Tier 1 FX dealer HSBC changes entire business model as times get tough

HSBC’s radical change of business model and desire to shrink its commercial size demonstrates another move closer to the FX trading core business activity by Tier 1 banks

HSBC has announced plans to overhaul its business model and accelerate a sweeping programme of cuts to slash costs and shrink its size.

Announcing the plans alongside its third-quarter earnings, HSBC signaled plans to flip its main source of income from interest rates to fee-based businesses.

This represents a milestone in Tier 1 banking, as it is not every day that a large, long established institution makes a complete change to the method by which one of its core business areas is capitalized.

HSBC said it would consider paying a “conservative” dividend following its better-than-expected performance in the third quarter.

The bank cancelled its dividend for the first time in 74 years following pressure from the Bank of England for lenders to scrap payouts in the face of the disruption caused by Covid-19.

This represents another allusion to concentration on FX dealing rather than retail and commercial banking business, as HSBC, like many other Tier 1 institutions, fully understands that market making and FX dealing represents participation in a huge, $5 trillion per day global market, and being at the top tier of it. This means considerable return, and without the real estate, staff and logistical cost of doing labor intensive high street banking with individual customers of small value.

Indeed, moving toward a fee-based business is an alignment with the trading world, where commissions and fees are charged instead of interest on loans, and paying interest on savings which were traditionally traded by banks.

In August this year, FinanceFeeds reported that HSBC’s profit after tax fell 69% year-on-year to $3.1 billion and that profit before tax was down 65% to $4.3 billion due to increase in expected credit losses and other credit impairment charges (‘ECL’) and lower revenue. Reported profit in the first half of 2020 also included a $1.2 billion impairment of software intangibles, mainly in Europe.

In Asia, HSBC reported profit before tax of $7.4 billion for the first half of 2020 in the face of higher ECL. Higher ECL charges materially impacted profitability in HSBC’s markets across the rest of the world, notably in its operations throughout Europe.

Reported revenue was down 9% from a year earlier to $26.7 billion, reflecting the impact of interest rate reductions, as well as adverse market impacts in life insurance manufacturing and adverse valuation adjustments in Global Banking and Markets (‘GBM’), notably in the first quarter of 2020. These factors more than offset higher revenue in Global Markets. Reported ECL increased by $5.7 billion to $6.9 billion due to the impact of the Covid-19 outbreak and the forward economic outlook, and due to an increase in charges related to specific wholesale customers.

During recent years, analysts have been bearing down on major banks, saying that their retail entities are shrinking. This is absolutely the wrong way to look at it as liquid markets such as FX, centralization, technology and electronic trading are the future, and today’s viewpoints from within are no exception.

In England, which is home to the largest investment banks in the world, all nestling on the docklands at Canary Wharf, handling over 60% of global FX trading volume at Tier 1 level, retail banking has become a thorn in the side of most of the trading sector’s giants.

Small towns are the places to look for evidence. Four years ago Ware, in Hertfordshire, about 30 miles north of Central London, was a bustling market town with half a dozen banks serving the 19,000-strong community, however the banks have fallen like dominoes. First HSBC, then NatWest, Santander and Lloyds. Then, during lockdown, Barclays shut up shop while the final bank in town, TSB, has ‘temporarily closed’ its branch. The result? Not one bank in town.

All of these firms have significant Tier 1 dealing interests globally, especially Barclays with its BARX single dealer platform, HSBC with international interests from the UK to Hong Kong, and NatWest, whose NatWest Markets division is the prime brokerage division of RBS, one of the world’s largest FX dealers.

This dynamic is not new of course, and FinanceFeeds has explained in detail the reasons why banks would rather concentrate on their core business as a more efficient method of generating revenue than retail branch banking with its low returns, high risks and massive operating costs.

Former bank executive and founder of the Campaign for Community Banking Services Derek French today stated “The devastating loss of banking services in Ware reflects a plague sweeping across the nation – which all communities must now fight against.”

“Our high streets are increasingly being blighted by empty and deteriorating former bank branches – as you find in this once thriving Hertfordshire town” said Mr French,

“We can expect many temporarily closed branches to shut permanently over the coming months and I anticipate that other branches will follow suit and close for good” he said.

