Ted O’Connor on the past and future of prime brokerage
O’Connor did not enter financial markets as an ingénue. Since both his uncle and his grandfather were on the floor of the New York Stock Exchange, it was almost genetically determined. He was introduced to Richard Rosenblatt, a floor broker on the exchange, in the first year of a business administration degree at the University of Connecticut, and interned for him through the summer of 1986.
Rosenblatt broked equity trades with the market-making stock specialists on behalf of institutional investors and index, merger and convertible arbitrageurs, plus a number of Chicago-based options market makers. Working for him, O’Connor knew immediately that he had found his natural home. “I was fascinated by the New York Stock Exchange,” he recalls. “It was where information flowed, and transactions took place. It was the hub of the equity world. It was the perfect place for me to learn the mechanics of investment strategies that are still employed today.”
However, the floor of the New York Exchange was also a world that was about to be transformed by the rise of electronic trading. As it happens, Rosenblatt was one of the first floor brokers in New York to adopt an electronic trading machine, in 1989. “I recall watching 1,000 share orders flow directly from a client to a computer I controlled, which released them directly to the specialist, and understanding that markets would be changed forever,” says O’Connor. “It was obvious that the advances in technology were going to change materially the way that professional traders executed their order flow.”
Though it is conventional to date the take-off of electronic trading to the introduction in 2005 of Regulation National Market System (Reg NMS), which not only replaced eighths and quarters with penny pricing, but did for the United States equity markets what the Markets in Financial Instruments Directive (MiFID) did for Europe: greater competition between platforms for orders, open access for ever platform to prices being quoted, and an obligation to achieve best execution for investors.
Though Reg NMS spawned new types of electronic trading platform, O’Connor reckons a more important change was the implementation in 2000 of Regulation Fair Disclosure (Reg FD), which put an end to the monopoly the stock specialists on the floor of the exchange and block traders on the trading desks enjoyed over the disclosure of non-public information by listed companies.
The 8(k) disclosure forms issued by the Securities and Exchange Commission (SEC) that clutter the investor relations sections of every listed company web site are a direct result of Reg FD. “The privileged access that specialists had to company information was brought to an end,” explains O’Connor. “After Reg FD, the information was broadcast to the entire world.”
It was clearly time to change direction, and O’Connor moved from the floor of the exchange to an upstairs trading desk where Rosenblatt & Co had started making prices in stocks on an agency basis, making use of some of the earliest electronic trading programmes as they did so. He had become, in effect, one of the earliest sales traders. It was the perfect launch pad for a career on the buy-side, and in 1992, after six years at Rosenblatt, O’Connor joined a value investing institutional money management firm called Sloate, Weisman, Murray & Company. Laura Sloate was a Benjamin Graham disciple, and I learned more about investing from her than anyone else in the course of my career,” says O’Connor.
Like almost all value investors, Sloate, Weisman, Murray & Company was (unfairly) undone by the Dot Com Bubble. After growing assets under management from $200 million in 1992 to over $2 billion by 1999, the TMT bubble that inflated rapidly from 1998 onwards made value investing look naïve by comparison with momentum investing. In 2000, Laura Sloate decided to exit institutional asset management, despite the fact the firm had secured a string of institutional mandates as a value manager only a year earlier.
“Having hired us as value managers, the clients would come to us and ask, `Why don’t you own Intel’?” explains O’Connor. “Our response would always be, ‘We don’t own Intel because it trades at 100 times earnings, and we have a portfolio of names trading at single digit P/E ratios and low cash flow multiples, because that is what you have hired us to do. If you woke up tomorrow and discovered we had Intel or Microsoft or Cisco in our portfolio, quite frankly you should fire us, because it would be going against the discipline and the mandate you set for us.’ The end-result was a lot of clients fired us anyway.”
The firm had more than $1 billion of redemptions in a single 12 month period. There was nothing unusual about what happened at Sloate, Weisman, Murray & Company. Julian Robertson shut his funds at the same time, and several Neuberger Berman funds also closed, because as value managers they could not make sense of the equity market in the first quarter of 2000. But it meant there was no longer an obvious role for Ted O’Connor at Sloate, Weisman, and that year he joined the Government of Singapore Investment Corporation (GIC), where he traded all of their North American business deep into 2001.
