LONDONInvestment banks feeling the pinch from increased regulation since the financial crisis could reap an earnings reward from a boost in trading activity under the European Central Bank's (ECB) trillion-euro quantitative easing (QE) program.
The flood of money into markets from the ECB's bond-buying has brought an increase in the volatility that traders crave as investors stake bets on the impact the scheme will have on inflation and long-term interest rates.
"QE is likely to underpin a sustained period of strength in euro capital markets," Citigroup said in a research note on Friday. "There has been a sharp spike in rates and foreign exchange volatility, which also points to a strong quarter for wholesale banks' macro revenues."
Revenue from fixed income, currencies and commodities trading, the so-called FICC universe, have historically been a rich source of profit for banks, but new capital rules and moves towards electronic trading have squeezed the sector in recent years.
The 10 biggest investment banks' revenue from FICC fell 7 percent in 2014, industry analytics firm Coalition calculates.
What's more, the investment bank balance sheets that support trading markets have declined by 20 percent since 2010 and by 40 percent in risk-weighted asset terms, Morgan Stanley analysts estimate. The analysts said that a further 10-15 percent reduction is likely over the next two years.
The trading environment in Europe, however, could be about to take a turn for the better.
"ECB moving to QE could provide a real fillip to earnings," Morgan Stanley analyst Huw van Steenis said. "Fixed income trading may buck the trend of five years of shrinkage."
Anshu Jain, the co-chief executive of Deutsche Bank, one of continent's largest trading banks, said in January that the ECB's bond-buying program would be of "profound importance" for Europe and its banks.
"You may see a progression which hurts net interest margins but benefits sales and trading revenue," Jain said on an earnings call with analysts.
Citigroup said that the best-placed banks would be those with significant euro-denominated franchises, including BNP Paribas, Deutsche Bank, HSBC and Societe Generale. JPMorgan is the biggest bank by revenue in the FICC space.
While it's too early to tell the exact impact of the QE program, which is expected to last until at least September 2016, the fees earned from the central bank's buying alone could be significant.
Economists at the U.S. Federal Reserve estimate that Wall Street firms could have made as much as $653 million in fees selling bonds to the Fed during its monetary stimulus program.
When the ECB launched its LTRO (longer-term refinancing operations) scheme in late 2011, revenues in the rates business of global investment banks improved the following year, increasing to $29 billion in 2012 from $27.4 billion the previous year, data from Coalition shows.
But traders and analysts question how much is really down to the first-order effects of ECB action or second-order effects such as volatility.
Price fluctuation has certainly picked up this year after months in the doldrums.
Banks benefit because such volatility allows them to charge higher margins on trades because of the greater risk around execution. It also helps them sell hedging instruments to investors.
But QE also presents risks. One of the biggest fears for traders is that ECB buying and the reluctance of some investors to sell because of regulation or client obligations could reduce the amount of debt actively traded in the longer term.
Signs of that squeeze are already showing in the soaring cost of borrowing in secured lending markets.
"Volatility and volumes are good for traders. Volatility but no volumes ... are awful for traders," one euro zone government bond trader said on condition of anonymity.
A survey of dealers this month showed concern that the Japanese government bond was not functioning well under lingering concerns that its QE program, launched in 2013, is reducing bond market liquidity.
However, data shows there has been no dramatic change in trading volumes over that period.
Even if ultra-low yields in government bonds put off some investors, bankers say they will be able to capitalize on those that rush to put their cash into assets with better returns.
"You trade flows," one investment banker said. "The trend is only just starting."
Data shows that cash is already flowing out of government bonds and money markets towards junk bonds and emerging markets.
But the real rewards will come if the ECB's stimulus serves to hoist inflation and bond yields with it.
"If QE is successful, long-term rates will go up and generally higher rates will lead to more activity and hedging opportunities. Banks will benefit as much as asset managers," another investment banker said.
(Editing by David Goodman)