Despite Counterparty Risk, Buy Side May Stick With Bulge Bracket

With the financial crisis raising alarms about the creditworthiness of bulge-bracket brokers, many observers expect agency brokers to pick up business from buy-side firms that are wary of counterparty risk. For now, however, there doesn't appear to be any mass exodus of bulge-bracket clients.

Yes, agency brokers are experiencing record trading volumes during these volatile times. But so is everyone else. It's not clear that buy-side firms are abandoning the bulge bracket. In fact, I was surprised to learn that despite the turmoil, many buy-side firms are sticking with the major brokers.

The buy side's relationships with the bulge bracket are based on the quality of research, in addition to the quality of execution and of the brokers' balance sheets, explains Stephen Davenport, director of risk management, investment management, at Wilmington Trust. While smaller brokers and boutiques may provide research in one area, Davenport says, he wants a broker that can provide research on macro issues, global issues, sector issues and individual stocks, as well as volatility analysis. These needs, he suggests, drive him to partner with large bulge-bracket brokers.

Further, buy-side firms often get more value for their commission dollars from the bulge bracket than from agency brokers, according to sources.

For example, one buy-side trader says that if he pays an agency broker a 3-cents-a-share commission, 1 cent pays for the execution and 2 cents go toward independent research. But, he contends, if he trades with a bulge-bracket firm, while 2 cents are credited toward external research, the third cent covers both the broker's proprietary research and the execution, in essence providing no-cost execution (or a penny's worth of free research).

Along with research, the abilities to commit capital to trades and underwrite IPOs also have been competitive differentiators for the bulge bracket. Now that the bulge-bracket firms are part of bank holding companies and are subject to more regulatory scrutiny and stricter reserve requirements, however, there is speculation that they will be less willing to commit capital to trades, eroding part of their advantage over agency brokers, which already provide a wide array of execution services.

In addition, agency brokers -- which do not conduct proprietary trading and thus view themselves to be conflict-free -- also can supply buy-side firms with trading technology. "The buy side certainly relies on companies like [us] and others for technology for self-directed electronic trading," says Ian Domowitz, managing director responsible for research and analytical products at ITG, which provides trade execution systems, OMSs and EMSs, algorithmic trading suites, crossing networks and transaction cost analysis services.

While the agency brokers are not gloating over the misfortunes that have shaken their competitors, they clearly sense an opportunity to pick up business. "Guys are coming to us because they're not getting the traditional coverage, capital commitment and IPOs aren't there anymore, and research has been downgraded because of the losses of the different bulge-bracket [firms]," observes Joseph Saluzzi, cofounder and cohead of the trading desk at Themis Trading in Chatham, N.J.

According to ITG's Domowitz, the changes at the bulge-bracket brokers may hurt their value proposition. "To the extent that the crisis distracts a firm from ... the self-directed trading of the buy side, it is certainly deleterious to the buy-side desks," he cautions. At the extreme, Domowitz suggests, a broker's new ownership could discontinue support or connectivity for a given platform.

On the other hand, the transformation of Morgan and Goldman, in particular, into bank holding companies "has helped calm the storm," notes Brian Baker, manager of trading at BB&T Asset Management. And now that Lehman has been taken over by Barclays Capital, he adds, "The counterparty risk is no longer a great concern." Still, Baker concedes, "The ... uncertainty associated with the Lehman deal has caused me to take a wait-and-see approach."

While it's too early to know what impact the new ownership structures will have on investment banks, it's clear that any deterioration in service levels could play to the advantage of the agency brokers. In the meantime, buy-side traders seem to be sticking with the bulge bracket -- for now.