Regulation Shifts Risk and Opportunities to the Buy Side, Finds Misys

As the sell side adapts to new regulation, not all of the risk is being eliminated from the system, because the buy-side is starting to take on some of the activities the sell side has been forced to shed.

“With the longer term implementation of Basel III, you are progressively going to see a reshaping of where risk is in the market. Some of the risk sits with the bank, some of it disappears, and some of it goes to the buy side. I don’t know what the percentage looks like, but I think each of those are big buckets,” says Bradley Ziff, senior risk advisor at Misys who co-authored a report last fall on the subject.

For the report, “The shift of risk from banks to the buy-side,” Misys interviewed over 50 industry participants last May and June, representing nearly $9.5 trillion in global bank assets, over $12.4 trillion in AuM from non-bank financial institutions (approximately $600 billion in alternative assets), and nearly $4 trillion in client advisory assets. Most interviews were with multi-asset or multi-solution money managers, typically offering traditional, long-only and alternative investment strategies, and most firms were based in North America or the U.K. but have a global presence.

The study found that Western banks have been de-leveraging their balance sheets in anticipation of upcoming capital requirements stemming from Basel III. And due to the U.S. Volcker Rule and U.K. Vickers Rule, dealers have rid themselves of proprietary trading activities, as well as some of their broader market-making activity and trading inventories.

“The exit of proprietary trading talent from sell-side organizations resulting from these rules has allowed key aspects of market-making, inventory management and lending to shift from a dealer-dominated activity to one where sophisticated investors have now assumed a key role in taking on market risk. This important development was highlighted by more than 75% of participants we interviewed,” says the Misys study.

Large investors such as pension funds and sovereign wealth funds have also started to take on more co-investor or even direct investors in these deals, thereby bringing more risk to that side of the industry.

The path ahead

The Misys study found that over 90% of participants think regulated banks will continue to assess their business lines and potential profitability, which likely lead to them taking on less risky assets and business, committing less capital and acting more as an agent than principal to a transaction.

These actions may lead to liquidity challenges and a tougher funding environment, says the report. “There also exists the potential for regulatory arbitrage as the buy-side and non- bank financial institutions (NBFIs) benefit from the trend in the transition of risk and risk-taking activities. As a consequence, the buy-side and unregulated NBFIs will typically survey the differential regulatory treatment of financial institutions, product structures and investment strategies and capitalize on those inconsistencies across multiple geographic markets.”

As NBFIs take on these risks, with hedge funds, for example, doing repo lending, infrastructure lending, trade financing, etc., it becomes harder to “put a lasso around them,” says Ziff, because there are so many more entities taking pieces of the market than when it was dominated by a handful of major banks.

However, he does think that by the second quarter this year, the Financial Stability Board will start to do something to address these changes, though it’s unclear what’s to come.

As a result of these shifts, though, service providers have an opportunity to meet new needs, such as regulatory reporting and more effective collateral/liquidity management due to balance sheet constraints, says Ziff. ”There is clear demand from buy-side clients seeking assistance in critical infrastructure areas and real opportunities for firms who seek to fully understand and respond directly to the emerging regulatory and business-driven demands of the new investing environment globally,” he adds.

As it is now, the shift of risk to the buy side is still a bit early, so while there’s an opportunity for service providers and technology vendors to offer risk and portfolio measurement tools, it will take more time to develop.

“A number of buy-side firms are being very cautious of buying, but I don’t think that means they’re building,” says Ziff. “I think there’s a market for the buy side wanting to risk evaluate with better systems and better measurement for the new risks they are going to look to undertake, but I think that’s a very gradual process.”