Sunday, July 23, 2017

Bond Trading Weakness in U.S. Large Banks

When Goldman Sachs reported its 2nd Quarter bond trading revenue had taken a nosedive, the news caught my attention because I had been reviewing the abysmal short term 2016 investment results, which would include bonds, derivatives, currency hedges, etc., of the three largest State of Illinois pension systems and the total negative returns (one eked approximately 2/10 percent).  This is not unusual for the Illinois pension funds which either have incompetent short term investment traders or contracted investment firms.  But when you see Goldman Sachs under performing, it gets your attention.

The Goldman Sachs loss of bond trading revenue was compounded by  large losses in commodities
trading in their FICC (fixed income, currency, and commodities) accounts for an accumulated 40% decline in fixed income revenue.They attributed this to the challenging environment of low volatility, decreased client interest, and difficult market making conditions (they had difficulty buying and selling at the prices they wanted when they wanted).  Bonds are not trading at the higher expected rates making low interest rate trades less profitable and less attractive to clients.  Morgan Stanley just barely beat out Goldman Sachs for the best FICC revenue.

If U.S. large banks, who are market makers, are having this difficulty in a low volatility, low growth, low positive interest rate economy, how difficult is it for eurozone banks where the ECB interest rate is zero and the ECB deposit rate is a negative 40 basis points and the banks are regulatory required to have a minimum asset ratio of high quality liquid assets (like bonds)?

Just for informational purposes on large systemically important bank trading activities, here is a three part Federal Reserve paper on the subject:

Part 1: Recent Trends in Trading Performance

 Part 2: What Happened during Recent Risk Events?

 Part 3: What Drives Trading Performance?

The report Summary is (the bold is mine):

"Using confidential supervisory data across four asset classes, we identify the key drivers of post-crisis trading performance for systematically important banks. We find that trading performance, as measured by VaR-adjusted trading revenue, is generally anchored by indicators of client facilitation and market making, such as trading volumes and bid-ask spreads, and that changes in asset prices have a smaller influence on trading performance. This finding suggests that banks have not had an overreliance on proprietary trading positions to boost trading performance during the post-crisis period, perhaps because trading operations have become more prudent given the severity of the crisis. It may also be that increased supervisory efforts and the anticipation of the Volcker rule have discouraged large-scale use of proprietary trading."

Do we have an arbitrage problem as indicated in this BIS Working paper?


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