"In North America and western Europe, we think studying economics or finance or history are the paths to becoming a great investor," says O'Connor. "The GIC hired provided a lot of scientists - people who were exceptionally bright in their own fields - and trained them to be investors." The architect of that recruitment policy was chief investment officer Ng Kok Song, who is now chairman of GIC Global Investments. Perhaps unwittingly, he also designed the prototype of what is now a global industry of sovereign wealth funds. It certainly provided Ted O’Connor with a ring-side at the creation of a new class of global investor.
“The GIC was the model for all of the sovereign wealth funds we see today, because it was set up in the 1980s to manage the growing surplus generated by the government of Singapore,” he recalls. “Initially, they needed to earn a rate of return on that surplus, and it achieved its purpose by investing with managers as well as purchasing government bonds. In effect, it was an allocator in its early days. That changed significantly after the Iraqi invasion of Kuwait in 1990, when they realised that Singapore was equally vulnerable to asset-stripping by aggressive neighbours, situated as it was so close to Indonesia and Malaysia, and not far from China and India. So the government of Singapore switched the GSIC mandate to active investment in global markets, to protect their wealth as well as earn a return on it. It was sheer genius. They were so far ahead of their time.”
After GIC, O'Connor joined a former colleague from Sloate, Weisman in starting an equity long/short hedge fund. "The one thing we did not do well was raise capital, but it was a wonderful learning experience," recalls O'Connor. "I served as trader, analyst and jack-of-all-trades. It taught me not only about portfolio construction, marketing and risk management, but about the operational challenges of an emerging hedge fund." It certainly provided ideal experience for a subsequent move into prime brokerage.
O'Connor joined Deutsche Bank at the beginning of 2004 as a sales-trader in the mid-market hedge funds group. He executed trades for around 30 hedge funds, which exposed him to order flow on a scale he had not seen since his Rosenblatt days. He also had access to a plethora of investment research and analytics, the accompanying trading ideas, and his first prolonged exposure to the bond, foreign exchange and derivative markets and their inter-connections with the equity markets.
But a seat on the Deutsche Bank trading floor also reacquainted O’Connor with the phenomenon he had first observed at Rosenblatt in the late 1980s: electronic trading platforms were dispensing with the need for traders to make prices in large lines of stock. In addition, the bifurcation of trading and information introduced by Reg FD was by 2000 a physical fact. Company information was gathered and processed by research analysts, not stock specialists on the trading floor, and a growing army of compliance officers was in place to police that division of labour.
“The greatest currency that exists on Wall Street is information, and the hedge fund community was enjoying much faster access to corporate information than the banking community was allowed,” explains O’Connor. “Analysts in possession of a piece of information had to consult a compliance officer before they could share their opinion with the trading floor. The compliance officer had to vet how the information was obtained before he could authorise its release. On many occasions, hedge fund analysts sat in the same meetings at the investment bank analysts, but could transact on the basis of the information much earlier.”
What O’Connor was witnessing was a shift in the competitive speed-to-market from stock exchanges (where prices were formed) and investment banks (which committed capital to trading ideas as well as executing customer orders) to hedge fund managers. It helps explain why investment banks were content, in effect, to outsource investment management to hedge funds, and get paid for financing their trades instead. It also helps to explain why the hedge fund industry grew at such an explosive pace between the implementation of Reg FD and the onset of the great financial crisis in early 2007. After all, much of the profit that once accumulated in the investment banking industry was effectively transferred to hedge funds.
The irony – that regulation drove the growth of the hedge fund industry - is not lost on O’Connor. “Regulation pushed people out of the banking industry,” he says. “It coincided with an appetite on the part of investors to allocate capital to risk takers, and with the bonus of the wonderful two-and-twenty fee structure. If you were a risk taker in a bank, and made $100 million in profits, you collected a bonus of $5 or $6 million. If you were a risk taker at a hedge fund, and you created $100 million of profit, you collected $20 million.” Of course, trading at a hedge fund was even better than that, since performance attracted more capital, at much lower cost than banks could provider.
More ironically still, the implementation in April 2014 of the Volcker Rule, which was introduced by the Dodd Frank Act, marks the apotheosis of this shift of activity from banks to third party managers. The proprietary trading desks of the investment banks were the last bastions of old-style trading. As it happens, the underlying continuity in regulatory measures between Reg FD and Dodd Frank is not always appreciated, since accounts of the period are coloured by the deregulatory measures typified by the repeal of the Glass Steagall Act and the re-regulatory measures of the post-2008 period.
