Big is better, managers say

The financial debacles that have roiled markets this year have put an unprecedented emphasis on counterparty risk, changing the way equity and fixed-income money managers conduct business with brokers.

“You have to be quite convinced that you are engaging in business with an entity which is going to be a keeper. That will mean a concentration of business away from the second-tier players and toward the best capitalized brokerage firms in the U.S. and probably some foreign entities that have implicit state sponsorship,” said Tad Rivelle, founding partner and chief investment officer at Metropolitan West Asset Management LLC. The Los Angeles-based fixed-income manager has $18 billion under management.

The move toward a limited group of large brokerage firms might appear counterintuitive, given that two former members of that exclusive club, Bear Stearns Cos. Inc. and Lehman Brothers Holdings Inc., both New York, faltered while others suffered major blows to their balance sheets.

But the time and cost of performing due diligence for an array of service providers is limiting the number of firms that any money manager — large or small — can afford to research. The few big players left, such as Goldman Sachs & Co. Inc. or Morgan Stanley, both New York, now operate as tightly regulated bank holding companies. That business structure provides some reassurance, in particular given allegations of massive fraud at a hedge fund owned by Bernard L. Madoff Investment Securities LLC, New York. Mr. Madoff was a legend in financial circles as a leading independent stock broker, market maker and expert in market structure.

“How many times do we have to say, "You've got to be kidding me',” said Steven Sheldon, principal at SMS Capital Management LLC, in Bellaire, Texas. He noted counterparty risk has become the key concern for all investors, large and small. The firm has $30 million in assets under management and uses Fidelity Brokerage Services LLC, Boston, for both trading and custodian services.

“You cannot pick someone nobody has heard of, but even big names are not necessarily safe. This has brought about a whole new level of skepticism among managers,” Mr. Sheldon said.

While money managers are now very cautious about any entity they deal with, Wall Street firms are also more intent now on cultivating relationships with conservative clients, rather than with high-paying customers such as hedge funds who generate hefty fees. In short, changes in the manager-broker relationship are coming from both sides of the trade.

“It was much more exciting (for the brokerage firms) to deal with hedge funds because they were doing leveraged trades and had a prime brokerage relationship that generated fees. You could tell there was an attitude of almost disdain toward traditional institutions as if they were barely worth the time,” Mr. Rivelle said. “But we have seen that they are much more interested in our business now.”

In addition, bulge-bracket firms might have to nurture their trading relationships with traditional managers, as agency-only execution brokers, free of potential conflicts of interests, have increasingly encroached on their turf during the market turmoil. One reason is that Wall Street trading desks have shied away from committing capital to complete large trades in difficult market conditions. Risk-averse large firms also have curtailed their proprietary trading, which had the effect of lessening the odds of finding an in-house match for large orders.

But according to George Bodine, director of trading research at consultancy Quantitative Services Group LLC, Naperville, Ill., a new breed of brokers may emerge to fill that void if Wall Street continues to curtail capital commitment for institutional trades.

“You are going to see new (brokerage) entities come out that will just concentrate on principal trades. If they can make better markets, you'll see them come out,” said Mr. Bodine, who is based in New York, where he previously served as director of trading at General Motors Asset Management.

“They (principal trading firms) have enough derivatives out there to hedge themselves,” Mr. Bodine added, as hedging via derivatives may make it a viable proposition for these firms to offer capital commitment.

The changes that have affected Wall Street this year are profound, according to Robert Gasser, chief executive officer at agency broker Investment Technology Group Inc., New York. “The landscape of U.S. market structure has changed irreversibly this year. It's hard to put the genie back in the bottle,” Mr. Gasser said.

After so much upheaval, both sides have a much diminished appetite for risky or overly trusting behavior. For instance, the fall of Lehman Brothers in September has left some customers' commission dollars tied up in bankruptcy proceedings, which has, in turn, revived interest in commission recapture programs.

Unlike commission agreements that are used by money managers to pay for research, commission recapture sends funds directly to an institutional investor client such as a pension plan. That's a return to doing business the old-fashioned way.

“Over the last two years, it has become very clear that pension funds and other owners of capital still value commission recapture. There is a good economic case for it, even for unbundled trade flow,”' said Ian Toner, head of commission management at Russell Investments, Tacoma, Wash.

“We have seen hundreds of letters sent by pension fund clients to their investment managers emphasizing that they see commission recapture as an important part of the investment management relationship,” Mr. Toner added. “A dollar saved is just as good as a dollar earned, after all.”

Perhaps the single most important factor reshaping the relationship among various financial industry participants is the new-found desire for more regulation or oversight — anathema just two years ago. But the bloodbath on Wall Street has shown that the smartest guys and other rocket scientists in the room need adult supervision.

“Sophisticated investors, that's an oxymoron, as you saw some of the most sophisticated (people) investing with Bernie Madoff. But even the so-called sophisticated investors deserve to have the protection of the government,” said Mr. Weild, who also is senior adviser at Grant Thornton LLP.

“Mutual funds have reporting requirements. But if you are not a regulated entity, you don't. We have a huge amount of assets invested in our capital markets and very little transparency. We have different sets of rules in the same game, which can cause harm to others playing on the field. It's just not fair,” said Mr. Weild, who expects stricter control over hedge funds.