BY: MICHAEL SAGL

In the wake of the 2008 subprime mortgage crisis, new regulations may have indirectly created a shift in the balance of power among financial institutions. “Safer” banking became the priority, but being safe is seldom the key for prosperity, especially in the world of finance. In order to compete, you have to cut costs, and while the banks are scrambling to recover, the buy side has taken control. Now the traditional system that we have grown accustomed to has been flipped upside down. It will be interesting to see how this change will affect the landscape of banking in the long term future, and what it will mean for investment banks.

A shift in the balance of power

Prior to 2008, the bond dealers and investment banks, which make up the sell side, used to control the fixed income markets. They would essentially maintain a warehouse full of bonds, and when an investor was looking to buy or sell securities, they would do it through an investment banker. Wall Street banks were the center of the financial universe.

And then the regulations came into play. Post-crisis regulations were implemented to make the banks “safer”. It was a necessary and obvious reaction, because restoring the public’s faith and trust within the system is critical for a functioning economy – after all, banks wouldn’t be able to operate unless the public deposited their money with them. Safe banks are great for the general public, but the problem with playing it safe is that it discourages risk taking strategies and erodes profits.

Time to cut costs

Banks can no longer afford to make markets and reap the benefits of collecting broker fees. Instead, they are cutting costs by selling off assets, eliminating business units, and laying off staff. This has created an opportunity for the buy side institutions, such as hedge funds and asset managers. Managers of these “buy side” firms now have more influence on the markets than ever before, and the emergence of financial technology platforms has lent them a helping hand. All of these new trading venues make it easy for these firms to execute high profile trades without the reliance of an investment bank.

For example: Portfolio manager John McClain at Diamond Hill Capital Management in Columbus, Ohio spotted a seller wanting to part with $2.2 million of notes. [1]

In the pre-2008 world: a bank trader would eat up trades like this. He could store them in his “bond warehouse” until some other buyer appeared, sell it to him, charge his fee, and call it a day.

But in 2016: - not necessarily the case. Banks do not want to inherit unnecessary risk unless they are sure they have a buyer for a particular deal. So how do these bonds get traded now?

McClain saw that the market for these bonds were particularly weak, and successfully underbid by two cents.  While two cents might not seem like a big deal, the fact that a hedge fund manager from Ohio has the capacity to reset a bond price without interacting with a single Wall Street trader is a big deal. In fact, a decade ago a transaction like this would have been unfathomable; and if this had been executed through a broker, it would have cost about $50,000 in fees.  Now the big banks, who used to employ armies of analysts to come up with brilliant trade ideas, are relying more on fewer resources, giving the buy side a resourcing advantage. [2]

Why does this matter?

While this may not seem very important, it’s interesting because bonds used to be Wall Street’s bread and butter. The bond market provides a platform for governments, businesses of all sizes, and investors to lend and borrow money. It’s made up of about $100 trillion[3], essentially making it the glue that holds together the world economy, and now it is flipped upside down. Buy side firms used to be price takers – meaning they would accept the best offer from an array of dealers. Today, the buy side traders are the price makers – meaning they have the power to hand out “take-it-or-leave-it” prices .[4]

But with greater power comes greater scrutiny

If the buy side wants to continue to reap these benefits, they should expect to pay the price. And in the world of finance, that price will always be regulation and criticism. As the balance of financial power begins to shift, regulations will have to adjust to protect against reckless risk taking and borrowing techniques. In fact, traditional hedge fund pricing techniques are already being criticized.

Investors have grumbled about hefty hedge fund fees for years, but can you really complain when your portfolio managers continue to produce impressive returns? In reality, you will probably just pay the fees and watch your profits skyrocket. But what happens when those returns struggle? Bond yields, which often set the benchmark for returns on many assets, are razor thin.[5]

An easy way for investors to preserve their profits against only modest gains would be to cut what they are paying money managers, and that’s exactly what has been happening over the last three quarters. Investors have pulled almost $25 million from hedge funds globally, and are now targeting firms that will accept much lower rates with adjusted pricing models.[6] This rapid movement is forcing more and more hedge funds to adopt different pricing options that maintain the attraction of investors.

Another “Big Short”?

Despite the troubles, there are people around the finance world trying to address these issues. One of them is Steve Eisman, who you might remember if you saw “The Big Short”. He was the character portrayed by Steve Carrell, with a knack for predicting market trends. Eisman has moved on from shorting the housing market and is now shorting hedge fund fees. Well – not exactly, but he has come up with a new product that will offer much cheaper investing options. It’s like a hedge fund, except clients directly own the investments that he puts into the fund. This allows the fund managers to accept more modest fees since the funds exposure lies directly on the investors themselves.[7]

So problem solved, everybody wins– right? Well in the short term, perhaps. But in the long term, a fund like this will have its limitations. For example, if the clients directly own the investments, they have the ability to pull money whenever they like. If investors have the freedom to do that, it makes it harder for the manager to generate larger returns by using leverage and other illiquid investments. If the fund doesn’t perform well, investors will take their money elsewhere no matter how cheap the fees are.

So where will this trend lead us?

It will be interesting to see how this trend will affect the finance industry moving forward. Just like with anything in finance, uncertainty is the x-factor. The regulations enforced after the 2008 financial crisis may have had a greater effect on the business than people realized. With the current emergence of powerful buy side firms, new technology platforms, and lending sites, there is less reliance on Wall Street today than there has ever been. While it may be impossible to imagine a world without big banks, the type of role they play in the future is something to keep a close eye on.

[1] http://www.bloomberg.com/news/features/2016-08-15/the-rise-of-the-buy-side

[2] http://www.bloomberg.com/news/features/2016-08-15/the-rise-of-the-buy-side

[3] http://www.bloomberg.com/news/features/2016-08-15/the-rise-of-the-buy-side

[4] http://www.bloomberg.com/news/features/2016-08-15/the-rise-of-the-buy-side

[5] http://www.bloomberg.com/news/articles/2016-08-18/steve-eisman-s-next-big-short-is-hedge-fund-fees

[6] http://www.bloomberg.com/news/articles/2016-08-18/steve-eisman-s-next-big-short-is-hedge-fund-fees

[7] http://www.bloomberg.com/news/articles/2016-08-18/steve-eisman-s-next-big-short-is-hedge-fund-fees