Wall Street banks’ equities-trading units aren’t getting much relief from the strongest stock rally since 2009, as sinking volume and already thin margins threaten to make their annual performance the worst in six years.
Third-quarter equities-trading revenue probably fell 14 percent from the same period in 2011, the fifth straight drop of more than 8 percent, according to estimates by Kian Abouhossein, a JPMorgan Chase & Co. analyst. Full-year revenue at the five largest U.S. investment banks may be the lowest since 2006, UBS AG’s Brennan Hawken wrote in a Sept. 19 note to clients.
Equities trading, which generated $40 billion for the nine largest global investment banks last year, has been an attractive business because capital requirements aren’t as strict as those threatening fixed-income returns. Lower volumes have damped that optimism as investors remain skeptical about the global economy, which may lead to job cuts.
“It’s already a business that was being run on quite thin margins,” said Richard Staite, an analyst at Atlantic Equities LLP in London. “Now you need to see more banks dropping out. The marginal players will have to or are already looking at these business lines and whether there is any justification for remaining in them.”
Stock Surge
Royal Bank of Scotland Group Plc said in January it was exiting cash equities, the trading of common shares on public exchanges, and failed to find a buyer for its European unit. Citigroup Inc. and London-based Barclays Plc, which have the smallest market shares by revenue among the nine banks, lost ground over the year ended June 30, while Goldman Sachs Group Inc. and New York-based Morgan Stanley, the biggest, gained.
Equities, which account for about a quarter of total trading and investment-banking revenue, includes commissions and gains from buying and selling stocks, futures, options and other equity derivatives, as well as fees and interest income from providing services and lending to hedge funds.
The estimated drop in third-quarter equities-trading revenue came even as the Standard & Poor’s 500 Index rose 5.8 percent in the three months and the Stoxx Europe 600 Index climbed 6.9 percent. The S&P 500 is up 15 percent so far this year, which would be the biggest annual increase since 2009.
The rally isn’t enough to stem the decline in volume. Average daily volume for U.S. equities was 6 billion shares in the third quarter, the lowest since at least 2008 and about half the 10.9 billion average in the first quarter of 2009. The figure has dropped year-on-year for 12 of the past 13 quarters. Volume on the London Stock Exchange fell 11 percent from the second quarter and is up 2.6 percent from a year earlier, according to data compiled by Bloomberg.
Lower Volatility
Outflows from equity mutual funds and lower volatility have helped depress volumes. Money has exited U.S. equity funds in 2012, the sixth consecutive year of outflows, Richard Ramsden, a Goldman Sachs analyst, wrote in a report last month. The Chicago Board Options Exchange Volatility Index, or VIX, has averaged 18.13 so far this year, down from 22.09 for the same period in 2011 and 23.65 in 2010.
Banks’ revenue also is reduced by the continued move to electronic trading, which accounts for as much as 70 percent of transactions on the Nasdaq Stock Market and generates lower margins than voice orders. Institutions pay an average of 2.05 cents per share for orders that require handling compared with 1.08 cents for those entered through algorithms, according to Tabb Group LLC.
BlackRock, Vanguard
The drop in volume and margins isn’t hurting all financial firms. Asset managers including BlackRock Inc. and Vanguard Group Inc. benefit from paying lower spreads and stand to gain from the third-quarter rally. BlackRock, the world’s largest asset manager, gets more than half its base fees from equity products and is expected to post its highest adjusted earnings per share since 2010 when it reports third-quarter results this month, according to the average estimate of 19 analysts surveyed by Bloomberg.
Even firms with the most market share are hurting. Goldman Sachs’s third-quarter equities-trading revenue may have fallen 23 percent from a year earlier to $1.8 billion, estimated Chris Kotowski, an Oppenheimer & Co. analyst in New York. Revenue at Morgan Stanley may have dropped 11 percent to $1.2 billion, according to Credit Suisse Group AG’s Howard Chen.
Spokesmen for Goldman Sachs, Morgan Stanley, Citigroup and UBS declined to comment. The companies will report third-quarter results later this month.
‘Under Pressure’
Banks are suffering from equities markets driven largely by macroeconomic and political events, such as Europe’s debt crisis, said Keith Davis, an analyst at Farr, Miller & Washington LLC, which manages about $800 million. The nine banks posted a 17 percent decline in equities-trading revenue in the first half of the year.
“It’s going to be a continued environment of risk-aversion and really quick trigger fingers on the part of portfolio managers to protect gains,” said Davis, who is based in Washington. “It will be quite some time before there are money flows into hedge funds and you have aggressive money going after aggressive returns like the old days.”
