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BlackRock Is Remaking the Capital Markets

With $3.3 trillion in assets under management, the world’s largest asset manager is redefining the relationship among asset managers, Wall Street and companies seeking capital.

WITH RANK COMES PRIVILEGE. NO ONE KNOWS that better than Laurence Fink, the voluble chairman and CEO of BlackRock, the world’s largest asset management firm. In September, while one of his lieutenants, Richard Prager, was meeting with a reporter, Fink hovered near the door of Prager’s office for a few moments before stepping in and asking what they were talking about. Prager, BlackRock’s global head of trading, told his boss that he’d been explaining what the firm is doing to make sure it continues to thrive in markets that are undergoing some of the biggest changes in a generation in the wake of new regulations and the seemingly never-ending financial crisis.

That was all the opening the 59-year-old BlackRock CEO needed. Fink, whose love of power and showmanship is tempered by a child’s wide-eyed curiosity and energy, raced on about the forces shaping BlackRock’s plans. It was a long list: an inexorable macro trend toward less dollar–based trading, French banks stoking counterparty fears, investors pushing up costs by demanding more “granularity” on securities, and the need to create the right asset management culture to manage all of this. After his five-minute soliloquy, the indefatigable Fink left as swiftly as he had entered the room.

Fink, who has an outsize grasp on the details of his $9 billion-plus-in-revenue business, has reason to be worried. BlackRock is one of the largest managers of fixed-income securities and relies on unfettered access to them and to efficient capital markets to manage its growing portfolios for retail and institutional clients. A lack of sufficient liquidity — financial jargon that refers to the ease with which a trade can occur at a given price — has defined the debt markets off and on since 2007. In the years since the 2008–’09 crisis, as investment banks have moved to deleverage and governments around the world have imposed restrictions on banks as a result of the Basel III accord and the Dodd-Frank Wall Street Reform and Consumer Protection Act, there has simply been less liquidity sloshing around in the system. That means firms like BlackRock can’t buy and sell the securities they need as easily and investors aren’t getting the prices they want. Liquidity is likely to continue to be under pressure as governments debate regulations, the economic environment remains shaky and banks reduce trading risk.

Prager is only a small part of the story unfolding at BlackRock. Robert Kapito, the firm’s president, is the man behind the charge to redefine BlackRock’s every interaction with the capital markets, overseeing one of the biggest structural changes in how buy-side firms work with their counterparts on the sell side in 30 years. It’s in keeping with Kapito’s humble roots that he hasn’t broadcast his plans to the world. If Fink is the public, ubiquitous face of BlackRock, Kapito has fathered the intense culture within the firm.

BlackRock, with $3.3 trillion in assets under management, more than three times the size of its nearest competitor, is retooling the long-standing relationship among asset managers, investors, Wall Street and companies looking for capital — and changing the value proposition for its industry in the process. To combat the growing problems in fixed-income markets and the changing market structure of Wall Street, BlackRock is taking a seat at the table with banks and issuers, helping them design bond offerings and advising them on deals. The firm has launched a global capital markets desk, as well as a syndicate desk, hiring executives from Wall Street banks with the promise of bigger opportunities and greater riches. At the same time, BlackRock is aggressively expanding its electronic trading capabilities — developing another way to get the liquidity it needs — and building a securities crossing network to match buy and sell orders within the firm so it can bypass the Street altogether and save its clients millions of dollars in trading costs. By building a capital markets desk, BlackRock will be able to get better terms on the securities it buys and sells, larger allocations when it wants them and deeper information about the primary markets.

For the 54-year-old Kapito, one of the firm’s founders, BlackRock has no choice but to build these new capabilities. “Yields are low, interest rates are low, liquidity has changed,” he says. “We have to think differently to produce results for clients.”

Historically, the interactions among investment banks, corporate issuers, money managers and investors have followed a standard script. A bank would advise a company — say, Kraft Foods — on its capital structure; when it should issue debt and at what rate; and whether it should buy back stock or shore up the equity on its balance sheet. The bank would then structure and offer securities to money managers, which in turn would buy them for individual investors and institutions.

