The future of trading

It was a month to remember: the unthinkable implosion of Lehman Brothers in September precipitated a downward spiral in global financial markets, the likes of which few have witnessed. As fear cascaded through trading desks across the world, prompting a mass sell-off in financial stocks, the banking industry – once regarded as the poster-child of free market capitalism – began to buckle, leading in October to the most severe crash since Black Monday.

In this nexus of collective panic, one pervasive image has now emerged iconic: that of the fraught trader staring aghast as the world’s stock-markets take a vertiginous dive into the financial abyss. As the crisis has unfolded, the trader has found himself occupying centre stage, the anti-hero in a compelling global drama of dishonesty, hubris and greed. Condemned as ‘spivs’ and ‘sharks’ by politicians and popular commentators alike, the trading community is now under fire and under scrutiny. As one senior trader at a major investment bank observes philosophically: “Trading has always been controversial” – but never so much as at this defining moment.

Those caught up in the drama – including desk traders, executives of trading platforms, hedge fund managers, prime brokers, banking chiefs and regulators – all foresee a post-crisis trading landscape characterised by varying degrees of adjustment. Politically, if not practically, it could not be otherwise. But the shape, extent and desirability of such change remain terribly uncertain. Will the equities markets see long-term trading restrictions, and can the now notorious credit derivative markets survive at all? Can the hedge fund community perform in a highly de-leveraged environment, and will the collapse of Lehmans force a transformation of the prime brokerage business? Furthermore, to what extent, if at all, will the trader’s bonus, now an emblem of the City’s excess, be stamped out? All these questions and many more are now open to debate.

Short shrift

Throughout the crisis, public outrage has focused on the trading activity of the equities markets – the flashpoint for the crisis. At the heart of this controversy is the strong belief that the markets and its constituents have been badly abused by traders cynically seeking to profit from failing companies, leading regulators worldwide to impose restrictions on short-sell positions.

Certainly, there are practitioners in the marketplace who share this view. Brian Taylor, a former executive at retail trading platform PLUS Markets and managing director of BTA Consulting, is one of them. He believes September’s conflagration revealed glaring inadequacies in the UK’s market-abuse surveillance systems, belying the notion of a fair and orderly market and leaving the retail investor exposed. “If the government and the regulators do not address this then companies will either de-list or will move to other safer jurisdictions,” he says. The Financial Services Authority (FSA) must take strict action to protect the lay investor by eliminating parties that obstruct the operation of orderly and fair markets, he adds.

The FSA did not respond to enquiries on this and other issues. It seems likely, however, that the watchdog will come under pressure to revamp its controls and improve its detection of illegal trading behaviour. Few believe, however, that these new controls will entail long-term restrictions on short-selling, not least for two reasons. First, instances in which it was immediately assumed shorting was responsible – particularly the rout of HBOS – no longer appear to be the case. In fact, notes one CEO of a trading platform who asked not to be named, it is clear from activity on retail platforms such as PLUS, which saw record trading volumes in September, that fearful retail investors dumping the bank’s stock were largely to blame.

Helpful restrictions

Nonetheless, some in the marketplace still believe the short-sell restrictions, insofar as they represented a pseudo-circuit-breaker, proved helpful and may lead regulators to devise a similar, rule-based mechanism on a long-term basis, says an executive at a major European bank. “In the next three to six months, you’ll probably have ­circuit-breakers on the down side, in the form of some type of uptick rule or quantity restrictions.”

The uptick rule – used in the US until last year – dictates the relative price movements at which traders may short a stock. Eddy Wy­meersch, chair of the Committee of European Securities Regulators (CESR), does not, however, foresee a full-scale shorting ban in any jurisdiction.

More worrying for investors is the indirect impact of the restrictions. Anthony Byrne, head of securities lending in Deutsche Bank’s global market’s division, says that controversy surrounding short-selling and securities lending has made some beneficial owners “less willing to put their shares in lending programmes” and could lead to an overall reduction in the amount of stock available for lending in future. Borrowing stock is likely to become more costly, which could have implications for a range of trading and hedging activities.

This would be an unfortunate outcome for a marketplace that has spent the past four years raising competition and reducing the costs of investing in equities, and serves to underline the disproportionate extent to which equities markets have featured in the political debates on the crisis. As Philip Allison, managing director, head of European client trading and execution at UBS, observes: “It is ironic that much of the debate recently has come back to cash equities - which is one of the most transparent markets.”

Credit exchange

Less transparent, of course, is the beleaguered credit derivatives market. Many in the industry, including regulators, question to what extent (if at all) credit derivatives will enjoy a future. Threats to the market include the global decline in cheap credit, a general investor retreat from such products, and tighter regulatory controls. But for industry grandee David Hodgkinson, group chief operating officer at HSBC, the credit derivatives market – and in particular the credit default swap (CDS) market – still have an important role to play.

“The CDS market and other markets are very valuable and very useful: the concept of the distribution of risk is one that’s very relevant to the future. But it must be genuine distribution: the risks themselves must be understandable and quantifiable,” he says.

