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Buy Side Reevaluates Counterparty Risk and Reliance on Sell-Side Trading Platforms

With bulge-bracket firms going under, buy-side institutions are scrutinizing their exposure to sell-side execution services and trading platforms.

While the buy side has paid attention to counterparty risk for many years, it is applying increased vigor to the process, adds Navin Sharma, VP and director of risk management at OppenheimerFunds in New York. "The analysis of counterparty risk in great detail is here to stay, and firms have gone to great pains to make sure they have a good handle on counterparty risk," he emphasizes. "We actually have multiple levels of credit analysis that consider, review and opine on new counterparties."

Multiple departments -- from risk, legal and compliance to fund operations/accounting and investments -- scrutinize OppenheimerFunds' counterparty risk, Sharma continues. "All of these areas are working together as part of a counterparty risk committee to make sure we don't leave any stone unturned in reviewing counterparty risk and related credit analysis," he says.

The Agency Advantage?

To avoid counterparty risk, buy-side firms are likely to look more closely at executing through agency brokers. Unlike the bulge-bracket brokers, agency brokers match customer order flows, so they do not act as a counterparty on trades. Whereas many bulge-bracket firms relied on trading for their own accounts and used mortgage-backed securities and other esoteric instruments combined with leverage to boost their returns, agency brokers mainly trade exchange-listed instruments (equities, futures and options), charging a commission on trades as their main source of revenues. Typically, they don't get involved with OTC derivatives such as credit default swaps.

"We have no proprietary trading," explains Instinet's Comerford of the company's agency model. "Basically, we have no exposure to the counterparty risk that some of our large bulge-bracket competitors have."

On the other hand, bulge-bracket firms provide a broader range of services -- including proprietary research, capital commitment to faciliate a trade when there is no liqudiity and access to IPOs -- than agency brokers. The bulge bracket also serves as market makers in fixed income, foreign exchange and commodities; and designs OTC derivatives to hedge portfolios.

Often, it is these services -- particularly the research -- that keeps buy-side clients engaged. But the advent of client commission agreements (CCAs) has only fueled concerns regarding counterparty risk.

As Lehman teetered on the brink of bankruptcy, asset managers with CCAs at the firm became extremely concerned that their commission dollar balances for paying research providers would be tied up with the bankruptcy filing. Some buy-side firms were not sure if they would ever receive their money back. According to some sources, these balances can reach as much as a few hundred thousand dollars. (For more on CCAs and counterparty risk, see related article, page xx.)

"We have been particularly vigilant about that," says BB&T's Baker of the firm's position with regard to soft-dollar accounts or CCAs with bulge-bracket brokers. Fortunately, Baker says, BB&T, which has $17 billion in assets under management, did not have large balances with any one broker. "It's your clients' money, and you want to protect it, and you want to be smart about how you are using it," Baker notes.

In addition to the security of their CCA balances, buy-side firms are highly concerned about exposure to credit default swaps, which contributed to the overall financial meltdown and the near collapse of insurance giant AIG, in particular.

"It's reaffirmed my view that you should be trading as much as you can with exchanges and not with over-the-counter transactions," emphasizes Stephen Davenport, director of equity risk management at Atlanta-based Wilmington Trust, which has $46 billion in assets under management. Wilmington Trust, Davenport relates, runs a call-writing options program with all listed options (FLEX options) at the Chicago Board Options Exchange. "You basically define your price, your expiration date and trade on the exchange, so you don't have [the other side of the trade] with one counterparty," he explains.

"This market has really reaffirmed the benefits of trading with exchange-traded options," adds Davenport. He notes that prices for exchange-traded options are published on an exchange and the Options Clearing Corp. (OCC) guarantees settlement, so the buy side is not depending on the creditworthiness of a single counterparty to ensure that the trade settles.

Technology Risk

The situation is all the more complicated because the buy side relies on large brokers for various kinds of trading platforms, algorithms and analytics in return for order flow that could expose them to technology risk should a brokerage default. Some examples are Lehman's Townsend Analytics (now owned by Barclay's Capital), Morgan Stanley's Passport and Goldman Sachs REDIPlus.

According to Dave Quinlan, executive managing director and head of strategy at BNY ConvergEx Group, while these systems continue to operate, buy-side firms are concerned about the viability of the brokers themselves. "The balance sheet concerns have nothing to do with the legitimacy of the technology," Quinlan adds. "The solidness of Rediplus or Passport or any other EMS technology provider hasn't changed. Those systems are still there. ... It's just a matter of whether the buy side has the confidence to do any transaction with the counterparty because they're fearful they won't be around to settle the trade." Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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