But Wall Street doesn’t have the resources it once did, and BlackRock doesn’t necessarily want to wait for banks to come to it with the choices on the menu. Instead, it wants to have a hand in designing the menu itself, helping to advise companies on their capital structure and how securities might be constructed. To do that, BlackRock has had to build capabilities that were once the sole province of investment banks. But Kapito and other senior executives at the firm are careful to point out that they are not trying to eliminate broker-dealers from the capital-raising process. They contend that it would be a mistake to try to replicate Wall Street’s high-cost infrastructure.

“We pioneered a capital markets capability not because we’re getting into the underwriting business; we’re not,” says Peter Fisher, 55, head of fixed-income portfolio management at BlackRock and former undersecretary for domestic finance at the U.S. Treasury. “But we do want to buy and hold the assets with the risk-return profile that we’re looking for — rather than just the ones on offer.”

BlackRock is the first mover in what will emerge as a new model for how business gets done between Wall Street and the rest of the financial industry, including money managers, which oversee trillions of dollars for retail investors and institutions such as public pension funds. Other asset managers ultimately will be forced to institute similar changes or risk losing ground.

“The big buy-side firms are displacing Wall Street,” says David Weild IV, who heads capital markets research at U.S.-based accounting and business advisory firm Grant Thornton.

BlackRock has grown substantially since Fink, Kapito and the six other founding partners spun out their business from private equity firm Blackstone Group in 1994 with $53 billion in mostly fixed-income assets under management. BlackRock now boasts more than 10,000 employees, operates in 27 countries and has expanded well beyond fixed income, which represents a little more than one third of its assets. The rest are spread among equities (44 percent), multiasset and advisory portfolios (10 percent), cash (7 percent) and alternatives (3 percent).

What hasn’t changed is BlackRock’s raison d’être: to build a firm whose interests would be aligned with those of its investors. Fink and company have maintained that mission through a series of acquisitions capped off in 2009 by the purchase of Barclays Global Investors, which made BlackRock the largest asset management firm in the world and put it neck and neck with Newport Beach, California–based Pacific Investment Management Co. in the race for the crown of biggest bond manager. 

“Rob and Larry have taken a firm from a handful of partners to more than 10,000 employees,” says Gregory Fleming, who runs the brokerage and asset management businesses at Morgan Stanley. “There are not many founder-entrepreneurs who have the skills to transition from launching a start-up to leading a global firm.”

In the wake of the 2008 market meltdown, global regulators have imposed higher capital requirements. Basel III, the global banking standard, increases the common equity that banks must hold and defines risk-weighted assets more onerously. It also dramatically increases capital requirements for banks’ trading books. The Dodd-Frank Wall Street Reform and Consumer Protection Act imposes additional burdens on banks’ business models and requires clearing of derivatives contracts. As banks are being forced to increase capital and reduce leverage and risk exposure, they have less desire to hold positions that their clients are buying and selling. As a result, big investors looking to sell anything from a corporate bond to a mortgage-backed security are driving down prices.

“In the current regulatory environment and because of the excesses, that pool [of Wall Street capital] has shrunk,” Kapito says. “So the leverage is going from 30-to-1 on its way to 8-to-1. The amount of balance sheet those firms have available to do those trades and to put positions on their books is just less.”

Primary dealer holdings of corporate bonds peaked before the credit crisis at about $240 billion. That number fell to about $55 billion during the crisis, recovered some in 2009, then dropped again, to about $65 billion recently, more than 70 percent off its high. “This pressure on primary dealer balance sheets becomes a strategic issue for investment managers because they aren’t seeing the same level of liquidity from the dealers that they did prior to the crisis,” says Richard McVey, CEO and chairman of MarketAxess, one of the dominant electronic trading networks for U.S. high-grade corporate, high-yield and other debt securities.

BlackRock, though, has plans to get around a tightened Wall Street. Kapito is retooling the firm with the help of Prager; Fisher; Steve Sterling, who was recruited from private equity firm Carlyle Group to run the new capital markets desk; and Robert Goldstein, who heads BlackRock Solutions, which offers sophisticated risk analysis, technology and advice to institutions, money managers and other investors.

BlackRock is turning some traditional practices on their head, taking a microscope to the securities in which it invests. As a result, Prager says, it has implemented a practice called “originate to manage,” in which it partners with Wall Street firms to work with issuers to sculpt new securities offerings. “We believe the future is an originate-to-manage model,” says Prager, 51, who was global head of rates, currencies and commodities at Bank of America Corp. before joining BlackRock in 2009. “So if the Street used to warehouse risk and then distribute it, Basel III makes that a very unattractive proposition. In the new model we’re the balance sheet. If we’re ultimately going to end up owning these assets on behalf of clients, why not bring us into the economic equation sooner?”

