Stormy waters

This article appears in the Oct. 2022 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.

The second quarter of 2022 was bleak for the investment dealer business, but the retail brokerage segment demonstrated surprising resilience despite accumulating headwinds.

The latest data from the Investment Industry Association of Canada (IIAC) shows that overall industry operating revenue fell by 9.9% and operating profit dropped by more than 20% in Q2. That coincided with the U.S.equities market entering bear territory and the S&P/TSX composite index finishing down by 14.5% for the quarter.

ETF assets dropped by $58.2 billion in the first half of the year, while mutual fund assets under management (AUM) were down by almost $300 billion — more than the entire ETF industry, which reported $288.9 billion in AUM at mid-year.

Yet the IIAC data showed that weakness was primarily concentrated in the large, integrated dealers (including the bank-owned firms) that were hit by a drop in investment-banking activity, as well as the institutional boutiques. The retail segment held up surprisingly well, offsetting lower fee and commission revenue with higher net interest revenue.

At the integrated dealers, operating revenue was down by 11.6% in the second quarter, and profit dropped by around 23%. The institutional boutiques suffered more, with their revenue dropping by 17.8% and operating profit down by 29.9%. Net profit held up better, however, declining by just 2.7%.

The contrast with the retail sector is striking. In the second quarter, operating revenue for retail firms overall was down by just 1.2% and, with expenses down by 1.5%, profit actually increased. Operating profit rose by 16.1% in the quarter to $215 million, and net profit was up by 37.0%.

Full-service firms led the retail segment. According to the IIAC’s data, revenue was down by just 0.3% for full-service retail firms in Q2, and profit jumped by 24.1% to $150 million quarter over quarter. While Q2 profit was down somewhat from the corresponding quarter last year, it remained well ahead of the full-service retail sector’s pre-pandemic performance. In Q2 2019, firms reported $106 million in operating profit.

This year, the full-service retail sector’s increase in operating profit came as operating expenses fell by 1.8%, outpacing the slowdown in revenue. Net profit also jumped by 50.6% quarter over quarter.

The retail introducers didn’t fare quite as well as the self-clearing firms. Operating revenue for the introducers was down by 2.7% in Q2, and profit was essentially flat (up by 1.1%). However, as with the full-service firms, the retail introducing firms’ profits were well ahead of their pre-pandemic levels, with profit for Q2 2022 up by about 37.5% from the same quarter in 2019.

This resilience reflects a trend that has emerged in recent years. From 2009 through 2017, the retail brokerage segment accounted for less than 5% of the investment industry’s total operating profit on average. That began climbing in the years before the pandemic hit and has continued to gain traction over the past couple of years despite unusual market conditions. Indeed, for the past year, the retail segment has accounted for 11% of overall industry operating profit, more than double its share since the financial crisis.

Amid this year’s market turmoil, the retail brokerage segment has outperformed the integrated dealers and the industry overall for a couple of reasons. For one, the retail segment hasn’t been as hard hit by the drop in investment-banking activity that materialized this year, given the heightened economic uncertainty.

According to data from TMX Group Ltd., equity financing activity in June was down by 67% year over year. In the first half of 2022, equity financings on the Toronto Stock Exchange (TSX) totalled $11.8 billion, down sharply from $28.3 billion for the same period last year. Financing activity on the TSX Venture Exchange (TSXV) also plunged, falling to $3.8 billion this year from about $6.4 billion in the first half of 2021.

This drought has been felt by the integrated dealers in particular, which saw equity underwriting revenue drop by 77.7% in Q2, and revenue from corporate advisory work down by 49.1%.

Investment-banking revenue is down for the retail firms too, but the drop has been smaller (just 16.2% in Q2). And this business line is less important: in 2021, investment banking accounted for only 8.4% of retail firms’ total operating revenue compared with 15.8% for the integrated dealers.

In the retail segment, fee and commission revenue are much more important. Both of those models took a hit in Q2 as trading volume on TMX Group’s exchanges fell. In the first half, trading volume was down by 26.2% year over year, although the total value traded was up by about 15% over the same period. And, on the TSXV, both volume and the value traded were down sharply in the first half, by 53.8% and 59.6%, respectively.

Amid these pressures, the retail brokerage segment saw its fees — which now represent the single largest source of revenue — decline by 2.1% in the second quarter. Commission revenue fell by 10.2%.

However, the drop in both fee and commission revenue amounted to $62 million, and was exactly offset by an increase in net interest revenue. Retail firms saw their net interest revenues jump by 72.6% to $146 million from $84 million in Q1 as the Bank of Canada delivered two 50-basis-point rate hikes in the second quarter.

Among the full-service retail firms in particular, the rise in net interest revenue more than offset the decline in fees and commissions in Q2 — enabling those firms to maintain flat operating revenue even as investment banking and “other” revenue declined, and equities trading posted a loss of $9 million. Fixed-income trading and debt underwriting were the only other revenue categories that managed to climb in Q2.

Now that the Bank of Canada has hiked rates by 175 basis points since the end of Q2, investment industry firms will look to higher net interest to cushion the blows hitting other parts of the business.