Yes, however why fight against it? Retail banking customers no longer really need to go into a branch, and such real estate-heavy, wage-heavy and logistically difficult operations are becoming non viable for small margin products such as retail loans and accounts.

Back in 2016, Britain’s financial giant HSBC removed 1,600 U.S. locations, including its subprime-lending business, and closed more than 500 branches in the United Kingdom, and Citigroup has sold or shut more than 1,300 U.S. branches in the past fifteen years, including its consumer-lending network, to concentrate on major cities.

What is difficult to comprehend here is not the actual figures involved or the corporate decision to reduce the number of retail outlets, downsize human resources, and move the focus away from resource and service-hungry retail banking but why this is being regarded as a negative matter.

Retail banking in its traditional format, via branches, is expensive and somewhat obsolete. It costs a fortune to rent or purchase premises, is time consuming and human-resource hungry and when considering the core business which is taking deposits from customers to lend out to other retail customers at small amounts and low interest, is a very marginal business indeed.

Compare that to the interbank electronic trading which is conducted by the same firms – both leaders in this industry, with number 1 FX dealer Citigroup processing 16.3% of all global FX electronic order flow for the entire world from one office in Canary Wharf, with no network of branches needed for this activity, and HSBC being the largest corporate FX dealer in the world, and its overall market share being 5.4% making it the 7th largest handler of FX order flow in the world, all conducted from its Canary Wharf site.

Between the two banks, over a fifth of the daily $5.5 trillion notional volume is being handled and processed.

This is the real core business of these banks, not retail banking with physical branches, which has become a dinosaur.

In 2015, Citigroup had just 812 operational branches, whereas in pre-financial crisis 2007, the firm had 2,183 branches operational.

When looking at the divisions that it is no longer concentrating on, it is high risk and low profitability efforts such as sub prime lending.

FX is a liquid and highly profitable business with very low operating costs for a large bank. There is no need for a branch network, and no need for customer facing facilities to deal with small accounts which have low interest or to provide small, high risk loans.

Despite the high risk category that Citigroup places the extension of credit to OTC derivatives firms, the bank having stated this year that it expects a 56% default rate on OTC derivatives credit, this perspective itself creating a counterparty credit risk issue for prime of prime brokerages and subsequently the entire FX industry in that it is becoming very difficult to gain credit, the banks would still rather focus on the much more profitable electronic trading sector than high street retail banking.

The leading banks have also created a degree of animosity by their own attitude to the non-bank FX world.

Yes, they make their money from trading, largely due to non-bank OTC derivatives firms sending trades to them for execution at Tier 1 market maker level, however have been in the past relatively hostile toward OTC derivatives firms in so far as ruling them out of having a client fund bank account for the purposes of custodianship of margin capital for trading.

So yes, they wanted to risk manage by saying that OTC firms have a high risk of default rate when extending counterparty credit, and that they are a high risk in terms of client money accounts, yet want to have their cake and eat it by concentrating on Tier 1 FX dealing.

This status quo has gone on for a few years, and has resulted in OTC liquidity takers finding alternative sources, placing non-bank market makers such as XTX and Citadel Securities at the top of the market share tree last year for the first time in history.

London’s banking sector is plate glass, ultra-modern and handles the lion’s share of all interbank Tier 1 FX order flow for the entire world. Citi and HSBC along with the other London banks work closely with prime of prime brokerages which then provide via ever-evolving and often in house technology, aggregated liquidity feeds to the astute and urbane brokerages of the City.

The retail, non-London centric, customer-facing mainstay of the exact same banks that handle, with great levels of sophistication and technological advancement, retail customers with ordinary products such as mortgages, current accounts and business banking facilities.

I conducted some research into the dichotomy between the electronic trading mainstays of London and New York for interbank dealers, and the retail entities of the same banks just two weeks ago in provincial England.

The dichotomy is so vast and the gulf is so wide, that even though these retail outlets are part of the same companies that we all hold in such high esteem, they are unrecognizable as part of a modern financial markets structure.

My findings were somewhat astonishing

In modern banking in many nations, a simple task can be performed over the counter, within just a few minutes as long as the relevant customer documents are presented but not in England’s high street branches.

You want to open a business account with a major, multi-billion pound British bank? Be prepared to wait up to three weeks to make a physical appointment with a business manager.

