Fickle markets, volume surge a boon to brokers

NEW YORK Thu Aug 11, 2011 1:55pm EDT

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NEW YORK (Reuters) - Sharp spikes in trading volumes amid the recent market rout have been a blessing for big Wall Street brokerage firms, which have suffered through several quarters of muted market activity.

Over the past several days, fierce market swings have caused trading volumes and volatility measures to soar. Trading in U.S. stocks has ranged between 10 billion and 18 billion shares for the past five sessions, levels near an all-time high set during the "flash crash" in 2010.

CME Group Inc, the biggest operator of U.S. futures exchanges, said a record 25.7 million contracts changed hands across all asset classes on Tuesday, August 9, with futures and options in gold and the Australian dollar in particular setting new records.

Such conditions can be highly profitable for trading desks at brokers like Goldman Sachs Group Inc and Morgan Stanley, which entered the market rout awash in liquidity, a solid base for profits during market stress.

"In times like this, trading desks get swamped with tickets and brokerages earn fees in the middle of those trades," said Joshua Brown, a vice president at money management firm Fusion Analytics Investment Partners.

To be sure, even as banks' trading revenues climb, fears of an economic slowdown and prolonged sovereign debt woes would hurt other parts of their business. Companies may put off plans for mergers, acquisitions or capital raisings, for example, cutting into the fees banks charge for advice on such deals.

But there are winners in every crisis, and this one is no different, said Clifford Smith, a finance professor at the University of Rochester's Simon Graduate School of Business who specializes in trading and risk management.

"It's not fun for most of us to live through, but if you're in the market to supply liquidity, like Goldman Sachs, you're seeing high volume, wide bid-ask spreads -- that's a silver lining," said Smith. "The brokerage industry is one I would expect to profit going through this process."

Goldman Sachs and Morgan Stanley declined to comment.

This week, spreads between corporate bond yields and Treasury notes surged to highs not seen in nearly a year, particularly in high-yield bonds, as investors fled riskier assets.

Brokers providing liquidity in the bond market aim to purchase debt at a discount and resell it to investors at a premium. The fear pervading the market can help brokers who are able to match risk-averse sellers with opportunistic buyers -- a key factor helping Goldman report strong profits even during the financial crisis in 2009.

TOO MUCH OF A GOOD THING?

Bank bonds in particular have been hit hard by the recent market turbulence. Meanwhile, the cost of purchasing protection against banks' defaulting on their bonds soared. That trend may actually help third-quarter results, since banks post accounting gains when their credit spreads widen.

Morgan Stanley reported $244 million in so-called debt valuation gains in the second quarter during a much less volatile time, and as much as $1.4 billion at the height of the crisis when many big banks' very viability was in doubt.

Several sources on trading desks and at brokerage firms echoed the comments of Brown and Smith. One executive said trading volumes at his firm have risen by a factor of five this week and trading revenue is up significantly.

Recent activity comes in sharp contrast to weak second-quarter performance on most Wall Street trading desks.

The single biggest issue holding back trading results was a lack of client activity: Investors weren't sure where things were headed -- the economy, the markets, politics, regulations -- so they sat on the sidelines, hindering the profit that brokerages earn from acting as market makers in between the trades.

But recent U.S. stock trading volume has clocked in at more than double the year-to-date daily average of 7.5 billion shares through August 3, resulting in a spike in trading commissions.

Meanwhile, the Chicago Board Options Exchange's Volatility Index, known as the VIX, has set new volume records and hit a level of 48 on Tuesday. The VIX has not been that high since March 2009, suggesting investors are betting that markets will continue to gyrate.

Insiders cautioned that surges in volatility are only good in small doses. If wild market fluctuations continue, with broad declines in equities, it won't be a good thing for anyone on Wall Street.

"I talk to my Wall Street buddies every day, and everybody's miserable," said Michael Driscoll, a former senior managing director at Bear Stearns who is a visiting professor at the Adelphi University School of Business.

"Even if they're making money in the short term, the fundamental glue that holds the whole business together is a very fragile investor and consumer psychology, and it's being severely damaged by what's going on here," he added.

Analysts also struck a cautious note, saying there is no guarantee that Wall Street majors were able to manage their trading inventories around chaotic market movements.

For example, the Dow Jones industrial average shed 1,176.50 points over the five sessions through Wednesday's close. But within that time, it also rose as much as 441.23 points in intraday trading.

Swift fluctuations in the dollar against other currencies and a steep decline in interest rates also may have caught traders off-guard.

"We would not anticipate that the higher activity levels could have been enough of an offset against the erosion of inventory," said Roger Freeman, an analyst who covers brokerage stocks like Goldman and Morgan Stanley for Barclays Capital.

(Reporting by Lauren Tara LaCapra; editing by Knut Engelmann and John Wallace)

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