Broker-dealers are rethinking operating models amid soaring costs due to rules coming into force this year, said speakers at a transaction services forum last week organised by Citi. And such moves are likely to raise costs and reduce returns for investors.
The various reforms – from the G20 requirement for over-the-counter derivatives to be centrally cleared to the financial transaction tax (FTT) due for implementation across 11 European Union countries – are forcing banks to restructure their cash equity businesses to rein in costs.
The FTT is set to impose a 0.1% tax on stocks and bonds and 0.01% on derivatives if a transaction is deemed to be linked to the ‘FTT-zone’, which includes France, Germany, Italy, Portugal and Spain. The FTT is expected to raise €30-35 billion in annual revenue across the 11 states from the move, which is expected to be signed off by mid-March.
At the forum, panel members expressed dismay that transactions cleared within the eurozone – even if parties to the transaction and the securities are based and booked outside the region – will be caught by the FTT. The panellists were from firms such as Citi, Korea’s Mirae Asset Securities, Hong Kong Exchanges & Clearing, Singapore Exchange and messaging services provider Swift.
Speakers also said they find it surprising there is no applicable intermediary relief, leaving market participants open to the risk of taxation in multiple jurisdictions. That is because the plan is for the FTT to be levied at every step the transaction passes through a chain of intermediaries.
The tax will increase the cost of capital and hedging for banks’ capital markets business, cause markets to decline and ultimately reduce investment returns for investors, argue panelists. These additional costs will compound the issues for banks’ equity businesses, which in recent years have seen global trading volumes shrink.
Commission volume and equity trading profitability last year hit multi-year lows. One bank’s Asia-Pacific head of equities says profitability for his business last year recorded a $2 million loss worldwide, down from a $7 billion profit three years ago.
The cash equity business was already not the “epicentre” of banks’ businesses directly hit by various OTC clearing requirements, as cash equities have traditionally been trading and cleared on exchanges.
Still, legislation such as Dodd Frank and the Volcker rule have forced banks to cut back on proprietary trading. This, combined with the general deleveraging by banks as a result of Basel III capital-adequacy requirements, has resulted in onerous costs for brokers’ cash equities business.
Globally, return on equity (RoE) for capital markets and investment banking is expected to drop to 8% once Basel III comes in, down from the 18-20% attained before the financial crisis hit, says Tjun Tang, Hong Kong-based managing director at the Boston Consulting Group (BCG).
That said, some banks are planning changes to business and operational models that would mean a smaller drop in RoE, to 12%, finds BCG.
Meanwhile, RoE is likely to remain at around 18-20% for retail banking and around 25-35% each for private banking and asset management.
“Given this, senior management at banks are having to re-evaluate their overall strategy,” says Tang. “Specifically, they are reviewing how much they still want to operate or allocate scarce resources in capital markets and investment banking businesses, and what they can do to raise RoE to more attractive levels.”
The business environment is likely to remain difficult, as deleveraging by hedge funds and an institutional investor preference to invest on a longer-term horizon mean trading volumes will remain low, says Pierre Rousseau, global head of equity and commodity derivatives for Asia-Pacific at BNP Paribas.
“It is surprising to see that new competitors are still interested to enter the securities industry, despite the depressed market environment and the increase in fixed costs,” says Rousseau. “At the same time, for the established players, the focus is switching from gaining market share to carefully managing profitability.”
To manage costs, senior equity-focused bankers like Rousseau say they have to re-align research on sectors they are covering with the corporate banking side of the business.
“Practically, this means we can easily link analysts’ expertise with that of our bankers, and also develop corporate access for our cash equity business by leveraging our corporate client relationships,” says Rousseau.
Others say they see outsourcing brokers’ mid-office functions, such as clearing and even compliance, as another way to cope with rising costs.