This is particularly true of the CDS market, which, despite being the most common credit derivatives product – accounting for some $62,000bn-worth of debt – remains privately traded and entirely unregulated. This is about to change, however. In September, it became clear that swings in the CDS market are having a direct impact on the fortunes of banking stocks, particularly as some hedge funds have been using CDSs as a proxy by which to circumvent restrictions on shorting, and express a negative view of the creditworthiness of certain institutions. For this reason, the Securities and Exchange Commission (SEC) has launched an anti-fraud investigation into the possible manipulation of CDS trading activities, while New York State has already unveiled plans to bring the CDS market under the control of insurance supervisors.

In Europe, the regulators are also assessing ways in which to better supervise, more broadly, the credit derivatives market – with attention falling chiefly on the valuation mechanism, says CESR’s Mr Wymeersch. “The main problem is that we are unable to value these instruments because they are privately traded, so we don’t know what the risks are.” Regulation in this space will likely be indirect, he continues, and will focus on creating stricter controls around disclosure and ratings. Regulators might even indicate the way in which products are valued. “We will regulate them functionally and make sure that there is sufficient disclosure,” says Mr Wymeersch. “We will also make sure that there is continuous disclosure, as the underlying portfolios often change over time.”

Efforts are also well under way to improve the market’s infrastructure and push such instruments onto exchange, thereby providing the necessary framework, transparency and improved pricing mechanism many feel are so sorely needed. If there are any winners from the crisis, it will surely be the major derivative trade processing platform providers. These include the Chicago Mercantile Exchange, which has entered into an agreement with hedge fund giant Citadel to create a joint electronic exchange and clearing facility for CDS products by year-end, and dealer consortium-owned Clearing Corporation, which is also planning to create a separate CDS clearing house by January.

Through the creation of a central counterparty, which would guarantee and net all trades, the systemic risk associated with counterparty exposure – underlined by the collapse of Lehman Brothers – would be substantially reduced. Many dealers fear that the move onto exchange – which would likely result in regulators imposing higher fees to fund the counterparty guarantees – will reduce the profitability of trading credit derivatives. But Ron Papanek, a market strategist at risk management firm RiskMetrics, says that this would not necessarily be the case. “Creating an exchange-like entity will likely increase the volume and efficiency with which counterparties can transact in this market, so you could argue that it will make it more efficient and profitable in the long run.”

Ban the bonus?

In recent years, the profitability of credit derivatives has served to dramatically inflate bonus payouts – another powerful source of public and political displeasure. Yet although popular condemnation of banking compensation schemes is undoubtedly fuelled by the politics of economic envy, more pointed complaints on the subject – particularly the suggestion that bloated bonus payouts have fostered a short-termist culture of excessive risk taking – have some foundation.

Extensive research carried out by professional services firm PricewaterhouseCoopers (PwC) has found a positive correlation between bonus structures and risk-taking in certain pockets of the banking industry, particularly on the trading desks. UBS was one of the first banks to identify these issues. In its report to shareholders published in April 2008, in which it outlined the failings that led the bank to write down nearly $40bn, it pointed to “asymmetric risk/reward compensation” and “insufficient incentives to protect the UBS franchise long-term”, as contributing factors.

If the potent combination of public outrage and political posturing had not put an end to the much-reviled ‘bonus-led’ culture by the end of September, the unprecedented move to part-nationalise vast swathes of the US and UK banking sectors in early October has likely sealed its fate. Under pressure from the UK government, the FSA is undertaking a review of compensation schemes. Although it is reluctant to intervene in such schemes directly, it has initially recommended that they be in line with “sound risk management”. The watchdog plans to undertake further research in this area and, according to John Terry, head of the reward practice at PwC, may introduce some form of principles-based regulation by the beginning of next year.

At a European level, CESR is also concerned to clamp down on “rewards for failure”, says Mr ­Wymeersch. “The question is: how do you build remuneration schemes? You have to build them on the long-term achievements.” Many banking executives agree. HSBC’s Mr Hodgkinson believes the sector should move to a model in which compensation is both deferred and conditional upon the performance of the company or particular part of the business.

Many banks are therefore “looking hard” at ways to better align trader rewards, says Mr Terry, including tying payouts to the long-term performance of trading desks and business divisions. The notion of ‘clawback’, in which bankers might be required to effectively hand back their bonuses if deals go wrong, is also under consideration.

Strong scepticism remains, however, as to whether it will be possible to effectively restructure and administer the remuneration system in this way. During his 20 year stint in the investment banking industry, Robin Osmond, CEO of trading platform Tradefair, and a former senior investment banker at Morgan Stanley and HSBC, managed several payout schemes, and says any such restructuring would be “hugely complicated”. Moreover, the potential flight of talent to other jurisdictions such a restructure would likely prompt would make any measures workable only on an international scale.

