Death, Decay, and Rebirth on Wall Street

The Investment Banking and Asset Management industry is evolving rapidly, opening the door for long needed change

Preface

In some ways, the investment banking and asset management businesses have always been evolving. However, over the period since the Great Recession and the collapse of Lehman Brothers, changes in the industry as well as evolving technology have supercharged this transformation. In this multi-part series I examine the current state of the industry in its historical context and discuss the opportunities for tech to continue to disintermediate the old guard — or at least those who don’t change themselves.

This is part i, where I give an overview and address Prime Brokerage and Sales & Trading. In part ii I cover Capital Markets. Part three will cover research and regulation.

Investment Banking and Asset Management

Despite its size and importance in the political and financial economy, the relationship between asset management and investment banking remains, in certain aspects, a bit of a cottage industry. In no small way, the reverberations from the Great Recession, particularly the conversion by major investment banks to Bank Holding Companies, along with subsequent regulatory changes, lead to both a widening of services offered by bulge bracket and money center banks, and an entrenchment of certain relationships with institutional asset management clients.

On the other hand, technological changes and market factors are requiring major adaptations. While the importance of the banks and their suite of services for clients will remain important going forward, the fundamental nature of many aspects of the relationship have inverted over the past 10 years. That requires major migrations and evolution in the business to new models and different profit centers. Those that have adapted aggressively have become market leaders, while those who were not as aggressive continue to struggle from questions and inefficiencies.

From the perspective of the relationship of the asset management industry to the bulge bracket investment banks and broader Wall Street brokerages and service providers, there are four main aspects: prime brokerage, trading, capital markets, and research.

Prime Brokerage

The prime broker is the custodian of funds for the institution. Post-2008, there was a large push to diversify prime brokers, and banks began competing more heavily, leading to the suite of services we have today such as margining, lending, compliance monitoring, cap intro, and accounting.

There are some key profit centers of the PB business that are more directly market driven but to a large extent the revenue equation comes down to some type of carry on custodied funds. It’s a highly competitive business that has been affected by a terminally low interest rate environment, but for regulatory reasons it has a high, defensible moat and is a major component of the the general plumbing of the financial system.

The prime brokerage business is likely to continue to grow in importance. Both new market players, such as BNP who recently purchased the PB business from Deutsche Bank[1], and established veterans such as Goldman Sachs are focused on recurring, fee-based revenue platforms[2]. PB is the golden goose for banks in this sense and despite pressures will likely be a key business for some time to come.

Sales and Trading

The Sales and Trading function consists primarily in the execution of marketable trades across asset classes for institutional clients, corporations, and the bank itself. It includes all market related activities up to and including the sale such as recommendations, analysis, execution, and other services. Most sell-side trading now is some variation of agency and flow trading. Block trading has become a much larger and more sophisticated component of the overall strategies and will remain a major component of revenues for the S&T desks. On the other side, the asset managers have access to electronic execution and other tools that have put the very best technology in their hands. Larger institutions now have a better and more comprehensive suite of execution capabilities than even the banks in many cases for minimizing impact and transaction costs.

The buy-side having better tools that can access more pools of liquidity cheaper and faster than the banks themselves has inverted the previous foundation of the relationship for large aspects of traditional institutional trading. Even large block orders can now be directly executed for a small fee on third-party platforms. In just one of many examples, I have personally completed a $94m trade in two clicks, with zero slippage either informational or price. Even just a few years ago a nearly $100m block trade would have required several back and forth calls between the heads of trading at the bank and the fund, risked major price and information slippage, and been anywhere from 10x to 100x more expensive.

The nature of the relationship will remain strong but more specialized on the sell-side and trends around commissions, volumes, and access to sophisticated, powerful, and democratizing low-cost tech in the hands of clients that can even outcompete the banks is unlikely to change.

Conclusion

This has been part one of the series which discusses two out of four of the main business lines that make up the relationship between the investment banking industry and asset managers. Prime Brokerage, while a competitive business, is a recurring, steady, fee-based business with high moats. It will continue to be an important part of an investment bank’s strategies.

Traditional Sales & Trading however has been under pressure for some time. The power relationship has been inverted between the banks and the managers as technology has given the managers better tools than even the banks have access to.

In part two I will examine the evolution of the Capital Markets business.

Citations

[1] BNPs $300 Billion Hedge Fund Gamble, Bloomberg, November 1st 2019

[2] “Goldman Sachs pressed on strategy as new CEO confirmed”, Reuters, July 17th 2018

Thanks to Chris Schippers for the header photo