It's not just the HFT industry that has cannibalized itself so much, while spooking regular traders out of the markets, there is hardly any revenue growth left (as the WSJ showed last week). After suffering a substantial drop in bank equity trading revenues over the past several years, there was hope that finally this key P&L items of sales and trading would post a modest pick up. Alas, whether due to lack of volatility, declining interest in equities, or simply because many no longer have faith in the market, this is not happening despite the S&P recently rising to an all time high of 2,400.
In 2016, the Office of the Comptroller of the Currency reported that equity trading revenues at U.S. banks fell 13% in 2016 from the previous year. The slide contrasts with a 9% rise in overall trading driven by interest-rate and currency products. Globally, the biggest dozen banks suffered a 13% drop in equity trading in 2016, the first meaningful annual decline since 2012, according to research firm Coalition.
And while there were some modest signs of a pick up in late 2016, this appears to have been a false dawn. According to the WSJ, as the first quarter wraps up this week bankers say the weakness experienced last year is continuing. That is prompting questions about whether banks should be preparing for a longer-lasting decline in the business, rather than a cyclical dip.
“Client volumes are down...that’s an industry issue,” said Morgan Stanley President Colm Kelleher at a conference in late March. When comparing Morgan’s first quarter of this year with the last quarter of 2016, he concluded that the equities business was “not doing as well.”
While equities trading isn’t as big at many Wall Street banks as bond and currency trading, it still accounted for $28 billion in revenue for the top five U.S. banks in 2016, or more than 10% of total revenue. Banks generate equities revenue in a variety of ways: from executing stock trades or buying and selling derivatives related to equities, to services like locating shares for clients to bet against.
The slow but steady decline in equity-trading-revenue is deepening despite higher volumes and big index price swings in the wake of the U.K.’s Brexit vote in June and November’s U.S. presidential election.
A key driver behind the revenue collapse is the direct influence of central banks, which have crushed volatility to near record low levels.
Overall subdued volatility in equities markets lead more trades to be executed via the cheapest electronic means, rather than by banks’ traders or through more expensive and complex derivatives. Equity-derivatives revenue fell 21% last year globally, according to Coalition, which works with banks to track industry trends.
Banks tend to earn more money when investors are willing to pay more to get trades done quickly, or at guaranteed prices due to worries over unpredictable price movements. Those fears have dropped. Expectations of stock volatility fell in both the U.S. and Europe overall last year, and has dropped further in 2017.
Morgan Stanley and Oliver Wyman estimated in a recent report that some $15 billion in expected equity revenue has vanished, due to “changes in client behavior and the growing role of electronic trading.” Additionally, about 15% of the fee pool in the biggest, most liquid markets, such as stocks, has moved to nonbank firms. Those firms can cheaply execute standard trades like moving in and out of exchange-traded funds.
Another driver: the transition away from human trading and toward passive, algo-intermediated markets.
Virtually all trading today involves electronic algorithms in some fashion, but some are more complex than others. Banks charge clients about four times the rate for the most complex individual “high touch” trades than ones that simply follow a pre-set portfolio strategy, according to Greenwich Associates.
Meanwhile, investment firms have balked at paying higher trading fees to banks due to a shift by their own clients to index funds, which command much lower fees. Those funds in turn put pressure on their bankers.
As discussed repeatedly on this website, the shift away from active trading and toward passive, has also slammed the buyside and hurt some of Wall Street’s best clients.
This means that some of the most iconic hedge funds, which typically generate big fees for banks, have been shutting down. Just this month, Eric Mindich’s Eton Park Capital Management LP said it would close, part of a trend that has left banks with fewer trading clients. Banks had already been responding to some of the changes. Over the past decade, banks shifted resources from human trading and research to high-speed electronic markets.
To be sure, banks tried to react to technological changes in the market, and over the past decade, banks shifted resources from human trading and research to high-speed electronic markets.
As the WSJ notes, for a while, that pivot paid off and from 2012 to 2015, equities trading revenue at banks either rose or stayed relatively stable, a contrast to fixed-income trading, which was hurt by regulatory changes and central banks’ low interest-rate policy.
However it did not last for equities. As revenues tumbled in 2016, operating margins in stock trading also dropped to 23% from 36% the prior year, according to Coalition. Banks often provide computerized trading algorithms to clients, but it is a competitive business with high development and regulatory costs.
The operating margins for completing stock trades fell to just 5% last year, according to Amrit Shahani, research director at Coalition. It was more than 7% in 2015, and more than 10% before the financial crisis.
Next, European rules set to kick in next year will bar investment firms from buying research from banks in exchange for directing trades to those banks. Analysts expect that investment firms will stop trading with some of the affected banks, or will demand lower rates because they are no longer getting bundled research.
Some banks, such as Barclays, realize what is coming, and have closed their “high touch” equity sales-and-trading desks in Asia, while Japan’s Nomura Holdings cut its research and derivatives in European stocks, and CLSA, a unit of China’s Citic Securities, closed down its U.S. stock research team.
Meanwhile, in the latest attempt to offset declining revenues, the biggest banks in stock trading are trying to expand market share in the prime brokerage business; that gamble too however is doomed to fail as in 2016 the hedge fund industry shrank for the first time since the financial crisis, with more hedge fund closures than openings.
What can prompt the much-anticipated return of not only equity trading revenues, but trader participation? Some ideas include a renormalization of capital markets, where zombie companies aren't rewarded with short squeezes or random Chinese takeovers, where a Shiller PE of 30x isn't considered a "new normal", and where central banks don't step in every time there is a 10% drop in stocks. Until that happens, Wall Street's melting ice cube will continue to liquify, resulting in even more transformations, where once busy trading floors such as this one...
... ends up looking like this.