“From 1998 to 2008, the banks did make an awful lot of money off proprietary trading,” notes O’Connor. “They saw a lot of order flow, which was a great source of information, and even though Reg FD put a `governor’ in place between the information and the trading desks, there was a lot of valuable insights available within the walls of investment banks, particularly for anyone pursuing an arbitrage strategy.” Order flow was particularly useful in pricing securities, giving the banks tremendous control of prices, especially in less liquid instruments.
Corporate finance activities such as new issues, initial public offerings (IPOs) and share buy-back programmes, and the ability to gauge and act on the impact derivatives have on cash markets, were at least as valuable as sources of information to fuel trading strategies as the customer order flow. “Investment banks with derivative arms were the most profitable, in terms of their proprietary trading,” says O’Connor. “They saw how sophisticated investors were using the derivative markets to express their investment opinions, or hedge out investment exposures.”
For a sales trader such as Ted O’Connor, regulatory changes meant Othello’s occupation was gone. “The sales traders were used increasingly to push product, and I found I was not speaking to a lot of decision-makers anymore,” he says. “The decision-makers were either principals at portfolio managers, or COOs and CFOs at hedge funds. If I was going to make my living in the banking world, I knew I had to develop connectivity to those decision-makers.” Unsurprisingly, by the time the idea of the Volcker Rule was first mooted in 2009, Ted O’Connor was already in year three of a calculated move into prime brokerage.
By 2006, he had become fascinated by the access fund managers now had to finance. Larger hedge funds were effectively sharing operational infrastructure with broker-dealers, and they gradually acquired comparable access to leverage. “Until 1998, broker-dealers had the most access to leverage,” explains O’Connor. “By taking down the barriers erected by Glass-Steagall, and making it possible to finance onshore assets through offshore entities, it became possible to arrange a much higher degree of leverage than Regulation T (Reg T) permits.”
By the turn of the century, European as well as American banks and broker-dealers were offering enhanced leverage of this kind to a variety of hedge fund strategies. “Under Reg T, a manager could buy $2 of equity for every $1 of investment, so you could extract twice as much alpha out of the markets,” says O’Connor. “With the repeal of Glass-Steagall, banks, and especially overseas banks, started offer 10 or 15 times leverage. Quant, convertible and merger arbitrage funds – any fund in the arbitrage business – could go out and deploy strategies on three, four and five times the scale they could before.”
LTCM is of course the most notorious exponent of ready leverage. The “no haircut” hedge fund put 30 or 40 times leverage on some of their trades, leading to a disaster which prompted some of the most lavish supporters of LTCM to adopt a more cautious approach after LTCM failed in September 1998. But whatever measures they took counted for nothing in the acute phase of the financial crisis in 2007 and 2008, and regulators set themselves the task of putting an end to the “shadow banking” industry created by Reg FD and the repeal of Glass-Steagall.
Though the full force of the changes has yet to be felt in the prime brokerage industry, it is already altering the type of business prime brokers want to do. As their cost of funding and capital has risen, they are all focusing on their most profitable business. For hedge fund managers, this is reopening a question which was posed to them in its most elemental form in 2007 and 2008.
The funding difficulties experienced in 2007-08 by the triumvirate of broker-dealers that had until then dominated prime brokerage in the United States – namely, Bear Stearns, Goldman Sachs and Morgan Stanley – encouraged hedge fund managers to shift assets to deposit-taking banks. Credit Suisse, Deutsche Bank and J.P Morgan were the chief beneficiaries of this change in attitude, and they have not relinquished their position since.
For Ted O’Connor, the shift of balances to bank-owned prime brokers made it easier to accept an offer in 2012 to head New York prime brokerage sales for Merrill Lynch, which was from September 2008 owned by the Bank of America. The fact that Stu Hendel had joined the bank from UBS in June 2011 - where he had a brief and unhappy spell after many years leading the prime brokerage division at Morgan Stanley - was an indication that Bank of America Merrill Lynch (BAML) was serious about growing its prime brokerage business.
That is exactly what BAML did, at least until 2013. In July that year the Basel III capital adequacy regime upped the risk-weighted capital allocations to prime brokerage exposures, in the same week as three American regulators – FDIC, SEC and FINRA – announced a “selective leverage ratio” (SLR) that forced banks to replace internal judgments about the riskiness of exposures with a regulatory formula. Inevitably, the regulatory formula imposes a more punitive capital adequacy test on less liquid assets, and demands the funding terms match.
