Anatomy of a Successful Fintech
Plus: Goldman Sachs Partnership Scarcity, Japanese Bank Consolidation, Ulster Bank
|Marc Rubinstein||Nov 13|| 12||7|
Welcome to another issue of Net Interest, my newsletter on financial sector themes. If you’re new here, thanks for signing up. Every Friday I go deep on a topic of interest in the sector and highlight a few other trending themes below. If you have any feedback, reply to the email or add to the comments. And if you like what you’re reading, please do spread the word.
Anatomy of a Successful Fintech
Fifteen stocks in the S&P 500 have returned more than 10x over the past ten years. They include Netflix, Amazon and Apple, obviously. Visa and Mastercard are in there as well, together with biotech company Regeneron. Yet one company has outperformed all of these. Like them, it uses technology to change the way we do things. Unlike them, its name is not well known outside Wall Street. The company is MarketAxess; its mission is to disrupt the way bond trading works.
The Way Bond Trading Used to Work
The must-read introductory text to bond trading is Michael Lewis’s classic, Liar’s Poker. Here’s how he describes it:
A new employee, once he reached the trading floor, was handed a pair of telephones. He went on-line almost immediately. If he could make millions of dollars come out of those phones, he became that most revered of all species; a Big Swinging Dick. After the sale of a big block of bonds and the deposit of a few hundred thousand dollars into the Salomon till, a managing director called whoever was responsible to confirm his identity. "Hey, you Big Swinging Dick, way to be."
The excerpt captures the way bond trading used to work—it was done by phone, and it was done with banks like Salomon acting as counterparty. That’s the way bond trading worked through most of the 1980s, when Lewis roamed the trading floor, and into the 1990s. Even when other asset classes like foreign exchange and equities migrated away from telephones and onto computers, bonds resisted.
The reason they resisted lies in the nature of the instrument. Bonds are less standardised; there are many different types of them. There’s only one Apple stock, but there are plenty of Apple bonds. For every common stock in the S&P 500, there are around 24 outstanding corporate bonds. Multiply that out beyond the S&P 500 and the number of bonds balloons, each with a different interest rate, a different maturity, different terms. The lack of standardisation makes it difficult to trade bonds on an exchange, leaving product and price discovery in the wilds of telephone lines. When an investor wants to buy a bond, they ring round bond salespeople at broker-dealers and enquire about price and availability.
In 1999, Rick McVey was running one such team of salespeople at JP Morgan in New York. Like others, he had begun to see the impact of technology in various pockets of the market. In equities, electronic communication networks were being set up; the following year ICE would be established as an electronic exchange for energy trading. He pondered the idea of a web-based, multi-dealer trading platform for credit.
“What was the real catalyst was sitting on top of the sales world and just seeing how much manual intervention there was even on all the odd lots that crossed the trading floor during the day.” [Source]
McVey pitched his idea to JPMorgan’s inhouse incubator, Lab Morgan, and MarketAxess was born. Many B2B fintechs bring natural customers in as seed investors. It’s a great incentive to get them to transact. Bloomberg did it with Merrill Lynch and ICE did it with Goldman Sachs and Morgan Stanley. MarketAxess was initially set up with $24 million from JPMorgan, Bear Stearns and Chase Manhattan Bank (subsequently part of JPMorgan). It later raised capital from several other broker-dealers. In its first full year of business, 82% of commissions derived from customers who were also its shareholders.
The benefits of electronification are plain. Electronic trading provides greater transparency and an audit trail; it can increase the speed of execution and lower both transaction and search costs.
MarketAxess launched a platform through which institutional investors could access the aggregate liquidity provided by multiple broker-dealers. Rather than phoning around, they could simultaneously request competing bids or offers and execute trades with the broker-dealer of choice from among those that chose to respond (the process is called RFQ—“request-for-quote”). MarketAxess would be paid a commission by the broker-dealer for facilitating the trade. The company began with a focus on US high-grade corporates, but soon expanded into European high-grade and emerging markets and later into high yield.
In its first full year of business, MarketAxess did $11.7 billion of trading volume (these days, it can do that in a day). What really got it going, though, was a regulatory intervention—the introduction of TRACE in 2002. That year, regulators required dealers to report secondary market transactions in certain bonds which were then disseminated to the market in a programme called TRACE. They started with 500 high-grade bond issues and then widened it out to 4,000 and then 17,000 and then 23,000 over subsequent years.
“One of the big changes for the market that was very supportive of our business model was the introduction of TRACE in 2002. We weren’t the only ones promoting transparency; the regulators actually did it for the whole market. That was part of the change—it wasn’t just electronic trading, it was the growth in transparency which in my opinion in hindsight was a great thing for the US credit markets. And it was really a turning point for electronic trading because investors and dealers had more market data and more information about where bonds should trade.” [Source]
The point about regulatory intervention is a recurrent theme.
Regulation as a Driver of Growth
Regulation is an important, yet underestimated, driver of business success. Justin Singer is the founder and CEO of a cannabis company, so he knows quite a bit about regulation. In a recent podcast, he argues, “The best venture opportunities are where you have the overlap of massive extant demand – known demand – and some sort of regulatory unlocking event.”
