The European equities market has become an increasingly deadly place to be, especially for smaller European institutions which, when compared with the likes of big hitters like US-based Goldman Sachs and JP Morgan, simply don’t have the economies of scale to compete.
Those who dominate this space do so because of the order flow they command and their ability to minimise risk. Giants such as JP Morgan and Goldman Sachs call this market their stomping ground and, as the age-old saying goes, flow, begets flow meaning the inroads laid by these mega-banks only get deeper the longer they stay on top. This self-fulfilling prophecy has seen Commerzbank outsource its equities trading and research to ODDO BHF, Deutsche Bank exit global prime finance and electronic equities, and Macquarie and Kepler Cheuvreux to team up through an equities and research alliance in a bid to take on the US giants.
It’s no secret that European flows remain significantly lower than those seen in Asia and the US. Meanwhile, the depth of liquidity in Europe – or the lack thereof – and the complexity brought on by the fragmented trading venue landscape that has only been exacerbated by Brexit mean these days it is generally more difficult to make a profit. For all of the above reasons, the Bloc lacks growth companies. All of this, paired with slashed commissions and the turbulence caused by the current macro and socio-economic climate, is creating a storm that only the biggest and the bravest can weather.
“The rates and commissions that these guys are charging for execution services have been cut-throat and really low,” says Graham Dick, responsible for market structure at Aquis. “Fairly reasonable-sized European brokers have stopped executing directly on the market and are going through these big banks for execution services.”
The American dream
In this market, size matters. Market conditions have concentrated the number of players able to profit in this space down to the very largest of institutions which happen to be US-based. Deep pockets in the US translate well into deep pockets in Europe. As smaller players have ducked out of the market, this has only emboldened the major institutions who use the execution flow outsourced to them to improve their internal crossing capabilities.
Mifid II increased the fragmentation of trading venues and diversity of liquidity sources necessary to connect to in Europe, meaning banks have been required to invest significantly into their smart order routers (SOR) in order to be effective. This has only been further exacerbated by Brexit and regulatory divergence between the UK and Europe.
“Today with over 70 liquidity sources vs circa 20 in Mifid I, effectively sourcing liquidity now requires a SOR to be able to consume and process vast amounts of data, including from the new mechanisms launching in response of Mifid II,” says Alex Harman, EMEA co-head of electronic trading and head of PT sales trading at Goldman Sachs.
“Over recent years we have subsequently observed banks and brokers with low touch platforms, who historically ran their own proprietary technology, increasingly outsourcing some or all routing via Tier 1 banks to able to compete, in particular the smart routing part of their platform.”
Goldman Sachs invested in a new smart order router in 2015 and spent two years integrating it into its platform ahead of the implementation of Mifid II in 2018. “This has been a major contributor towards our share growth over recent years, enabling clients using our platform to more effectively source liquidity, which is ultimately their main objective,” adds Harman.
It is estimated that Goldman Sachs, JP Morgan, Morgan Stanley, and Bank of America Merrill Lynch account for a range of 14-18% market share each, totalling up to roughly 60% of the market.
Around 10% of your clients provide 90% of your turnover, notes Dick. “It’s only the biggest of the big firms that are actually able to connect to every single player in the pool of liquidity. For certain big buy-side firms, it’s only the biggest sell-side brokers that can use risk in terms of capital commitment when they want to do a whole portfolio stock in one go,” he adds.
“On the agency broking side, you can off-lay risk better if you’re larger. The more feedback trades you’ve got from all of these medium-sized brokers coming into your central pot the more you can match those flows up and lower your risk and the higher your probability to execute at VWAP. The more you centralise flow or the more you control flow the lower execution risk is and that has become a big play. That’s the big game, the El Dorado, the more you cross up internally the more you could make money.”
The market over the last few years is littered with other acquisitions as players realise bulking out is the only way to compete. Most recent were Liquidnet, which was acquired by TP ICAP, and ITG which was acquired by Virtu. However, with economies of scale comes high risk and high stakes. Bulking out through acquisitions is a costly process and players need deep wallets to even begin thinking about entering this market.