Another consequence of the changes emanating from Basel III, Dodd-Frank and other new regulations: The fixed-income markets are now ripe for automation. BlackRock has taken the best practices from its equity-trading capabilities — which are highly electronic — and extended those to fixed income, money markets and securities lending. The firm has taken another radical step by building its own crossing network to bypass Wall Street when it has a buyer and a seller of the same security in-house. Clients keep the spread — a substantial way to reduce costs, which is especially important when markets are as inefficient as they are now, with returns projected to be skimpy going forward. Goldstein is even planning to establish a crossing community within BlackRock Solutions.

“It’s really very simple,” he says. “We have many clients who could execute trades with each other right on our platform.”

The changing fixed-income markets are a thorn in all investment managers’ sides. “The buy side is exploring the alternatives,” says Robert Gasser, CEO of Investment Technology Group, a New York–based independent agency research brokerage. “If these guys [the banks] are not carrying inventory, markets still have to function, and investors still have to buy and sell.”

Other big asset managers, such as Valley Forge, Pennsylvania–based Vanguard Group, which has $627 billion in fixed-income assets, have worked with Wall Street syndicate desks and issuers to source public securities. Such asset managers have long done reverse inquiries, going directly to dealers with a request for specific terms from an issuer. But BlackRock’s moves go many steps further, forcing huge changes among money managers, many of which don’t have the scale, power or desire to implement similar initiatives. Some have reservations about the practice. A trader at Boston-based Loomis, Sayles & Co., which manages $120 billion in fixed income, says the firm is concerned about getting too involved with issuers and bankers given the confidential nature of information gleaned from such conversations. And Newark, New Jersey–based Prudential Fixed Income, which has $327 billion in assets under management, prefers not to cross trades, in part because it doesn’t want the appearance of conflicts of interest that could arise from matching trades inside the firm. “We favor the transparency of finding the best possible price from an independent broker-dealer,” says Prudential Fixed Income CIO Michael Lillard.

BlackRock, however, has a long history of protecting confidential client information. BlackRock Solutions’ very premise relies on its practice of partitioning off rivals’ investment information.

BLACKROCK IS WELL AWARE THAT IT IS REWRITING the rules. Kapito starts out a conversation on the effort with a long prelude explaining record low interest rates, how mom-and-pop investors have been suffering and subsidizing Wall Street banks, the changing demographics that are pushing people toward less risky fixed-income products and how much harder it is to do business in such an environment. But it doesn’t take long for Kapito to show his Street smarts, wondering aloud why his partners had agreed to talk at all about what he considers corporate secrets. He says he doesn’t want to draw a road map for his competitors. During a second interview Kapito softens. His large rivals will have little choice but to do the same thing as BlackRock, he says.

Kapito grew up in Monticello, New York, a small, working-class town about 90 miles northwest of Manhattan. His father, aunt and two brothers ran a tire and auto repair shop there for 50 years. His father suffered a debilitating stroke when Kapito was 13 but continued to work in the office. Kapito put himself through college, taking a thrifty approach to his higher education. He spent his first two years at the state-run University of Buffalo before transferring to the more expensive Wharton School of the University of Pennsylvania, where he is now a trustee. At Penn he met his wife, Ellen, who was in the school of nursing and has been an oncology nurse for 30 years. Kapito, who has four children, regrets that his parents never got to see his success. (His father died in 1986; his mother in 1997.) He expects long hours and complete loyalty from his employees, but he treats them like family. 

After graduating from Wharton with a BS in economics in 1979, Kapito began his career on Wall Street in the public finance department of investment bank First Boston. He left two years later to get his MBA from Harvard Business School. In 1983 he rejoined First Boston on the mortgage desk after the firm’s head of sales and trading told him the best opportunity would be to work for Fink.

Fink helped develop the mortgage-backed security and other debt securitization products that bundled mortgages into one instrument, diversifying the risk and allowing banks to get loans off their books and write more mortgages. Though structured products ultimately turned into many of the toxic securities at the heart of the 2008 crisis, they would also dramatically lower the cost of credit, especially the 30-year mortgage, and expand home ownership. Fink and Kapito, who still talk as often as 15 times a day, grew the group into the most profitable area of the firm.

