Although it is unlikely that the recent failure of certain financial institutions will have an impact similar to the collapse of Lehman Brothers in 2008, the current climate does bring to mind that distressed era. In reviewing the article that we published in Traders Magazine in 2021, it is clear that the same guidelines that we recommended for investment managers and asset owners at that time still apply today—in fact, they apply at all times, not only in turbulent ones. 

What You Need to Know:

  • If the market starts feeling like the current problems are not isolated to one or two institutions, we will start seeing other dealers under more and more pressure, resulting in relevant regulators stepping in to try to reassure the markets. It is possible that as other banks are pressured, they will start getting out of the least profitable trading/clearing businesses, which will negatively impact buy-side clients.  
  • All buy-side counterparties should make sure that they have current trading, legal and operational alternatives for every asset class that they trade; they should not wait to utilize such alternatives until it is too late. Transitioning to alternatives will always be slower than expected as you try to re-orient the manner and the counterparties with which you trade.

Below, find an updated version of our previous article: its tenets hold true as much today as they did when originally written. 

After the collapse of Lehman Brothers in 2008, buy-side entities were forced to develop a greater appreciation for the legal fine print that governs trading activity with their sell-side counterparts. The dangerously weakened financial position of banks—and the fire drills that called into question their survival—grabbed investment managers by the lapels and impressed upon them the need to become better stewards and risk managers of their investors’ assets. Investment managers and asset owners painfully realized that their strategies were irrelevant if they could not maintain the trading activity called for by the investment strategy. 

Legal trading documents became more relevant in the shadow of the financial crisis as banks exited or severely curtailed various businesses and client lists and as the financial industry generally became more risk averse. It wasn’t uncommon for investment managers to receive calls at the end of the day for tens of millions of extra margin to be posted the next day or shortly thereafter across asset classes.

Before the events that triggered the 2008 financial crisis, many investment managers routinely ignored or underappreciated these legal agreements. Few took the time to understand the documents or negotiate their terms; even fewer managers understood the rights that they were giving away to dealers in these agreements. Instead, they viewed agreements as either secondary to maintaining good relations with their personal contacts at dealers or just plain irrelevant. But the spectacular blow-ups of several hedge funds and dealers off-boarding clients on an overnight basis made the need to understand legal trading agreements vital.

If investment managers learned their lesson, it appears to have been short-lived. Today, many are again showing less interest in trading agreements than they should or disregarding them altogether. While we have yet to see a repeat of 2008, industry insiders have witnessed dealers paying close attention to their balance sheet, culling their customer lists, and lowering their level of service. Additionally, some dealers are getting out of certain businesses altogether.

These trends will undoubtedly have consequences for counterparties, big and small, requiring them to constantly evaluate their business relationships with banks and their legal rights under trading agreements. If they don’t, investment managers put their funds and their clients’ investments at risk.

As stated above, the most important step any counterparty must make is to make sure they have legal and operational alternatives for every asset class, and at least one alternative per asset class.  

No investment strategy is invulnerable to volatility and disruptive and unforeseen events, especially over a long period. And those events can negatively impact the performance of any fund. Investment managers need to know that dealers can use these events as a justification to terminate trading relationships. The consequences of termination can be severe. Termination may not only inflict financial damage, but also hurt an investment manager’s reputation, making it harder or close to impossible for them to form new relationships with other dealers. What explains why investment managers disregard legal trading documents? One reason is supreme confidence in the personal relationships fund managers have with their counterparts. Fund managers believe (albeit falsely) that their relationships are so strong that they will always trump the rights and obligations established in underlying legal agreements. In their minds, if the performance of their fund’s investments gives rise to concerns at the dealers, they can simply call up their contact, play some golf, and allay any fears. Problem solved. Not true. 

A second reason managers will often cite is that banks, with unmatched financial resources, will always do what they want to do no matter what’s in the documents. What’s the use in spending time and resources negotiating the trading agreement?

A third reason relates to time and money. The owners and principals of investment firms often see their in-house legal teams as cost centers that stand in the way of making money. They want to execute transactions as quickly as possible and not be delayed with considerations of a long list of hypothetical circumstances or events.

But, as history has shown, all three of these reasons are misguided and wrong. In my many years of negotiating with all types of dealers across thousands of agreements, before banks decide to end their trading relationship with an investment manager of a fund or asset owner, the following questions will often figure prominently in their internal deliberations:

  • What is the status of the entire investment portfolio the client is trading with us?
  • How expensive is the client’s business for us?
  • How much information do we have about the client’s investment strategy?
  • What level of transparency is there into the internal investment processes of the client? How does the client think about risk management?
  • How cooperative and forthcoming has the client been with us in sharing information about its financial reporting?
  • Do we have rights to terminate the trading relationship without utilizing events of default or termination provisions specified in the agreements?
  • What do we know about the founders?
  • Do we have legal rights that give us any immediate opportunities to terminate the relationship if the clients’ investments keep falling in value?

Any sophisticated buy-side entity needs to keep these questions in mind as it negotiates the terms of its legal trading agreements—whether it is 2008, 2011, 2021, today or tomorrow. By better understanding what is important to dealers and the regulatory framework in which they operate, buy-side players can better anticipate potential disagreements and protect their rights.

Dealers have been pushing for more stringent terms, pointing to recent fiascos as justification. Nobody wins when the failure of a single fund causes billions of losses to exposed dealers, but buy-side entities should understand the rationale for these terms and conditions, some of which could be used to terminate trading relationships even as a buy-side investment strategy is performing well. General agreement to more stringent terms would mean a greater number of funds being blown up in future. 

And always remember: dealers do not insist on provisions in the agreements unless they intend to utilize them in the future if conditions warrant.

Revised from original reprinted with permission from Traders Magazine. © 2021 Markets Media Holdings LLC

To see our prior alerts and other material related to the collapse of Silicon Valley Bank and other financial institutions, please visit our resource page by clicking here.