“People recognise the challenge is difficult without potentially some more economies of scale but that can destabilise those businesses and they struggle to resolve those challenges,” adds one industry insider from the buy-side.
With the large US institutions accounting for such a large portion of order flow in this market, it begs the question as to what European regulators might do in order to counteract this. Despite European regulators’ approach to market structure in the Bloc of late being very much focused on a European market for European players, in a truly competitive market it is unlikely they would step in to foster more business for European banks and brokers.
“It would be bizarre to live in a world where all the global investment banks were from the US. As much as the EU dislikes the UK, they dislike the US even more, and they definitely don’t want to ever feel like they’re being held to ransom by a financial intermediary that isn’t European,” says one buy-side industry insider on the condition of anonymity.
“Because of the way that competition rules work they would have to put some pretty dramatic policy in place to prevent it because at the end of the day if it’s a totally free market and the best five happened to be American then that’s just the way it is. It’s not like France can take a stake in a European bank and artificially pump up its liquidity or something.”
Europe’s new champion?
With the space now occupied by the largest US players, it begs the question, if the Bloc did want a home-grown champion, who could it be? Of those available, the pool is limited. Troubling market conditions and suffering equity capital markets revenues have severely injured many of the European players. Credit Suisse, still reeling from Archegos, predicted another profit loss for the second quarter of this year, attributing its downfall to monetary tightening and the macro-economic climate. Deutsche Bank’s second quarter earnings were also dampened by the macro-economic climate, while UBS warned in its first quarter earnings that geopolitical uncertainty was causing continued caution from investors. Of the contenders, BNP Paribas seems most likely. In the last year the French bank has been bulking itself out and biding its time, ready to pounce when the moment is right.
“If you’re going to have a crack at it you might as well do it now because so many European players are ducking out of the game,” adds one buy-side industry insider.
In the last year, the bank has completed its acquisition of the remaining 50% stake in equity brokerage Exane following a 17-year partnership. Exane also boasts a strong research product. The bank also moved to hoover up the prime services and derivatives clearing clients of Credit Suisse following the Archegos debacle.
BNP didn’t stop with Credit Suisse’ prime services business. In its next play, the bank completed the transfer for the global prime finance and electronic equities clients, technology and key staff of Deutsche Bank after the German institution confirmed in 2019 that it was bowing out of the market in a major restructure. It then expanded its broker-to-custody offering to span across Europe, supporting its continued push to the top tier.
“Deutsche Bank needed to take risk assets off its balance sheet because of the problems that it was were having, and so it decided to get rid of its prime brokerage business, which was fairly volatile in terms of revenue source. BNP took the opportunity to pick up that asset at a discounted price,” says an anonymous source familiar with the matter.
“The other thing BNP have been historically strong on in the past is clearing and settlement and its custodian services, and so I think it believes that if you can leverage prime brokerage business with custodian services then that gives it two bites of the cherry to make money with the same client. That’s the bank’s strategy. Bringing all of those things together makes theoretically quite a strong nucleus. Whether that’s ultimately big, strong and powerful enough to compete with the big US investment banks remains to be seen. I would be cautious because so many have tried it before and so many have failed.”
The bank’s acquisitional approach to growth as opposed to organic growth is opportunistic but high risk. By spending big and expanding the business, the bank has acknowledged that in this market, size matters. Block by block it is building out its toolkit with a high-quality balance sheets to support its new prime services businesses and a strong existing derivatives business.
“Europe needs a champion. I think BNP has seen an opportunity,” argues a buy-side industry insider. “They want to be a global investment banking powerhouse that means there isn’t this oligopoly of financial services. As we’ve seen in both asset management and investment banking, it’s get big or get out. If BNP want play at the deep end of the pool it has to go big and get global.”
BNP Paribas declined to talk to The TRADE about its recent inroads into the European equities markets, however, how the bank’s European equities offering develops will certainly be something to watch in the years to come. Whether or not BNP has managed to do what it takes to have a real impact and compete with the major US banks remains to be seen.