Regardless of how deftly or inept the financial crisis is handled, the financial services sector is facing tectonic change: how firms are managed; how staffers are compensated; how ideas are generated and researched; and where transactions will take place. Mega-trends such as transparency, centralized exchanges, increasing specialization and disaggregation of services will rule the day, and will sharply impact the size, scope and power of the industry relative to its meteoric rise over the past two decades. Risks will be taken, money will be made, and innovation will continue, just not at the pace and in the same manner to which we’ve become accustomed during the halcyon days of the 1990s and early 2000s. Here are a few of my prognostications for how the industry will change in the wake of Government intervention over the next 18-24 months.
Compensation
TARP money or not, high-performers will be paid. But cash compensation will be capped at a fraction of the amounts previously paid out, and the stock that is awarded will have long-dated vesting and be subject to clawback for losses attributable to personal performance. I believe we’ll see a $1 million cash compensation cap, 5 year cliff stock vesting and a clawback on unvested shares. I think smaller amounts of total compensation will also be likely, but the changes will be less stunning than the cash limitation and cliff vesting provisions of all new restricted stock and option programs.
Research
Once dominated by the sell-side, the majority of research consumed by the buy side will be sourced from third-party providers. Many if not most top sell-side research analysts will leave to set up their own shops, and leverage lightweight, flexible technologies for publishing and disseminating their research. They will likely leverage the services of third-party brokers to monetize their research through Commission Sharing Arrangements (CSAs). Further, “expert networks” will continue to proliferate, seeking to connect those with domain experience with those in need of deep, targeted insights. Gerson Lehrman Group (GLG), the 800-pound gorilla in the field, will continue to flourish, but the long tail of expertise not covered by their network will also become available. The key to accessing research in a fragmented landscape is the discovery layer, the matching of interests with knowledge. This will continue to be a “hot button” topic as investors work to become more efficient and streamline their investment process.
Exchanges
Derivative contracts will migrate towards exchanges, forcing standardization across much of the derivatives industry. Interest rate swaps and options, credit derivatives, the whole lot, and not just for standardization and transparency, but for collateral management. Possibly the largest element of the “bailout black hole” relates to counterparty risk, e.g., were AIG to have gone bankrupt, it could have dragged many of its counterparties down with it. However, had it been forced to post collateral pursuant to a centralized clearinghouse function, it couldn’t have delayed its day of reckoning to a time when the problem was so large it didn’t have the necessary liquidity. While the largest over-the-counter derivatives dealers might have squawked at such a move in the past, nobody has demonstrated the financial management required to earn the right to squawk now. And while this move will take away significant profitability from the banking sector, it could make up some of the losses through higher trading volumes due to liquifying and deepening previously opaque markets.
Hedge Funds
More regulation will come, and if done sensibly should not prove to be a damper on a healthy, robust hedge fund marketplace. Revealing the names of investors? A dumb, patently political move. Focus on risks and reporting. For hedge funds that aren’t publicly traded, and whose investors are accredited, the main purpose of disclosure is for regulators to understand the concentration of risks across the financial markets, and to avoid the “too big to fail” problems we’ve had repeatedly ever since LTCM bit the dust in 1998. Somehow, Meriwether and Co. seemed to have started a trend. Few got the joke back in 1998 and even fewer got it in 2005/06, when risks were really ramping up (i.e., the GSEs) yet more fuel was added to the fire. I’ve said it before and I’ll say it again: hedge funds aren’t bad and they play an essential role in fostering liquid, efficient markets. But the SEC has been understaffed and ill-prepared to monitor these risks. With a well-trained and appropriately staffed SEC, hedge fund should simply be another part of the regulatory rubric covering broker/dealers, RIAs and mutual funds.
Conclusion
This is simply the beginning of a discussion concerning the changes we’re likely to witness across the US financial landscape. The Obama Administration has an historic opportunity to use its brains to support sensible, thoughtful, changes in our legal and regulatory environment. It will invariably have to fight against politicos in Congress that have other, more populist agendas, divorced from the realities of fostering healthy financial markets and more geared towards garnering headlines in the local papers. That said, it is time for some changes, and the ones I’ve outlined above should help investors, the markets and the institutions charged with financing their growth.
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