John Walsh looks at the challenges facing the Irish stockbroking industry as a result of the downturn.
The stockbroking industry in Ireland expanded at an unprecedented rate in the boom years. But now, it has been hit by a triple whammy: shrinking volumes, commissions and a market that is now over-broked. There is inevitably going to be consolidation but which firm(s) will be left standing? Moreover, senior industry figures claim that regulatory reforms are needed to bring the sector up to best international practice.
One thing is for certain, however, until there is a sharp turnaround in the international investment landscape, the future of the Irish market will remain very uncertain.
In the staid world of Irish stockbroking up until the early 1990s, the scene was mostly about wealth preservation for a limited pool of high net worth individuals. There was a limited amount of corporate finance activities and initial public offerings (IPOs) were not a regular feature of the domestic landscape.
But from the early 1990s until the collapse of the Iseq and the implosion of banking shares at the end of 2007, it was a boom period for Irish stockbroking firms. Irish shares and the Iseq index provided lucrative returns for domestic and international investors. Corporate finance departments were kept busy with a steady pipeline of IPOs, mergers and acquisitions, and a good flow of advisory services.
The private client departments were able to mine the growing numbers of high net worth individuals for business.
But the Iseq has seen a precipitous drop over the past three years. In February 2007, the index hit a gravity-defying 10,000. It has been hovering around 3,000 for the past two years. Moreover, not only has the volume of trades dropped, but the margins on institutional trades have contracted. Three years ago, the margins averaged between 30-35 basis points. Now they are down to 15 basis points.
The Dublin broking community has also been badly affected by the destruction in wealth across both the private and corporate sectors. High net worth individuals have been haemorrhaging cash on the back of falling markets. Much more damaging has been the collapse in property values.
There was a clamour towards highly leveraged syndicated property deals. The glass-bottle site in Ringsend is a case in point. Davy Stockbrokers organised a consortium of investors to back property developer Bernard McNamara’s 41% stake of the €412m site. It is now valued at €60m which has left investors nursing heavy losses. But the glass-bottle site is only one of many property deals both in Ireland and abroad which have lost significant amounts in value. Consequently, brokers’ private client departments have been badly affected.
The cheap credit of most of the past decade fuelled a merger and acquisition frenzy among Irish corporates. Very often, property was at the centre of these deals as companies tried to hive off and monetise their property assets. There was a slew of IPOs as corporates cashed in on buoyant capital market conditions. Again, there has been a sharp tail off in both of these activities over the past few years.
To borrow a phrase from the current Minister for Finance Brian Lenihan, it all came to a shuddering halt towards the end of 2007.
Fanning the flames?
That there was a massive speculative bubble in the economy which burst with disastrous consequences is not in doubt. The banks have come in the firing line for stoking much of this bubble. Irish Nationwide and Anglo Irish Bank, in particular, were guilty of indiscriminately doling out loans which triggered an unsustainable rise in asset prices.
But what role did stockbroking firms play in fanning the flames of the bubble? A senior investment figure claims that Irish stockbrokers are just as culpable as the banks. “What really screwed the economy was short-termism. Investment strategies were based around ramping up returns over as short a time-frame as possible.”
The investment source, who didn’t want to be named, says that the use of CFDs [contracts for difference] created a culture of speculation rather than encouraging long-term investment strategies. Moreover, there was an excessive amount of leverage going into property deals. These strategies were sound when the markets were going in the right direction but when they turned, the losses shipped were horrendous.
CFDs are highly leveraged instruments which allow an investor to take a position on an underlying asset by stumping up a margin. The upside if the market moves in the right direction far outstrips an ordinary punt on equities. But if the market moves in the opposite direction, then the losses are proportionate to the amount of leverage in the deal. In late 2006 and early 2007, roughly one-third of the trades on the Iseq were in the form of CFDs which the investment source blames for the accelerated downturn of the Irish market when the credit crisis kicked in.
But a senior figure in one of the stockbroking firms says the effects of CFDs on the Irish market have been exaggerated. “The CFD argument is a fallacy. A CFD is indeed a highly leveraged product which is, in turn, buying a leveraged product because ordinary shares are leveraged. But if there was a margin call, then the investor had to pay up the next day so CFDs came to a head very quickly. The damage was done in property.
“At least with CFDs, the cheque had to be written the next day and positions closed out. The ability to do damage is the ability to write cheques. If there is a bank lending money to operate cheques, then that is a different matter. People got damaged doing CFDs because they were poor traders. The idea that brokers were pushing CFDs is off the wall.”
The broker argues that only non-advisory investors had access to CFDs. “We were reluctant to get into CFDs but there were customers clamouring for them. If we didn’t do it, then they would have gone to another broker.”
