Is bond trading dying?
NEW YORK |
NEW YORK (Reuters) - Fixed income trading revenue is falling, and some of the best minds on Wall Street disagree on whether this is temporary weakness or slow death.
Trading volumes are down significantly from post-crisis heights. The market for structured credit, once a big source of revenue growth for Wall Street, has been almost non-existent since the subprime crisis erupted. Although trading in more basic products, like Treasury bills, is strong, margins have been crushed because competition has pushed down the premium that banks require for making trades.
The bond market faces huge structural changes that will be as important as the pressures on stock trading revenue in recent decades. Much credit derivatives trading is moving to exchanges and clearinghouses, and banks will make less money from just serving as middlemen between two clients.
"This is something that anybody running a FICC business is super, super concerned about," said Robert Cummings, a managing principal at StormHarbour Securities LP who traded bonds at Citigroup for a decade. He was referring to fixed-income, currencies and commodities, or FICC in Wall Street parlance.
None of this bodes well for the bottom lines of large Wall Street banks such as Goldman Sachs Group Inc and Morgan Stanley, which relied heavily on bond trading for big profits last decade.
During Goldman Sachs' conference call last month, analyst Meredith Whitney asked Chief Financial Officer David Viniar whether the bank is positioning for the same kinds of changes in fixed income, currency and commodities trading that affected its equities business in the last decade.
Viniar said he wasn't sure what would happen, but said Goldman might have to cut the capital allocated to that business, lay off workers or find other ways to reduce expenses if volumes stay where they are or slow more.
"It's pretty clear that some of the technological advances that happen in equities are going to happen in some of the FICC businesses," Viniar said.
A DIRTY WORD
The fixed income business showed surprising resilience after the financial crisis. In 2009 and early 2010, banks posted record quarters for trading as the turmoil of the downturn spurred investors to rethink how they allocated their capital. Corporate and national debt issuance was strong, which often helps spur trading. (See graphic: r.reuters.com/xuk79r)
"After the subprime crash of 2008, fixed income was a great business to be in," said John Fay, global head of fixed-income, currencies and commodities at the brokerage and clearing firm Newedge. Times have changed, though, he said.
"Now you're at the end of a very long period of low interest rates. The market is waiting to see what's going to happen. We could experience a period of low interest rates and low volatility for some time."
That is what some bond traders fear.
New products such as credit derivatives on portfolios of bonds, known as synthetic collateralized debt obligations, helped bolster the bottom line last decade. But investors are more suspicious of innovation now because these types of products exacerbated losses on toxic mortgage debt.
"'Derivative' has become a dirty word," one bond trading executive at a big bank said. Moving to simpler products is "the biggest change in the market that we've seen" in recent years, he added, and the biggest obstacle to boosting profits.
The global bond market stood at $90 trillion at the end of last year, with $495 trillion worth of related derivatives, according to the Bank for International Settlements. While the size of the market has grown, activity in highly profitable products like CDOs has collapsed, while activity in low-margin products like Treasury bonds and government-backed mortgage securities has risen.
In 2010, the five biggest Wall Street banks -- Goldman Sachs, Morgan Stanley, JPMorgan Chase & Co, Citigroup Inc and Bank of America Corp -- reported $89 billion worth of trading revenue from fixed income, currencies and commodities, a 21 percent decline from the previous year. In the first quarter, those five companies reported additional FICC trading declines ranging from 4 percent to 35 percent.
If the changes afoot in the fixed income market were only because of customer preferences, traders might not be too worried. Products fall in an out of fashion fairly quickly. Many investors swore off complex products in the late 1990s after hedge fund Long-Term Capital Management collapsed, only to reembrace them in the middle of last decade.
But the fixed-income market is in a technological shift similar to the change in equities over the last four decades.
Stock trading profits first got squeezed in the 1970s after the U.S. Securities and Exchange Commission banned fixed commissions. That led to more competition from discount brokers like Charles Schwab. Pressure has risen since then with the advance of online trading platforms and the shift to decimalization in the 2000s.
Equity trading is now a high-volume, low-margin business that requires few employees to execute enormous trading volume. But the growth in volume has not made up for the even bigger decline in commissions. Trades that garnered dollars per share a decade ago now only collect a few pennies per share.
"The profits have gone out of that business," said Hans Stoll, a finance professor at Vanderbilt University who has performed research on equities and options pricing. "People can trade for themselves; we don't need market makers."
The bond market may face similar changes as the most profitable trades move to exchanges and trades become simpler to study and execute on electronic platforms. The over-the-counter derivatives market will feel the greatest impact from that shift.
One executive who is working on the technological overhaul at a large bank expects the portion of those trades executed electronically to climb to 70 percent from 5 percent today.
Traders will still be needed to handle large or complex deals for important clients. However, the executive said similarities to equities are real when it comes to standard, highly liquid products like interest rate and credit default swaps.
"That's a sea change," said the executive, who spoke on condition of anonymity.
Meanwhile, management teams have been working to trim bond-trading operations.
Several big banks including Goldman Sachs, JPMorgan, Citigroup, Bank of America and Deutsche Bank had "departmental layoffs" that mainly targeted these sales, trading and research operations, according to one recruiter who works with the banks. That followed broader layoffs at the height of the credit crisis, in which 10 to 15 percent of company-wide staff was culled.
It has been difficult for the banks to make more cuts because ranks are already so thin, said the recruiter, who did not want to be identified to protect business relationships.
Still, more layoffs by the middle of the year are likely if trading volumes do not recover. Executives at smaller trading shops say they have seen more resumes from bond traders worried about their futures at giant Wall Street banks.
"There's a big question mark as far as how this area is doing," said Jeanne Branthover, who heads the financial services practice at Boyden Global Executive Search. "Fixed-income trading is not what it used to be and they are prepared to cut their losses. It's going to involve firings and it's probably going to happen in the next two months."
Despite the bond market's challenges, there are important distinctions that may allow banks to retain more profits from FICC trading than they have from stock trading.
Highly liquid products, like Treasury bonds and interest-rate swaps, could easily move onto exchanges. But it will be more difficult to do so for corporate bonds, for instance, because they are much less uniform.
Meanwhile, developing nations like India will issue more debt, and their companies will become bigger corporate bond issuers over time. This could lift issuing and trading volume, said Nomura analyst Glenn Schorr. He thinks the rest of 2011 will remain "sluggish," but that Wall Street will deliver a 7 percent compound annualized growth rate in FICC trading revenue over the long term.
"FICC is not permanently impaired," Schorr said.
StormHarbour's Cummings is less optimistic.
"I really think (banks) are going to struggle and continue to struggle as they have recently with very big, bloated fixed costs and revenues that are continuing to come under pressure," he said. (Editing by Dan Wilchins and Robert MacMillan) (Email: email@example.com; +1 646 223 6116)
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