Recent investment bank results have revealed a continued slump in fixed income business, but a new approach to market making could help drive future profitability, according to Stu Taylor, CEO of fixed income solutions provider Algomi.
First quarter earnings statements from banks released this month have shown a continued collapse in fixed income fees, with analysts citing Basel III reforms for constraining banks’ ability to hold bond inventories.
Credit Suisse reported a 21% decline in revenue from fixed income, currency and commodities business, down to SFr1.6 billion. Bank of America saw a 15% fall in revenues across the same asset classes, while Citigroup and JP Morgan Chase reported drops of 18% and 21% respectively. Goldman Sachs was less badly affected, but still saw its fixed income business down 11% to US$2.85 billion
However, one bank was able to grow its fixed income business despite tough market conditions. Morgan Stanley’s fixed income revenue increased 9% to US$1.65 billion in the first quarter.
While regulatory changes have cast doubts on whether banks can continue to operate their traditional fixed income businesses, Taylor, who has held senior role in fixed income at UBS and Merrill Lynch, believes investment banks can still play an active role in bond markets.
“The impact of regulation on bank balance sheets is going to be a permanent feature of this new landscape but it doesn’t mean bank fixed income business can never be profitable again. The key to profitability will be getting the market making model right,” he said.
Flushing out risks
A recent report from the International Organization of Securities Commissions (IOSCO) on the fixed income market said the implementation of Basel III, which limits the amount of risks banks can take on their balance sheets, had successfully led to a reduction in “phantom liquidity”, where banks generate liquidity in the fixed income market by taking on risks themselves.
However, IOSCO also noted this had led to an overall reduction in bond liquidity, but said future developments would likely lead to improved conditions for investors.
Taylor said banks should be at the forefront of these developments by altering their business models to be more focused on acting as a broker in fixed income, rather than holding inventory.
He explained: “Banks need to redefine what it means to be a market maker, becoming less focused on using their balance sheets to take on risk themselves and instead become a distributor of fixed income products.”
By acting as a central hub to match up buyers and sellers, banks could continue to make revenues from fixed income while also remaining compliant with Basel III capital requirements.
IOSCO’s report also predicted that the development of all-to-all platforms, where investors can deal directly with each other and become price makers, as exists in electronic equity markets today, would also alleviate liquidity concerns in the market.
Human touch needed
While there are a number of initiatives to create equity-like electronic trading platforms for fixed income, Taylor said the nature of the market makes it difficult to apply this sort of technology.
“A lot of noise has been made about the role of all-to-all platforms but they aren’t suited to the fixed income market. It’s too fragmented and many attempts have been made, even pre-crisis, but they have all failed. It’s very hard for electronic systems to tease out liquidity, the market needs to be brokered,” he said.
Because of the difficulties in applying equity-style electronic trading to the market, Taylor added, it is vital banks are able to reform their own market making models to ensure liquidity remains in the market, otherwise investor confidence will be impacted. The knock on effects of reduced liquidity in the secondary market could hurt primary bond issuance and ultimately affect the real economy by making it harder for firms to raise cash on capital markets.
Algomi was set up to provide solutions for investment banks, exchanges, brokers and platforms to improve trading velocity in fixed income, offering connectivity and consultancy services.