HSBC, which is a giant with electronic trading presence in London, Hong Kong and mainland China, has retail branches on every street in every town, the length and breadth of the land. I made research to see what is needed to open a simple business account, with no credit facilities. It is nigh on impossible.

Instead of being greeted with an experienced staff member who can explain how this very straight forward, everyday task can be carried out, I was confronted with “we don’t, we can’t, it isn’t” and many other negatives. The representative, who had very little knowledge of business banking, explained that any applicant needs to see a business manager, who only visits the branch once a week.

This pattern proliferates across many rival banks. RBS and Barclays, both vast institutions, Barclays being the world’s 4th largest FX dealer with 8.45% of global FX market share, were equally negative and operated a similar manual system in which an actual account manager needs to visit in order to conduct an application, a process that could take several weeks.

This is not only completely outmoded practice, as many banks in many modern nations with developed financial markets and technology sectors will be able to conduct this simple procedure on the spot, with the client walking away with an account number and internet banking log in credentials, but it is also very expensive for both the customer and the bank itself.

Customers, especially those with businesses, have to spend almost a day going to an appointment, which could be several weeks after inception of their business, which is a day lost, and a day lost for a senior executive is expensive.

This is also expensive for banks. Banks do not make the majority of their profit from retail current and business accounts, however the practice of form-filling in branches with human resources, and having to make appointments for a business manager that travels between branches in a company car, whilst not seeing customers during the traveling period, is a massive cost, and is resource and time hungry.

Thus retail banking in its traditional form is a legacy industry, which is why it is surprising that any analysts with a modicum of experience or common sense find this downsizing of retail business and concentration on centralized institutional electronic business to be anything newsworthy.

Citigroup’s corporate focus bears this out.

Fourteen years ago in 2006, Citigroup’s retail consumer banking made up 55% of its entire profits – despite the fact that even back then it was the world’s largest FX dealer. today, it is less than 30% of the bank’s entire profit.

Corporate and investment banking, part of which encompasses the bank trading desks of Canary Wharf, accounted for 33% of profit in 2006 but today represents 61%.

HSBC has gone down a similar path. Corporate and investment banking at HSBC now accounts for 75% of the entire business’s profit, whereas it was just 53% 10 years ago and the bank has scaled back its retail banking in that it now accounts for 23% of profit whereas 10 years ago it was 42%.

So no more 100% mortgages, low interest loans and risky pre-financial crisis retail business which cost the banks a fortune.

Instead, the centralizing of retail and small business banking onto online accounts with no branch and a central call center is gradually taking the place of branches.

Corn Street in Bristol, one of the world’s very first commodity trading and financial markets centers – its name coming from the corn trading stones in the City’s merchant era was home to some of the world’s largest retail and commercial banks. Today they are mostly fashionable bars and pubs, with evocative names such as “The Corn Exchange”, “The Commercial Rooms” or “The Old Bank” but it is clear that a glass of locally brewed Butcombe beer is more profitable than a low interest current account, ironically served to Bristol’s financial markets executives whose business is now conducted completely electronically.

In the same city, Hargreaves Lansdown, a £6 billion company, is a case in point. Hargreaves Lansdown has no branches at all, yet it is the UK’s largest financial services firm, providing clients with the Vantage platform, a proprietary technology which allows customers to manage their entire portfolio from one platform, including FX trading and CFDs via HL Markets, the firm’s white label solution from IG Group.

In the 1980s, Hargreaves Lansdown was a small independent pensions and life assurance brokerage in Clifton, which referred business to insurance firms and large banks in their retail business. Now the tables have turned.

The future for the large banks is investment banking, investment in Fintech such as blockchain technology that automates previously resource hungry activities such as ledger, and electronic trading, largely FX, by providing Tier 1 feeds to prime of prime brokerages.

Quite clearly, the Millennials will wonder what a branch of a bank is. They will never have to be confronted by dejected staff who know that the dinosaur effect has set in, and it is worthy of note that the lobbyists for keeping branches open are silver haired and past retirement.

Instead they will manage their retail banking online, and probably frequent what used to be a bank branch during evenings out to enjoy nouvelle cuisine and cocktails served on the counter which was once a bank teller’s desk, before returning to their positions the next day in electronic markets or FinTech development.

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