Each season CFA Society Minnesota invites finance students to learn about the CFA Program by interning with the local society. Students assist society committees with research for their projects, and are encouraged to take on tasks that broaden their skills and industry insight. Chris Roebber will be a junior this fall at the University of Minnesota Carlson School of Management. Chris wrote this commentary with the assistance of Freezing Assets contributors John Boylan, CFA and Lissa Rurik, CFA. If you’d like to work one-on-one with a future CFA Candidate this season, please contact us to volunteer!
Ominous Trading Future Leaves Banks with Questions
Large Wall Street banks have received a lot of flak in recent years. Whether it’s been the shady mortgage dealings or the seemingly obscene bonuses of bank executives, public scrutiny has been at an all-time high. But as banks are finally settling government lawsuits from the 2008 meltdown, a new challenge has presented itself, trading volume has fallen, the floors have gone silent, and trading revenue has seen double digit percentage drops. Large investment banks’ that rely heavily on trading revenue may want to consider changing their business model as the industry is becoming far less attractive due to economic, regulatory, and technological changes.
The falling trading volume and respective losses in revenue are telling signs that the current model is in danger. Global revenue from FICC (Fixed Income, Currencies, and Commodities) has fallen 16% since last year and 23% since 2010[i]. But it’s not just FICC revenue that has been in a slump, equity trading has fallen drastically as well. This past June’s trading volume was the lowest for the month since 2006 and last year’s average volume was 37% lower than its peak in 2009[ii]. In a volume driven industry, these dampened numbers are cause for great concern. Most traders point to a “boring” economy. Everyone from institutional investors to individuals is in a wait and see approach, rather than making big bets on the market. While traders may be partially right that some of the falling volume is due to this wait and see idea, regulatory and technological changes are cutting profitability, making this more than just a cyclical issue.
Rapidly changing regulations are making the industry far less profitable for the long term. Higher capital requirements have made it more costly to hold inventory and the Volcker rule has limited risk taking and could bring proprietary trading at large banks to a halt. These regulations have added up to a lower estimated return on equity than ever before. Sanford C. Bernstein bank analyst Brad Hintz estimates Goldman Sachs’ trading division to have an ROE of 7%, significantly lower than the firm’s theoretical cost of capital of 10%. If the golden child of Wall Street is struggling to produce the required return, their competitors cannot be far behind. Regulatory changes are not the only culprit though.
Changes in technology have shrunk spreads and hurt the long-term profitability of banks trading arms. High frequency trading is changing the industry outlook and not necessarily for the better. Advocates of HFT say it adds liquidity and decreases spreads. This is bad news for traditional market making traders. With small spreads, increased regulation on risk and an uncertain prop trading future, there is very little opportunity for traders to maintain margins. I would argue then that the increase in HFT is hurting big banks by decreasing profitability of market making traders. The margin contribution of high frequency trading businesses is dwarfed in comparison to the larger traditional trading platform. Banks would much rather have a healthy equity trading business making billions then a HFT arm generating hundreds of millions. The risks and ominous future of the industry has even brought the COO of Goldman, Gary Cohn to question the vitality of their dark pool, Sigma X, in a recent Wall Street Journal op-ed.
Clearly trading divisions are in turmoil right now, from both cyclical forces driven by a wait and see approach, to long-term regulatory and technological changes. Large investment banks with the heaviest focus on trading could suffer the most. These banks should sell off their high frequency trading arms and begin to transition away from depending so heavily on trading revenue. Investment banks can consider a more conservative approach like Wells Fargo, which has a smaller investment banking arm and instead focuses heavily on consumer lending. Another option is to focus more on traditional activities like M&A advisory. But at the end of the day, the status quo cannot stay for much longer.
iBurne, Katy, Justin Baer, and Saabira Chaudhuri. “Empty Trading Floors Fray Nerves on Wall Street.” The Wall Street Journal. Dow Jones & Company, 13 July 2014. Web. 14 July 2014.
[ii]Strumpf, Dan. “U.S. Stock Trading Volume Slump Continues.” The Wall Street Journal. Dow Jones & Company, 1 July 2014. Web. 14 July 2014.