As their return on equity declines, investment banks need to become more like information companies, not giving away their research to generate trading, according to a recent Boston Consulting Group report on capital markets. As investment banks retrench, other capital markets players such as asset managers and information service providers will find new opportunities. Big data and cost mutualization will be key capital markets trends going forward.
Continued pressures on banks
Investment bank revenue was lower in 2015 than at any point since 2009, and BCG is forecasting further declines in 2016. At the same time, despite cuts of roughly $8 billion in operating expenses, the overall cost of doing business for investment banks has risen by 4% since 2010. Moreover, the full implementation of Basel-induced regulatory costs on capital will offset all the balance sheet rationalization that banks have achieved to date.
BCG argues that the role of capital is changing as access to liquidity and the demand for risk transformation services are becoming less dependent on capital as markets become more automated and investments become more passive. The implication is that investment banks need to alter their business model: “If investment banks are to compete, they must recognize their ability to generate revenues as information companies.”
Banks will need to change their research business models
Specifically, investment banks need to change their pricing model for research:
“[Investment banks] should avoid giving away [research, benchmarks, market prices, and other intellectual property] in the hope of generating revenues through alternative channels, such as trading. Indeed, the industry as a whole is moving away from implicit charging and so-called soft-dollar arrangements. Investment banks must keep pace and consider charging explicit fees for the services that they now provide in addition to the products they supply.”
Cash equities is one of the least profitable business lines for investment banks, in large part because of the costs associated with research. BCG estimates cash equities revenues at $21.1 billion for 2015, generating a net loss of $200 million. It is forecasting an 11% decline in cash equities revenues for 2016. If that is the case and the cost base stays the same, cash equities will lose $2.5 billion in 2016. Or put another way, investment banks would need to carve out $2.5 billion in cash equities expense to break even. Not a happy prospect.
…And embrace big data
As big data becomes increasingly central to markets, BCG recommends investment banks consider leveraging internal data and technology systems to diversify revenues. The top ten investment banks are already actively investing in Fintech firms offering data and analytics, one example being Goldman Sachs’ investment in Kensho [subscription required for link].
BCG sees investment banks becoming more like service providers as they more explicitly charge for information assets such as research and benchmarks. In addition some banks “will seek to monetize their rich information sets and will explicitly charge for data, applications, and intellectual property. They may seek research utilities for financial-data models, as well as sell data from their systematic internalizers and dark pools (private markets).” The business model will become more like prime brokerage, where banks offer a variety of services to their hedge fund clients.
Asset managers will gain the upper hand
Other capital markets participants will benefit from investment bank woes, according to BCG. Buy side assets are projected to increase from $74 trillion in 2014 to $100 trillion by 2020. Investment management revenues are forecasted to grow at a compound annual growth rate of 3% to $300 billion by 2020, representing a 45% share of the overall capital markets revenues pool, as the sell side share shrinks from 53% in 2006 to 31% in 2020.
BCG believes that investment managers will hold the majority of inventory in securities markets, often giving access to better pricing and general market information than dealer market makers. Consequently, more trading will circumvent the banks going direct to other buy-side firms, hedge fund replicators, and online wealth-management services.
Big data will displace conventional research
Sell side research will also become disintermediated as big data expands:
“The proliferation of big data will shift emphasis away from the traditional sell-side research model. Buy-side players—armed with large volumes of reported trade data, inventory information, economic indicators, market news, and other forms of data—will increasingly adopt an independent approach to the investment-decision-making process.”
Asset managers will leverage big data in multiple ways:
“Furthermore, greater access to historical data and statistical analysis will enable investment managers to… use machine-learning algorithms to discover clearer market entry and exit signals. They will be able to answer natural-language questions about the impact of events on asset prices, as well as derive structured data from unstructured sources, such as the Internet, social media, and text published by newswires.”
Exchanges, information service providers, and infrastructure firms have also been doing well, and are expected to benefit from an increasing trend of ‘cost mutualization’ as both the sell side and buy side seek to reduce costs through shared services. Utilities and industry consortia offer outsourced solutions for duplicated post-trade processes that add little value.
Although BCG sees this trend as confined to middle- and back-office processes, investment research potentially lends itself to ‘cost mutualization’ through platforms like Sum Zero or Seeking Alpha.
Capital markets revenues will grow
Despite investment banking revenue declines, BCG projects that overall capital markets revenues will increase 12% from 2015 to 2020. Asset managers will be the largest beneficiaries of investment bank turmoil, but information providers and exchanges are also expected to benefit.
After asset management, BCG sees big data as the next largest growth opportunity in capital markets, generating $43 billion in incremental revenues over the next five years.
BCG has an axe to grind, which is to generate more consulting engagements with investment banks to help them navigate the supposedly treacherous waters ahead. As such its forecasts may be biased to the downside for investment banks and to the upside for asset managers. Asset managers are under their own pressures as low cost passive investments erode fees. It is not unlikely that overall capital markets revenues decline over the next five years rather than grow 12%.
Things may not be so rosy for information providers either if banks continue to rationalize to the degree BCG is projecting.
Nevertheless, the challenges for investment banks are real and the resulting impact on cash equities and research in particular will be significant. Thanks to MiFID II, banks are struggling with their pricing model for research, although we believe that it is in the investment banks’ interests to delay the shift to price transparency as much as possible. For the time being, pricing sell side research will continue to be a negotiation, although the buy side will become more aggressive in the negotiations than they have in the past.
BCG is correct that 2016 will be a tough year for cash equities, and we can expect more rationalization and consolidation. We also agree that big data will transform the research process on both the sell side and buy side. Already two major investment banks, Morgan Stanley and UBS, have set up alternative data units to supplement their more traditional research. We also like BCG’s point about ‘cost mutualization’, and we suspect it will have front office applicability, at least for research, as well as for the back office.