Squeezing Hedge Funds Is Path to Profit at Three Big Banks

  • Morgan Stanley, Goldman Sachs, JPMorgan market share climbs
  • Citigroup, Bank of America post drop in stock-trading revenue

In the battle for supremacy on Wall Street’s equity trading desks, the most successful banks are dangling a precious resource in front of hedge-fund clients: a balance sheet.

Morgan Stanley, Goldman Sachs Group Inc. and JPMorgan Chase & Co. grabbed a bigger share of the market last quarter by forcing hedge funds hungry for financing to send more stock-trading business their way. The three firms booked $5.1 billion from equities in the third quarter, or 76 percent of the total posted by the five largest U.S. investment banks, according to their financial statements. That was the most for the period since 2012.

Regulations put in place since the financial crisis help explain why. A new rule intended to make banks safer and avoid government bailouts forced lenders to fund less risky assets with more equity, reducing returns. As a result, some companies left the business and the ones left standing are raising prices.

“The firms can now tell their clients that want access to the balance sheet, ‘I have to make sure I get paid enough,’” Guy Moszkowski, an analyst at Autonomous Research, said in an interview. That may mean demanding a richer spread on lending, or insisting on “more market share of a customers’ business flow,” he said.

Hedge funds, in many cases, are in no position to argue. Average annual returns over the past three years were just 2 percent, spurring investor withdrawals. Under pressure to cut costs, funds are acquiescing to banks’ insistence that they concentrate their business in exchange for the best service available.

The trend helped Morgan Stanley hold its No. 1 ranking among prime brokerages for the largest global hedge funds, followed by Goldman Sachs and JPMorgan, according to a 2016 survey conducted by Global Custodian, which follows the international securities-services industry. Bank of America Corp. and Citigroup Inc. ranked seventh and 10th, respectively.

Spreading Wealth

“In environments where clients have limited fees to spread around, they probably want to spread it around to the people they think are the biggest and the best, and we are that,” Morgan Stanley Chief Financial Officer Jonathan Pruzan said Wednesday in an interview.

Daniel Pinto, head of JPMorgan’s corporate and investment bank, highlighted the firm’s progress in equities and prime brokerage Thursday in a town hall meeting in Manhattan for traders and investment bankers. Amid the industry’s declining stock-trading fees this year, the bank has managed to retain more revenue than competitors, he said.

Equity-trading revenue declined at Citigroup and Bank of America enough to cut the total amount earned by the five biggest U.S. investment banks by 4.8 percent to $6.7 billion, compared with the year-earlier quarter. Bank of America, where revenue fell 17 percent, blamed lower volume in cash equities and derivatives. Morgan Stanley, with a 6.4 percent increase, cited derivatives as a source of strength.

Bank of America equities head Fabrizio Gallo is still in the process of shifting away from an emphasis on cash equities, Chief Executive Officer Brian Moynihan said Thursday during a Bloomberg TV interview. “The heritage of the company was much more of a cash-based equity business, and he’s had to move to a more electronics-based and derivatives-based business,” Moynihan said.

Citigroup was challenged despite making equities trading, and hedge fund services specifically, a key focus for growth. The bank has upgraded its technology systems, hired senior managers and earmarked more of its balance sheet for the business.

Wallet Share

“We’ve made the right investments in people, the right investments in technology, and now it’s up to us to gain as much of our clients’ wallet shares as we can,” Citigroup Chief Financial Officer John Gerspach said on a call with journalists Friday. “When you are the No. 8 or the No. 9 player and the overall market volume, as I’ve said, is down, that means that most clients are going to stay with their No. 1 or No. 2 current providers, and it’s a little more difficult to break in.”

The battle among the dealers is a sign of a larger trend, according to Morgan Stanley’s Pruzan. While the CFO didn’t single out Morgan Stanley’s prime brokerage when Moszkowski asked about its contribution on a conference call Wednesday, he acknowledged how pressures are reshaping the industry.

“You’re going to see -- just like in many other financial-services products -- the concentration of market share among the top players,” Pruzan said. “That’s what you’re seeing in equities.”

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