There has been a precipitous decline in the profitability of trading shares, so why do investment houses continue in this seemingly unprofitable enterprise?
Share trading has become commoditized, and a myriad of factors are responsible. Firms have to assess the viability of this activity in both the short and long term.
How Is This Article Useful to Practitioners?
Trading stocks now accounts for a smaller percentage of industry revenue and profitability, and investment banks’ fixed-income, currency, and commodities (FICC) businesses are accounting for a larger percentage. FICC has become more profitable, whereas equity trading has become more competitive, which creates razor-thin margins. Corporate actions such as mergers and acquisitions have been decreasing since the global financial crisis and since the issues with the fate of the euro and the U.S. fiscal cliff. Consequently, companies’ use of shares as acquisition currency has dropped. In addition, difficulties that active managers face in outperforming the market have led to an increase in passive investing, embodied in index funds and exchange-traded funds. Furthermore, the proliferation in trading venues and the speed of technology development that finds its expression in algorithmic and high-frequency trading make the game even tougher.
The biggest investment banks, those with substantial market share, are able to take on execution risk from clients and efficiently move large blocks of shares with minimal price disruption. But other banks are reluctant to exit the business, which often ties into advising on company mergers. Banks may also be hoping to return to profitability in the near term and thus avoid the need to allocate more capital against their trading book. This struggle for profitability has affected the quantity and quality of analyst coverage and research.
Those overseeing trading operations as well as analysts who cover the banking and brokerage industries may well find these conclusions useful for their work.
Once a mainstay of investment banks’ and brokerages’ business, share trading has fallen victim to increased transaction speed following from improved technology and an increasingly uncertain market environment that has caused investors to make their decisions much more slowly. Those firms with the largest business base may be able to hang on, but they will need to consider other models of profitability because what has affected share trading has begun to affect transactions in all types of financial instruments.