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.