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You may be tempted to think that investment banking and asset management are great ways to invest in the market recovery. In fact, there is incredible competition between firms and regulatory pressure to restrict the business functions that the same company can perform. It's not all roses in financial services.

In 2010, the five largest investment banks (by mergers and acquisitions deal volume) were Goldman Sachs (GS), JPMorgan Chase (JPM), Morgan Stanley (MS), Credit Suisse (CS), and Bank of America (BAC). Each of these companies is huge and faces competitive and regulatory pressures. There are many examples where these companies are downsizing or being forced out of old business lines. Investors should not just rush in and buy shares in investment banks.

Morgan Stanley to Cut Jobs from East

About 15% of employees working for Morgan Stanley in Asia may lose their jobs in a recent downsizing move expected to improve the company's performance. Equity underwriting in Asia (ex-Japan) has dropped to a four-year low, and Morgan Stanley has fallen in market share, becoming the fourth largest underwriter. The layoffs will affect investment bankers and other employees working in country offices, but global capital market offices and mergers and acquisitions are expected to take a hit. According to sources, "The cuts would involve 55 to 60 bankers in Asia-Pacific excluding Japan."

Another 1,600 Morgan Stanley employees are expected to lose their jobs in another round of global job cuts, half of which will happen in the U.S. The job cuts that will amount to about 6% of employees will include both bankers and support staff. Some Asian managing directors like Zhang Jianyong have already left the company. The staff can anticipate news about their bonuses any time from now, but the matter is still private, so sources cannot be identified.

Other banks that are expected to lay off staff include Citigroup (C) and UBS (UBS). Both will see about 10,000 employees sent home, with Citigroup exiting from emerging markets and UBS majorly pulling out of fixed-income trading.

Swaps to be Traded on Exchanges, Not Just by Brokers

Top brokers who have previously dominated the swaps market will see about a third of their revenues in jeopardy if the legislation to trade swaps on exchanges is passed. Swaps are financial instruments that help traders hedge against interest and foreign exchange rates. The swaps market is worth about $640 trillion, and top brokers have managed to rake in about 33% of their revenues by matching buyers and sellers in the over-the-counter trades. The new swaps law enshrined in the Dodd-Frank Act will have brokers compete in open exchanges with other investors, and the trades will have stricter regulations.

Aite Group's senior analyst, Simmy Grewal, indicated that top brokers would be at risk if the swaps regulations were passed. According to Grewal:

The exchanges are huge with deep pockets and they are not the types of companies you'd want invading your space.

Trading swaps on exchanges will be a move aimed to promote transparency and effective regulation. The Dodd-Frank Act will see about a half of the swaps industry moved to exchanges, and this will obviously reshape the industry. The new law is also expected to protect the financial system from challenges that resulted from the crumble of Lehman Brothers, a leading swaps trader.

The swaps market is about twenty five times greater than the futures market, but analysts at Morgan Stanley predicted a preference for futures on the exchanges if Dodd-Frank is passed. According to the analysts:

The greater certainty in the futures model...will favor futures over swaps leading to cannibalization of the swaps market.

The Commodity Futures Trading Commission [CFTC] requires that companies whose dealings in swaps exceed $8 billion will have to register as swaps dealers, and with the increased collateral and capital requirements that result, some traders may switch to futures. The CFTC intends to introduce two new types of regulated markets: Designated Contract Markets (DCMs) to offer swap-like futures at the exchanges, and Swap Execution Facilities (SEFs) for brokers to trade in swaps.

Top swaps brokers, including ICAP and Tradition, are trying to stay relevant in the swaps business with trading platforms like i-Swap and Trad-X respectively. ICAP's boss, Michael Spencer, indicated that they would work to ensure that the business survives even after the Dodd-Frank Act is passed. According to Spencer:

In terms of regulation, some parts are better crafted than others, but we are where we are and we have to make sure ICAP is well positioned.

Ex-Bankers Pushed to Hedge Funds

The unimpressive performance of hedge funds and doubts of where to get capital funding does not seem to deter professionals from turning away from banks to venture into the hedge fund industry. Traders in search of better pay or those who have lost their jobs at investment banks are set to give the hedge fund industry a try in a wave of new launches in the next year. This push is also accelerated by rules banning all banks, including those with subsidiaries in the United States of America, from proprietary trading. The Dodd-Frank bill, which incorporated bans on proprietary trading due to their systemic risks, has undermined the potentially profitable venture for banks that have struggled for profitability since the financial crisis.

Tougher regulations and weak deal making have forced cost-cutting layoffs. Investment banks across the globe slashed hundreds of thousands of jobs since the market peak in 2007. This, coupled with dwindling profitability, has also put banks under pressure to cut bonuses and benefits, reducing the incentive to stay on with the promise of a more lucrative job elsewhere.

The question of whether the start-up hedge funds will be able to raise sufficient investment capital cannot be dismissed. The bulk of the money flowing into hedge funds since the financial crisis has mainly gone straight to the biggest names while start-up hedge funds have generally struggled. Of the biggest new ventures that have failed to make their backers money include one of the most hyped launches since the financial crisis, Edoma Partners, which has since been hit by poor returns and investor exits, and it is set to shut down after barely two years in business.

However, expectations are that the coming year will herald more start-ups in credit -one of the top-performing and most popular sectors in 2012 - since many of the big ones so far have focused on trading equities. Research indicates that the average credit hedge fund is up about 9% this year. This is more than the average hedge fund's 4%. With the Volcker rule's 2014 deadline for banks to comply nearing, many banks will now have to make big cuts, meaning several new launch attempts in the first quarter of next year. According to a portfolio manager at BlackRock, David Barenborg:

If you consider what's going on for banks at the moment from a compensation point of view, plus the increase in regulation and impediments to expressing risk, then working at a hedge fund looks like a compelling option at the moment.

Investing in big investment banks is not as simple as slam-dunk. There are strong forces facing these firms even as the stock market rallies.

Source: Investment Banks Face Challenges In 2013