The interdealer always wins

The uptick in trading volumes since the subprime blowout has meant big profits for interdealer brokers.
Playing in the financial markets tends to be a zero-sum game, which is to say that one guy's profit is another guy's loss. But there have been few obvious winners from the subprime turmoil.

Among that select group are the interdealer brokers who take a margin for executing trades on behalf of securities dealers. As the investment banks continue to admit ever-greater losses, profits at the main interdealers are all up thanks to the big increases in trading volumes.

"We have seen many crises in the financial markets, but this was a once-in-a-lifetime event," says Don McClumpha, Asia-Pacific deputy chief executive of Icap, the world's biggest broker.

On August 16, 2007, at the height of the subprime panic, trades in the fixed income and foreign exchange markets totalled $1.3 trillion û more than $200 billion higher than the previous record. Volumes hit $1.2 trillion the next day.

Since then, investors and financial institutions have scrambled to hedge or offload risky assets and unwind carry trades, and speculators have moved in as they try to bag profits from the panic. All of this creates more trades and bigger price movements.

"The unprecedented volatility has been hugely beneficial for interdealer broking volumes across most of the mainstream facets of our business, which is really mainstream derivatives, foreign exchange and bond markets," says McClumpha.

According to Icap, trades in spot foreign exchange, US Treasuries, and US and European repos have all risen by more than 25% during the past year, and that growth is clearly reflected in interdealer revenues.

BGC Partners' first-quarter revenues rose 24% compared to the same period in 2007, to $338 million. GFI's first-quarter revenues rose 31% to a record $315 million and its 2007 brokerage revenues were up 32%. Tullett Prebon posted 20% revenue growth in 2007, to $1.5 billion. Icap's 2008 annual report shows a record profit of $658 million, before tax and other deductibles, which represents a 31% increase over the previous year.

Asia has contributed significantly to this revenue growth as capital has flowed out of the turbulent US and European markets in search of more stable returns, a move which many analysts consider to be a structural shift rather than a short-term quirk.

The post-mortem of the credit crunch is also likely to benefit the interdealers as regulators pressure market participants into creating systems and procedures that ensure better execution and more transparent pricing, but the move towards greater use of electronic trading and more streamlined post-trade processes had started long before that.

Indeed, the interdealers were forecasting strong growth even before subprime, thanks to the increased use of derivatives for hedging purposes and yield-enhancement, the liberalisation taking place in many emerging markets and the growth of the asset-management industry and algorithmic trading.

Interdealers' most recent revenue numbers look impressive but they are not significantly out of line with the industry's general growth trend. In fact, the interdealers are making such fat profits that the investment banks are keen to get a piece of the action for themselves.

Two separate consortia of investment banks are exploring the possibility of setting up their own competing broking businesses, although it is hard to imagine how either could rival the big brokers if the banks are in competition with each other, according to Michael Gooch, chief executive of GFI. "Goldman Sachs won't deal on the platform that he is not a member of. BNP won't deal on the platform that he is not a member of. And so on and so forth. So they never get the full liquidity puzzle," he said in a conference call with analysts after GFIÆs first-quarter earnings announcement. "The interdealer broker being independent and being able to offer services and get liquidity from all players will win the liquidity puzzle."

The exercise might succeed in putting some pressure on pricing though, which is probably the point, but the industry trend is in the opposite direction û towards greater consolidation. As financial markets become more commoditised, interdealers are faced with the challenge of earning their crust from falling margins. To do so, they have to better manage their costs and increase their capacity, which favours bigger players and, as a result, even greater consolidation. For once, the investment banks may not get what they want.

A longer version of this story first appeared in the July issue of FinanceAsia magazine.
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