Results season is in full swing as the banks report their first quarter figures, with virtually every one on the Street reporting muted fixed income revenues. The foreign exchange business is being partially blamed because of low volatility, but market participants say this is more than just a cyclical downturn and that there are signs of a more secular shift in the world’s largest cash market.
JPMorgan kicked off the merry-go-round in mid-April, reporting that its fixed income markets revenues, which include its foreign exchange business, slumped by more than a fifth over the same period in 2013 to $3.8 billion. The drop was attributed to weaker performance across most fixed income products and a comparatively strong 2013.
As other results trickled in, the message was the same: lower fixed income revenues, particularly in foreign exchange. Goldman Sachs admitted to “significantly lower net revenues in…currencies”; Credit Suisse noted its “lower foreign exchange client business”; and last week BNP Paribas pointed to “weak activity in the… forex businesses”.
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Banks say this is partly due to historically low levels of volatility. When volatility is high, traders place large currency bets that can pay off when exchange rates swing in their favour. When volatility is low and exchange rates barely move, it hits traders where it hurts most – their P&L.
But analysts have good reason to believe this isn’t a freak quarter, and point to signs of a longer-term slowdown in the forex business.
Market rigging probe takes its toll
Sell-side trading resources have thinned out considerably over past months, according to a research note published last month by analyst firm Greenwich Associates.
A considerable number of bank traders have been suspended in the wake of the probe into FX benchmark rigging. Furthermore, front-office resources such as heads of sales are spending a disproportionate amount of time discussing regulatory issues such as compliance, says Kevin McPartland, head of market structure research at Greenwich Associates.
“This is all time and resources that used to be focused on generating more trading volumes, and hence revenues, from clients,” says McPartland.
Furthermore, McPartland believes that we are seeing a “wholesale re-thinking of long-standing FX market practice” as salespeople and traders become less comfortable with sharing client trade ideas and market colour based on their view of other clients and the market as a whole.
“With regulators particularly sensitive to any activity that even appears improper, trading desk employees do not want to create any perception that client confidences are being breached,” says McPartland. But this sharing of information has historically been a strong driver of direct voice trades to bank’s top brokers.
Brian Kleinhanzl, analyst at investment bank Keefe Bruyette & Woods, says litigation is dampening traders’ appetite for taking risk.
“Some have had the ability to do more exotic trades, [but] given heightened regulation and internal reviews, they might be pulling back on risk,” he says.
Margin squeeze
US banks are starting to feel the pain elsewhere too, since derivatives trading migrated to swap execution facilities (SEFs) under the Dodd-Frank Wall Street Reform and Consumer Protection Act. FX derivative trading on SEFs is still in its infancy, but analysts say those products that do make it onto Sefs and are subsequently cleared attract much lower margins.
“The more business that is done electronically, the lower the margins because multi-dealer type platforms are more competitive,” says Seb Walker, partner at consultancy firm Tricumen.
In addition, trades that are centrally cleared require both the bank and its counterparty to post margin, which reduces counterparty risk but arguably also eats into the spread a bank would otherwise make on a trade.
How can banks recover falling margins? The answer could lie in selling more complex products that come with higher margins. In the wake of the crisis, a number of large banks shunned complex derivatives to focus on flow products such as spot FX and vanilla forwards, and have come to be called ‘flow monsters’.
The largest players have industrialized their internalization engines to capture as much flow as possible, putting pressure on smaller players to compete on price, says Philippe Morel, senior partner and managing director in the financial institutions practice at Boston Consulting Group.
But given the current challenges facing the banks, it could be time for a U-turn.
Zohar Hod, global head of sales at SuperDerivatives, a derivatives pricing firm, says: “If banks don’t take this view and take on more risk, the only way they can win this game is to become great at adding more volume to their existing vanilla business. Not an easy task."