The State of the Art
If Wall Street has proven anything, it's an ability to continually reinvent itself...
"It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another." Gordon Gekko
You don't have to be a big hitter to see that Wall Street has forever changed. What was traditionally an exclusive club of power players and money makers became a household hobby when technology made enablers of the mainstream. In the storied history of the financial markets, the rate of change has been nothing short of remarkable. The last ten years revolutionized an industry once known for clubby relationships and handshake agreements. The next ten years will forever alter the structural DNA as the old guard chases an ever-evolving digital world.
When I started at Morgan Stanley, I arrived at my turret while the skies were still dark and transcribed our derivative positions by hand. As ancient as it sounds, the risk management approach was that arcane. We "paired" single stock positions into hand-written strategies in an attempt to manage the complex components of our collective risk puzzle. That meticulous process was standard practice on the Street as traders relied on an acquired acumen and scribbled T-accounts to base million dollar decisions. It was an innocent approach to an intricate machination, where inefficiencies were commonplace until arbitrage emerged to capture risk-free returns.
I remember when we started pricing over-the-counter products and would "win" business by 30, 40 or 50 volatility points (a subjective assignment of valuation). Customers could "collar" their stock and lay off risk without the requisite footprints and we gladly facilitated the orders. Technology companies also awoke to write naked puts in lieu of stock buy-backs. If their short options were exercised, their cost basis was cheaper than it would have been in the open market. If not, the premium expired worthless and the income slipped through a tax-free loophole. Microsoft did it. So did Dell. Intel too. They were happy campers and our firm was a profit machine as the wheels of capitalism continued to grease a seamless coexistence. In time, as other sell-side players entered the market, the relative edges rounded and fat dripped off the risk-free bone.
The emergence of market efficiency paved the way for new, more intricate risk management products and strategies. If Wall Street has proven anything, it’s an ability to continually reinvent itself, recreate risk and appeal to a customer segment eager to differentiate returns. During this evolution—or perhaps because of it—the information age democratized finance and paved the way for retail oriented order flow. This introduced a fertile audience to the minxy mechanism as desperate housewives flocked to stocks and the promises they held. The feeding frenzy in the late 90’s was manic and many of those lessons have been forgotten despite the bitter pill of the post-bubble spill.
Due in large part to a coordinated agenda to increase risk appetites following the dot.com implosion, we've arrived at a time when over 60% of the U.S population invests in the financial markets. That number will continue to appreciate as Wall Street reinvents the investment wheel and politicians identify ways to prolong the inevitable ramifications of our societal addictions. The Federal Reserve understands that we’re stuck in the middle of inflation (things we need) and deflation (things we want) and the dichotomy between debt-induced largess and legitimate growth is slowly being unmasked. Indeed, despite prognostications to the contrary, we may well be in the early innings of stagflation*, which is to say that the end product is the same but historical precedence need not apply.
Coincident to this big picture conundrum, there has been a steady migration on Wall Street as sell-side players chase the sexy sirens of hedge fund wealth. This shifted the structural chemistry in the marketplace as neophyte risk managers employed outsized leverage with hopes of capturing the smaller moves of a range-bound tape. Paradoxically, the demand for return has created a compression in the marketplace that was once hidden in a docile tape. We’ve spoken about the pressure beneath the surface for a long time and now, with the emerging markets acting as a catalyst and derivatives exacerbated volatility, that seismic shift has seemingly come to bear.
The bulge bracket firms still command respect, of course, but their moxie has waned as a function of this Darwinian evolution. The motivation to trade with the big cap brokers was once predicated on the promise of fat IPO's and advantageous execution but that is a thing of the past. Further, with Red-FD rounding the relative edges of information and technology providing one-click access to shared networks, customer business has shifted to 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. This will have a profound effect on virtually every spoke of the Wall Street wheel.
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 far-reaching implications for the financial complex. The convergence of technological advances and regulatory oversight won't eliminate the broker-dealer intermediary but their roles will shift as a function of customer need. We've seen seeds of this evolution sow in the last year alone as Smith Barney slashed its technical team and Fulcrum Global Partners shuts its doors. And lest you think that they are exceptions to the new world rule, stay tuned for more real-time examples of this dynamic.
Traditional brokers will need to highlight their human capital and provide a platform that marries low cost trading solutions with real-time information flow. The current "one and done" morning call won't cut it, not in the world of instant messages and real-time decision making. 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 and compliant value if they’re to stay in the mix. There will always be a Wall Street and a need for capital markets. The trick, for an industry mired in overcapacity, is to proactively adapt before the trade passes them by.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at email@example.com.
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