Investment Banking – FICC at the Nadir

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SEE LAST PAGE OF THIS REPORT Howard Mason

FOR IMPORTANT DISCLOSURES 203.901.1635

hmason@ssrllc.com

October 22, 2013

Investment Banking – FICC at the Nadir

  • There is no “war of attrition” in FICC, rather highly proactive management by leading players as the basis of competition shifts, as it does in many maturing industries, from product- to process-innovation, and returns become driven more by scale/service on standardized products than premium pricing on customized products.
  • This transition is nearer the end than beginning with over half of OTC derivatives now centrally cleared in rates versus ~20% in 2007; we do not expect the ratio to climb meaningfully above 70% given there will be a market for bilaterally-cleared products including those not meeting current clearing-house requirements (e.g. cross-currency swaps and rate option products), those with limited liquidity (e.g. long-dated swaps in minor currencies), and those with exempt counterparties (e.g. in the US, Central Banks and non-financial end-users who are hedging).
    • For investors concerned about the transition of trading to tightly-regulated swap execution facilities (SEFs) beginning in February in the US and probably 2014H2 in Europe, central clearance, and the associated standardization of legal/operations terms and hence price-comparability, drives down the bid-ask much more than a change of execution venue.
  • Going forward, for leading players who have built front-end electronic platforms that integrate with client infrastructure, scale economies on centrally-cleared product will match and then overwhelm the adverse impact (in terms of both lower volumes and returns) of higher capital requirements on bilaterally-cleared product. For instance:
    • MS shed $110bn of FICC risk-weighted assets in 2012 versus a planned $80bn over the next three years in total including 2013. Offsetting this, as an illustration of scale benefit, MS reports that the second 10 million of equity executions/day costs just 3% of the first 10 million; we believe FICC scale economies are equally compelling.
  • We want exposure to FICC in well-capitalized, scale players who have the resources to fund investment in high entry-barrier technology and the information-scale to layer in analytic services. BARC and GS are stand-outs with near 20% of revenues in FICC; BARC has higher exposure to Europe and hence elevated secular growth as the bank loan market is dis-intermediated (see Exhibit).

Overview

Beyond cyclical issues in Q3 (with seasonal slowdown in July/August and the government debate interfering with a return to conviction trading in September), we believe investors are over-discounting risks in the FICC business from regulation of the OTC derivatives business (with an annual revenue pool of ~$50 billion). As in other industries going through a maturation phase, the basis of competition in FICC is shifting from product- to process-innovation and the driver of returns from premium-pricing of customized product to scale/service on standardized product. Morgan Stanley’s CFO, Ruth Porat, framed the complex transition clearly (see Exhibit 1).

Exhibit 1: Process Innovation in FICC

Source: Morgan Stanley, September 2013

Industry maturation has been accelerated by regulatory design first with higher capital and margin requirements on “customized” derivative products, and second with mandated central clearance and tighter regulation of execution for more “standard” products. We believe the downward adjustment of bid-ask spreads associated with clearable OTC derivatives, while significant, has largely occurred and the transition to mandatory trading on tightly-regulated swap execution facilities (SEFs) beginning in the US in February 2014 will not have as meaningful an impact (although it may suppress activity as industry participants acclimatize to the new rules).

In support of this, we note that independently of CFTC mandates the industry has been migrating towards central clearance, particularly since the financial crisis, and hence the standardized variation margin associated with a centralized clearing platform (CCP) rather than the previously unregulated and more discretionary collateral requirements of bilateral clearance. As shown in Exhibit 2, over half of OTC interest rate swaps (representing just over half of total OTC derivatives notional outstanding of ~$650tn) are now centrally-cleared versus 20% in 2007 and the CFTC target that over 70% of OTC derivatives be centrally-cleared. ISDA reports that: “in addition to interest rate derivatives, market participants are also [centrally] clearing OTC credit derivatives, having made great strides in standardizing CDS contract terms; as a result, the number of CDS indices and single-name [swaps] are now [centrally] cleared”.

Centralized clearance has already contributed to a meaningful decline in bid-ask spreads of up to 60% on some products as legal and operational (but not necessarily economic) terms are standardized to meet CCP requirements for central-clearance and netting. However, we do not expect the cleared market to become meaningfully more than 70% of the total given there will remain a need for bilaterally-cleared OTC derivatives (operating under the existing ISDA framework) including: products that are not yet CCP-eligible (such as cross-currency swaps, interest-rate swaptions and cap/floor options); products with limited liquidity (such as long-dated rate swaps in smaller currencies, some single-name CDS, and commodity/energy derivatives); and products where the counterparty is exempt such as, in the US, central banks and non-financial end-users using a product for hedging.

Exhibit 2: Mix-Shift towards Central Clearance

Source: ISDA

We do not expect the transition to mandatory execution on swap execution facilities to have as meaningful an impact on bid-ask spreads as the transition to centralized clearance. The first SEF swap trade was completed on the Javelin facility on October 2nd and Javelin has since submitted a made-available-for-trade (MAT) notice to the CFTC for certain interest rate and credit default swaps. As SEFs obtain CFTC approval for MAT submissions, the industry will transition from the present situation where dealers may choose not to use an SEF to one where, with some exemptions, swaps must be traded on an SEF with a MAT approval.

The CFTC has set a deadline of February 2014 for the elimination of off-SEF trading for certain products but, in practice, the transition is likely to be more gradual as some US dealers are routing execution through London-based entities which are not “US persons” and so not subject to CFTC regulation. This by-pass will not be feasible probably by 2014H2 as Europe, through the European Markets Infrastructure Regulation (EMIR), is catching up and will mandate execution on organized trading facilities (OTFs); until this regulatory convergence, the regionalization of liquidity may dampen activity levels.

Implications for Investment Banks

We do not agree that a “war of attrition” will lead to prolonged sub-par returns in FICC as undifferentiated capacity waits passively for weak hands to exit. Rather, the industry is going through active adjustment, nearer an end than a beginning, which involves two elements:

  1. Downsizing of the business in premium-priced customized derivatives and the associated risk-weighted assets and high-cost sales personnel: We believe these products represented a higher portion of the businesses at GS and MS than at universal-bank competitors (with the possible exception of Deutsche), and this explains their share loss over the last year including the last quarter. We believe the reset is largely complete with FICC representing ~20% of GS revenues last quarter (equal to Barclays and versus just under 10% at MS – see Exhibit 3 and Appendix) compared with an average of near one-third over the period 2010-2012. Another indication that the reset is nearing completion is that MS reduced FICC Basel 3 RWA by $110bn in 2012 compared with total planned reductions for 2013-2016 of $80bn (see Exhibit 4).

Exhibit 3: Revenue Mix – Q3 for MS and GS; Q2 for BARC

Source: Company Reports

Exhibit 4: Timing of Reductions in FICC RWA at MS

Source: Morgan Stanley

  1. Investment in Electronic “Front-End” Client Platforms providing access to markets and liquidity, tools for margin and risk management, portfolio reporting, and analytics/research. Examples of these single-dealer platforms (SDPs) include Barclays BARX FX platform for currencies and Deutsche Bank’s autobahn platform for FICC and equities. A key objective of these platforms is deep integration with client infrastructure so foster client preference (and increase client switching costs) and hence mitigate outright price competition on bid-ask spreads. Morgan Stanley CFO, Ruth Porat, was characteristically clear on complex subject-matter (see Exhibit 5):

Exhibit 5: How MS Will Get Paid for Electronic Platform

Source: Morgan Stanley, September 2013

Appendix: Average Contribution to Net Revenues at GS 2010-2012

Source: Goldman Sachs, May 2013

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