What will shape the new face of the US equity markets?

But with markets now recovering, it’s time to look for opportunities. Banks are still experimenting, and a clear-cut model of what a successful equity business might look like in future has yet to take shape. Still, some hints of the likely face of the new world order are emerging.

Automatic change

Firstly, in the battle of man versus machine, machine will likely make further inroads. According to Tom Foley, an analyst at Standard & Poor’s (S&P), the full service brokerages’ response to declining margins on the equity side has been fairly uniform: to try and automate the process as far as possible. He notes: “They have made investments in their electronic trading platforms so that their customers can trade equity shares without having an individual person involved – and it’s cheaper to run an electronic trading platform than it is to have a large number of equity sales people.”

Mr Foley cites Goldman Sachs, always quick to respond to tough market conditions, as “probably the leaders in terms of the investment in electronic trading for equities”.

But Goldman is not alone. “One thing all of us in the brokerage community are trying to do is really leverage technology – to make ourselves more efficient and to offer some tech-savvy solutions to our clients,” says Emily Portney, chief operating officer of JP Morgan’s equities Americas business. “For example, we’re really embracing algorithms on our trading desk. They can help us price business or in many instances better track movements in the market to create ‘alpha’.”

JP Morgan has been impressively open about the challenges faced by its cash equities business, but part of the problem is structural.

“Commissions are being severely compressed due to the rise of alternative trading venues and program trading. Now, you’re lucky to get 4.5 or 5 cents [per share], which is often just a top-line number. Take away a possible trading loss (if the bank risks its own capital) or possible expenditures under soft dollar arrangements, and it becomes even less. Net we might be taking home 3 cents in the end, and this is before taking into account the cost of staff and technology,” Ms Portney says.

Direct competition

Part of the solution, according to Ms Portney, is to compete directly with low cost competitors such as electronic communications networks (ECNs) and direct access providers. She argues that full service brokers can get a piece of the action: “There’s no reason that we, as a full service broker, can’t also compete in the 1.5 cent to 2 cent [commission] business,” she says.

That will not necessarily undermine the 5 cent commission business. “The way we see it is that this low cost agency business is not cannibalistic. A portion of our clients’ wallet is being allocated to direct access brokers or to places that have strong algorithmic trading capabilities, so we really have to be able to participate in this flow. Our clients are doing it, regardless, so we can either participate or miss the revenue opportunity altogether.”

JP Morgan has responded accordingly. According to Ms Portney: “We are rolling out, as we speak, a direct access capability. We are taking algorithms that we use on a proprietary basis in our derivatives area, tweaking them, and rolling them out to clients.”

Job mergers

One of the key challenges full-service brokers face in a world of declining commissions is the number of people involved in their business model. There may be a sales person, a sales trader, a trader, a research analyst, and possibly even a broker on the floor of the stock exchange – a total of five people ‘touching’ a single transaction.

With margins down, some of those roles will inevitably have to be merged – though exactly how is still being debated. Sales and sales traders may be merged, or the trader and sales trader may end up being one and the same person. Greater overlap between fixed income and equity staff is another possibility, being experimented with at some banks, according to S&P’s Mr Foley.

But it is the role of equity research – at the centre of the $1.4bn settlement Wall Street reached with regulators last year – that is perhaps the most contentious. In a pre-global settlement world, investment banking business on average provided 35%-40% of the research budget at firms, according to a report from the Securities Industry Association. Now that analysts are no longer allowed to tout firms on behalf of their investment banking colleagues, their budget will, with time, have to come entirely out of the brokerage business.

But as institutional clients try to cut costs – and regulators, at the very least, demand greater disclosure of expenditures – it is unclear how much fund managers, who typically have their own analysts anyway, will be willing to pay for research.

“Research is a work in progress,” says David Hendler, an analyst at Creditsights. “Many of the big institutional investors now only want to pay for execution – not for research which is often self-serving.”

Many of the full-service brokerages have reiterated their commitment to research. But they’ve fired a lot of analysts, and pay those that remain less. It is not beyond the realm of possibility that some may end up outsourcing the entire research operation to untainted, truly independent research outfits.