Hedge fund crucible

Hedge fund traders, of course, have taken home the most substantial paycheques in recent years, but few will enjoy such spoils in future, not least because 2008 has proved disastrous. Since January, the average hedge fund has lost about 10%, according to the HFRX daily index from Hedge Fund Research, marking its worst year since records began. Undoubtedly, the restrictions on short-­selling have, and will continue, to affect hedge fund returns adversely, but of more long-term concern, says Mr Osmond, are the weakened credit markets. The days when hedge funds could trade with vast sums of borrowed money based on a sliver of collateral are over, he says.

“There is a growing realisation that many hedge funds were leveraging returns on an underlying bull market. It wasn’t that they had an industry redefining model for asset management,” he says. Not everyone is so pessimistic, however.

Nevertheless, Mr Morley agrees with the widespread prediction that the hedge fund industry will naturally contract. This trend is already under way, with the first half of 2008 experiencing a 15% increase in liquidations over the same period in 2007, reports Hedge Fund Research. A recent wave of investor redemptions indicates ever-faster deteriorating confidence in the hedge fund sector, particularly at the lower end. In September alone, hedge fund withdrawals hit $43bn, according to TrimTabs Investment Research. A second, far larger, wave of redemptions is widely expected, which many anticipate will push a substantial number of hedge funds into liquidation during the coming year.

But the shrinking of what is a bloated industry will be in the best interests of investors, says Mr Morley, exposing “wannabe” hedge fund managers returning ‘beta’ (returns in line with the direction and volatility of the market) that is leveraged. “They’ll disappear, and that’s how it should be,” he says. Meanwhile, typical hedge fund earnings, traditionally in excess of 20%, are likely to dwindle to normal equity returns for the foreseeable future, says Mr Osmond.

Prime brokerage broken?

Like banks, hedge funds with weak capital bases will also find themselves in a difficult position, proving increasingly unattractive to the embattled prime broker community. Having been locked in a fierce five-year war to attract hedge funds and their highly profitable transaction flows, the prime broker community – the majority of which now shelters under a banking licence – will have to be more discerning about the liquidity and exposure of future clients, and the quality of collateral they are prepared to accept when lending. As one trading expert jokes: “There’s a whole new type of risk management: it is called ‘I am not going to do business with you’.”

But this scrutiny will operate in both directions. For those hedge funds using Lehman Brothers as their single broker, the lessons of the broker’s collapse were particularly harsh. Jeff Hudson, CEO of trading software provider Vhayu, notes that at least two of his customers “were out of the market” for more than two days following the bank’s bankruptcy. As such, Lehman’s collapse has finally killed off the waning ‘prime’ broker model as it was traditionally conceived, and will prompt the vast majority of hedge funds to move to a multi-prime model.

But for many of Lehman Brothers’ clients, being unable to trade was a lesser concern than the security of their assets which, under the practice of rehypthecation, are legally transferred to prime brokers in order to back loans. The community’s concerns were vindicated when it was discovered that $22bn of the $40bn held by Lehmans’ European prime brokerage had been rehypothecated, leaving many funds, including Olivant Advisors, the activist investment firm, unable to access or locate their assets. The resulting collective anger regarding the practice of rehypothecation – which, according to one fund manager, means “grabbing assets that someone else owns for a purpose other than the one they were intended for” – will probably force many funds to review their contracts.

The cost of protest

But protests will incur a cost. Prime brokers use rehypothecated assets in order to raise cash and, in turn, fund leveraged purchases, or to support securities lending. If the practice is seriously challenged, the entire prime broker model could come undone, divesting the industry of a never-more vital source of cheap finance and substantially increasing the cost of lending. For the time being, much hedge fund cash has been moved out of prime broker accounts and into money market funds, while managers seek more long-term solutions. This includes turning to alternative markets to raise funds and moving assets to custodians, such as State Street.

It seems unlikely, however, that rehypothecation will be eliminated altogether: rather, those prime brokers willing and able to offer a range of risk and cost-adjusted options surrounding the custody and appropriation of client assets, as well as clear visibility on those assets under rehypothecation, will find themselves in a stronger position to attract clients in the long term. Knowledge that the prime broker in question is buoyed by a truly robust balance sheet will also be critical. Many commercial banks are already benefiting from this point of differentiation, allowing them to compensate for the downturn by charging a premium for their services, says one prime broker.

As such, the crisis could well precipitate a major shift in the entire global business. Prime brokerage – long the preserve of the US broker dealer – will become a strongly European business. In the short term, however, even European prime brokers privately anticipate that the industry – which has traditionally enjoyed about 20% return on equity – will suffer from the downturn in securities lending, the hedge fund shakeout, de-leveraging and the increased cost of capital. This will result in negative growth rates for some time to come.

Few will welcome this outcome – after all, no one favours a decline in profitability, however unsustainable the prevailing regime may be. Nevertheless, the industry is undergoing some necessary corrections in several areas that have long-enjoyed artificially high growth. In the meantime, the crisis should expedite the progress of many desirable market qualities, including increased transparency, efficiency and greater competition. For the lay investor at least, this is to be welcomed.