Is capital commitment still something the brokers are offering these days?
For those who are new to this concept, once upon a time brokers would offer their own capital and balance sheet to buyside customers. These customers would execute a block trade with the broker, who in making that block, would be on the hook for the created liquidity. The brokers balance sheet would reflect the open trade until the broker could complete the trade itself by finding the liquidity it manufactured for the buy-side account. It did this hopefully at a profit.
But as broker capital requirements have changed over time thanks to new regulations such as MiFID II and others, this type of trading has become less profitable and more infrequent. According to Larry Peruzzi, Managing Director International Trading at Mischler Financial Group, this type of trading has become the ghost of trading past.
Well from what we are seeing capital commitment is way down from 2010, Peruzzi began. While not a truly scientific data point, I estimate that between 8% to 10% of trades are now being done with some sort of capital commitment.
In its glory days between (2000 to 2005, Peruzzi added that capital commitment ran at closer to 40% at its peak.
So, what gives?
First, the current environment is giving capital commitment stiff headwinds. This is a combination of MiFID II regulations in Europe that dictate how and where stocks trade. Also, the prevalence of buy-side to buy-side crossing networks that lower clients risk. Thirdly, agency commission rates below 1 cent per share making a commission premium less palatable. The current sideways market that make capital pricing difficult and lastly, agency algorithms that closely replicate clients objectives.
Spencer Mindlin, Capital Markets Analyst at Aite Group, shed some light on the issue for Traders Magazine.
The traditional sell-side community has been under the regulatory spotlight, making it increasingly risk-averse and consequently dampening any potential innovation or significant risk taking for fear of regulatory scrutiny, Mindlin began. Theyre also under pressure due to increased capital requirements and calls to tighten up balance sheet usage.
Mischlers Peruzzi added that al is not lost when it comes to capital commitment or principal trading. While looking bleak prima facie, he said some larger bulge firms are still able to profit on capital trading but it has morphed more into guarantee VWAP and Market on Close pricing rather than blind portfolio bids.Traders Magazine reached out to several bulge brackets brokers to get their view for this update but none responded to emails or calls.
But what about the second tier or smaller brokers?
Smaller brokers do not carry the net capital needed to hold positions in their account while waiting for an exit point, Peruzzi said. In its simplest form, a broker profits in capital trading when they assume a position (long or short) where they then exit the position at a more advantageous price. The commission premium acts as a protection buffer.
Aites Mindlin added that the traditional sell-side faces growing competitive threats from nonbank, mostly from a high frequency trading background, who have moved in to fill the gaps left behind by the bulge bracket firms across most major asset classes.
As banks retrench from their traditional roles, these trading firms have gradually taken over that essential liquidity-provider role in the market, Mindlin said. To a certain degree, this is not a huge surprise, given the increasing regulatory scrutiny focused on the market-making business and the collapsing spreads in the global equities market.
Will the market see a resurgence in capital commitment trading or is it relegated to the memory of more seasoned traders?
Well, things always seem to come full circle and capital trading will someday rise again, Peruzzi opined. What we would need is for markets to return to predictable trading patterns where regulators must create a more conducive environment. Also, clients need to be willing to pay a premium and technological advancements that have driven the growth in Algorithms, crosses and conditional trading platforms need to make advancement in capital trading. Also, and perhaps most importantly, the rate of job loss in trading needs to slow so that the intellect of capital trading does not become extinct.
Aites Mindlin was also optimistic about the future of principal trading. He said first that the need for capital commitment is not going away and might experience a resurgence but MiFID IIs changes to market structure, such as dark pool caps and systemic internalizers, may have created demand for capital commitment – but its probably still a bit early to tell. Also, the looming access fee pilot is likely to dry up liquidity from displayed markets and the buy-side will need trading partners to provide liquidity to fill the gaps created from participants backing away on displayed markets due to the lack of incentives to make markets, particularly in illiquid issues.
Lastly, the increased adoption of the electronic RFQ protocol, actionable IOIs, and request for stream (RFS) functionalities, not to mention OMS and EMS vendors have been ramping up their capabilities to support high-touch trading channels via electronic workflows, Mindlin said, could affect capital commitment trading. Buy-side traders will continue to seek and need to demonstrate best ex – even more so when trading upstairs – and electronic trading is the best (or only) way to demonstrate why the decision was made to trade on risk.
This article originally appeared in the June 2010 edition of Traders Magazine
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.
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.
Malles said there are about a dozen firms that he can ring to get good size done. That list includes regional brokers, too, who will stand up in the stocks that they traffic in. A regional might “sell you a hundred up a couple of cents and that might be as good as the larger firms,” Malles said.
Henry Mulholland, who heads Americas trading and sales trading for Bank of America Merrill Lynch, agreed that capital has become more important to clients. The rise in capital usage began in the second half of last year and has “ticked up meaningfully in recent months,” he said.
Volatility coming in has been one factor behind capital’s rise. Volatility, as measured by the Chicago Board Options Exchange’s Volatility Index–or VIX–has cooled tremendously since the crisis of 2008 and 2009. Generally, the markets are considered volatile when the VIX tops a measurement of 25. During the crisis, the VIX crossed 80, twice. And it hovered above 40 until early last April.
The VIX didn’t fall under 25 routinely until late-summer 2009. From late-February 2010 until late April, it ran consistently in the high-teens.
But no trend is perfect. Last month, volatility picked up during the Greek debt crisis and it averaged at 31 for a two-week period, from May 6 until Traders Magazine went to press. And once again, according to one knowledgeable trader, capital requests died down during the period.
