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June 1, 2010

Cover Story: Rebound

Capital Commitment Makes a Comeback from Crisis Lows

By Michael Scotti

Despite access to an ever-growing menu of electronic trading toys with greater sophistication, some money managers are finding that there is still room in their repertoire for the tried and true of block trading: capital commitment.

Armando Diaz, Citi

In fact, among the biggest clients on the Street, their usage of capital trades rose 11 percent in 2009, according to a recently released Greenwich Associates report. This tier-one group of clients--greater than $50 million in annual commissions--traded 29 percent of their dollar volume with broker capital.

Brokers report that the death of capital commitment has been greatly exaggerated. That's not only true for Greenwich's top tier, but also the next group, which pays $20-to-$50 million a year in commissions. This group saw a 20 percent rise in its capital trades, to 12 percent from 10 percent, Greenwich reported. Still, many traditional long-onlys say they have been weaned off capital as electronic trading tools have supplanted much of their interaction with sales traders and their high-touch services.

But whether you work at a hedge fund or a traditional long-only fund, there is one axiom that remains a constant: There is only one means to a block trade when no natural liquidity exists, and that's by hitting up a broker for capital.

"The sellside is the only venue that can instantaneously manufacture liquidity," said Armando Diaz, who heads franchise trading at Citi. The percentage of risk trades at Citi, according to Diaz, is up by 50 percent from nine months ago.

Traders credit the uptick in capital commitment to a decrease in volatility and competition among brokers. However, client demand has been the key driver, as aggressive managers have looked to pick stocks that are breaking from the pack and they need capital to get there fast.

Traders say that capital trades plummeted during the heart of the financial crisis for two reasons: 1) Volatility was so wild, that both investors and brokers had no idea where to price orders; and, 2) Even if a broker and client could agree on a price, the risk premiums would have been astronomical, so clients opted for self-trading and high-touch help from sales traders-they averaged into their price, rather than making a big bet.

"Stocks were getting so whipped around, it didn't serve the buyside well to ask for capital," said Scott Bacigalupo, who heads U.S. sector trading at Bank of America Merrill Lynch. "It became very expensive for them to access capital because the markets had to widen out."

But things are better now. Both brokers and money managers report that capital usage has regained the ground it lost during the financial crisis.

"It's an uptick from 12 months ago and probably status quo with where things were two or even three years ago," said James Malles, head of U.S. equity trading at UBS Global Asset Management in Chicago.