Goldman Sachs: FICCxed Income

By | October 23, 2015

Goldman’s third quarter earnings left some people disappointed and as usual, people who follow the company wonder what the future holds for the FICC business. Here is a typical question that was asked over and over again in the past few calls:

Good morning. Harvey, maybe we pick up where you left off on the whole cyclical versus structural debate in FICC… (Glenn Schorr, Evercore)

Barak, a diligent read of this blog followed up with excellent question in his comment to my last post about Goldman:

What are your thoughts about the downtrend in FICC income?
This activity is around 30% of revenue, and went down 28% in q2 and 33% in q3 2015.
Management claimed that this is due to increased volatility that caused institutional investors to hold back.
I would like to offer an alternative explanation, focusing on Fixed Income:
Bond trading is leaving Investment Banks trading desks and going electronic. This is a secular trend and not based on market “mood” as GS management trying to explain.
The claims about lower volumes are not supported by facts. Trading volume in bonds during q3 and YTD is about the same as 2014.
https://www.sifma.org/uploadedfiles/research/statistics/statisticsfiles/cm-us-bond-market-trading-volume-sifma.xls
On the other hand, trading volumes at Electronic Bond Trading venues are rising steadily:
http://investor.marketaxess.com/volume.cfm

That was a good enough reason for me to look deeper into that topic with the help of GS’ investor relation department. To put us in perspective, the red circles note the areas on which I’m going to focus:

Goldman's Structure

Let’s zoon in on ICS (Institutional Client Services):

ICS

(source: http://www.goldmansachs.com/investor-relations/presentations/credit-suisse-2015-presentation.pdf)

The client franchise

To understand the top-line drivers in this business it is important to understand who makes the main part of Goldman’s ICS client franchise. Goldman has pretty heavy client concentration among asset managers: institutional such as PIMCO, hedge funds, pension funds and so on. While working with the largest investors around the world has it’s benefits, the activity of these clients is less steady than the activity that a client like Coca-Cola would generate. When those clients risk off and pull back, as happened in Q3, Goldman will experience periods of lower revenues in this segment. An important part of the service those clients require is to be able to call their dealer and say “I want to sell you this bond at that price”, get a price and then decide whether or not to execute the trade. Being able to fulfill such requests requires the dealer to use it’s balance sheet and carefully manage the risk–something that an electronic venue can’t provide. Going back to the Q3 revenue drop, thinking about it in the context of the client franchise, the main reasons for the decline in FICC are the uncertainty about the Fed’s interest rate decision, the Yuan devaluation and also, the timing of the Jewish holidays this year. It is not only that the Jewish holidays all fell in September this year but also they fell on weekdays wherein last year many of these holidays took place over the weekend.

Secular trends

While part of the drop in activity is related to cyclical factors, some secular trends are worth mentioning: the decline in mortgage trading is probably here to stay and the trend of allocating more capital towards passive investments such as index funds is also something that isn’t expected to reverse. In addition, commodities used to have both physical and trading aspects and Goldman, conforming to new regulations, had to exit the physical commodities business, which made about 20% of it’s FICC commodity-related revenue.

Electronic trading

Some observers of fixed-income markets think that these markets will, over time, resemble the equity markets where most activity is done through electronic systems that connect buyers and sellers, cutting off the middleman in the process. According to Goldman, the fixed-income market is not what it is because of what technology is capable of, it is not like until too long ago technology wasn’t able to disrupt that business and now it can. Actually, attempts to create  centralized networks were made through the years, including an attempt by Goldman itself, but those initiatives never took off. Clients want their transactions priced rather than wait to find liquidity and they are willing to pay to dealers who are willing to commit their balance sheet in order to facilitate that.

One more thing to note about the fixed-income markets is that these markets are a lot more complicated than the market for equities. Take Goldman for instance: while it has only one type of shares (equity) it has dozens on fixed income securities, each one with substantially different characteristics. That makes the fixed income markets much less fungible than the markets for equities and while the market overall is much bigger than the market for equities, activity in many of those fixed income instruments is relatively low and many of them don’t even trade every day.

So, any change in this business will be driven by the buyside participants rather than by available technologies. However, Goldman points to the equities business, where a shift towards electronic trading occurred and Goldman managed through this change by reducing headcount, improving technology and as a result, revenues went up. Actually, thanks to Goldman superior returns, it can invest more in the technology arms race should a need for that arise.

But hold on, Barak, in his comment, mentioned that trading in electronic venues is taking off. While volumes in electronic venues indeed take off, these volumes are just a drop in the ocean. Take September 2015 for instance: the total monthly volume in MarketAxess was $82.4bn while the total daily volume in the market has been $747bn. If we’ll look at it on a monthly bases, the total volume at MarketAxess makes 0.4% of the total. Moreover, those trades that go electronic are usually in very liquid products where margins for fixed-income dealers were very low to begin with.

The way I view this is twofold:

  • Goldman has a strong client franchise in FICC and those clients currently trade less owing to a various macroeconomic considerations. These clients tend to trade products that aren’t so liquid and those trades require intermediators who are willing to commit capital to help clients execute those trades. “Electronification” in the markets takes place on the margins and in products in which spreads were low to begin with.
  • Should a technological change occur, Goldman already proved that it can profitably deal with it, as seen in equities. Also, this will help Goldman to reduce headcount and reduce it’s balance sheet commitment. Another theoretical way to think about it is to think of Goldman as made of two parts: “ICS” and “Other”. The “Other” business includes IB and IM, two businesses that get high multiples by the markets and I&L, which the market probably ascribes a bank-like multiple to. Since Goldman trades not far from book value, the only conclusion we can arrive at is that the market prices the ICS business significantly below book value. So, if this business were to liquidate tomorrow and capital be returned to investors and associated costs would be cut, current investors stand to win. This is, of course, only a theoretical exercise and I don’t expect any of this to happen, but the bottom line is that investors in Goldman currently buy the ICS business at a steep discount to it’s intrinsic value in a base case and will not stand to lose much should this business gradually wind down in a bear, as unlikely as it currently seems.

On competition

According to Goldman, the competitive landscape in the FICC business has never been better. We just heard that Credit Suisse is pulling out of Rates and FX, Deutsche and Barclays are expected to announce a similar move soon so pricing is getting much more rational. Anyway, most of the recent decline is attributed to volumes and levels of client activity rather than weak pricing. When the clients that make Goldman’s franchise will return to normal levels of activities, those who chose to stay in the business and commit capital to help their clients (mainly JPM and GS) will probably find themselves in a very cosy situation.

Final thoughts

Having taken a deep dive into this topic, I feel much better about Goldman’s positioning and it’s ability to deal with structural changes, should those take place, just as it did so many times in the past. While I don’t underestimate the challenges that Goldman face, I don’t think that the FICC business is dead and I think that when the cycle of client activity will turn, the market will re-price this business and Goldman’s employees and shareholders will get the smile back on their faces.

Finally, I want to thank Barak for asking his question and giving me the push to take a deeper look into this topic. As always, the readers thoughts are welcome.

Yaniv

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