The banker has no clothes - Hot Shots! Part Deux
Can macro traders pay investment banker bonuses
“The IPO Window is OPEN” Jefferies CEO Rich Handler tweeted only a few days ago, just before stock markets and bond yields collapsed!
In Part 1 of “The banker has no clothes” we discussed traditional banking and neobanks with a focus on the US and UK.
In Part 2 today we discuss the impact on Investment banking and trading businesses.
Senior bankers sitting in their beach houses in the Hamptons or, in the French Riveria were looking forward to the post Labor Day IPO window. Time will tell how bad things get but it may be up to their macro trading desks to bail them out this year.
The 2024 investment bank recovery has been patchy to date. Senior bankers - like any good salesperson - have pounded the airwaves and studios of Bloomberg with interviews about how “fundamentals are strong” but the percentage growth rates in IPO revenues are from such a low base and the mismatch between private and public market valuations so significant that the floorboards of capital markets have been creaking.
Equity capital markets have been driven by more opportunistic follow-on primary offerings (fund-raising by already listed companies), secondary offerings (sales of stock by existing shareholders of listed companies), and convertible bond offerings.
The number of both large and mid-size companies coming public even in the liquid US markets has been tepid. Mid-size companies prefer to stay private for longer and private equity keeps raising money but spending it at a much slower pace and exiting its portfolio company investments at an even slower pace!
Bain estimated that in the 9 years to 2021, private equity deals averaged $504bn per annum and exits averaged $508bn per annum. The pace of investing started to pick up in recent years. In the last 3 years, around $550bn of private equity deals have been done owing to cheap valuations of traditional mid-cap companies in public markets like the UK. But exits over the last 3 years only averaged $428bn with 2024 already pacing well below this. The brief broadening out of the equity market rally beyond the Magnificent 7 and AI stocks was illustrated by the significant outperformance of the Russell 2000 US mid-cap index (mid-caps in the US can be up to a $10bn market cap) but with the recent market sell-off, all bets are probably off for now.
The infamous “dry powder” of the private equity industry could get deployed as bargain hunting kicks in but just as likely is caution from both bank and private credit lenders. The exit environment is the big “elephant in the room”. If private equity couldn’t get out in a bull market what happens in a bear market?
Which brings me to what could save 2024 for investment banks…
An ideal investment bank has both pro-cyclical and counter-cyclical businesses. The businesses that are most exposed to the bull market are ECM and M&A followed by equities and credit/securitized trading. The business, that benefits the most from turmoil are the rates and foreign exchange trading businesses, known collecting as macro trading. Debt Capital Markets is somewhat in between - quiet when volatility picks up but very busy soon after if interest rates do fall as a result.
If I knew whether this was the beginning of a new period of sustained pressure on equity markets and heightened bond market volatility or not, I would be sitting at home day trading VIX options! But so far activity levels have picked up markedly. For instance, CME Interest Rate futures and options volumes barely grew in the first half of 2024 but were up 23% year on year in July. Average daily volumes across all of CME group’s products were in the 25 million contracts range for most of the year but the market volatility that accelerated late last week resulted in an almost doubling of this.
So where are all the macro traders?
Macro trading and financing of these trades generates investment banks more than $100bn of revenues per annum. This is a big business that hasn’t faced the same level of competition and margin pressure as equities and credit trading. Macro trading and financing of these trades is around half of all sell-side investment trading revenues and well over one-third of the industry once adding in advisory businesses (ECM, DCM, and M&A).
Probably the best mix of Tier 1 franchises is JP Morgan. Always strong in rates and credit, it is now the market leader in foreign exchange trading - a business built by investment bank co-CEO Troy Rohrbaugh - and is a top 3 player in equities trading.
Goldman Sachs lacks the macro trading strength, particularly outside of US rates, that JP Morgan has but it is the market leader with hedge funds that are likely to be trading more actively in such periods of volatility. Goldman’s legacy as having more of a proprietary trading DNA means that its traders have a knack for doing well in volatile periods - just look at their underperformance in the more benign macro environment pre-COVID and outperformance during and after the Covid-19 dislocation. Goldman’s FICC (Fixed income, Currencies, and Commodities) trading revenues were a record $23bn during the volatile 2009 year.
By contrast, Citigroup has a counter-cyclical investment bank if you don’t include its transaction bank - which is a huge play on higher rates - under this umbrella. Citi is a top 3 macro trading firm and strong in DCM but an increasingly weaker player in credit and traditionally weak in equities, ECM, and M&A.
Citi’s investment bank was carried by its macro traders ever since the Global Financial Crisis. Its FX franchise benefitted from the global and wide-ranging corporate relationships that the transaction bank had. At a time of increased margin pressure from electronic trading and nonbank competitors, Citi’s FX revenues proved to be quasi-captive flow and hence sticky and unique. Liquidity provider banks are always willing to pay much higher fees on third-party electronic trading platforms to access corporate flow than asset manager flow as it is seen as uncorrelated and less price sensitive. Citi’s network is also skewed more towards emerging market FX than the more commoditized G10 FX space.
In Rates trading, always a strong player, the business was rebuilt following the Global Financial Crisis by the legendary Andy Morton, who now runs the whole of Citi’s Markets business.
But Citi’s macro trading desk has struggled a bit in the last 2 years and given its huge size relative to other Citi businesses it has been a big drag. Part of this is pressure on macro trading across the industry in the last 18 months following several record years. Part of this is Citi’s balance sheet optimization plans. And Citi’s smaller footprint with the booming multi-strategy hedge fund industry has also played a part.
Citi’s macro trading revenues were down 6% year on year in 2023 and down by 17% year on year in the first half of 2024. Most banks don’t break out macro trading from the rest of FICC, but Bank of America does and its macro trading revenues were flat year-on-year in 2023 and down 12% year-on-year in the first half of 2024.
More important though is the mix difference. Citi’s macro trading revenues were more than half of its investment bank (markets + investment banking) in 2023, while at Bank of America, macro trading was around 28% of investment bank (markets + investment banking).
If the macro volatility is here to stay, investment banks like Citi will benefit disproportionately. Out of the European banks, Deutsche Bank has traditionally been a strong macro trading firm, but it has a large credit financing business and transaction bank, which are likely to do less well.
What’s next?
In Part 3 of this series later this week, we look at risk management on Wall Street, and who won in previous periods of turmoil, and why. I was a TMT sell-side equity analyst during the dot com bubble, a financials sell-side equity analyst during the GFC, and ran corporate strategy at the world’s largest interdealer broker ICAP during other periods of turmoil. We were the primary marketplace for trading Yen and lived through the Swiss National Bank shock unpegging of the Swiss Franc in Jan 2015 so have a few thoughts….