Starting July 26, the 10 investment banks involved in the settlement will be required to provide research from independent providers to clients alongside their own, at a cost of $85m a year. Though in principle it’s only for a period of five years, in practice it may well led to a permanent change in the structure of the industry.

“We’re preparing for an industry that has five or six major bulge bracket providers of research,” says Bill Kennedy, director of global equity research at Smith Barney, the brokerage unit of Citigroup. “This assumes some of the second and third-tier investment banks decide to get out of research because they can’t make money doing it.”

Instead, he believes some 250 independent equity research firms may be established. “Because of the global settlement and the entrepreneurial spirit found among equity research professionals, we may see a lot of boutiques pop up,” he says.

New research model

Citigroup moved radically in the wake of the settlement to establish the independence of its research by moving its equity analysts into a separate unit of the company, and bringing in Sally Krawcheck, formerly head of independent research firm Sanford C Bernstein to head up the business.

Mr Kennedy is confident that Citigroup can make the new research model work. “Clearly, the major investment banks are employing a wide variety of strategies,” he says. “While many of the major banks are retrenching from research, Citigroup and Smith Barney are bullish on the equity market and we have the fundamental view that quality research still has tremendous value. We think this presents a window of opportunity to make some incremental investments in certain regions in order to capture market share.”

Quality counts

The formula that will make the new research model pay is nothing new, according to Mr Kennedy: “What will make research work in the future is the same thing that has worked in the past: quality analysis, coupled with accurate stock-picking.”

But the fact that Citigroup is the largest financial services company in the world (Smith Barney alone has some 12,200 financial consultants worldwide) is a vital part of the mix. According to Mr Kennedy: “The Citigroup platform leverages off the notion of cross-selling: trying to leverage intellectual content to multiple distribution channels such as institutional sales, private client, consumer business, etc.”

He notes: “Our strategy is to leverage our content with our trading capabilities. We want to service our clients with quality research and good investment advice. The reason clients want to do a trade with Citigroup is because they’re going to get good research, follow-up service and superior execution.”

Mr Kennedy has no illusions about the direction of margins, in what will ultimately end up being a volume game. “The general view is that the wallet for the equities business will remain flat at best, particularly in light of the pressures faced by our clients and their need to reduce their own costs. For sell-side firms, it really becomes a market share game.” And, in this view: “The organisation that provides the best quality research will win the market share game.”

Worth the risk

But lest you think it is just about volume, one trend to also emerge very clearly in recent months is the increased importance, for investment banks, of risk-taking.

“We have a core revenue base that allows us to stomach a bit more volatility, so in the pursuit of overall higher revenues, we will be prepared to take more risk,” Citigroup’s head of global equities James Forese told investors in November.

According to Creditsights’ Mr Hendler: “Brokerages have been making a lot of money in the last couple of years on proprietary trading, because the higher margin, lower capital risk-taking business was gone.” But now that the lower capital-risk business had made a comeback, banks are still keen to gamble – and to get investors to accept that “proprietary trading is just one of the things that we do,” he says.

Banks like Goldman Sachs – whose ‘value at risk’ (the amount of money it can lose in a day due to bad market conditions) was up by 25% to $71m in the first quarter – are not shy about it. Mr Hendler notes: “They’re not ashamed – they think they’re good at it. They’re relishing the spotlight and celebrating it, like a coming out party.”

Natural extension

That’s not surprising in an environment where banks are making a ton of money on their trading. But it’s also a natural extension of what’s happening in the brokerage business. As pure agency trades are being done by low-cost providers, investment banks have increasingly been left doing block trades and more difficult transactions where they risk their own capital. It’s only a small stretch from that to increased proprietary trading. There’s pressure on the franchise, and this is where investment banks’ comparative advantage lies, or so the argument goes.

The banks argue that they have better risk management systems in place and can cope with the increased risk. But Mr Hendler is cautious: “Investment banks accentuate the positive part of it, and downplay the negative. But the reality is that proprietary trading is more cyclical and less predictable – and banks’ own capital is at risk.”

Greater volatility, it seems, looks set to also be a part of the future equities landscape for investment banks.