Still, lower volatility is only part of the story for the upswing in capital-intensive trades. The other is how stocks are performing. Clients’ increased appetite for capital is due to stocks now moving based on their technicals and fundamentals again–as opposed to moving lockstep with the entire market or their sectors. This phenomenon, or “dispersion,” began in the second half of last year and “is accelerating now,” said Mulholland, adding that it’s no surprise that portfolio managers would look for capital to lock in alpha in such an environment. “We had a feeling that 2010 was going to be a stockpicker’s year,” Mulholland said.
The backdrop for this rise in capital commitment comes while the industry as a whole has experienced a drop in total commissions. The recent Greenwich Associates annual survey shows that commissions were down in 2009 by 13 percent, to $12.1 billion. That’s down from $13.18 billion in 2008, which was a record year.
Although commissions last year dropped from 2008, last year’s numbers don’t appear as bad when considering they were on par with 2007 and 2008’s were through the roof.
One reason for the lower commissions over the last year is that the majority of portfolio managers rode the market upward from the lows of March 2009 and didn’t make many adjustments to their core holdings, several sources told Traders Magazine.
The earnings for Q1 of this year also didn’t provide any major surprises that would have caused portfolio managers to get aggressive in either moving in or out of a position, said one source. Typically, volume will pick up anywhere from 150 to 200 percent during earnings season, but that did not happen at the end of the first quarter this year.
One buyside trader at a large fund said the low volatility might benefit brokers risking capital, but, conversely, the lack of movement in stocks often doesn’t push managers to make decisions. “There is a lot less conviction from PMs in a low-volatility environment, so you won’t see those trades where capital is a great way to start an order,” the head trader said.
For the first quarter of this year, institutional business has continued to be tight. One senior sales trader at a regional broker estimated that most firms were down between 10 and 20 percent in the first quarter, compared to the same period in ’09. He said, “We have banking, research, and capital, and it is a battle every day to do business.”
That’s one reason why firms are offering capital, to separate themselves from the pack, explained one sales trader at a firm that offers capital and research. “The Street has gotten very competitive again with its capital,” he said.
Michael Nasto, head trader at U.S. Global Investors, which manages $3 billion in equities, said there’s nothing not to like about a broker committing capital. “If you can get half your order done, you just decreased your risk,” he said. His firm specializes in natural resources and brokers have been aggressive shopping lists of stocks in which they would make two-sided markets.
But not all buyside traders want capital, even if they can get it. For some, it is an issue of their commission budget, as a capital trade cannot be credited to pay for brokerage services. And with commissions tighter these days, with the lower blended rates, every commission dollar really counts.
Still, to get 40 percent of an order into the portfolio “up a few cents is pretty tempting,” said one buyside trader. “You need to use capital in the context of your budget, so you can’t always use it.”
At the end of the day, capital commitment is about partnerships, traders said. Brokers understand there will be losses associated with the business, but each trade is done in the context of the larger business relationship.
Mulholland of BofA Merrill said there is a lot of dialogue and transparency that is involved in putting together large trades with capital. “We’re trying to offer a solution at the right price to our clients,” Mulholland said. “If they need to get a tough trade done, we’re going to do it for them.”
Technology is also beginning to play a bigger role in risk.
Citi’s block trading desk has developed a messaging system called TotalTouch that allows clients to hit or take a firm quote.
For clients, the system offers a continuously updated one-sided quote that brings certainty of execution. But for Citi, it puts its capital at risk. Quotes are generated by a model, but the sector trader inputs which stocks he is willing to trade. The trader also controls pricing and can override the model, depending upon how aggressive he wants to be.
The system is currently available only to a select group of clients, essentially its tier-one accounts. TotalTouch was introduced in the first quarter of this year.
“We’re electrifying the high-touch market, or introducing risk to the fully electronic markets,” Citi’s Diaz said. The quote is essentially a stop, which ensures that a customer will do no worse than that price.
“I think this will add to the high-touch business,” said Diaz, a 21-year veteran who joined Citi in 2008 after leaving Goldman Sachs. He began developing the system 18 months ago.
Clients are comfortable with the workflow of electronic trading, he explained, so “there is no reason high-touch trading can’t be click-and-trade.”
For the equities business, actionable IOIs, or indications of interest, have been the Holy Grail of trading. Diaz believes TotalTouch is the first of its kind to have reached the market. So far, he considers the system a success because it has met his expectations. He declined to specify what those expectations are, other than to say that clients who have it, “like it and use it a lot.”
Several money managers contacted by Traders Magazine said they were unfamiliar with the new system. But they said the TotalTouch product sounded similar to Bank of America’s Premier Block Trading offering, or PBT, which was launched in 2004. PBT, however, was different in that it made two-sided markets. PBT was an electronic trading product that went head-to-head with Bank of America’s high-touch desk. Because the sales traders viewed PBT as competition, it never gained the trading desk’s support. It failed because BofA sales traders would simply get a price from clients and do better, sources told Traders Magazine.
Like all trading technology, Diaz said TotalTouch allows the desk to trade more efficiently. Quotes are sent through traditional IOI venues and order management systems. Once a client clicks on a quote, both the sales trader and the trader get a pop-up. An algo begins working the order immediately. The trader monitors the stock and can hedge if necessary, and the sales trader is freed to provide service to the client.
One major benefit is that electronic responses from clients avoid “economic or concession leakage.” That’s a frequent occurrence when negotiating a trade using capital over the phone and the market ticks against the broker. That can add up over 12 months of trading, Diaz said. “We’re taking more risk, but we’re doing it more efficiently.”
Not all Citi clients are on TotalTouch, so there are still capital negotiations done over the phone. Diaz also offered his assessment of how block trading will evolve: “To succeed in the future, brokerage firms will need to improve their ability to handle risk and do it in a world that is electronic.”