The conventional wisdom is thus that investment banks and securities firms should abandon securities trading and stick to more attractive activities, such as managing assets and originating securities. Investors have hopped on this bandwagon, penalizing banks that earn substantial trading revenue with low price-to-earnings ratios (Exhibit 1).
Market making revisited
Despite all the bad press, the economics of market making and brokerage compare well with those of other core banking activities, such as underwriting securities and managing assets. Over the past 20 years, trading revenue has grown just as fast as other sources of bank income and been only a bit more volatile (Exhibit 2). And despite declining margins, trading revenue has grown even faster in recent years because of the global boom in securities trading. From 1995 to 1999, market making and brokerage revenue grew at an 18 percent clip annually, slightly faster than the overall average revenue for the whole securities industry. At the same time, the trading of securities accounted for more than half of the total revenue growth for some of the largest securities firms (Exhibit 3).
Historically, trading volumes surged every time the structure and efficiency of markets improved—for example, the 1986 "Big Bang" reforms at the London Stock Exchange and the 1997 order-handling rules in the United States. So the prospects are good: forthcoming regulatory changes—such as the introduction of single stock futures in both the United Kingdom and the United States—will stimulate the trading of securities by increasing the market’s efficiency and give market makers more flexibility, thereby improving their margins.
In the United States, NASDAQ’s SuperMontage will increase the market’s transparency by introducing a quasi-central limit order book in over-the-counter (OTC) stocks. (The SuperMontage will display three levels of orders or quotes on individual stocks rather than just the best bid and offer, so participants will be able to get a better sense of the depth of prices of and interest in a particular security.) The repeal of the NYSE’s Rule 390 will authorize the off-exchange trading of all listed stocks, thus boosting the market’s efficiency and allowing market makers to match orders internally and to capture both sides of the spread. Decimalization, which was recently introduced on the NYSE and is now being launched in OTC stocks, should also stimulate demand because spreads will narrow, thereby reducing the cost to trade.
In Europe, the changes will be even more far-reaching. The existence of more than 20 separate International Settlement Depositories makes clearing and settlement for intra-European trades three times more costly than they are for US ones. The implementation of a proposal to establish two main clearinghouses would eventually reduce much of that cost and stimulate cross-border trading, but even without this change, the trading of securities is booming among retail and institutional investors alike. European retail investors are diversifying their portfolios of bonds and local equities, taking advantage of new higher-yielding securities and cross-border opportunities. Institutional investors, overly concentrated in local securities, are also diversifying. As a result, from 1996 to 1999 the compound annual growth rate for the trading of European equities (31 percent) outstripped that of the United States (25 percent). We expect this trend to continue.
Meanwhile, the businesses that were supposed to save investment banks—M&A and equity origination—are becoming less attractive. They enjoyed record years in 1999 and 2000, but the sharp devaluation of technology stocks, the downturn in global equities markets, and the slowdown of many economies will all have their effect. In the United States, the telecom and technology sectors accounted for nearly 60 percent of investment-banking activity last year; this level is already falling off as investors question the growth trajectories of these businesses and as companies restructure their balance sheets.
A factory, not a fashion show
Far from killing the business of market making and brokerage, technology will actually save it
If market making and brokerage is an attractive business, why do so many industry players disparage it? The main reason is confusion about the role of technology. Far from killing the business, technology will actually save it. Sure, commissions and spreads are falling, and this trend won’t be reversed. The old people-intensive business model, for the most part, no longer holds. Huge parts of the business—trading in bonds, cash equities, and standardized derivatives—are becoming commoditized. Winning in this environment will require banks to reach unprecedented scale, and a handful of them will take the lion’s share of the profits. But emerging technologies will make competing in this new environment profitable for the eventual winners, allowing them to increase—dramatically—the volume of trades they can process while lowering their costs and increasing their profitability. The leading players will recognize that technology is an advantage, not a threat.New systems can automate everything from front-end order capture to back-office clearing and settlement. At the front end, new services now enable both institutional and retail investors to enter their trades directly into their brokers’ systems or electronic communications networks (also known as alternative trading systems). Firms process far more trades, and both costs and errors are lower. Bloomberg, Bridge Information Systems, ITG, and Reuters offer such services, and most investors now have electronic-data-interchange links to their brokers.
