Investment banks’ fourth quarter financial reports have revealed many are struggling to make money in the fixed income market, with industry experts expecting big changes to their business models in 2014.
The past few weeks have seen the bulge-bracket publish their end-of-year numbers for 2013 and a common theme has been falling revenues in fixed income.
Goldman Sachs’ full-year figures for 2013 saw its fixed income, currency and commodities client execution volumes or revenues down 13% compared to 2012. Deutsche Bank cited poor performance in fixed income and currencies as the primary cause of a 27% fall in corporate banking and securities revenues over the same period, Citi’s full-year revenue from fixed income dipped 7%, while JPMorgan’s was flat for the year and down 7% from Q3 to Q4 2013.
Fred Ponzo, managing partner at investment bank consultancy GreySpark Partners, said regulatory changes are making it more difficult for banks to profit from fixed income.
"OTC business has been driving fixed income revenue in recent years and there are two main factors impacting this. The first is many liquid products are now migrating to swap execution facilities and becoming very vanilla products, which reduces the margin banks can earn,” he explained.
“The other is Basel III, which means banks face much higher capital costs for taking on risk, so the exotic products that have been very profitable will be less so in the future.”
Basel III imposes higher capital costs for banks to hold risky assets and thus reduces their ability to hold inventory, take positions and make markets.
A recent report from Bernstein Research suggests that these factors are driving many fixed income investors towards independent alternatives.
“Lower inventory levels at the Street's market makers are boosting institutional demand for alternative fixed income trading venues, such as MarketAxess and Electronifie, from clients seeking a 'capital lite' form of market making,” the report said.
Stu Taylor, CEO of fixed income solutions provider Algomi, said the pressures on banks from both regulatory change and non-bank competition is redefining their role in the fixed income market.
“We’ve already seen major restructurings in banks’ fixed income businesses with headcount reductions in the front office and now we’re seeing the back-office infrastructure being resized as well,” he said.
“Outsourcing is becoming a major theme. There are thousands of fintech companies Europe and they’re the ones that are innovating. The smart banks will demarcate what is proprietary and do this in-house, while other service areas will be outsourced to specialist who can do this better.”
Recent reports suggest UBS is planning to outsource parts of it fixed income trading platform, a move that could generate significant cost savings over the next few years. The bank already took steps to reduce head-count in its fized income business in early 2013 and is now looking to make further cost savings. UBS’s revenue figures for Q4 2013 are due to be published on 4 February but Q3 numbers show its fixed income business was flat on a quarterly basis.
Ponzo suggests that banks operating in fixed income fall into two broad categories, which will affect how they respond to declining earnings.
The first are those with major fixed income franchises that have been using this revenue to subsidise their equities business. He said these banks will have to reduce costs across both fixed income and equities in order to preserve their franchise.
However, those investment banks that focus on equities may take a different approach: "The banks that are primarily equities houses will move to a more agency-style model instead of acting as a principal trader as this reduces the need for capital and thus the cost of doing business."
But Taylor warns, "It's difficult to make revenue from the agency model as it's low margin and doesn't have the kind of volumes that we see in the equity market. What we may see is more of a hybrid model of doing some agency business and some risk- taking business."