Goldman Sachs: A Bull in the Digital Age
A decade ago, Goldman Sachs executive Gary Cohn was asked if he’d license the bank’s proprietary securities pricing software, SecDB, for $1.0 billion. He said no. How about $5.0 billion? Maybe. Today, Goldman Sachs gives away SecDB for free.
What happened over the past decade? Let’s first take a look at Goldman Sachs’ business and operating model back in the rock & roll age of investment banking. Then we’ll review the key changes that have since upended much of the industry. Finally, we’ll consider why a “Goldman 2.0” can emerge as a winner in the context of the industrial transition.
Goldman 1.0
The value that an investment bank like Goldman Sachs created for its customers used to be access and execution. Goldman provided access to buyers (or sellers), connecting two parties for a financial transaction. The bank also provided flawless execution of complex deals, from M&A to bond offerings and restructuring. It also thrived as a one-stop shop for financial transactions and advisory.
Operations rested on finance analysts, incentive systems, risk management, relationships, and the technical capabilities to trade securities (e.g. NYSE-linked platforms, clearing house, etc.). Software, then, was used to gain a competitive advantage. For example, SecDB calculates 23 billion prices for nearly 3 million positions, per day. Shaving off a second in a trade could make the bank millions.
In that world, Goldman captured value through a fee-based or commission-based revenue model. Want to issue debt? Pay a 2% fee on the face value. Want to acquire your competitor? Pay a percent of the purchase price. Want to buy a large block of shares in the open market? Pay a spread or commission over the price. In simple terms, Goldman was paid for being the middle-man.
What changed?
A few key changes are happening on Wall Street. The biggest is that electronic trading has squeezed margins. Large institutional clients (e.g. hedge funds, mutual funds) are moving their trading in-house, enabled by accessible and cheap computing power. We see this trend erode margins at banks, and slash revenues in the trading lines of business. For example, in 2016 Goldman’s Equities revenue of $6.9 billion was 12% lower than 2015, “due to significantly lower net revenues in equities client execution.” That revenue figure was $11.3 billion in 2007.
Additionally, the Street saw competitive and regulatory shifts. Bankruptcies and large mergers changed the landscape. Costs and salaries came under pressure. Wall Street also saw the growth of fintech firms including Bloomberg, while banks’ own customers like Blackstone built their own platforms like Aladdin. Regulations reduced investment banks’ ability to take on certain risks, capping potential rewards. Being a middle-man, especially in public market transactions, became less valuable.
Goldman 2.0
Goldman is shifting from a one-stop-shop to knowledge-based solutions. This includes selling data solutions and advisory. Advisory services are already core competencies (e.g. financing, M&A, restructuring). What’s new is that the firm has begun to offer software. It provides platforms that enable customers to price and transact more profitably on their own. Goldman appears to parallel search for a value capture model. It’s using Software-as-a-Service to sell some web-based apps that customers can customize. It’s also giving away software for free, in hopes of upselling higher-margin services.
To make the shift, the company is transforming some of its operations. It now employs over 9,000 programmers and engineers (25%+ of its employees), rivaling Facebook. According to Business Insider, tech specialists include “platform engineers, engineering business analysts, liquidity managers, compliance professionals and (of course) programmers fluent in technology to optimize trading.” The tech team at Goldman is by far the largest of any banks’. The firm is also investing in R&D for platforms to rival those of Bloomberg. It’s leveraging its proprietary processes and data collected from its historic transactions.
A Wall Street Journal article from June 2016 predicted that investment banks of the future will be smaller, and will have more technologists than bankers. Goldman Sachs seems to be bullishly moving in that direction.
Readings
https://acnprod.accenture.com/t20151013T084158__w__/us-en/_acnmedia/Accenture/Conversion-Assets/DotCom/Documents/Global/PDF/Dualpub_1/Accenture-Digital-Disruptions-Investment-Banking.pdf#zoom=50
http://www.businessinsider.com/goldman-sachs-has-more-engineers-than-facebook-2015-4
http://www.wsj.com/articles/goldmansachshasstartedgivingawayitsmostvaluablesoftware1473242401
https://www.wsj.com/articles/radical-changes-are-on-the-way-for-investment-banks-1464904490
Afaf,
Very interesting point of view. Certainly the financial regulations have significantly impacted the ability to banks, especially Goldman Sachs, from gaining the attractive ROEs it once did as capital requirements and the reduction of proprietary trading have hindered the ability to take risk within the business. It used to be the case that investment banking revenues could be funneled towards the proprietary trading desks at Goldman, turning an already profitable business into a highly profitable business. Lower capital requirements meant that traders (and sales & trading make no mistake still is what powers GS) could do more with the amount of capital which they were allocated. Goldman is one of the last remaining banks to hang on to some principal investing businesses (most notably, it’s private equity fund Goldman Sachs Capital Partners) but as regulatory pressures continue, these more attractive, but more risky lines of business may also be forced to be divested. These regulatory developments will really put pressure on Goldman Sachs to earn the attractive returns it did in the 1.0, pre-crisis era; luckily, its peer set is also facing the same pressures and time and time again GS has proven its ability to more quickly and intelligently navigate a shifting landscape.
I think the other interesting development at Goldman Sachs is the the introduction of the retail banking unit, Marcus, which will attempt to access a new capital base to bolster its balance sheet and lower its cost of capital.