Technology is also revolutionizing the post-trade process, reducing per-ticket clearing and settlement expenses. Cross-border European trades cost an estimated €28 ($24.90) to settle, compared with only €1 or €2 for settlements executed with more highly automated systems. To automate the back office, financial institutions should look at custodian and clearing banks. State Street, for example, has invested $250 million to $300 million annually in technology for the past five years and can now offer inexpensive back-office services to other firms. Financial institutions must keep an eye on these players, since they are now creeping into the execution of trades.
New systems allow trading firms to match trades internally, thereby capturing the entire spread between the bid and offer price
Paradoxically, technology can also increase margins per trade and improve the ability to manage the execution of block trading. New systems allow trading firms to match trades internally, thus capturing the full spread between the bid and offer price and avoiding exchange fees, though internalization can boost profits only for institutions with enough volume to ensure a high internal matching rate. New order-management software can automatically break up and manage large trades to minimize their impact on market prices, thereby giving the customer a better price and boosting margins in the process. This is particularly useful in portfolio reallocations, which entail the trading of large blocks of many different securities.Newer technology can also give market makers and brokers a better understanding of their customer base. Banks and securities firms that have always won business by building personal relationships with a few big investors can now use software to determine the profitability and appropriate service levels for a much larger number of accounts. Another new technology will permit trading units to change their service model away from primarily "push" (deluging portfolio managers with the latest research) and more toward "pull," which allows investors to access research selectively and analysts to aggregate and tailor information easily. Multex.com, for example, gives investors access to research from most major institutions. Consortia such as Securities.Hub are making it possible for investors to access, in a single place, the initial-public-offering calendars, research, and other services of leading firms. All of these efforts increase margins per account and may boost trading volumes as well.
Getting to scale
Investing in these new technologies obviously raises the fixed costs of any trading business. Scale, which makes the business more attractive in several other ways, will therefore be needed. Besides lowering the marginal cost per trade, a greater volume of orders cuts volatility and risk. With a larger order flow, an institution can match more of its trades internally, thereby putting up less capital in each transaction and holding a smaller inventory of securities. As a result, there is a clear negative correlation between trading revenue and the value at risk (VAR) relative to trading volume (Exhibit 4).1 Merrill Lynch and Morgan Stanley Dean Witter, for example, have a much lower VAR relative to their trading revenue than do firms that have smaller order flows. Bigger companies will find trading to be a more stable and profitable business.
Increasingly, winning businesses will need to provide services beyond trade execution. Some investment banks, for example, now offer prime brokerage services—all of the back-office and financing services that support a trade—to hedge funds and other players.
A faster way of capturing extra order flow, following the lead of wholesale trading houses in the OTC market such as Knight Trading Group and Spear, Leeds & Kellogg, is to purchase order flow from smaller broker-dealers. Because wholesalers process a large volume of trades, they can often act as the counterparty on both sides of a trade, thus boosting margins. Investment banks have recently bought several of these wholesalers: Goldman Sachs purchased Benjamin Jacobson & Sons and Spear, Leeds & Kellogg, while Merrill Lynch purchased Herzog Heine Geduld. But perhaps this model has been too successful, for few independent wholesalers are now left; Knight is the most important of them.
Acquiring customers in Europe is going to be more difficult for US banks, since European retail investors naturally turn to local institutions, and European bank acquisitions are complicated by large branch networks and strong labor unions. A more promising strategy is to capture order flow through another channel. Morgan Stanley and OM Gruppen, for example, launched Jiway, an exchange where retail investors trade the top European stocks (more than 400 of them at present). Goldman Sachs launched PrimeAccess, a service that provides international-trade execution, research, and some IPO allocations to on-line brokers (mostly in Europe), including Direct Anlage Bank and Banca Popolare di Verona. Merrill Lynch and Credit Suisse First Boston (CSFB) are launching similar services; to this end, CSFB built an alliance with Postbank’s on-line broker, Easytrade, in Germany.
A role for proprietary trading
Many banks abandoned the trading of securities because it has been associated, wrongly, with the scandals of so-called proprietary trading. In the second half of the 1990s, banks often put their own capital at risk to make speculative macroeconomic bets—for example, bets on the direction of interest rates or currency movements. Not surprisingly, the returns were highly volatile, and the shareholders and managers of these banks were sometimes caught off guard.Such trading has received a huge amount of well-deserved bad press. These activities are essentially no different from what hedge funds do, but while George Soros’s investors are prepared, at least in theory, to stomach huge losses as well as gains, shareholders of blue-chip banks are not.2 In recent years such opportunities have been more limited, and the resulting risk of these trades is better left to hedge funds, whose investors can diversify their own portfolios appropriately.
