I recently listened to a podcast with Mark Carnegie, founder of M.H. Carnegie and Co, an asset management firm with over $900m in assets under management.
Quite bluntly, he stated that investment banking is a dead-end career route for young professionals. Margins are disappearing and the 'value-add' of investment bankers is rapidly declining.
As someone who has completed an entire university degree in awe of the prestige and opportunity provided by the bulge bracket investment banks, my first instinct was to defend the profession.
IPO Share Allocations and Pricing
But, unfortunately, there is some truth to Mark Carnegie's statement. In a recent Bloomberg Opinion Money Stuff newsletter, Matt Levine noted an interesting example from equity capital markets.
When a company first lists their stock on a stock exchange (an IPO), its financial advisor (usually an investment bank) will organise something called a book-build. They call a bunch of sophisticated investors and ask 'hey, do you want to get in on this IPO?'. The investor either says 'yes, I'd like # amount of stock', or they say no. Repeat this process enough times and the financial advisor then goes back to the IPO client to say 'guess what, we've got lots of demand for your IPO'. The client says, 'wow, that's amazing, here's a multimillion-dollar fee' for your expertise. Everyone's happy.
Here's how Matt describes it:
Ben Batory, head of Franklin Equity Group Trading at Franklin Templeton, said for decades he and his team have kept track of how many shares they asked for in IPOs—as well as how many they received and at what price—on loose sheets of paper. He and his counterparts at other firms talk of calling multiple bankers on a deal to make sure their orders are recorded correctly. And then they wait. The morning after an IPO prices, a banker calls them, tells them how many shares they got, at what price, and what percentage of fees they owe to each of the dozen or so underwriters. It is up to Mr. Batory, or someone in his shoes, to keep track of it all.
This system is primed for errors. I would hazard a guess that this information is kept in an excel spreadsheet rather than on paper, but the point still stands. Most systems which rely on human beings are prone to errors.
So, naturally, an online solution to this has now been created.
Backed by Franklin Templeton, Fidelity Investments, Goldman Sachs Group Inc., JPMorgan Chase & Co. and Morgan Stanley, among others, [Capital Markets Gateway] was launched in 2017 by former bankers at Robert W. Baird & Co. …
When the system is up and running, buy-side firms—of which nearly 100 are signed up—will be able to see what deals are pricing when, what the terms are and digitally enter their orders with lead bankers, so long as they have an existing relationship with them.
Once IPOs and other offerings are priced, instead of waiting until the following morning to learn via a phone call if they received any allocation, fund managers can find out electronically that same evening.
So essentially, instead of an investment bank calling up investors and confirming their order volumes and managing allocations behind closed doors, it can be done online. Investors simply input how many shares they want, the system automatically allocates them, and the investor finds out their allocation the next day.
As Matt Levine identifies, this technological invention eliminates the need for an investment bank to intermediate.
If people call you up and say “I want to buy the stock” and you write down their names on a piece of paper and put it in your pocket, you can go to the client and say “I have a $10 billion book of demand for your stock,” and the client will be like “wow you are amazing, our hero, here’s a $20 million fee to pay for your expertise and hard work and market knowledge and investor relationships.” Whereas if people type their orders on a website and the client looks at the website and sees $10 billion of demand for the stock and you are standing next to the website looking important the client will say “could you move please, you’re blocking our view of the website.”
Of course, this is slightly oversimplified. Based on supply, demand, and the company's intrinsic valuation, the bank will need to appropriately price the shares (which, now that I think about it, can probably also be automated to an extent), but automating share allocation seems like a no brainer.
An On-Chain Alternative
Ok, so we've established that automating certain procedural elements of the investment banking workflow makes sense. Here's another interesting opportunity for automation: rethink the sales and trading desk altogether.
On a basic level, the Sales and Trading desk at an investment bank is responsible for dealing with commercial and institutional clients. This includes selling financial products, portfolio management, risk management, trading on behalf of clients, among other things.
The value-add of the investment bank is:
- Strong relationships with clients and diverse network of clients
- Providing access to the full suite of financial services offered by the bank
- Expertise in portfolio management
- Ability to get the 'best price' when executing trades on the client's behalf
There's no doubt that you or I could benefit from the portfolio management expertise of an investment bank.
Certain aspects of this value proposition are predicated on the bank's technology systems and its people's expertise. But let's examine #4 more closely.
When you log on to your stock brokerage account (e.g. IG Markets, CMC Markets, Robinhood etc.) and try to buy a stock, you'll see two different prices: the 'bid' price and the 'ask' price.
