The biggest overhaul of financial regulation since the 1930s is creating one of the largest sources of revenue growth for JPMorgan Chase & Co. (JPM:US), according to managing director Carlos Hernandez.
The bank said it expects the investor-services unit, one of three parts of the corporate and investment bank, to boost return on equity by about 4 percentage points in coming years as the firm helps customers comply with rules governing how swaps trades are executed, collateralized and cleared. That compares with drops of about 2 percentage points in the CIB’s banking section and 3 percentage points for the markets unit.
“The secular trend for these clients is the constant need to reduce execution costs,” Hernandez, global head of investor services, said in an interview at his office in New York. “It’s creating pressure from our clients to become more efficient.”
The swaps market is being regulated for the first time after some contracts helped to amplify the credit crisis and made it more difficult for international regulators to know how interconnected banks had become following the 2008 failure of Lehman Brothers Holdings Inc. Mandatory swaps clearing begins March 11 for dealers including JPMorgan and their largest customers.
The rules may cost JPMorgan $1 billion to $2 billion in revenue, according to a Feb. 26 presentation. To reduce this loss, the fees it can charge customers to help them trade, clear and collateralize swaps may produce new revenue of $300 million to $500 million by 2015, the bank said.
“There will be other parts of the house that are impacted,” such as the swaps-trading desks that will see compression in bid-offer spreads, Hernandez said, referring to the difference in what the bank charges to buy and sell a swap. “The headwinds in some businesses are the tailwinds for our investor-services business.”
JPMorgan earned $5 billion in 2008 trading over-the-counter fixed-income derivatives, including swaps, as the collapse of Lehman Brother Holdings Inc. that year widened bid-ask spreads.
Those days are unlikely to return as rules meant to add transparency to swaps prices allow investors to know levels at which derivatives are trading before they buy or sell.
Standardizing contract terms so they can be processed by clearinghouses and requiring trades to be done on regulated exchanges or similar systems will further cut dealer profits by more closely aligning trading with the futures market, where banks earn smaller fees for executing and clearing trades for clients.
Hernandez’s group will offer trade execution, collateral management, clearing services, prime brokerage and fund financing and administration, he said. The unit acts only as an agent for its clients and doesn’t trade directly with them, Hernandez said.
“I tell everybody it’s like flying a plane with one passenger or 200 passengers,” he said. “Because of the fixed costs associated with an airplane, the marginal cost of those 199 people is low.”
The Dodd-Frank Act is requiring most swaps trades in the U.S. to be backed by clearinghouses, which require upfront collateral. Global bank regulations are compelling lenders to keep more cash and easy-to-liquidate investments on hand to protect against losses. That may boost demand for high-grade assets by $2 trillion to $4 trillion, according to an April 2012 report from the International Monetary Fund.
As much as $6.7 trillion in additional collateral may be needed to satisfy new bank capital rules and swaps-clearing mandates, securities-industry consultant Finadium LLC said in December.
Scarcity of cost-effective assets to back swaps trades has led some market users to engage in so-called collateral transformation, in which lower-rated securities are exchanged for cash or highly rated securities. The extent of that transformation will depend on whether banks and money managers believe too few assets are available to cover their swaps positions, Finadium said.
Fees for collateral transformation are included in the $300 million to $500 million revenue estimate JPMorgan made last month.
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