raleigh, N.C. "It's made us more diligent to assure that our process of evaluating brokers is as it should be," he comments. "We're constantly reevaluating the brokerage landscape. We're doing this on a weekly basis."
According to Baker, prior to the credit crisis BB&T analyzed and reviewed its brokerage counterparties on a quarterly basis. "Now we have more informal dialogue and ad hoc committee meetings to discuss counterparty exposure," reports Baker, who oversees equities and fixed-income trading and confers with the firm's chief investment officer.
Even after the collapse of Bear Stearns in March, a lot of people didn't expect Lehman to go under, he notes. But with so many household Wall Street names in the news, Baker adds, he had to pay attention to the "little whispers and hints and rumors that started surfacing this past May or June, some of which had some degree of merit." With the fate of brokerage houses changing direction so quickly, "You really have to be forecasting," he adds.
As concerns mounted, Baker says, he curtailed trading with certain firms. "Nobody wants to stop doing business with anybody," he comments. "On the other hand, I don't want to say that we had counterparty risk exposure with XYZ yesterday and today they're out of business."
While the buy side has paid attention to counterparty risk for many years, it is applying increased vigor to the process, adds Navin Sharma, VP and director of risk management at OppenheimerFunds in New York. "The analysis of counterparty risk in great detail is here to stay, and firms have gone to great pains to make sure they have a good handle on counterparty risk," he emphasizes. "We actually have multiple levels of credit analysis that consider, review and opine on new counterparties."
Multiple departments -- from risk, legal and compliance to fund operations/accounting and investments -- scrutinize OppenheimerFunds' counterparty risk, Sharma continues. "All of these areas are working together as part of a counterparty risk committee to make sure we don't leave any stone unturned in reviewing counterparty risk and related credit analysis," he says.
Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio
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