ICAP (IAP) is arguably the best positioned among the interdealer brokers for financial regulation, because over half of the company's operating income comes from electronic trading and post-trade risk and information services.
But ICAP's three main businesses face mixed prospects. Electronic trading is being affected by temporary but potentially long-lasting government intervention in interest rates and currencies. However, electronic foreign exchange platform issues, such as balance between high-frequency traders and large-order financial institutions, could lead to permanent market share change. Regulatory reform in Europe and the United States will also meaningfully affect electronic trading, such as via a push for more OTC derivatives trading to be done through platforms such as swap execution facilities, or SEFs. Interest-rate swaps is the largest category of OTC derivatives, and ICAP is one of the best positioned to capture interest rate SEF market share, as it can leverage its existing customer relationships from being one of the largest voice brokers in rate swaps and made the strategic move to have large swap dealers co-invest in its platform.
Early and wide adoption by the industry would have a network effect that gives ICAP a sustainable competitive advantage in that asset class. Conversely, we view the industry's adoption of another platform as one of the company's greatest risks, as it likely would lead to a rapid decline in market share.
Following the balance sheet and operational weaknesses that were exposed during the recent financial crisis, the company’s post-trade risk and information services look poised to grow with increased regulatory scrutiny of financial institutions. As ICAP’s post-trade services and electronic trading segments have operating margins in excess of 40%, compared to less than 20% for voice broking, the company’s operating margin will be higher than historical from a business mix shift.
Regulatory reform in the financial services industry remains an area of opportunity, but also threatens the company due to potential structural shifts. Institutional brokerage is a competitive industry with frequent pressures on both revenue and expenses. Increased electronic trading and transparency in OTC markets have been decreasing the revenue per institutional brokered volume. Despite the management of multiple interdealer brokers agreeing that the industry has too much capacity, compensation expense ratios remain stubbornly high.
Over the next five years, we're forecasting a 3.5% compound annual growth rate. The low growth rate is from voice brokerage being over 65% of total revenue and our forecast of low organic voice broker head count increases. Following the balance sheet and operational weaknesses that were exposed during the recent financial crisis, the company’s post-trade risk and information services look poised to grow with increased regulatory scrutiny of financial institutions.