Whole markets have grown out of changes in regulation. Singer cites examples including the growth in communications markets following spectrum auctions, the growth in the funds industry following changes in tax rates, the rise of the turnaround industry following the introduction of bankruptcy laws and the growth of internet companies following the passage of section 230.
Electronic bond trading is another example.
Following the financial crisis, regulations were introduced to increase transparency further and reduce systemic risk. In particular, regulations were introduced which dampened banks’ appetite for pre-crisis levels of bond trading. The Volcker Rule limited proprietary trading and Basel capital rules made the whole business of bond trading more capital-intensive. The upshot was a massive retrenchment by dealers. At the end of 2007, primary dealers held $265 billion of corporate bonds in inventory; today that number is $15 billion.
At the same time as dealers’ inventory of bonds was declining, the volume of bonds outstanding was increasing. What was left on their books represented less than a day of trading volume in US corporate bonds. In response, investors examined ways to trade directly between each other, bypassing the dealers. In 2012, Blackrock tried to solve the problem by creating a platform with other large asset managers. It attracted 60 clients but was unable to kickstart volumes. The following year, it instead formed a partnership with MarketAxess.
The partnership became known as Open Trading. It enables users anonymously to source liquidity from the entire network of participants, not just dealers, hence its classification as an “all-to-all” marketplace. Currently around 1,700 institutions are on the network. Since launch, it has grown to represent around a third of the platform’s credit trading volume.
By improving participants’ access to competitive prices, Open Trading delivers notable cost savings. MarketAxess estimates that so far this year, its platform has saved users $852 million in transaction costs. That’s more than the company itself made in commissions ($479 million). The implications of this are significant. Michael Munger analyses the economics of transaction costs in his book, Tomorrow 3.0: Transaction Costs and the Sharing Economy. He notes:
The middleman sells reductions in transactions costs, at a price much less than the transactions costs being replaced. This in turn makes possible transactions that otherwise would never happen.
Uber and AirBnB both sell reductions in transaction costs and so does MarketAxess. In all cases, it leads to greater transaction volume.
In order to meet the volume of orders, dealers have begun building algorithms to automate smaller ticket trades. They have been helped by the proliferation of data. And as liquidity has built up, new participants have been attracted to the market. One new segment comprises ETF traders who have crossed over into the underlying corporate bond market. These non traditional market makers played a big role during the dislocation of the market in February and March of this year when news of the pandemic hit. Their share of trade volume on the MarketAxess platform increased from ~28% to ~37% at the peak, helping the market to retain a degree of resilience.
On the back of Open Trading, MarketAxess has innovated further. Last year it launched Live Markets, an order book that creates a single view of two-way, actionable prices for the most active bonds. This is the way markets work in equities, but the fragmentation of the corporate bond markets has historically made it difficult to replicate in credit. Currently around 300 investors are approved to use Live Markets, together with 17 dealers, including Goldman Sachs, which streams live prices on the platform on over a hundred bonds. Although continuous trading order books have been a feature of bond trading in the retail market, this is the first time they have been deployed in larger ticket institutional markets.
This year, the company also launched a portfolio trading initiative to allow users to trade baskets of bonds in one swoop, mirroring exchange-traded fund portfolios. The growth in exchange traded funds is narrowing the gap between bonds and equities and leading to growth opportunities in trading. Bloomberg reported this week that this approach had its busiest-ever month in October in “the latest sign that systematic methods are rapidly disrupting the world of fixed income”.
MarketAxess currently has a market share of 22% in high-grade bond trading and 16% in high yield. Historically, its market penetration has been much stronger in smaller ticket trading sizes. These are the ones dealers were quicker to give up. Trades of ticket sizes in excess of $5 million make up around 45% of the market and here, MarketAxess only has a share of around 10%. Further penetration of that segment of the market is key to the company’s ongoing success.
Yet it faces competition from other electronic platforms, notably Tradeweb, Bloomberg, start-up Trumid and Liquidnet.
Tradeweb, which IPO’d last year, predates MarketAxess—it launched electronic trading in 1998, albeit with a focus on government bonds rather than corporate. It has since expanded into corporate and currently has a market share of ~8% in high-grade electronic trading with additional volume done in a hybrid voice/electronic format.
Bloomberg recently revised its price model for electronic trading. Previously it was offered as a bundled service but its pricing brings it into line with other platforms. In a sign of a more competitive environment developing, its global head of trading said that the new fee structure “will enable us to accelerate developments that address fast-moving changes in electronic fixed income and derivatives trading.”
Trumid is a six-year old startup backed by Peter Thiel and George Soros. In August it raised a new funding round, valuing it at $1 billion. Its focus is the big ticket trades that MarketAxess finds elusive. In October it did $27 billion of volume, which is roughly 20% of the volume MarketAxess did. That’s up from 5% last year, making this a player to watch.