In view of the magnitude of losses shipped by investors, it was perhaps inevitable that legal action would ensue. Bloxham Stockbrokers is mired in ongoing legal action on bonds it sold to Irish investors including the Sisters of Charity of Jesus and Mary. Davy Stockbrokers has already settled a case with the league of Credit Unions again on action taken by the latter again on a bond product.
There has been speculation for some time in the Dublin investment community that a number of high net worth individuals had been consulting law firms with a view to taking legal action. The basis of this legal action would hinge on the amount of leveraged/risky products contained in an investor’s portfolio and the quality of the advice given by the stockbroker.
But militating against these types of cases is the complexity of proceedings. The burden of proof is very high. Moreover, legal action could be lengthy and extremely expensive for the losing party. Many high net worth individuals have been wiped out and are not in the position to risk losing a case. Law firms are unwilling to take on pro bono cases because of the level of resources it would take without any guarantee of success.
“The firm I work for has been contacted by a few high net worth investors who have been badly burned. They blame the brokers. So far no action has been taken. But if there is a successful case, then that could open the floodgates,” says a lawyer connected to one of the big firms in Dublin.
Future of broking
There has been a considerable amount of management buy-out activity among Irish brokerages over the past decade. But Merrion Capital is the only firm taken over by a foreign outfit, the Icelandic Landsbanki in 2006 which paid €90m for 84% of the company. Merrion’s management bought the firm back in November 2008 for €30m.
The Dublin-based investment source says that the Irish brokers are based mostly on a transaction-based model rather than the international norm of an annuity/fee-based model.
The difference between the two is that a transaction-based model generates much greater income because it charges per transaction rather than taking an annual fee for managing a client’s capital. But annuity models are seen as a much more lucrative investment because they deliver much greater returns over the longer term.
The UK’s Financial Services Authority (FSA) is putting together legislation that would require stockbroking firms to secure the vast bulk of their income from an annuity model.“Under Mifid [Markets in Financial Instruments Directive] there is a much greater push for transparency in fees anyway. But all Irish brokers are a mixture of fee-based and transaction-based. And in all fairness, most of the transaction costs would be 1-1.5% and maybe 2% for certain products. But it is not as if they are 8-9% and loaded into the first year’s premium. There would definitely be a case to answer in those circumstances. But what happens in the UK will definitely impact here, so there will be a move to annuity-type business,” says the broker.
Perhaps more seriously, accusations have been levelled against Irish broking firms that they do not follow best practise and do not always work in the interests of their clients. Specifically that there isn’t enough independence between the private client and institutional departments of the business. So for example, if a buy or sell order is made through the private-client division, it goes straight to the institutional side of the business. Consequently, the best price is not always achieved.
“I have heard these allegations and it is nothing more than pub talk,” says the senior stockbroking source. “The simple fact of the matter is that private client and the institutional sides of the business are managed separately. It is a requirement under Mifid, that we get the best price for our clients, so that allegation is absolutely not the case.”
In any sector which is characterised by a shrinking pipeline of business, there is inevitably a wave of consolidation. The Fexco takeover of Goodbody Stockbrokers had not been completed at the time of going to print. The price is believed to be in the region of €25m. AIB bought Goodbody 20 years ago for IR£27m. Goodbodys will seek about 55 redundancies following the takeover.
The management of Davy Stockbrokers bought the company from Bank of Ireland in the last quarter of 2006 for €340m. The price reflected top of the market conditions. When the downturn happened, there were plenty of pundits lining up to call time on Ireland’s largest stockbroker. The argument was that the firm had become too heavily leveraged.
But the decision to keep its bond desk during the boom years has paid off. It is the only primary dealer in the country, which has generated a healthy revenue stream on the back of Government issuances. Moreover, its figures were buoyed by the Bank of Ireland and CRH rights issues.
Nevertheless it has made roughly 90 redundancies since 2008. A company spokesperson says no further redundancies are planned. Davy doesn’t disclose its trading figures. “Our balance sheet is strong and we are well within our banking covenants,” says a company spokesperson. In view of the levels of debt it is carrying, it is unlikely to be a takeover target. But it is unlikely that it would meet the capital requirements needed to take over another broker.
Merrion Capital looked as if it would exit most stockbroking activities apart from corporate finance when John Conroy took over the firm earlier this year. But the firm has retained its institutional equities and wealth management divisions.
NCB’s largest shareholder is Sean Quinn. In view of the troubles at Quinn Insurance and the other parts of his business, there is speculation that this will have implications for his stake in NCB.
“On Thursday, August 11th, only 17 stocks on the Iseq saw over €1m worth of shares traded. In contrast to the UK FTSE, 100 saw north of £1bn shares traded. With the pool of available commission shrinking and competition intensifying, the future for Irish broking is likely to involve a sharply reduced number of players whose focus will switch from being an Irish “local broker” to ones which offer a service in the Irish names coupled with the more liquid UK and European stocks to bring home the bacon,” says another broker.