COMMENT: FICC's not dead yet

October 21, 2013

By Keith Mullin

LONDON, Oct 21 (IFR) - I've always been a bit of a contrarian. I guess it's just in my nature. So I'm going against the flow by saying I'm getting a little tired of everyone writing off the fixed income, commodities and currencies trading businesses as if they're ready to be read their last rites.

I also continue to be bemused by the general over-reaction of shock and horror at the lower quarterly FICC numbers coming out of the banks. For reasons that are pretty clear, client trading volumes have been much lower in the current cycle and have invariably been non-existent in the run-up to and amid all of the political nonsense in the US (which is far from over) and around the will-they-won't-they quantitative easing saga, global growth concerns, EM wobbles, peripheral eurozone woes, bank stability issues, war in Syria and other stories. There's an unbreakable link between news flow and the urge to trade.

People say volatility is the trader's friend, but the reality is that most people play event-risk from the sidelines sitting firmly on their hands. If volatility is the trader's friend, uncertainty is his sworn enemy. Price volatility has invariably been on the screens only and not underpinned by order flow. I've heard countless times of late that if you try to deal on a screen price, it mysteriously vanishes. It's like walking into a shop to be told you can't buy anything.

Client and counterparty reluctance to trade around the fundamentals is exacerbated by very poor liquidity, which creates an eternal negative feedback loop. The days of free dealer liquidity are well and truly over as competition and market issues as well as capital and other regulatory constraints are brought to bear - the virtual disappearance of prop trading in size among sell-side shops; lower trading velocity among hedge funds and real-money accounts; derivatives and market infrastructure reforms; capital cost of holding inventory; margin compression; declining bank balance sheets and less leverage. And let's not forget the notion of trading a risk-free asset has gone out of the window, which has had a significant impact.

Having said I'm not writing off FICC as a business, it's clearly undergoing something of a makeover. Transformational industry issues bumping into multi-dimensional event-risk factors will make for a poor trading environment all day long. But my point is that while the latter will always be present in one form or another, the former will at some point settle. Reported FICC numbers shouldn't be looked at microscopically on a quarter-to-quarter basis. They need to be looked at strategically and on a cyclical basis.

It's worth pointing out that FICC has always been a highly volatile business from a net revenue perspective. I plotted Goldman Sachs's FICC number - as a proxy for the industry - for the past 34 quarters, which is far back enough to have preceded the run-up to the global financial crisis. I added FICC revenues from the institutional client services group to the debt securities and loans line in the investing and lending division to better match the combined number formerly reported as FICC in the old trading and principal investments division.

This exercise certainly put the 44% FICC reversal in the Q313 numbers into perspective. The dispersion of the net revenue results over my chosen period has been notable, but that's the nature of trading. In the pre-crisis period of 2005 through Q107, Goldman's FICC number jumped wildly but averaged 35% of the firm's overall net revenue. The average taken over the past nine quarters (when event-risk was rife and regulatory issues pressing) was 31%. The reversion line doesn't look that dramatic. The average reported numbers for the two periods are only 10% apart. JP Morgan's FICC to combined CIB/Asset Management net revenue ratio is about the same.

Over time, we'll see FICC capacity freed up as dealers (slowly) tailor their offerings to highest perceived value-add, client fit, cost of capital and perhaps more realistic capital allocation. Market-share gains will benefit the scale players and the world will increasingly split into a small bulge-bracket and a cabal of specialists.

But as derivative trading morphs into the SEF world and vanilla cash volumes go increasingly electronic, and the buy-side and sell-side reach an accommodation in the new world, increased transparency will drive better price discovery and as the economic cycle improves and banks get through deleveraging, I think it's fair to suggest volumes will rise in lock-step. Don't write FICC off; it's simply entering a new chapter in its volatile life-cycle.