Understandably, the proportion of the corporate balance sheet eaten by prime brokerage became harder to sustain throughout the industry, particularly as the return on prime brokerage assets had dipped below other lines of business. Prime brokerage also sports relatively high fixed costs, in terms of people and technology. Every prime broker is now re-considering the return that investment is yielding. “Tougher capital and liquidity ratios have changed prime brokerage far more than anyone anticipated even a year and half ago,” says O’Connor. “All prime brokers now have to hold more capital against their transactions, driving up the cost of funding the assets. Ultimately, that cost is passed through to the hedge fund community.”
He advises portfolio managers to understand the impact on investment returns of the increased cost of funding their trades. “There is less leverage available, and that reduced supply of leverage is also more expensive,” says O’Connor. “My belief is that we are going to see a widening of spreads in a number of arbitrage strategies. The velocity of trades will also be slower than the current generation of hedge funds has become accustomed to.”
More broadly, O’Connor believes hedge fund managers have to understand in detail exactly what assets they hold in their portfolios, because transactions devour more collateral than they once did. With swaps now being centrally cleared, rather than transacted bi-laterally with banks, it is also essential to hold collateral eligible at a central counterparty clearing house (CCP). Lastly, with cash deposits of up to 29 days in duration now attracting a 100 per cent haircut under American regulations, banks can no longer use it unless it can attract a term of at least 30 days.
The cash restriction alone amounts to a material alteration in the commercial economics of the prime brokerage business. However, regulators are also seeking to limit the proportion of a client portfolio that can be re-hypothecated. “A large part of the benefit of being an efficient prime broker was using as much of client long inventory to facilitate client short positions,” explains O’Connor. “The regulators are looking to limit the percentage of long inventories that can be used in that way.”
Hedge fund managers, he adds, need to understand the impact of that restriction on the sustainability of a short position. Less obviously, they need to understand the diminished value of their long positons to their prime broker in an environment in which they cannot be re-hypothecated, or which may be re-hypothecated at greater risk as prime brokers strive to maintain or lift returns.
“There is going to be a lot of dialogue between hedge fund managers and prime brokers about what it means to be a good client, because all the prime brokers are now managing their platforms to a return on assets (ROA) threshold,” says O’Connor. He predicts that mid-sized hedge fund managers with multiple prime brokerage relationships will now start to concentrate balances with their primary prime broker, to ensure that their business matters to that prime broker.
Naturally, the relationship will work both ways. A client that matters to a prime broker can expect readier access to company information and research, leverage, hard-to-borrow securities, consulting services and capital introductions. “Prime brokerage and equity commission dollars will ion future have a different value at different prime brokers,” says O’Connor. “Managers will get an equivalent amount of resources in return.”
However, O’Connor disputes the idea that there is a dollar threshold at which a client ceases to matter as too facile. “There are minimum thresholds that all prime brokers want all clients to adhere to,” he says. “But there is also a minimum ROA they want clients to adhere to, and that ROA is derived not just from prime brokerage revenue, but from all other revenue that a client is producing for a bank. In addition, a client such as a quant fund that consumes a lot of leverage and balance sheet, and pays razor thin execution rates, will have a challenge meeting ROA thresholds.”
It follows that a hedge fund manager which matters to the prime services division of a bank alone is much more vulnerable than one which has a wider relationship, especially if the manager is devouring any of an increasingly expensive balance sheet. “A $500,000 client with a 30 basis point ROA is a terrible trade, while a $500,000 client with a 300 basis point ROA is highly desirable,” says O’Connor. ”A balance sheet is a finite and increasingly valuable commodity. Prime brokers are thinking long and hard about who they are allocating that finite commodity to. The focus has shifted from revenue to ROA.”
This is creating an opportunity for second tier prime brokers, as the largest banks reach their limits of their balance sheet allocations to the hedge fund sector, or even seek to curtail their exposure to it. The obvious candidates to benefit are Citi, Jefferies, Scotia Capital and Wells Fargo, and BNP Paribas and Société Générale. The introducing and execution-only brokers, such as BTIG, are focused on executing trades for smaller equity long/short funds of up to $100 million in assets under management, not least because larger funds require more resources, better technology, full asset class and market coverage, research and corporate access, and especially more balance sheet.
Whether either type of institution will snaffle Ted O’Connor remains to be seen. But if there is a pattern to be discerned in his career, it is that he likes to work in businesses that are either growing fast or poised to do so. So it would be surprising if Ted O’Connor did not turn up on the buy-side again, especially if he can find an emerging or established fund manager that wants to understand the changed world of prime brokerage and capital-raising and needs help to build the treasury function, distribution networks and operational and compliance infrastructures that the new world demands as the minimum conditions of success.