Dangers of disintermediation

The on-going trauma in the markets has already caused a major shake-up of the financial services industry. Bear Stearns, Lehman Brothers and Merrill Lynch are no longer independent securities dealers. Meanwhile, major financial institutions such as AIG and Royal Bank of Scotland are now state-controlled entities.

Despite the vast amounts of capital being injected into the banking system, financial institutions are still reluctant to pass on credit to their clients, be they retail customers or multi-billion dollar institutions.

Dealers are also reappraising the value of the bundled services they offer. For example, many financial institutions have cut the bargain-basement credit they extended to end-clients in the expectation of receiving lucrative derivatives deals in repayment.

Prime broking units, meanwhile, have stopped acting for many hedge funds. That's because leading service providers like Goldman Sachs and Morgan Stanley cannot justify the capital allocations needed to sustain this area of business at mid-2007 levels.

Stronger, cash-rich clients, meanwhile, are worried about posting excess collateral with dealers. Many hedge funds now ring-fence surplus capital by placing it with custodians such as Bank of New York or State Street after some of them had their money frozen when Lehman Brothers went bankrupt. And a number of major end-users are sounding out interdealer brokers and exchanges with a view to trading directly with them rather than via dealers.

That's not surprising. Trading costs for some large counterparties are more than double what they were at the same time last year. In part this is due to the increased risk premium. But dealers are also being accused of trying to prop up flagging profits elsewhere by hiking fees in areas of finance that lack transparency.

Plunging trading volumes since September have also forced intermediaries like brokers to question how their business strategies might need to change. And with some dealers accepting they are no longer in a financial position to meet the needs of their clients, a window of opportunity may have opened for brokers to deal directly with end-users and not incur the full wrath of the eight or so major international dealers that traditionally have acted as counterparties for the vast majority of global derivatives transactions.

As the financial crisis lingers, the likelihood of disintermediation looks set to grow.

Christopher Jeffery.