Rethinking The Wall Street Business Model (Part I)

“Too Big To Fail.” “Shrink Wall Street.”” Ban credit default swaps.” These are just a few of the themes dominating the discussion around the Wall Street business model. They all, unfortunately, miss the point. Size, scale, and instruments that properly used help manage risk have their benefits. Lost in the fallout of the financial crisis is the reason why Wall Street exists: to facilitate capital formation and to provide tools for efficient capital allocation. These are customer-focused activities. This cuts across the Wall Street firm, touching underwriting, credit, M&A, security sales and trading, derivatives, foreign exchange and asset management. I’d argue that these business lines are appropriate for the Wall Street firm and really do help customers, be they corporations, municipalities, sovereigns or institutional investors, achieve their objectives. The problem is that both regulators and risk managers have not kept pace with the increasing scale and complexity of the 21st century Wall Street firm, leading to the dramatic (over) reaction to the financial crisis by the US Government and the populist backlash from ripped-off US taxpayers. Further, the role that ratings agencies have come to play in the capital formation and asset allocation process must also be considered, because without them the recent crisis could not have happened. And this chaos has opened the door for opportunistic, PR-centric intellectual lightweights and politicos to foment movements around new regulations that will hurt – not help – capital formation and market efficiency. In short, it is a mess. But some reason needs to be brought into the discussion – and fast.

First, which elements of today’s model don’t fit and should be shut down or hived off? Then, what needs to be done to ensure that the model functions as intended? My over-riding goal is to provide customers with the products and services they want without promoting the privatization of profits and socialization of costs. Somewhere along the line we got off the rails, and it is easy to point fingers, e.g., ill-informed and simple-minded regulators, greedy and opportunistic Wall Streeters, incompetent and money-grubbing rating agencies, etc. Bottom line, we need to move beyond the finger pointing and towards real solutions. Here are my initial thoughts of what needs to be done, with an eye towards practicality and reason:

Idea #1: Separate proprietary trading operations from Wall Street firms

When thinking about Wall Street, it is important to remember its core mission: to facilitate capital formation and provide tools for capital allocation. Internal proprietary trading operations do not fall under either category. They are, in essence, subsidized hedge funds with an implicit Government guarantee. Artificially cheap financing costs. Less transparency than their independent hedge fund counterparts of like scale. These operations are readily separable from the customer-driven business. There is simply no rational reason why they should exist as an appendage of a Wall Street firm. Move them out and make them compete in the free market with their independent peers. Note, however, that this does not mean that all proprietary trading risk is wiped away on Wall Street. Desk traders as part of the main sales and trading operation will always take proprietary positions, making markets and taking views. This is a far cry from the separate, off-trading floor synthetic hedge funds run across Wall Street (like Andrew Hall’s Phibro, which was recently split off from Citigroup (C), or my former employer, DB Advisors), and are part of the customer-facilitation business.

Idea #2: Push over-the-counter assets onto exchanges

This is not just limited to credit default swaps. Most derivative contracts. Most cash bonds. Even many larger syndicated corporate loans. There is no good reason why such assets shouldn’t be listed and traded in a public forum. This would help with liquidity, transparency and risk capital weighting. This would also assist with the overall risk management of the firm. Many assets have been slow to migrate to exchanges because – surprise – transparency and liquidity tends to drive down bid/offer spreads, making them a less interesting proposition for those standing in the middle of these deals, e.g., the Wall Street broker/dealer. Trading volumes should somewhat mitigate spread compression, but the benefits to society of moving previously opaque assets onto exchanges shouldn’t be minimized. This is a no-brainer.

Idea #3: Eliminate sell-side payments to rating agencies (and perhaps the agencies themselves)

I’m including rating agencies in the Wall Street discussion because they are inextricably linked. Paying for favorable research is a non-starter in the equity business. Why should it be any different in the fixed-income world? The way the rating agency industry has grown up is fraught with conflict and must be changed. Is rating agency research valuable? Let the market decide. Insist that the buy-side pay for it. If the very concept of quasi-sanctioned ratings falls by the wayside, and it becomes more akin to the buy/sell/hold of high-quality equity research, then two things will happen: (1) value-added research providers will emerge to compete with the rating agencies, as firms will fill the information vacuum once headline ratings are eliminated; and (2) the buy-side will have to get back to basics and do real research, without offloading their fiduciary duty to the rating agencies. Only good stuff comes out of this change. Sure, pension funds and endowments across the globe will have to rewrite their investment policies to eliminate allocations tied to ratings, but then the brainless exercise of filling these allocations will stop and be replaced by bona fide research. Unlike Wall Street, the rating agency business is one that really need not exist. Stop the gravy train and make the buy side pay for value.

Idea #4: Revisit risk-weighted capital methodologies and move towards a mark-to-market framework

In a world where Wall Street assets are far more liquid and transparent, but where assets are far more correlated than previously imagined, a new view of risk management and capital provision needs to emerge. Wall Street firms will principally have two types of assets: exchange-traded and non-exchange traded. Exchange-traded assets will each attract their own risk capital provisions based upon liquidity, volatility and float, with a portfolio-wide benefit given for some measure of imperfect correlation among the asset classes (though with correlation matrices that are informed by fat tails and black swans, which we know are extremely fat and not so rare). These assets will always and at any time be marked-to-market. The non-exchange traded assets are more complicated. As I’ve written previously, I believe these assets should be marked-to-market unless they are (a) intended to be held to maturity AND (b) the firm has term financing in place to be able to carry the asset until maturity. There can be no 30:1 levered balance sheets aren’t almost entirely marked-to-market; this problem became immediately apparent in the wake of the market meltdown. “You mean [name your favorite Wall Street firm] can’t finance itself overnight??” This should never happen, yet it did. It shouldn’t happen again.

Idea #5: Give traders an equity interest in their strategies

The compensation culture on Wall Street is severely messed up. Trader payouts look like a long call option: lose your salary on the downside but get a percentage of profits fueled by a massive balance sheet and cheap capital on the upside. And with a calendar-year orientation driven by the annual bonus cycle, there is motivation to swing for the fences to lock down that “career year,” or to swing for the fences when you are down since, hey, what do you have to lose beside a few hundred grand of base salary? I know it sounds crass, but this is reality. Sure, clawbacks can help address some of this asymmetry, but overly complex and punitive pay structures will cause the great traders to all move to hedge funds, leaving Wall Street the victim of adverse selection (some would argue this already happens today). But what about literally creating a trading account for each trader than can rise and fall, where only a portion of the year’s gains can be withdrawn with the balance remaining invested in the trader’s strategy? One of the big downsides of trading on Wall Street and not at a hedge fund is that you start at -0- at the beginning of each year, while at a hedge fund you get the benefit of compounding capital, e.g., I get to keep my capital account and compound off that higher base each year. Over time, the power of compounding drives many traders to hedge funds, but there is no reason why such an alignment of motives shouldn’t exist on Wall Street. Wall Street’s shareholders should want this, too, because traders will begin thinking long-term, like their better hedge fund brothers and sisters. Shifting from an asymmetric payout culture to an entrepreneurial hedge fund culture would help with risk management as well, smoothing returns and generating more rational decision-making over time. Revolutionary, yes. Impossible, no.

This is simply the beginning of my thoughts on this theme. I’d love to hear your ideas, too. I’ll be sure to incorporate your thinking into my next installment.

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