Banks and shadow banks are meant to exist in separate worlds, but the financial links between them are increasingly seen as a source of potential instability. That’s a problem for banks because the business of forging those ties has lately been among the hottest activities on Wall Street.
The largely unseen lending boom in the fixed-income, currencies and commodities (FICC) trading arms of big banks has been driven by two of the strongest trends of the past decade: the secular rise of private markets and multi-strategy hedge funds. Now, with watchdogs focusing more on the risks and with interest rate cuts around the corner, the question is whether so-called FICC financing is about to run out of steam.
This matters for the banks. They have been investing capital and resources in this lending as well as the prime-broking operations that predominantly finance hedge funds’ stock market bets to counteract the squeeze on traditional market making from electronic upstarts, such as Jane Street and Citadel Securities.
Goldman Sachs Group Inc. has highlighted the growth by reporting financing revenue separate from other trading in its markets divisions for several years. Its aim has been to show shareholders that trading is less volatile than commonly assumed. More recently, Barclays Plc and Deutsche Bank AG have followed suit.
Other big banks might not report such numbers in earnings, but many are still big players pursuing growth. Bank of America Corp. has made some of the biggest gains in the past couple of years, according to bankers in the field, after it decided to put more capital into its trading arm three years ago.
Total FICC financing revenue among the top 12 banks in the US and Europe hit $26.1 billion in 2023 from $18.4 billion in 2019, according to data from Coalition Greenwich. That’s a compound annual rate of more than 9%. The expansion has been persistent and steady, in contrast to highly volatile trading revenue. Coalition Greenwich expects financing activity to be 5% to 10% higher again this year, according to Raman Kalra, research manager.
Over the same period, Goldman Sachs’s FICC financing rose to $2.7 billion from $1.4 billion. Last year’s total was slightly down on 2022, but it looks to be back in growth mode this year: The first two quarters each produced more revenue than any previously reported three-month period.
Across banks, there are two broad strands to the business. Macro involves lending linked to government bonds, currencies, commodities and related derivatives, while spread products involve financing things like structured credit, private asset managers and markets and warehouses for things like buyout loans or mortgages that will be packaged into securitizations and sold.
“Credit and securitization have been driving a lot of the growth in FICC financing revenue,” said Kalra. “A sizable portion of this can be attributed to the expansion in size and activities related to private markets.”
The variety of lending banks offer to private equity and private credit firms, their funds and their investors has gone through a rapid evolution. One Bank of England official called it a “Cambrian explosion,” earlier this year. The UK central bank is one of the watchdogs that is demanding more detail from lenders about their activities and risk management in this area.
Partly that’s down to the ongoing growth of private markets and their desire for leverage to juice returns, but some of the recent activity has been a substitute for private equity selling portfolio companies at acceptable prices. If valuations recover, demand for that financing could diminish.
Another spur has been the disruption that higher rates brought to regional banks, which left many struggling to retain deposits and pulling back from lending to commercial property, for example, according to bankers. That has allowed investment banks to do more private, securitization-like financing. A cut in rates could see that business shrink too.
On the macro side, the big growth area has been repo financing – which is where a bank swaps cash for bonds such as US Treasuries for a set period. It is used heavily by hedge funds in areas like relative value or basis trades that arbitrage out small pricing differences in bond and derivatives markets. The use of repo by hedge funds stood at more than $2 trillion at the end of March this year, which is treble the volume outstanding at the end of 2017 and almost double the levels of September 2022, according to data from the Office of Financial Research, a US Treasury Department agency.
Much of that growth comes from the 10 biggest hedge funds, which typically account for more than half of the volume. Many of those will be multi-strategy funds, whose total borrowings have more than doubled over the past four years to more than $2 trillion, according to the OFR.
Repo is a very low-margin product for banks, paying just a few tenths of a percentage point in interest, but it also uses little capital and is very competitive with a wide array of European and Japanese commercial banks entering the market alongside the big investment banks in recent years. Consequently, growth in revenue from repo on Wall Street hasn’t been great, according to Angad Chhatwal, head of fixed-income research at Coalition Greenwich.
The big investment banks still need to do it in order to win other trading and financing business from big hedge funds, which is higher margin, Chhatwal added.
Repo faces big challenges soon after the Securities and Exchanges Commission adopted a rule to push Treasury trading and repo through central clearing, which will increase margin requirements for dealers and investors when it comes into effect in stages between early 2025 and mid-2026. Repo financing and related trades could become much less attractive for hedge funds, crimping their activities.
On top of the regulatory attention and rule changes is the potential for interest rates to be cut drastically in the next couple of years. FICC financing and prime brokerage generate revenue through fees and interest-related income – some of which is earned over time and some booked up front.
The long-term growth of private markets shows no signs of dropping off soon, but multi-strategy hedge funds will have a wobble if they fail to keep up their high returns. The coming drop in interest rates will definitely hit revenue, however. The hottest (and most reliable) thing in investment banking might be about to cool down again. That would be bad for Wall Street but could offer some relief for regulators, investors and others worried about the risks of interlinking lenders and markets.
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