In 1986, Fink lost $100 million on an interest rate bet and the mortgage department went from darling to loser overnight. Kapito says the importance of the loss has been overstated in Wall Street lore about the founding of BlackRock. “We made money and we lost money over the years,” he says. The work had become less fun, Kapito explains, as the mortgage market changed and Wall Street’s focus shifted from client service to proprietary trading.

Fink came up with the idea of setting up an asset management firm that would use risk tools that previously had been available only on the sell side, and he started talking to Kapito about it. Fink introduced Kapito to Susan Wagner and Ralph Schlosstein from Lehman Brothers, and the four refined Fink’s concept. Kapito recruited Keith Anderson, whom he had hired on the First Boston mortgage desk, as well as Barbara Novick and Bennett Golub, who were mortgage specialists. They were joined by Hugh Frater, an investment banker in the mortgage finance department at Lehman.

In 1988 the group of eight formed Blackstone Financial Management under the umbrella of Blackstone Group. They realized that to analyze risk they needed to build sophisticated systems. The task was left to Golub, who has a Ph.D. in applied economics and finance from the Massachusetts Institute of Technology, and Charles Hallac, the firm’s first employee, who had worked for Golub at First Boston and is now chief operating officer of BlackRock. The two bought a Sun Microsystems workstation and stuck it between the refrigerator and coffee machine. From that computer they constructed models to track collateralized mortgage obligations. They built a portfolio management system after one of the portfolio managers complained that he couldn’t keep track of his positions in Lotus 1-2-3, a popular spreadsheet program at the time. Hallac and Golub printed out reports from the portfolio tracking system on green paper, the only available paper in the building one night. (The “green package” is still available to BlackRock Solutions clients.) The technology that Golub and his team created helped the firm generate impressive 40 percent-plus margins.

Experienced at sales and trading, Kapito and Anderson took charge of portfolio management. Kapito was always on the markets side, building portfolio management and performance from scratch, maintaining the firm’s relationships with Wall Street and running day-to-day risk oversight and operations. He continues to work in an office 20 feet away from the trading floor.

By 1993 the group, which had changed its name to BlackRock to differentiate itself from its parent, had $23 billion in assets. The next year the group split off from Blackstone. Fink wanted to entice talent to his business by offering equity, but Blackstone co-founder Stephen Schwarzman didn’t want to dilute his ownership, saying Fink should instead dilute his own. Blackstone ended up selling its 32 percent share to PNC in Pittsburgh for $240 million. The PNC deal closed in 1995, and four years later BlackRock went public at $14 a share.

BlackRock had had third-party clients since it advised General Electric Co. on what to do with subsidiary Kidder Peabody’s $7 billion portfolio in 1994 amid a bond-trading scandal and plummeting bond markets. In 2000, BlackRock formalized BlackRock Solutions as a separate brand and unit, selling its services to competitors, pension funds and others. In addition to technology, BlackRock Solutions also offered advisory services, acting as a fiduciary for client portfolios. The advisory service would prove to be a godsend during the financial crisis, as many banks sought BlackRock Solutions’ services.  The firm realized it could both cover the costs of its expensive technology endeavors and learn from the challenges of processing others’ work by formally going after external business.

In 2005, BlackRock, still largely an institutional fixed-income shop, wanted a more meaningful presence in equities. That year it purchased State Street Research & Management. The $375 million acquisition was small, but the success the firm had in transferring State Street’s portfolios to its technology platform gave management the confidence to do more. A year later BlackRock purchased Merrill Lynch Investment Managers from Merrill Lynch & Co. The deal gave Merrill a 49 percent stake in the company, and BlackRock got equity capabilities as well as retail business and a global footprint. The deal doubled BlackRock’s assets under management, from $425 billion in 2005 to $1 trillion.

