Improving Prime Brokerage Market Share Should Lift Profits At Goldman, Morgan Stanley

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GS: Goldman Sachs logo
GS
Goldman Sachs

U.S. investment banking giants Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) have seen considerable growth in the prime brokerage industry this year, with data compiled by research firm Preqin showing that their market share has increased from around 31% at the end of 2014 to roughly 37% now. [1] Favorable industry conditions this year have helped investment banks report higher equities trading revenues from their prime brokerage services over the first two quarter of the year. This, coupled with the swelling market share, is likely to have a positive impact on their third quarter results too.

While both Goldman and Morgan Stanley have aggressively pursued growth in this sector over recent years, their efforts have been complemented by a steady reduction in competition from the largest European banks. JPMorgan (NYSE:JPM) holds the third spot in the global prime brokerage industry in terms of market share, followed by Credit Suisse (NYSE:CS) and Deutsche Bank (NYSE:DB). [2] However, both Credit Suisse and Deutsche Bank have lost some ground since 2014, as they work towards reducing their prime brokerage business to meet stricter leverage ratio requirements.

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The prime brokerage industry has seen considerable change since the economic downturn of 2008, with stricter regulatory requirements and lower profitability forcing the world’s largest banks to rethink the importance of this business in their overall business models. Prime brokers provide services such as securities lending, leveraged trade executions and cash management, primarily to hedge fund clients. And while the size of assets under management at hedge funds around the globe have gradually recovered from the low of $1.4 trillion in 2008 to almost $3 trillion now, many investment banking giants have slashed their presence in the industry considerably. [1] Preqin highlights the fact that although banks garner a commanding 83% share of the primer brokerage industry, independent prime brokers have seen considerable growth in the last couple of years. In fact, the independent prime broker Interactive Brokers now figures in the list of top 10 prime brokers in the world – having displaced BNP Paribas from that position this year. [3]

Notably, the retrenchment is quite evident among European banks. The weak pace of recovery in Europe has made it difficult for these banks to improve their capital ratios adequately over the years – forcing them to cut down on investment banking operations in response to increasing investor pressure. This stands out in the case of Credit Suisse, which slipped to the fourth position on the list of global prime brokers from #2 in 2012. [4] The Swiss banking giant detailed plans to resize its prime brokerage unit last December, and is expected to announce more cuts as a part of its reorganization plan later this month. While UBS (ranked #6 worldwide) is in the process of reducing the size of its prime brokerage unit, Deutsche Bank is also expected to make similar changes in the near future.

This trend plays out in favor of Goldman Sachs and Morgan Stanley, who have been more than happy to pick up the slack introduced by retreating competitors. While fee revenues for providing prime brokerage services are not very high, the investment banks benefit from the corresponding trading revenues they generate by fulfilling the mandates provided by hedge fund clients. To put things in perspective, the prime brokerage business accounted for 35% of the total equities trading revenues in 2014, according to data compiled by the research firm Coalition – up from 25% in 2009. [1] As Goldman continues to grow its share of the industry, the positive impact on its top line will be visible in the form of increasing equities trading yields. You can see how an increase in this yield increases Goldman’s share value by making changes to the chart below.

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Notes:
  1. Goldman, Morgan Stanley win back hedge fund trading business, Reuters, Oct 6 2015 [] [] []
  2. How Policy Regimes Are Reshaping the Prime Brokerage Industry, Preqin Blog, May 18 2015 []
  3. In Focus: Prime Brokers, Preqin, Mar 2015 []
  4. Goldman tops fast-changing prime brokerage market, Hedge Fund Intelligence, Oct 4 2012 []