From the desk of John Arnesen,
Consulting Lead, Pierpoint Financial
A month ago, I read Securities Finance Times, issue 276 that reported on first-quarter revenue for those service providers that report such data publicly. I was less interested in the Q1 year-on-year comparisons, given what was going on last year, but I was astonished, possibly even shocked, by the range of revenue posted and by whom. I have to assume all figure quoted in the article refer to net fees, i.e. revenue generation, after any compensation paid to beneficial owners or other parties. Unfortunately, JP Morgan was absent from these figure as it is my expectation that the massive agent lender programmes run by JPM, BNY Mellon and State Street, would dominate a list of Q1 2020 earning tables, but that isn't the case.
Blackrock posted $127mm in Q1, State Street $99mm, and BNY Mellon $41mm. How does State Street manage to post more than twice the revenue of BNY Mellon? If it is a like-for-like comparison and includes revenue from principal activity, the data is becoming less comparable over time. Either way, this is nothing, nor is Blackrock's stellar performance, as here comes the Leeroy Jenkins of securities finance in the form of Charles Schwab that posted $204mm in revenue! That is a tremendous amount of revenue by any standards. Admittedly, the acquisition of TD Ameritrade in 2020 had a lot to do with this, but that isn't the point. Retail-driven securities lending programmes dominate revenue generation over the traditional agency lending programmes run by custodial, third-party and direct lenders. Now admittedly, this isn't a like-for-like comparison as the Charles Schwab figure doesn't distinguish between fully paid-for and margin lending, and despite my digging around, I couldn't find figures for E*Trade or Fidelity, and it's not clear whether Freetrade has a lending facility. Notwithstanding this, retail investors are a force to be reckoned with, and if mobilised to embrace lending en masse, they could add liquidity to stocks that currently lack it while generating a return for themselves and the retail brokerages that service them.
I don't think I was alone in viewing the events in January around GameStop and AMC as an aberration, centred around a single mission to punish short-sellers and 'stick-it-to-the-man'. Upon reflection, that was too crude an assessment of the situation, and it's unlikely it will prove to be a one-off event. I now think it was a defining moment in what several fintechs refer to as the democratisation of finance. Robinhood makes this a prominent tagline on its website, but the concept of bringing the capital markets to the man-in-the-street is not new, particularly in the US.
After the second world war, Charles Merrill set out to educate Americans on what they needed to know to invest with confidence and even took out ads in the New York Times and published pamphlets on financial terms and practices. Yet, despite his efforts and even opening branches of Merrill Lynch in other regions, only a tiny proportion of citizens owned stocks in the 1950s. This didn't change significantly until the late 1960s, boosted by economic output and as a countermeasure to the existential threat of communism by investing in American businesses. By 1970, 30 million Americans were shareholders. In 2020, a Gallup Poll reported that 55% of Americans own stock in some form. That leaves much room for expansion, and the rise of the likes of Robinhood and other easy-to-use apps and platforms is indeed making this possible. So while the increase of securities ownership may not be entirely new, technology development has made it ridiculously easy to buy and sell stock, literally within minutes. That led to an explosion in daily trades in the first three quarters of 2020 to a 75% increase for a total average of six million, as reported by E*Trade, TD Ameritrade and Charles Schwab. Robinhood alone opened three million new accounts in Q1 last year, and 50% were first-time traders. No doubt, many of these neophyte investors were enabled by the technology-driven access to fractional share ownership.
On the face of it, it's hard to object to more people, especially youngsters having access to investment and trading opportunities regardless of whether their motivation is born out of an anti-establishment view of finance and out to get those fat-cat hedge fund types. GameStop was an extraordinary event and demonstrated what can happen when highly motivated people don't necessarily have profit as a primary driver. It would be arrogant to suggest retail investors should be protected from themselves and not have the same access as professionals. I believe they should be allowed to lose money like anyone else. That is not to say that these apps do not have a responsibility to ensure they don't encourage or reward excessive margin or options trading or make information unclear. That is one for regulators to work out and would seem to be consistent with long-running efforts to discourage portfolio churning by advisors.
In some regions of the world, retail investors make up a high percentage of investment activity, and their access to markets is well developed and increasing. This is particularly true of South Korea, where, as of May 2021, short-selling is now available to retail investors. In true pan-Asian fashion, it comes with limitations, but equally, some practical and sensible requirements. Retail investors keen to short the market will be required to complete a pre-learning and mock trading examination. Securities lending documentation will need signing, and then a further distinction will be made based on one's level of experience. A novice will be restricted to a maximum of $27k, a limit of $63k will apply to those who have shorted the market five times or more in the past and have borrowed a total of $45k of stock in the past, while an unlimited amount can be sold short after two years for those deemed to be professional investors.
Does this seem a reasonable way to extend investing to the masses while requiring some demonstrable measure of competence, and should we follow this as an example and make it accessible in all developed markets? Why can't we do something similar in the west?
Given the millions of new accounts opened at Robinhood, E*Trade and Fidelity since the start of the pandemic, retail investors are an emerging force to be reckoned with, and when emboldened by forums on sites such as Reddit, can affect prices in a very material way. Is this sustainable? Has the lockdown, boredom and stimulus money led to this frenzy? Once the cheques stop, we will know whether it was a simple as this. I suspect not.
Retail investor supply is invaluable to hedge funds, given that the individual stocks they buy are less index-orientated and has a higher probability of becoming special. The chart below is a good proxy for how few deep specials there actually are: $22bn represents 0.000011% of outstanding balances. Despite this modest value, it still represents at least $1.1bn in fees or over 10% of annual revenue.
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