Things were calm in 2006 as BlackRock integrated MLIM. Then came 2007, when the market got some of its first hints of the mortgage crisis. By 2008, CEO after CEO was calling BlackRock for advice on the contents of what would turn out to be catastrophic portfolios filled with little-understood structured securities. BlackRock assessed Bear Stearns Cos.’ mortgage portfolio before JP­Morgan Chase & Co. CEO Jamie Dimon decided to buy the firm with the Federal Reserve’s assistance. As part of that deal, the Fed took on Bear’s riskiest assets; BlackRock helped manage the portfolio. Later, BlackRock advised the Fed on American International Group’s credit-default-swap portfolio and counseled UBS about its asset troubles. Fink spent the crisis shuttling between New York and Washington, advising the Treasury and honing his very public personality. Kapito minded the shop back in New York. Friends and colleagues say that although Fink loves the attention he has gotten as CEO of BlackRock, Kapito is perfectly happy keeping a low profile.

“Larry and Rob have created a fabulous partnership where they have divided up the work,” says David Nadler, vice chairman of Marsh & McLennan Cos. “Larry spends more time in the public arena, and Rob keeps the engine going. But it would be a mistake to underestimate Rob’s strategic vision and innovation for the firm.”

In 2009, BlackRock bought BGI from Barclays Bank. Not only did BGI have a huge institutional index business, it owned IShares, the powerful exchange-traded-funds brand. Today, BlackRock’s $3.3 trillion in assets is bigger than the Fed’s balance sheet. In fact, the Financial Stability Oversight Council has not yet decided whether BlackRock should be deemed a nonbank systemically important financial institution (SIFI) — one that is too big to fail.

STEVE STERLING WAS RUNNING THE CREDIT BUSINESS at Carlyle Group when he got a call in November 2009 from Rick Rieder, CIO of active fixed income at BlackRock. Kapito had asked Rieder, Sterling’s longtime friend from their days together at Lehman, to place the call. Sterling had spent 20 years on Wall Street, starting out at Bank of America in leveraged finance and loan syndication, then working at Lehman running leveraged loan capital markets, then finally going to Bear Stearns, where he oversaw high-yield capital markets. Rieder wanted to know if Sterling was interested in managing a capital markets desk at an unlikely place: BlackRock.

Sterling took his time before saying yes. He wanted to make sure that the changes BlackRock was anticipating were inevitable and long term. “I spent a lot of time with folks at BlackRock, thinking hard about whether there had been sufficient structural change in the markets to create sustainable capabilities for something like this, or was this more temporal?” says Sterling, 48. He decided that the structural changes were indeed real and that the key revenue drivers for investment banks, including proprietary trading, were going away. That would force them to change in ways they would never have voluntarily. Banks would also need to figure out a way to sustain revenue on a smaller balance sheet.

The latter is where BlackRock’s capital markets desk would come in. If banks have to turn over their capital much more quickly and aggressively, then BlackRock can insert itself into the capital markets process in a much more meaningful way. Sterling, who chooses his words carefully, notes that he needed to know that BlackRock, despite its size, retained an entrepreneurial spirit and that executives like Kapito weren’t figureheads but instead deeply involved in the day-to-day running of the business and obsessed with the details. Convinced of BlackRock’s logic and commitment, Sterling took the job.

Less than two years after joining BlackRock, Sterling has had success with his team. The firm established a Chinese wall between the new, private capital markets group and the public securities group. This gave the capital markets group unfettered access to information that the Street would share about issuers’ potential deal making, securities offerings and the like. The Chinese wall is there to ensure that the information can’t leak to BlackRock portfolio managers who may have positions in the companies or other companies that would be affected by those changes.

BlackRock is trying to make sure that banks think of it first and that it gets the best allocation of any securities they are distributing. To do that, Sterling has created a syndicate desk, now one year old. Traditionally, a syndicate desk at an investment bank talks to investors around the world about a deal. BlackRock’s desk is designed for the firm’s internal needs.

Wall Street now has one central point at BlackRock for new-issue offerings. When a bank comes to the firm with an idea, Sterling’s team shares it globally with the firm’s portfolio managers. “That ensures that there is a gateway to BlackRock through which all the capital of BlackRock has the opportunity to see the idea, with the notion that we can concentrate our buying power and we can concentrate information,” Sterling says.

Even more important is the new information that the syndicate desk is giving BlackRock. Once again the firm is using the power of technology to give it a leg up. The syndicate desk uses BlackRock’s systems prowess to capture the flow of information from the primary markets to better understand its own portfolio managers’ behavior as well as how certain broker-dealers are performing in the market with new issues and other secondary offerings. For example, BlackRock can assess the volatility of the market by sector, duration and credit quality; the performance of a product and how well it is trading over time; what concessions to the market have been made by the broker-dealer; and other factors. If a broker-dealer is not pricing transactions appropriately, Sterling will take his business elsewhere.