Liquidnet’s focus is chiefly in equities, but it’s in the process of being acquired by TP ICAP whose strategy is to unleash it on credit. Interestingly, the CEO of TP ICAP illustrated the value in these businesses by describing how difficult they are to replicate: “We know from our own efforts in institutional services that it’s not efficient to pursue buy-side firms to onboard a new platform provider, and many do not want to be the first. Doing that organically is hard, it's expensive and it’s slow to achieve integration… It's much more efficient to build on existing technology and to leverage existing industry partnerships and extend existing customer relationships than to start from scratch.”
Although the competitive landscape looks fierce, the principal competition comes from voice. Electronic trading makes up less than 40% of high grade trading and less than 25% of high yield. That compares with 80% electronification in equities and 70% in foreign exchange.
The fragmentation within corporate credit remains a major reason for the slower migration. Larger blocks are especially loyal to the old ways as investors remain nervous about information leakage. When turbulence hit the markets in February/March this year, the share of electronic trading dipped. It recovered to a slightly higher level than before, but it is not yet clear what the long-term impact will be. Indeed, predicting the long-term path of electronification is hard. At its 2016 investor day, JPMorgan laid out estimates of where electronification rates would get to across various asset classes in subsequent years. In 2019 it provided an update and for many it was way off.
If the market can be cracked, the spoils could be considerable. MarketAxess earns around $200 on every $1 million of credit traded. The incremental cost of executing a trade is pretty close to zero, so profit margins are high, at around 60%.
None of this is lost on the market, which is why the stock trades on 65x earnings and 25x sales. For other fintechs looking to see how it’s done, there are a few lessons: choose a big market that you can make bigger, incentivise your customers to participate, use regulatory change strategically, and take your time.
More Net Interest
Goldman Sachs Partnership Scarcity
Every two years Goldman Sachs conducts a process to decide which of its employees gets promoted to partner. They’re not real partners, of course—the company went public over twenty years ago and hasn’t been a partnership since; technically they’re “participating managing directors”. What they participate in is three things: $950,000 of annual salary, access to Goldman-sourced investment opportunities, and the status of being a partner of Goldman Sachs.
The first of these – the cash – is easy for competitors to replicate; the second is harder and the third is nigh on impossible. In order to maintain the integrity of the status it confers, Goldman needs to control the supply of new partnerships carefully. Which is why the process takes place only once every two years. And it’s also why the number of new partnerships has been constrained over recent years, when the status of working for Goldman Sachs at all has diminished against competition from tech companies.
Last night, Goldman announced its latest cohort of just 60 new partners—according to the FT, the smallest cohort in twenty years. The firm has to manage the cost of disappointing those who missed out with the benefit of protecting the value of its currency.
Japanese Bank Consolidation
Easy monetary policy has crushed bank profitability all over the world. Policymakers know it’s not ideal and have explored ways of mitigating its impact. One way to combat lower revenues is to reduce costs. Although that’s not something policymakers can steer, what they can steer – or at least, attempt to – is market consolidation. There are over 5,000 banks in the US and close to 6,000 in Europe and smashing some of them together is bound to release some cost. In July the European Central Bank published a guide talking up the scope for bank consolidation in Europe.
“Well-designed and well-executed consolidation can help address the overcapacity and low profitability problems that have been damaging the European banking sector since the last financial crisis,” wrote ECB supervisor Édouard Fernandez-Bollo.
The ECB accompanied the rhetoric with guidance on the capital approach regulators would adopt in the event of a merger.
This week the Bank of Japan took the concept a stage further. Back in May, the Japanese government set the stage by exempting regional banks from antitrust legislation. Now, banks will be given an incentive to merge via a “Special Deposit Facility to Enhance the Resilience of the Regional Financial System”. Banks will be paid an annual interest rate of 0.10% on current account balances they hold at the Bank of Japan if they embark on a merger before the end of March 2023. If they don’t want to merge, they are still eligible for the bonus as long as they cut costs as a stand-alone entity.
It’s a novel approach. Historically, the relationship between bank shareholders and policymakers has been characterised by conflict, but on this there may be some alignment. The Bank of Japan is already a pioneer in monetary policy management; its actions will be of interest abroad.
Dan Davies, author of a guest post on Net Interest a few weeks ago, thinks bank-watchers should be looking at Ireland.
He’s talking about the fate of Ulster Bank, Ireland’s fourth largest bank. In September, its parent company NatWest Group placed the business on strategic review with the option that it could be put into runoff. Normally it’s only bad banks that get the runoff treatment; Ulster isn’t a bad bank. It’s had an office in Dublin since 1860 and currently has around 14% of the Irish mortgage market and €22 billion of deposits. It’s just that it isn’t very profitable. High fixed costs and low interest rates push the return on incremental capital way below the cost of capital required to sustain the business.
In the old days, deposits always had some value. US banks would trade hands on a multiple of deposits; Metro Bank in the UK was launched on a deposit-based strategy. If NatWest Group does choose to put Ulster into run-off, it reflects the diminution of that value, with implications for banks everywhere.