Before September, I hadn't heard the words "counterparty risk" in a long time. Now, not surprisingly, I can't have a conversation on the Street without discussing counterparty risk, nor, I presume, can traders trade without those words hanging in the air.
Although we've been talking about the buy side becoming more independent of the sell side for the past three to five years, in volatile times like these we realize how dependent buy-side firms are on their bulge-bracket brethren. In fact, as Editor-at-Large Ivy Schmerken reports in this month's cover story ("Buy Side Reevaluates Counterparty Risk and Reliance on Sell-Side Trading Platforms"), while the buy side is examining the possibility of moving away from the bulge bracket and trading instead with agency brokers to avoid counterparty risk, even with the current turmoil buy-side firms are not ready to give up on their bulge-bracket relationships yet — at least, not as long as their trading commissions are being used to pay for both execution and research. According to sources, the buy side still gets more bang for the buck with the bulge bracket.
One area in which counterparty risk is driving the buy side to seek changes in its relationship with the sell side, however, is the client commission agreement. While the CCA was a great concept that helped buy-side firms unbundle their commission dollars from execution dollars, the current instability of some broker-dealers has highlighted the risk that a buy-side firm faces when it pools its research dollars with one broker-dealer. As always, though, out of chaos comes opportunity, and there already are some sell-side firms working to create a CCA utility to offset some of that risk (see "CCAs May Get a Face Lift As Counterparty Risk Looms Large?").
Counterparty risk even comes into play with regard to algorithms and technology. Buy-side firms may increasingly execute trades on their own, but they still rely on the bulge bracket's algos and technology to trade. If, say, Goldman Sachs went out of business today, how would REDIPlus users cope? Then, of course, there are the dark pools, many of which are broker-owned. There has been talk that these broker-owned dark pools will lose order flow to independently owned crossing networks as the buy side seeks to minimize its exposure to the reeling brokers.
Amid the counterparty risk concerns, there is more change occurring in the markets right now than we've seen in years. Buy- and sell-side traders alike are trying to get a handle on the upheaval and figure out what it all means for the future of financial services. To provide a little perspective, Advanced Trading asked some industry experts to offer their insights on what the new Wall Street might look like (page 36). But no one knows for sure how the financial crisis will shake out or what scars and opportunities it will leave on the industry. If you have any ideas, comments or predictions that you'd like to share, please send them our way ([email protected]) — we'll be sure to post them on AdvancedTrading.com and share them with the industry.