In a sense, BlackRock is creating a mini–investment bank to protect itself from what it believes is the future decline of the investment banking industry. Its syndicate desk is responsible for the distribution of risk in an offering. The last thing BlackRock wants is for its clients to participate in transactions that don’t perform well.

Historically, some asset managers have initiated discussions with banks about what they might want to buy or the amount of money they want to put to work. Asset managers have never been good at reverse inquiries because those deals are one-off — a way to help finance a troubled company, for instance.

BlackRock is doing reverse inquiry on steroids. The firm is institutionalizing the practice by pairing an in-house capital markets professional with a portfolio manager on a specific investment idea. The two work together to put specific terms and pricing around the idea and then take it to a broker-dealer. BlackRock gets to influence the terms of the deal and how much it receives for client portfolios. The broker-dealer takes the idea to the issuer, who knows that BlackRock is behind it and that there will be meaningful capital to back it up.

BlackRock also provides strategic capital when a broker-dealer comes to it on a restricted basis. For example, BlackRock could provide capital for mergers and acquisitions that haven’t been announced. Recently, the firm was brought in on an M&A deal for a major health care company. BlackRock had input on the blend of debt and equity, and the senior and subordinated debt mix. For providing the bridge capital, it was paid a fee — 100 to 150 basis points — that was rolled into its funds. BlackRock did 50 transactions in the first 11 months of 2011 on its capital markets desk, with about 40 percent being strategic capital trades. In fact, 20 percent of the capital deployed by BlackRock in U.S. corporate credit in 2011 came from the capital markets group. The firm plans to launch a European capital markets debt capability in the first quarter of 2012.

Ultimately, BlackRock plans to expand its capital markets desk to equities, which it is now only doing on a one-off basis. The firm has done cornerstone capital commitments to anchor initial public offerings, primarily in Asia. The commitments give offerings more certainty of execution. BlackRock plans to do more of these types of deals in Europe and the U.S. as well. Sterling will formalize the European and U.S. equity efforts in the first quarter and will expand to Asia for both equity and debt by early 2013.

Sterling is careful to point out that BlackRock is not going around the banks. First, it doesn’t want to replicate the banks’ cost structure, which includes hiring teams to call on issuers. Second, BlackRock’s funds are limited in the number of private placements they can hold and the firm wants secondary liquidity in issues that only a bank can provide. But most important, BlackRock doesn’t believe it has to go direct. “We can create what we have today through a partnership by leveraging their resources, not replicating them here,” Sterling says.

ROB GOLDSTEIN JOINED BLACKROCK as an analyst in 1994, two weeks after graduating from Binghamton University with a BS in economics, when the firm had just 80 people. His job was to do quality control for the green package, which meant that he analyzed the numbers the computers were spitting out and made sure no one relied solely on the mathematical models or some magic number to assess a portfolio’s risk. Five months after joining, the now-37-year-old Goldstein was part of a group brought into a conference room where Fink announced that GE had retained BlackRock to liquidate the mortgage portfolio of Kidder. A GE banker handed a disc with the portfolio information to the group at 10:00 that night. By the next day BlackRock had started to produce reports, the transparency of which amazed the GE and Kidder executives.

His background in BlackRock’s technology business has given Goldstein the confidence to be excited about the benefits of electronic trading, central clearing and crossing. It’s all about liquidity, he says. To combat liquidity problems, BlackRock is crossing as many trades as it can internally. That means if the portfolio manager of one fund or account is selling a security and another manager wants to buy it, BlackRock can simply cross the two trades and bypass Wall Street altogether.

BlackRock’s ambitions go well beyond internal crossing. The firm is creating a crossing community within BlackRock Solutions that will include BlackRock and all its other clients. BlackRock Solutions processes $10 trillion worth of positions a year, giving it a huge community in which to find crossing opportunities. Goldstein says the offering will be available in early 2012, emphasizing that the capabilities are completely optional and will be tracked and settled like any other trades that run through BlackRock’s system.

