Investment Banking wallet outlook - all eyes on equity derivatives

- "Our analysis clearly illustrates the IB wallet is going ex growth, declining -4% 09-12E CAGR and to grow only 3% CAGR in 10E-12E."
- "The main catalyst for our base case ex growth revenue trend is that clean fixed income revenues are likely to decline from the peak 2009 year by -22% in 2010E/09E and a further -4% CAGR in 2010-12E, accounting with 55% share for the largest part of the $330bn IB revenue wallet in 2009."
- "So where is the IB revenue wallet growth going to come from? In respect to IB product cycle in different economic stages, with the market becoming more risk open, one should expect a shift to the next risky asset class to drive IB revenues after 2009 being the best FICC trading year ever: Equities, in our view."
- "In addition, there is no sign of innovation within the IB industry driving a new IB revenue wallet super-cycle. One of the products offering potential long-term growth is Insurance-linked-securities. However, following the structured credit crisis we do not see client appetite to buy illiquid structured products. For details on Insurance-linked securities, please refer to our note, “Insurance Linked Securities: The second leg of growth in the ABS market?” published on 4 June 2007."
- "Hence, the key driver for growth in the IB wallet going forward has to be equities. In particular, we focus on equity derivatives rather than highly commoditized cash equity business as the key IB revenue driver considering its higher long-term profitability, lower operating gearing, and more diverse business mix."
- "Equity Derivatives – the key determinator for IB wallet growth. We analyse in detail the key sub-business segments within equity derivatives and their potential IB revenues impact. We conclude equity derivative business is to grow 9% CAGR 2010-2012E – the fastest growth within all IB client flow related businesses assuming 5% CAGR equity market performance in 10-12E."
- "The historic equity derivative revenue growth rates of c.15%p.a. are unlikely to be achievable as clients operate with less leverage and demand relatively simple structured products. More importantly regulation should be a trigger of structural change in Equity Derivatives reducing profitability, with ROEs declining from 42% to 22% in a 2011E sensitivity, mainly due to new capital rules accounting for 2/3rd of change rather than revenue loss related regulation at 1/3rd. The regulatory changes will lead to re-assessment of the business model in our view and structural trend changes within the business wallet as we outline in detail in our report."
- "We expect Delta One to be a key growth segment in our view, accounting for $10.7bn revenues wallet in 2009 with CAGR 9% 10-12E. These activities require large scale operations to maintain significant size index-based portfolios and competitive technology with the appetite and willingness to hedge at times longdated risk. Investment costs required for algorithmic trading are relatively high, and equity finance activities are balance sheet intensive, as a result, we believe this segment will remain dominated by the scaled players with strong balance sheets. In
addition we see material growth opportunities within ETFs at 20%p.a. The key players are GS, SG and BNPP."
- "Within equity derivative structuring we expect retail business to remain relatively slow and unlikely to reach peak volume levels at highly leveraged and risk payoffs post the structuring crisis. However, strategic corporate business will remain a material high growth segment in our view. We expect structuring to grow from a 2009 wallet of $7.7bn by CAGR 10% 10-12E. Overall, due to difficult to hedge risk and capital charges post Basel 2.5, IBs require scale in the structuring business to generate acceptable ROEs over-the-cycle in our view leading to further consolidation in this business segment. As a result, we expect the structured equity derivatives industry to become more oligopolistic post regulatory changes. There are business opportunities so and we remain surprised about competitors’ inability to replicate a Societe Generale Lyxor-type structure. The key players are SG, BNPP, DB and GS."
- "Our largest sub-segment business concern is regarding the equity derivative flow business, becoming more cash equity-like with literally every IB now focusing on expanding this business segment, with a 2009 wallet of $7.5bn and CAGR 5% 10-12E. We witness overcapacity building up reducing spreads and increasing operating leverage. In addition, with regulation increasing price transparency the more commoditized equity derivative flow business is becoming even more of a scale platform business with a strong IT infrastructure a key differentiator. More importantly, the race to own high trading market share is key for price discovery (i.e. liquidity provider) to optimize client facilitation business and generate flow prop related revenues. Hence, the importance of flow prop as such will not be diminished but becomes more vital in a continuously declining flow equity derivative profitability world. We see flow prop as part of client facilitation business in a more transparent equity derivative trading business. Overall, very few players (3-4) will be able to be liquidity providers in such a scale focused business and we are concerned about the aggressive expansion strategy of all IBs including Tier II players to build-up scale. Within flow equity derivative, there is the potential for some IBs to close geographic gaps and grow the flow business aggressively, in particular French and European Banks in the US, with ongoing structural growth in Asia. The player by far being strongest in this segment is GS. We see the oligopolistic flow market structure still uncertain with MS, UBS, DB and French Banks potential contenders in our view."

JPMorgan Global Investment Banks 20100908

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