Banks including Zurich-based UBS and Morgan Stanley have cut their fixed-income trading units as new rules force them to hold more capital against complex securities. Equity products haven’t faced the same increases, as most trade on exchanges.
Equities trading “has been overlooked for some of the deeper cuts given the attractive capital-light profile,” consulting firm Oliver Wyman and Morgan Stanley analysts wrote in a March report. “As a result, the economics of these businesses are likely to continue to be under pressure as banks fight tooth and nail for market share.”
Job Cuts
The number of front-office equities employees, who produce about half as much revenue per person as fixed-income salesmen and traders, has climbed 1 percent since 2009 at the 10 largest investment banks, while the ranks of their fixed-income counterparts have dropped 8.9 percent, according to data from industry analytics firm Coalition Ltd. That may change as companies are forced to respond to the volume drop, Staite said.
“With these volumes, you can’t just get paid for being there, for polishing the handle on the big brass door,” said James Glickenhaus, general partner at New York-based asset manager Glickenhaus & Co. “These banks are beginning to see that they’re going to have to start being more efficient, and I’m not sure they’re all going to do so well at that.”
Nomura Holdings Inc. said last month that it’s folding cash equities outside Japan into its Instinet unit, the brokerage it acquired in 2006. That may result in 200 job losses, according to a person briefed on the plans. ING Groep NV, the biggest Dutch financial-services company, said yesterday that it will cut 130 jobs as it closes its emerging European equities operation.
‘Strategically Important’
UniCredit SpA, Italy’s largest bank, said in June it would scale back its central and eastern European equities business. RBS in April agreed to sell most of its Asia-Pacific cash equities unit to Malaysia’s CIMB Group Holdings Bhd.
While there are too many firms with equities units given the current volume, investment banks are reluctant to exit the business because it’s seen as necessary to securing underwriting deals and advisory assignments, said David Trone, an analyst at JMP Securities LLC in New York.
“In a normal business industry, there would be rationalization,” Trone said in an Aug. 29 interview on Bloomberg Television’s “Market Makers” program. “But you don’t have that happening because it’s a strategically important product to be in. It’s very hard to do these other things, like M&A, if you don’t have an equities business.”
Prime Brokerage
Amid the decline, the top equities-trading banks have suffered less than smaller players. Goldman Sachs, which generates the most revenue from equities, captured about 22 percent of the total for the top nine firms in the year ended June 30. That was more than 3 percentage points higher than in the previous 12 months. Credit Suisse, Morgan Stanley and New York-based JPMorgan, which ranked second through fourth in equities trading revenue in 2010, all gained share over the four quarters through June, with Morgan Stanley posting the largest increase among the banks in 2011.
The top four firms have benefited from having the biggest prime-brokerage units, according to 2012 rankings from hedge- fund magazine Absolute Return & Alpha. Morgan Stanley Chief Financial Officer Ruth Porat has said the business, which provides services to hedge funds including trade processing and securities lending, helps drive other equities-trading revenue as clients are more likely to trade with the firm.
Citigroup, UBS
Citigroup and UBS had the biggest drops in revenue market share as trading losses exacerbated the industrywide decline. New York-based Citigroup shut its equities proprietary-trading unit in January after 2011 losses and changed management following what CFO John Gerspach called derivatives “underperformance.”
UBS said it lost 349 million Swiss francs ($372 million) in the second quarter tied to Facebook Inc.’s initial public offering. The Swiss firm has promised legal action against Nasdaq OMX Group Inc., which UBS said performed a “gross mishandling” of the IPO. The bank has the top market share in European equities trading, according to a Greenwich Associates survey of institutional investors released last month.
Earning commissions and spreads from trading common shares on public exchanges accounted for about 40 percent of investment banks’ equities revenue last year, according to Coalition data. Less than a quarter came from equity derivatives, which include exchange-traded funds and uniquely structured bets on market volatility. An additional 30 percent came from prime brokerage, and about 10 percent from futures and options.
In 2007, derivatives accounted for about 40 percent of the total, while cash equities generated 29 percent and prime brokerage 24 percent. Options and futures contributed 7 percent.
‘New Reality’
Equities trading also may have been hurt by a lack of confidence in market structure after $862 billion was erased from stock values in 20 minutes in the so-called “flash crash” of May 2010. This May, Nasdaq was overwhelmed by order cancellations and trade confirmations were delayed on the first day of trading in Facebook shares. In August, Knight Capital Group Inc. was rescued by an investor group after a computer malfunction caused a $440 million trading loss.
Each incident has hurt retail investors’ willingness to trade, Glickenhaus said.
As long as the economy continues to struggle, “these businesses are going to be slow to get to their former form,” said Davis of Farr, Miller & Washington. “Unfortunately, that’s the new reality.”