Crossing fits into the larger puzzle of electronic trading, for which BlackRock is preparing in a massive way. Dodd-Frank is changing the equation by requiring clearing of over-the-counter derivatives contracts. To do that, instruments need standard features; once instruments are standardized, they can be traded electronically. That’s all BlackRock needed to know before it put in place an electronic trading plan. Of course, BlackRock’s executives have been watching what has happened with equities for years as human traders have been replaced by hundreds of electronic venues where market participants can get liquidity. It was just a matter of time before fixed-income trading was automated, with or without Dodd-Frank.

Still, BlackRock is early. The majority of fixed income is still executed when a trader picks up the phone and calls a dealer. “The catalyst for doing it now is that there will be a paradigm shift; maybe it’s five years out there,” Goldstein says. “It will look like what equities did ten to 15 years ago.”

Goldstein has been studying what happened in the equity markets and trying to apply those lessons to fixed income. He’s connecting BlackRock’s Aladdin trading platform to more and more liquidity pools. Already, BlackRock sees fixed-income volumes rising and average trade sizes getting smaller. “Because of the liquidity challenges people are facing, the ‘science of trading’ has become much more complex,” he says.

Outside of BlackRock Solutions, Kapito has combined the electronic trading team in BlackRock’s global trading area under co-heads for fixed income and equities. “Dodd-Frank is the catalyst, but there has also been tremendous advancement in technology capabilities,” says Supurna VedBrat, co-head of the market structure and electronic trading team for BlackRock's portfolio management group. “The market has pushed us to execute faster and smarter and to be more streamlined in order for us to have access to liquidity. It’s the right time for us to be innovative and disruptive, so we can incorporate e-trading at the center of our trading strategy.”

Although BlackRock plans to start hiring for its e-trading fixed-income effort in early 2012, right now that’s still in the design stage. The firm wants to connect to as many liquidity pools as possible. “If you want the best access to liquidity, then you want a framework that can allow you to pick which trading channel you want at what time,” says VedBrat, a computer scientist and theoretical mathematician who started at BlackRock in 2010 as a strategic business adviser to Prager.

But BlackRock can’t operate in a vacuum; it depends on the industry at large. As such, it’s been active in lobbying for changes in some of the Dodd-Frank proposals for electronic trading of OTC-cleared derivatives. For one, while it is supportive of central clearing, it has written to regulators that liquidity providers should have time to hedge their positions before publicly disseminating trade information. BlackRock is concerned that bid-ask spreads could widen if there isn’t sufficient time given before disclosure is required. The firm is also watching rules about swaps execution facilities, where derivatives will be required to trade, to make sure that these new entities aren’t introduced too soon into the market.

BlackRock’s moves are the first volley in a larger game that will play out over the next decade as the financial industry reorganizes itself in the face of politics and populism, massive government debt in the developed world and a continued paucity of economic growth. As recession has stalked the U.S., some think a shrinking Wall Street has a lot to do with it. Kathleen Gaffney, who has been managing fixed-income investments for 27 years and is co–portfolio manager, with Daniel Fuss, of the Loomis Sayles Bond Fund, believes the dysfunctional fixed-income markets are preventing companies from getting access to capital to expand, despite historically low interest rates.

“We blame Wall Street, then clamp down, but we’ve lost sight of how liquidity is positive for the economy,” says Gaffney.

No sector of the financial industry will be left untouched by Wall Street’s efforts to rightsize. Investment managers are now thinking through how to take on some of the tasks that Wall Street once did or risk getting left in the dust. “As Wall Street retrenches, why wouldn’t I want my money manager to have more of a say in how securities are designed?” asks Christopher Li, president and CEO of Lockheed Martin Investment Management Co., which manages the company’s pension assets. “If BlackRock is going to be at the table with issuers and banks, it seems that every money manager will have to do something similar so they also have a say in future offerings,” he adds.

Still, Fink — Mr. Outside — has reason to be worried. With or without the benefits of capital markets expertise, investment managers’ fees are inextricably linked to the health of the markets, which, with the future of the euro hanging in the balance, doesn’t look particularly good these days. But Mr. Inside has reason to be optimistic. With $3.3 trillion in assets, BlackRock is still innovating. “We’re reinventing how money is managed, and in order to do that, you can’t be afraid to change, to reinvent, to retool the factory,” Kapito says.

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