- Bid - the highest price somebody is willing to buy the stock for (e.g. $9.95)
- Ask - the lowest price somebody is willing to sell the stock for (e.g. $10.05)
This means that you can either buy the stock at $10.05 or if you own it, you can sell it at $9.95. The difference between the two is known as the spread.
The broker makes the spread.
- Part A puts in an order to buy 100 shares at $10.05
- Party B places an order to sell 100 shares at $9.95
- The market maker quickly nets out the transaction by transferring party B's shares to Party A and makes $0.10.
An intermediary such as an investment bank operates in a similar way. You order through them, they pass it on to a market maker, and both parties take a clip before you receive your shares.
My goal with this example was to highlight that the 'real' or 'best' available prices are unknown to most people. Most exchanges will have different spreads for the same financial product, and this difference is exacerbated in lower volume, smaller market capitalisation stocks and financial products.
There is also something called 'dark pools', which are private exchanges for trading securities that are not accessible to the average joe. Prices simply aren't transparent or verifiable. We trust reputable brokerages and market makers because they have fancy badges and accreditations from multiple different government regulators, but that's the extent of the verification.
I think that blockchains have the potential to revolutionise the concept of 'price discovery', and this will be one of the first major disruptors in blockchain technology.
Here's a little primer by Balaji Srinivasan (who coincidentally, Mark Carnegie also highly recommends to anybody interested in the space).
In blockchain, there's something called an oracle, which is used to bridge the gap between physical world information and blockchain ledgers.
The basic idea is that an oracle allows for validation and consensus verification of real-world data which can then be recorded on a blockchain without the need for a centralised source of information (i.e. CMC Markets). By aggregating a wide range of sources from all over the internet, oracles can 'discover' the true price of a financial product (i.e. the $10.01 above) and record it on an inalienable blockchain.
If oracles can effectively discover the true price of financial products, all investors are more likely to benefit from accurate and reliable pricing.
Obviously, this threatens margins for brokerages and the Sales and Trading desks at investment banks when it comes to order pricing. If the 'best' prices are available online on a blockchain for everybody to see, it eliminates the need for this function.
I'm interested to see how investment banks respond to the increasing equality of information worldwide. For many investment banking services, the value-add is their access to information, research, and relationships which are currently impossible for retail investors to access.
Above, we've seen that this allows investment banks to profit from (1) IPO book builds, and (2) trading financial products for customers at a better price than they would otherwise be able to access.
As information becomes more readily available, investment banks will need to re-think their value proposition. Value-add can no longer be an intangible, relationship-based concept which comes with a multi-million dollar price tag.
In my opinion, investment banks could take advantage of this change in a few ways:
- Establish early partnerships with blockchain protocols working on financial market price discovery. It's the same customer acquisition tactic that they already employ. Customers want to choose a brokerage with the best available spreads. If a broker is working directly with blockchain protocols to find the best available price, and the prices are clearly communicated, this adds value to a customer's trading experience.
- Optimise customer-facing online systems to provide access to the 'best' information. Information is empowerment. Part of the value-add for investment banks may be governed by how well they provide accurate information (this ties in with the first point).
- Forego Sales and Trading margins for customer growth. Blockchain-based price discovery is on the absolute vanguard of modern finance. First-movers will have a massive advantage in attracting new customers and poaching customers from other banks. Goldman Sachs is already doing this with its smart AI-powered investment advisor called Marcus.
- Establish Blockchain and Cryptocurrency advisory divisions. It appears that clients are becoming interested in cryptocurrency as an asset class and investment opportunity. However, the technology is foreign to most people, including sophisticated tech investors. Goldman Sachs Sydney recently forked its Financial Institutions Group division to create a Fintech team. As blockchain protocols require funding (from traditional institutions) and look towards M&A opportunities, I hope that investment banks will jump at the opportunity. There is a fascinating development in modern project financing through Decentralised Autonomous Organisations (DAOs) which has enabled blockchain projects to receive and allocate funding without the need for an intermediary, but I'll save that for another post. Since relationships are core to the value proposition of investment banks, I think there is an opportunity for banks to intermediate funding for blockchain protocols (at least before DAOs become mainstream) by building these relationships early.
Banks will need to identify tangible value in a world where information becomes more accurate and accessible. Otherwise, Mark Carnegie's prediction may become reality faster than we are willing to accept. Fortunately for the banks and brokerages, the best time to plant a tree is now, and there are a wealth of opportunities just around the corner.