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Wall Street Meltdown Making Buy-Side Firms Really Rethink Sell-Side Relationships

Investment management firms to start saying no to derivatives.

In the aftermath of the elimination of four bulge-bracket firms (Lehman Brothers through its bankruptcy and sales of assets to Barclays and Nomura; Merrill through its sale to BofA; Goldman and Morgan Stanley through becoming bank holding companies) from the ranks of independent brokerage firms, new research from TowerGroup finds that the unprecedented restructuring underway on Wall Street will have major and lasting impact on the investment management business.

TowerGroup believes the apparent demise of the independent brokerage model will force investment management firms to carefully reassess their reliance on Wall Street brokerage firms for research, trade execution, market insight, and back-office services. "Brokerage firms play a vital role in the smooth functioning of the overall financial system by providing liquidity, being market makers, and assuming risks, which becomes critical during periods of market uncertainty," says Dushyant Shahrawat, a senior research director in the TowerGroup Investment Management practice and author of the report, "How the Massive Upheaval on Wall Street Will Impact the Investment Management Business." "Although many Wall Street firms have found new homes in large commercial banks, it is highly unlikely their new parents will allow them to perform all these essential functions," Shahrawat wrote in the report.

Derivatives may lose their luster, the TowerGroup suggests. "Now that fewer brokerage firms facilitate over-the-counter derivatives trades and structured products, asset management firms may reduce their use of the products (at least temporarily) and instead make greater use of exchange-traded instruments," says Shahrawat. "Intense scrutiny in the use of derivatives and structured products will force asset management firms to reassess their use of these products, the way they are valued, the way firms manage risk related to them, and counterparty exposure related to them."

In all, TowerGroup predicts that the Wall Street upheaval will impact the buy side in eight key ways:

1. Less capital commitment from Wall Street.

2. Disruption in the provision of execution services.

3. Changes in securities lending services

4. Greater focus on risk management

5. Decreased buy-side appetite for structured products

6. Shift in order flow from dark pools to crossing networks

7. Buy-side opportunity to hire top Wall Street talent

8. Elevated positions of second-tier brokers, independent EMS providers, and OMS vendors

"This colossal upheaval raises scores of questions for asset managers, both in the short term and looking ahead to 2009," Shahrawat says. "Who will provide capital in times of need? Who will be confident enough in their risk models to assume risk for clients and counterparties? Who will fuel the underwriting of new companies and even new industries? Who will drive the growth of structured finance?"

TowerGroup believes recent changes in the brokerage industry will have both direct and indirect implications for the IT budgets at asset management firms. TowerGroup anticipates a decline of three to four percent in technology spending across the investment management industry in 2008 and 2009, as firms are forced to cutback expenditure amid declining assets under management and growing pressure on fees.

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