New York – Historically, Wall Street investment banks built their equity capital markets businesses around a three-part strategy which included research, trading, and investment banking. However, trends over the past few years suggest that each of these businesses have come under attack. This leads us to wonder whether investment banks will be able to sustain their cash equities businesses in the future – including their equity research franchises.
The Three-Legged Stool
Traditionally, Wall Street executives have described the strategy they employed to build their equity capital markets business as being a three-legged stool made up of equity trading, investment banking, and equity research.
These executives expected that they would build and distribute a great research product to retail and institutional clients that they would commercialize in a few ways. The first is to have buy-side clients trade with the bank thereby generating equity commissions. In addition, the banks would be engaged by corporate issuers to provide investment banking services and research coverage for these issuers. This virtual circle would be completed as buy-side clients and corporate management would pay even more for access to the other. Of course, the investment bank would provide additional services which would enable them to collect even more from either corporate issuers or asset managers.
Unfortunately, in the past decade each of the three legs of this stool have come under significant attack casting doubt as to whether investment banks will be able to rely on this model to build successful capital markets businesses in the future.
Equity Commissions in Prolonged Decline
One of the most obvious trends hitting the sell-side over the past few years has been extremely weak equity trading volumes and falling equity commissions that has resulted from this trend. Unfortunately, we see no sign of this trend abating.
According to Richard Repetto, an analyst at Sandler O’Neill, the average daily equity trading volume on the NYSE in August 2012 was 1.4 billion shares – the lowest level since at least 2004. In addition, NASDAQ OMX’s matched US equity trading volume fell 11.1% from July to 1.13 billion shares per day, the lowest monthly average in almost seven years. Average daily trading volume at the CME Group were 9.9 million contracts per day in August, the lowest this year, while trading volume fell 17.6% to 1.34 million on the IntercontinentalExchange compared with the same month a year ago.
Wall Street firms have not just been impacted by declining equity trading volumes. They have also been adversely impacted by the fact that a growing proportion of the trades that have taken place have been high frequency trades which generate even less commissions than already low commission ECN or ATS trades.
According to Tabb Group, high-frequency trading will make up 53.5% of all electronic equity trading volume in the US in 2012, a total that is slightly down from 55% in 2010. This is particularly important for research budgets, as high frequency traders require little to no research.
These trends have resulted in plunging equity trading commissions for brokerage firms and investment banks. According to Greenwich Associates, the amount of equity commissions paid by U.S. Institutional Investors to their sell-side brokers dropped 6% in Q1 2012 from the previous year to $10.86 bln – a level not seen since 2007. The most recent decline marks the third consecutive annual drop in the total US equity commission pool, and puts the current commission level close to 22% below the levels seen in Q1 2009.
Informal conversations that Integrity Research has had in recent months with sell-side investment banks and buy-side firms suggests that the Greenwich Associates data might be understated as we are hearing that firms now see 30% to 50% lower equity commissions than the levels seen in late 2008 / early 2009. This trend is one reason that a number of smaller brokers and boutique investment banks have either merged or shut down altogether in 2012.
Corporates Taking Banking In-House
Wall Street’s investment banking business has also suffered in the past few years. According to a recent article in Bloomberg Businessweek,
“Banks have had a tough past few years. Financial companies including Goldman Sachs and Deutsche Bank AG have cut about 88,000 jobs in 2012 alone and global deal volume has plunged 53 percent from 2007, a victim of the recession and European debt crisis. Now, with the average size of deals shrinking, more European companies such as BP Plc and Siemens AG are eschewing bulge-bracket banks for M&A advice in favor of using their own employees for smaller deals, further hurting bank revenue.”
According to data from Freeman Consulting, almost a third of completed European and U.S. M&A transactions this year were done in-house. For the U.S., that represents the largest adviser-free proportion of deals since 2003; for Europe, it’s the most since 2004.
According to a recent study by analytics group Coalition, revenues for global investment banks generated from M&A and new stock and bond issuance dropped 25% in the first six months of 2012 from the same period a year ago. Revenue derived from investment banking and M&A advisory work for these same global firms fell 48%, to $6.48 billion, in the first nine months of 2012, compared with the same period in 2007, according to data compiled by Bloomberg.
Sell-Side Research Under Attack
As we have written countless times over the past decade, the sell-side research model has come under considerable pressures in the new millennium. Some of these pressures include regulatory changes like Regulation FD or the SRO rules established under the Global Research Analyst Settlement which have limited the value of traditional Wall Street research.
The growing popularity of independent research in the past decade has also presented a competitive threat to the sell-side research model. Paradoxically, while independent research has grown in attraction, many buy-side firms have also expanded their own internal research staffs to make use of these alternative research and data sources.
In addition, the commercial pressures discussed earlier in this article have also put pressure on the sell-side research model as investment banks have found it increasingly difficult to fund large equity research departments.
Despite these factors it is important to note that sell-side research has recently benefited from the compliance concerns that have engulfed many independent research firms as the buy-side has felt that sell-side research is inherently less risky. Also, large regional and bulge bracket investment banks have been able to capture an increasing share of a shrinking equity commission pool because they provide the buy-side a large suite of valuable services, whereas independent research firms have a much more limited offering.
It is clear that investment banks’ three legged strategy to build up their equity capital markets businesses is at risk as a number of developments have prompted equity trading, investment banking, and equity research all to struggle simultaneously. The big question is whether any or all of these legs of the stool will be able to stabilize anytime soon. Otherwise, investment banks will need to reevaluate whether they can profitably operate a traditional equity capital markets business, or whether they need to re-imagine these businesses altogether.