And completing our mini series of analyst reaction — some commentary on what Glass-Steagall III means for inter-dealer brokers.
To begin with here’s Philip Middleton of BofA Merrill Lynch on Icap:
Big issues – scope, regulatory arbitrage
The precise definition of proprietary trading would, should such a proposal be enacted, be crucial, as the President’s words clearly imply that marketmaking will be exempt; without this, many markets would be faced with damaging illiquidity. As with all current regulatory issues, regulatory arbitrage is likely to be a key consideration.
ICAP – how much is prop?
We have seen no data categorising ICAP’s business in terms of end customer, marketmaking or proprietary. Our view, though, is that the interbank market is crucial to providing liquidity to the end customer; hence, arguably, this activity is related to serving customers.
Prop trading externalised?
If banks are prevented from prop trading, we would presume that risk capital will be provided in other areas. For instance, many of the firms active in high frequency equity trading are essentially hedge funds. Thus, the IDBs’ client base might fragment, which would arguably be positive for business; certainly, bank mergers are usually regarded as bad for the IDBs.
Another source of noise
This proposal certainly will add noise to ICAP’s performance. Our view at present remains that the company is at the epicentre of systemically important markets, with a business model which goes with the grain of current regulatory actions. We think it has the flexibility to ride out any market structure changes which may ensue. Investors, though, will once again have to brace themselves for more swings in sentiment.
Clearly, this topic will be high on our watch list for the company. At present, though, we maintain our pre-existing price objective and recommendation. IDBs flourished during Glass-Steagall, and we believe that non bank owned prop shops are increasingly important in the marketplace. We believe that ICAP’s positioning as a global business active across multiple asset classes, and with leading edge electronic connectivity and industry leading post trade operations, leaves it extremely well placed to adapt to changing conditions. Ultimately, we believe that trade occurs due to a mixture of customer need and profit opportunity. If you assume neither of these is set to disappear, you would assume that a flexible, market-leading business would continue to prosper.
And here’s Mark Williamson of KBC Peel Hunt:
Clearly the issue that has spooked the market and of relevance to the IDB’s is the curtailment of proprietary trading. Most banks have reigned back significantly the capital allocated to proprietary trading in the post credit crisis environment and pure prop trading is thought to account for just 1-2% of bank trading revenues. There are of course some notable exceptions including the likes of Goldman Sachs and Morgan Stanley but these institutions are likely to be in the minority.
Turning to the implications for IDB’s and Tullett in particular we consider that the proposals are of little significance. Both Tullett (c80%) and ICAP (c65%) have a high proportion of revenues being derived from plain vanilla flow products (Interest Rates, Currencies and Bonds) rather than the more exotic derivative products such as CDS. Flow products are used by business to manage the exposures arising as a consequence of global trade. While these products are sold by investment banks they are typically used to meet client needs as opposed to proprietary trading needs.
Trading in the more exotic products such as CDS have already declined significantly as the credit crisis hit and de-leveraging commenced and businesses such as GFI, that did have substantial exposure, have repositioned their businesses accordingly. We would view any weakness inspired by the Obama proposals as an opportunity to Buy Tullett.
At the moment, the market seems to disagree with those views. It seems to be saying that Icap and Tullett will suffer because a large portion of their revenue comes from the prop trading desks of the big banks.
Panmure Gordon’s Vivek Raja reckons around 20% of Icap’s trading volumes related to bank prop trading.
Exposure to prop trading
According to ICAP, c20% of its trading volumes relate to bank prop trading, a figure that we suspect probably understates the actual significance of prop to ICAP’s flows. This is a hard number to pin down since a) banks do not separately report prop trading in their P&L statements, and b) ICAP merely facilitates banks’ dealing flows without needing to determine their clients’ agenda.
Risks to ICAP
In our opinion, the greatest risks to ICAP’s trading volumes are in commodities, equity derivatives and structured credits which all together account for less than a quarter of total revenues. We are less concerned about ICAP’s high volume, flow products like rates, treasuries, spot FX, which account for the majority of trading volumes. We also see ICAP’s post trade and information businesses as likely beneficiaries of OTC structural reform – these businesses together account for nearly 10% of revenues, a proportion which is growing.
In early trading on Friday, Icap is the biggest fallers in the FTSE 100 and Tullett Prebon, the second biggest faller in the FTSE 250:
Related links:
‘Volcker rule’ takes bankers by surprise – FT
Obama and Wall Street in depth – FT