Running a Large Trading Business is Hard: Surprise!

I feel for John Costas. I really do. Word this week that Dillon Read, the outsourced, hybrid proprietary trading/third-party asset management platform of UBS, will be winding up this week after suffering a loss didn’t surprise me. Why? Because I know how hard it is to run one of these platforms, having run the DB Advisors organization which was similar in structure and spirit, and larger in AUM than Dillon Read. That said, I was fortunate to have been at the helm of an extremely profitable trading operation, even in the face of a high degree of complexity. And, like UBS, complexity was one of the reasons why we restructured the platform during my tenure. But at the end of the day only three things really matter:

1. Attracting and retaining top trading talent;



2. Creating and supporting a strong risk management culture; and



3. Possessing the psychological and economic wherewithall to withstand expected levels of volatility, even if the absolute numbers are, well, absolutely large.

Because if you lack any of these three things, you’re toast. You are pre-ordinated to fail. And some of these things were clearly lacking at the intersection of the Dillon Read/UBS relationship.

Here is little extract from yesterday’s article in the Financial Times:

UBS executives said the bank had underestimated the complexity of lifting the
proprietary trading operation out of the investment bank and establishing it as
a separate asset management business.

Peter Wuffli, UBS chief executive, said it had also “under- appreciated the
synergies of a proprietary trading operation being directly integrated into the
investment bank”.

But Mr Costas said returns from the $3.5bn proprietary fund had been at or
above plan for 18 months until the subprime problems in the first quarter.

DRCM also struggled to raise money from external investors, attracting only
$1.2bn for its first fund, which closed at the end of last year. This will be
returned to investors.

Complexity of lifting out a proprietary trading operation? Depending upon the strategy or strategies being run, it can be truly mind-boggling. This is where my empathy kicks in. The first fund my team spun out of DB Advisors, QVT Financial, LP (which was running about $2.3 billion of assets at the time of spin-out) ran a large and complex multi-strategy book with hundreds of OTC derivatives positions (CDS, asset swaps, etc.), significant, concentrated illiquid asset positions and a raft of convertible bonds. They were (and still are) a top-performing fund with the rare combination of exceptional absolute returns and very low return variability. But theirs was not a plain-vanilla long/short book, to be sure. Their prime brokerage relationships were stunningly complicated. And they ran both proprietary and third-party money.

That said, we had a bunch of things working in our favor when it came time to spin them out:

1. Dan Gold, Managing Partner of QVT, is a super-smart, detail-oriented business builder that had a strong team to work on the spin-out process;



2. I had a great team working on my side to help with the legal and operational aspects of disentangling the QVT entity from the Deutsche Bank organization, including John Hitchon (one of the heads of Prime Brokerage at DB), Paul Bigler and Christine Morgan;



3. Dan and DB Advisors were able to undertake this year-long process - which was a HUGE distraction - without adversely impacting QVT’s returns; and



4. Deutsche Asset Management, which was the fiduciary on the third-party monies run by the QVT team, worked hand-in-glove with DB Advisors, QVT and existing investors to make the transfer smooth and seamless.

This is what I said in the Financial Times about the DB Advisors platform at the time of spin-out:

DB Advisors was set up two years ago as a separate legal entity within
Deutsche Bank and houses several internal hedge funds run by some of the bank’s
best traders.

External money is managed under the DB Global Masters programme and several
single-manager funds.

Roger Ehrenberg, head of DB Advisors, said the departures were part of the
“life cycle” of the business.

“We bring in top talent, provide capital to support varied investment
strategies and, if desired by the manager, jointly execute a transition to
independence with DB Advisors as a significant day one investor and strategic
partner … we look forward to a long term mutually beneficial
relationship.”

But even in the best of cases this transition is a time-consuming, distracting, costly and gut-wrentching process. And the complexities of managing the legal and regulatory aspects of a hybrid proprietary trading/third-party asset management entity can be overwhelming, especially when you run a tight ship. I did it and and it is HARD. So in the UBS/Dillon Read case, the amount of the loss is likely not the driver of their folding, but the problems of performance (and, therefore, their inability to raise significant third-party assets) and the issues of managing such a complex organization. And these are good reasons for packing it in. Because if you don’t have the demonstrated ability to attract and retain top talent, which enables you to build a diversified hedge fund trading platform, which enables you to produce attractive, low-volatility returns, which facilitates the raising of significant third-party money, you are just wasting your time. And this is what I am assuming my friends at UBS and Dillon Read concluded. It is a tough row to hoe, fellas. Just a little too tough, I guess.

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COMMENT:

AUTHOR: Yaser Anwar

EMAIL: yaser@yaseranwar.com

URL: http://www.yaseranwar.com

DATE: 05/04/2007 11:57:54 AM

In an effort to catch up with MS, LEH’s moves to ramp up their Alternative Investments divisions, UBS it seems is trying too hard, [read: HF hotels and now this fiasco] and in the interim straying from their core competence- wealth management. 

“When it’s too obvious, it’s usually the opposite”. These were the words ingrained into me by a fellow trader when I started trading. 

In this post’s context it means: About two years ago, when the housing market started stumbling, it was known that the US ABX index will be the one where lots of money could be made due to the unraveling of the housing market. 

This led to forays by various brokers into unchartered waters, mostly third-tier houses like your FBR. 

Here we are now with huge losses on balance sheets of UBS, FBR, CIBC etc. all thanks to wrong bets made on Credit Derivative Swaps on ABX Index. All these guys did was become dinner for the wolf, Paulson & Co.  (the firm who made the bundle on ABX CDSs).

What did they do wrong, UBS-FBR-CIBC etc? Long-story-Short, they were too early to the trade, got 

frustrated and reversed, precisely at the wrong time, and now Mr. Market has shown them that if you stray from your core competence and play the “fairly obvious” trade game, you’re bound to come up short.

Another thing UBS & others trying to ramp up their AI exposure is, when you try to take a page out of someone else’s book, in this case MS & LEH, at least look at the page you’re taking out. What do I mean? Simple- instead of bearing the costs of doing it on your own, buy a balance sheet stake in the top firms. Will you have to pay a premium? Yes and it is probably a lot better that way because if you blow up, you’ll end up paying that much and then some anyway. 

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3 years ago | view comments |  Trading