As the era of large independent investment banks draws to a close, so too, some in the industry are saying, is the era of capital use for executing trades.
For most buyside traders in the institutional equities space, there will be less capital available to facilitate large block trades, industry experts say. And when it is used, they add, it will be more expensive and deployed more carefully.
“I’m just not finding that capital commitment is there at this moment,” Jennifer Setzenfand, a senior trader with Federated Advisory Services Company, said, speaking from a panel on liquidity at last week’s Security Traders Association’s annual conference in Boca Raton, Fla. “Nobody’s taking any risk; everyone’s risk models are freaking out, essentially.”
One veteran block trader with decades of experience at a bulge bracket firm, who declined to give his name, said it’s highly unlikely that any of the remaining large trading houses are going to take down large sums of risk from customers in the foreseeable future. The severe volatility alone, he said, makes it nearly impossible to hedge oneself properly when taking on bigger risks.
“Now, if you take on risk in a stock, the stock can drop $2 to $3 in your face and you’re long 500,000 shares, and you’re just dead,” he said. “It’s not worth doing it.”
At the beginning of the year, there were 11 bulge bracket shops: five independent firms and six commercial banks. The equity departments of three of the independents—Merrill Lynch, Bear Stearns and Lehman Brothers—were absorbed into commercial banks. The other two—Goldman Sachs and Morgan Stanley—converted to bank holding companies. At the end of the year, there will be nine commercial banks in the bulge.
Before the subprime-induced credit crunch began to pummel financial markets in August 2007, the bulge bracket investment banks had extended vast amounts of capital to the buyside to facilitate trades. Of those, Goldman, Morgan Stanley and Lehman led the pack.
While they generally lost money on a net basis, the capital cemented the relationship. The investment banks made money by offering the buyside other services, explained Dushyant Shahrawat, research director at the financial consulting firm TowerGroup. Large commercial banks and second-tier brokerages also offered capital, he added, but to a far lesser extent.
The credit crunch throttled the balance sheets of the independent investment banks. And because none of them emerged unscathed, the buyside’s ability to obtain capital has since narrowed considerably.
This is because the survivors are now likely to be more risk-averse as all are federally regulated bank holding companies, Shahrawat said.
“When you’re under the Federal Reserve’s purview, that might turn the heat on what you can and cannot do with the capital that you have,” Shahrawat added, “because it’s not capital you have raised through investors or commercial paper. It’s depositor capital.”
The immediate problem is broker-dealer skittishness in the face of record volatility.
As banks and other financial institutions have fallen, uncertainty has run amok, particularly in the equities market. This, in turn, has awakened the volatility that had been raging and slumbering periodically since August 2007. However, this latest, most virulent strain—since Sept. 15—continues to storm upward and set new records on the Chicago Board Option Exchange’s Volatility Index.
The extraordinary volatility has widened spreads and made trading large blocks of stock an extremely risky proposition, industry experts say. As that volatility is reflected in pricing for capital, the conditions are anything but ideal for using capital for large block trades.
The head trader at a large investment management firm said that the business for large blocks in excess of $100 million started shrinking when bank write-offs began in late 2007.
“I think that game changed a lot,” he said. “I do believe [capital] left, but it left more in size and in price. Costs of capital widened out, plus the competitive landscape changed overnight. I think it’s still there, but I believe it’s smaller in scope.”
Still, the major players are expected to make some capital available to their buyside clients. UBS, for instance, is doing so with an eye toward the volatility and prudence, said Robert Harrington, its managing director for U.S. Cash Equity Trading.
Routine capital isn’t going anywhere, Harrington said, even in tight markets. And block capital remains an important part of UBS’s offering, as well.
“Well, there might be fewer people doing it, but I don’t see it completely drying up,” Harrington said of capital for routine trades. “That’s kind of a staple of the business, and even in the tight markets, you’re there to provide liquidity to the clients prudently.”
