(This story originally appeared on IFRe, a Thomson Reuters publication)
* Banks focus on core clients on regulatory squeeze
* Positions get crowded as large players dominate
* Risk capital provision increasingly rationed
By Christopher Whittall
LONDON, June 16 (IFR) - Capital-strapped banks' laser-like focus on a shrinking pool of core clients is helping to cement the dominance of large asset managers on the buyside to the detriment of smaller investors, which are finding it increasingly difficult to secure balance sheet-heavy services from their dealer counterparties.
While start-up funds face an uphill battle even to get on the radar of banks' sales desks, strategists say there is evidence of a rising correlation in credit markets thanks to the narrower range of views being expressed, as assets become concentrated in a handful of ultra-large investment managers.
Many see the trend as an inevitable consequence of the Basel III-induced squeeze on banks' markets businesses, which has sparked a root-and-branch overhaul of client coverage models. This is felt nowhere more keenly than in fixed income, where bank strategies based on the mindless accumulation of market share have given way to an ethos based on cost-cutting and efficiency more akin to how equity trading businesses operate.
"We have been doing this for almost a decade in the equities business: tiering clients, doing detailed account reviews of the services they use; and adopting a holistic approach to relationships and profitability," said David Escoffier, chief executive of Newedge and deputy head of markets at Societe Generale. "We had no choice: margins were thinner in equities. Fixed income still has some way to catch up on both topics, unfortunately."
Banks have long categorised clients internally according to how much business they bring in, but fixed income, commodities and currencies divisions historically took a more slapdash approach than their equities colleagues.
Raking in more than half of investment banks' revenues, FICC units paid scant attention to costs, often building silo-ed sales teams for different products.
Plummeting returns on equity in this part of the business (thanks to calm markets and beefed-up capital requirements) have forced a radical re-think.
Investment banking heads have scythed down walls between asset classes, invested heavily in electronic trading and piled vast sums into analytics to understand what kind of business clients execute and exactly how much value it represents to their organisations.
The upshot is that banks are less inclined to offer capital-intensive services such as derivatives clearing for niche investment managers that trade infrequently and aren't a great source of bank profits. Meanwhile, the leverage ratio has forced a re-think on how dealers allocate balance sheet across all their markets businesses.
"There is a global client platinum list within Citigroup that aligns sales coverage across asset classes," said Michael Bitton, global head of delta one at Citigroup. "In the delta one space, balance sheet and capital constraints mean our business becomes more focused on the largest hedge funds."
Many believe the radical overhaul of client capital provision and coverage - particularly in fixed income - has helped to fuel the vertiginous growth of the largest asset managers, which is swiftly becoming self-perpetuating.
"I want to keep it clean, but there isn't much I wouldn't do for BlackRock," said one senior banker.
This sentiment is echoed throughout the dealer community, which cannot help but pander to the world's largest asset manager (which now handles USD4.32trn of AUM, over three times the amount it held at the end of 2008) and other massive funds.
Credit strategists at JP Morgan say the increasing concentration of assets is contributing to the rise in single-name correlations with less plurality of views in the market. The largest 10% of funds now hold 60% of European high-grade credit - up from around 45% in 2008, the strategists said.
The sheer size of these asset managers has begun to attract the attention of regulators, who are concerned that they may pose a systemic risk. Funds have also come under scrutiny for allegedly throwing their weight around to secure precious primary allocations on bumper deals such as Verizon's US$49bn mega-trade in 2013.
But large asset managers have defended their right to preferential treatment from their bank counterparties, arguing that it is a natural evolution of the market in reaction to the new regulatory environment.
"Smaller asset managers have had the benefit of cross-subsidy from scale asset managers," said Stephen Grady, global head of trading at Legal and General Investment Management, which has £463bn of AUM. "As liquidity and risk capital provision has decreased and the cost of regulation has increased, it has essentially increased the marginal cost of servicing sub-scale clients [for banks].
"Investment banks are making decisions as to which clients they will focus on, is more prevalent in secondary markets currently. In primary markets, the same starting paradigm exists; however, the cross-subsidisation has not begun to be addressed."
Not everyone agrees that biggest is necessarily best when it comes to choosing which clients to deal with. Antoine Cornut, a former sellside executive who founded a credit hedge fund called Camares Capital in 2012, acknowledges that hedge funds tend to be smaller than traditional asset managers, but points out that they often represent more value to dealers than long-only managers that buy and hold bonds and only trade secondary in very liquid products.
"Hedge funds trade daily in high volumes and will use more exotic products," said Cornut.
Higher-margin business remains valuable as large parts of the FICC product set are shoehorned into a more equity-like trading model. Ultimately, fixed income still generates its revenues through risk-taking - not commissions, as in the equity world. The hope is that the top clients will still see value in that proposition in the new world.
"We're not afraid of a move to an agency model, but we haven't found a client that wants it to replace the current model. Every asset manager is worried about their size in corporate bonds and their ability to move risk - they still need bilateral risk partners," said Ciaran O'Flynn, co-head of FID e-trading at Morgan Stanley. (Reporting By Christopher Whittall, editing by Matthew Davies)