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Best of 2005: The State of the Art


Duke & Duke?


Editor's Note: This article was published on 4/11/2005

You don't have to be in the trenches to see that Wall Street has changed. What was once an exclusive club of power players and money makers became a household hobby as technology made enablers of us all. In the storied history of the financial markets, the rate of change has been nothing short of remarkable. The last ten years have revolutionized an industry once known for clubby relationships and handshake agreements. The next ten years will forever alter the business as we now know it.

When I started at Morgan Stanley (MWD), I arrived at my turret while the skies were dark and transcribed our derivative positions by hand. As ancient as it may seem--and conscious that this has a "walk five miles through the snow" feel to it--the risk management approach was that arcane. A single stock position was "paired off" into buy-writes, conversions and ratio spreads. The meticulous process was universal as traders relied on phones, Quotrons and an acquired acumen to guide them through the frazzled fray.

As option desks typically set the standard, we were the first to beta test new systems. I remember when we first started pricing over-the-counter products (instruments not listed on the exchange) and would "win" business by 30, 40 or 50 "vols." A reborn industry was in its infancy and nobody complained. The customer was happy, the firm was profitable and the wheels of capitalism continued to grease. In time, as technology evolved and the margins inevitably slimmed, the fat slowly dripped off the bone and the easy money began to evaporate.

The emergence of relative efficiency forged the way for new products and applications. If Wall Street has proven anything, it's an ability to reinvent itself and recreate risk. During this evolution-or perhaps because of it-the information age democratized finance and paved the way for retail flow. This introduced a fertile audience to the minxy mechanism as desperate housewives flocked to stocks and the promises they held. The feeding frenzy that followed was nothing short of manic and the ramifications remain an integral aspect of our future path.

Despite the fright of the implosion, we've arrived at a juncture in history where 62% of the world's population invests in the financial markets. That number has nowhere to go but up as the powers that be reinvent the investment wheel. While the privatization of Social Security seems like a far-fetched and flawed solution--there is massive risk to that demand reward--the Fed understands that we're yet to root a sustainable economic recovery. The dichotomy between debt-induced largess and legitimate growth has been unmasked by the dollar devaluation of recent years but the looming stagflation must be discussed when dissecting our directive.

Coincident to the big picture conundrum, there has been a steady migration on Wall Street as talent is seduced by the sexy sirens of the hedge fund world. This has shifted the balance of power as the lure of open-ended payouts encourages risk-taking and outsized leverage. The environment is similar to the retail bravado of a few years back as a 8000 masters seek to lay claim to the universe. Paradoxically, the demand for return has created a compression in the marketplace that is masked by the low volatility and trading ranges. This dynamic isn't causation for a disconnect but the pressure beneath the surface is building in seismic proportions.

The bulge bracket firms still command respect, of course, but their moxie has waned in recent years. The motivation to trade with the big cap brokers was once predicated on promises of fat IPO's but that is a thing of the past. Further, with Red-FD rounding the relative edges of information, customer business has increasingly focused on low-cost solutions and volume discounts. The regulatory environment will only stiffen--particularly if the screens aren't green--and pave the way to increased transparency throughout the Street.

As research expenses can no longer be justified by investment banking revenue, an emerging trend of "outsourced information" should soon become industry standard. In time, a customer will have the ability to "opt-in" to a pool of commoditized research much the way they can currently craft a risk profile. This will ultimately benefit the investing public but has profound implications for our industry. The convergence of technology and regulatory oversight won't eliminate the broker-dealer intermediary but their roles will surely shift as a function of customer need.

Traditional brokers will need to highlight their human capital and provide a platform that marries low cost trading solutions with dynamic information flow. Therein lies the task at hand for financial professionals around the world-the sell-side, once a conduit of execution, must reassert themselves and demonstrate relative value if they're to stay in the mix. There will always be a Wall Street and a need for capital markets. As the landscape continues to change, however, they'll need to proactively adapt if they expect to maintain a competitive advantage.

Good luck today.


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