Michael Lewis famously lambasted Salomon Brothers clients in Liars Poker thirty years ago as being intellectually inferior and ignorant to the risks they purchased from the savvy Wall St bankers. The 3-6-3 club (borrow at 3%, lend at 6% and be on the golf course at 3pm) is a story Lewis relates about his sucker clients on the buy side. Fast forward to “The Big Short” and Lewis makes heroes out of the buy-side investors who bet against the major Sell-side firms during the US Mortgage crisis. These buy-side investors undertook their own research and backed their judgment with their own money, ultimately being proven correct despite the pressure of short-term losses.
The buy-side is the new force in financial markets and some big changes are afoot. Traditional sell-side roles are already being either absorbed by buy-side investors or outrightly challenged in the new order.
The newspapers seem obsessed with the implication for liquidity, pricing and efficiency without the traditional sell side participation. Banks withdrawing capital from market making and prop trading is somehow detrimental. But financial markets evolve quickly to better allocate capital. The newspapers assume that the old sell side/buy side model is the ONLY way to organise financial markets. This is not the case. Here are some examples of how less trading delivers more liquidity…
1. Decline in transactions volumes does NOT mean there is less liquidity.
There are many paths by which a security of an issuer A can find its way to its final home with buy-side investor B. The most direct way is A issues directly to B. A less direct way is A issues to a dealer C, who then turns around and resells to investor B. In 2007, 65% of US Treasury issuance was channeled through dealers in this indirect way. At last month’s US Treasury auction, only 11% of issuance went through dealers, with the bulk being direct A to B placement of securities.
Trading volumes will fall sharply where dealers are cut out of the process of finding buy-side homes for securities. BUT the final outcome will be the same -the security finds its home with less intermediation. This can only be good unless you are employed as a dealer.
2. Buy side patience means better liquidity with less turnover
Equating the notion of liquidity with actual trading volume is a fundamental mistake. Liquidity is generally measured by how much of a discount to the current price an investor will receive if they need to sell their holding over some time frame. Time becomes a critical factor in determining liquidity and buy-side firms arguably have more patience when it comes to liquidating a portfolio.
Prop traders are notoriously short term oriented. With a short time horizon, the haircuts they tolerate are much greater than buy side investors. Prop traders need intermediaries to dump securities quickly. Buy side investors, on the other hand do not want to take haircuts and are less likely to dump securities with intermediaries, instead waiting for another buy-side investor to turn up and absorb the position. Less demand for intermediation means less turnover.
The net effect of less turnover and less intermediation is lower transaction costs in aggregate. Liquidity actually increases while trading volume falls due to the patience of the buy-side investors. This can only be a good thing, unless you are on the sell side.
3. Financial supermarkets are not optimal.
The decade of the 1990s witnessed an enormous amount of merger activity in the financial sector. This was predicated on the view that there were economies of scale and synergies to be harvested by the financial supermarket model. Capital could be deployed more efficiently and diversified while cross selling activities should provide clients with a single stop service. The problem with this model is internalising who actually bears the wealth consequences of risk taking. The decision makers in financial supermarkets use other peoples money so individual incentives are difficult to align with shareholders.
Due to regulatory constraints, capital restrictions and compensation issues, the buy-side has become populated with private pools of capiital managed by investors who were formerly employed on the prop desks and dealing floors of the financial supermarkets. This trend resembles the pre-1990s banking system of old, where partnerships were common, and incentives aligned. The difference is that the private capital pools are operated outside of the bank regulators remit and within the funds management licencing frameworks. In short, traditional sell-side functions have been relabelled ‘buy-side’ but they do exactly the same thing.
Many, smaller buy side operations are springing up to compete with the supermarkets.
4. Beta and the rise of the ETF
Who wants to deal in 1000 different securities every day? Active buy side investors might earn alpha from stock selection, but 98% of their return is the market i.e. beta. The ETF market has made beta easy to access and hold for the long term. Traditional sell side function of selling each investor 1000 securities has been substituted with a single ETF. Less intermediation and better liquidity…
The bottom line is that turnover has fallen without harming liquidity in the new buy side dominated financial world.
BONUS FED BLOGLET: Up is the new down
Janet Yellen announced on Wednesday that investors should expect only ONE rather than TWO rate hikes this year. Interest rates fell on the comments…Up is the new Down!