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Deutsche is brave but right on fixed income

By Owen Sanderson
27 May 2014

Equity analysts, Barclays shareholders, regulators and even journalists have all had a pop at fixed income trading of late. Apparently, it’s too expensive to run and doesn’t make enough money. Too many people, too much capital (leverage or RWAs to taste) and too many banks involved. So it is refreshing to hear the case for staying the course in the business.

When Deutsche Bank announced its capital raising last week, it took the opportunity to offer some thoughts about the future of fixed income trading, by far the largest driver of its investment banking profits.

Its thoughts were, contrary to the received wisdom, that it was a good time to be a full service bond bank. Yes, regulation was a challenge, and trading volumes were down, but more investors were switching into bonds, more bonds were outstanding, and there was still plenty of room to go further, as European capital markets move off balance sheet.

At a time when fixed income revenues are down 20% across the Street, making these assertions took some guts.

But Deutsche has few options open. If it planned to cut fixed income, it should have already done it. Banks that wanted out have already moved. Trading desk inventories have already collapsed, prop desks have been spun out or rebadged, and agency business is the order of the day.

And for Deutsche to shrink its bond flow business would mean cutting out the heart of its investment bank. The division contributed €2.4bn in revenue in the first quarter of 2014 — more than a quarter of bank-wide revenues of €8.4bn, more than half of investment bank revenues of €4.1bn. This result, as for most other banks, represents a lean year, down 10% from 2013. Most of the time the division’s standing is higher still.


Last man standing

The other, more important part of Deutsche’s argument hinged on the competitive landscape. The future of fixed income trading will contain fewer banks, and if Deutsche can be part of the top tier, it stands to reap the rewards for sticking by the business.

Even banks that came out of the crisis in good shape are re-evaluating their areas of strength. Barclays plans to cut 7,000 jobs, mainly in fixed income, and run-off its long-dated derivatives. Credit Suisse wants to focus on credit and securitization

If Deutsche can hold its nerve while all its competitors are pulling back into specialist niches, it stands to gain. Goldman Sachs, JP Morgan, Citi and BAML are not going anywhere, but there is room for at least one European bank at the top table, and as competitors drop out, margins at the top will increase.

That means a war of attrition in the medium term. Deutsche needs to stay in the business in size, and convince its shareholders to take the pain as well. Skinny margins, regulation and low volumes will hurt, but they will hurt rivals more.

Longer term, technology should help banks that can stay the course.

Clearing and its associated collateral challenges mean banks are now making sincere attempts to optimise their trading desks for efficiency. Counterparty risks are being aggregated and hedged or managed centrally. Collateral is supposedly being sent where it is most efficiently needed.

The bigger the bank, and the wider the suite of fixed income products it trades, the larger these gains will be. 

Electronic trading, too, should be better for big banks. E-trading platforms are both portals to a market maker’s liquidity provision, and portals to a network of the bank’s clients. On both counts, big banks should score. More e-trading plays into the hands of the firms that are industrialising the bond trading business.

Investment banking is becoming a more diverse business, with different answers looking right for different firms. UBS is a market darling right now because it is focused on advisory. But that doesn’t mean every other house should do the same. Deutsche is right to shut out the noise, and concentrate on what it does well. 

By Owen Sanderson
27 May 2014