Most major banks have now scaled down these speculative activities, but taking principal positions is a necessary—and potentially lucrative—part of market making. The difference is that such positions are closely related to customer business, not speculative bets. In making markets or executing a large client trade, a bank must often take on some or most of the position for a period and stands to gain (or lose) from price movements during that time. In fixed-income businesses, trading gains (or losses) from this kind of activity can overwhelm spread or commission revenues. Naturally, banks also gain valuable information about market sentiment from market making. They can, and should, exploit this information to manage their inventory of securities efficiently and (if risk limits are observed) to gain from taking principal positions for the bank’s account.3
The sweet spots
Other parts of the trading business will continue to earn higher margins as well. One task that will never be fully automated is block trading, or executing the huge trades that would move prices too much if put into the market all at once. Traditionally, "upstairs" traders break these trades into smaller ones and work them over several days to obtain the best overall price for the customer. Electronic-trading algorithms are replacing some of this activity; trades of 100,000 (or even a million) shares may soon be executed electronically.4Even so, the average size of block trades is increasing in parallel. Last year, J. P. Morgan executed a $1.9 billion trade; other trades too were reported to involve more than $1 billion. Given this trend, upstairs trading will always be needed. What will change is the definition of a block trade; in other words, the size of trades defined as block trades will increase.
Margins also remain substantial in more complex derivatives and bundled products. There has been tremendous growth, for example, in derivatives that allow would-be IPO millionaires to realize their assets before they exercise their options. Other opportunities exist for structuring intergenerational wealth transfers and for taking short positions on market movements for large investors. In fixed income, demand for credit derivatives is likely to continue growing despite recent hiccups. Bundled products, such as portfolio reallocation, index trading, and arbitrage, are attractive as well.
The low-margin commodity side of market making and brokerage will eventually look quite different from the higher-margin trading side
Over time, the low-margin commodity side of the trading business and the higher-margin areas will look very different. The former will be ruled by programmers developing new trading algorithms; the latter will remain labor-intensive and high touch. For those higher-margin areas, investments in talent will be of critical importance. Still, there will be important synergies between the two sides of the business. Proprietary trading, for instance, will depend on information that is derived from the flow of customer orders. With a strong flow, a trading firm can reduce its inventory and net more trades internally. We therefore expect the leading players to develop strong capabilities in both the automated, volume-driven business and the high-touch areas.Only a few players will win
With the price of new technologies likely to be several hundred million dollars a year, competing in this new environment will hardly be cheap
With the price of new technologies and talent likely to be several hundred million dollars a year, competing in this new environment certainly will not be cheap. Some players are already investing heavily, and this seems to be paying off: investors report that the biggest spenders on all forms of information technology have lower trading costs than do their more frugal counterparts.How should banks react? Different, and difficult, choices will have to be made. Institutions with a strong share of trading volume should move full-speed ahead. Given the scale and speed needed to win, Mergers and acquisitions are the most promising way to obtain new technology and order flow quickly; relying on organic growth will be difficult. A global presence is a necessity, since much of the growth will take place outside the United States, and some new technologies—and institutional learning—can be leveraged globally.5
To gain a foothold in other countries, joint ventures may offer an alternative. In Europe, for example, the prevalence of universal banking means that a pure-play acquisition is tough, and an acquisition of a universal bank would bring in several business lines that are much less attractive. At the same time, the biggest players can’t afford to ignore the talent needed for the high-margin parts of the business. Technology, scale, and skills will differentiate the best from the rest.
Yet the game isn’t over for smaller and more regionally oriented institutions. Smaller banks have a good position to make great outsourcing deals with larger players that want to gain order flow. Besides getting paid for order flow, smaller institutions might gain access, for example, to the larger bank’s research and IPO calendar. In Europe, several smaller or more retail-focused players have partnered with large trading houses to offer customers more cheaply executed trades, a broad array of research, and access to European and US securities. In addition, smaller firms can make markets in niche securities for which skill is more important than scale. The regional bank WestLB, for instance, may be able to compete successfully in making markets for some German derivatives.
Trading is being redefined by technology and is creating terrific opportunities for a host of banks. It is clearly time for another look.
No comments:
Post a Comment