Rates rush may end in tears

September 11, 2009

Investment banks have made out like bandits over the first half of this year, largely from so-called “flow” businesses, like rates and foreign exchange (FX) that have been unlikely beneficiaries of the credit crisis. This has tempted several other investment banks to enter or
expand in those businesses.

However, the volatility and lack of competition that widened bid-offer spreads are disappearing fast. The underlying business is commoditised and requires massive scale. Only a handful of players will make money, and even then they may not make very much.

Before the crisis, FX and rates — the collective term for trading government bonds and interest rate derivatives — were, like cash equities, something of Cinderella businesses. Trading currencies and government bonds — and even the associated derivatives — was seen as an unglamorous business, but one that investment banks had to be in in order to be taken seriously.

During the credit boom, the rates business became steadily less appealing. It gradually shifted from being one in which clients called a few brokers to get a price to one where the majority of transactions were done electronically. These new platforms blew away the brokers’ mystique because clients could see prices for themselves.

Banks had to have an electronic platform if they wanted to remain in the business because clients were demanding cheap and efficient trade execution. This represented a huge investment, mostly in information technology. The combination of higher costs and lower revenues squeezed profits.

All this changed during the crisis. Some banks disappeared or withdrew from the business. In chaotic and volatile markets, the old-fashioned broker’s skills came to the fore again.
Bid-offer spreads — the means by which dealers make money in both FX and rates — ballooned to some three to five times pre-crisis levels.

The extraordinary profits made from such flow businesses have been behind investment banks’ recovery and the strong resurgence in their share prices.

Now regulators are adding to the appeal of flow businesses by increasing the capital required for other profit centres like proprietary trading and structured credit. Banks can also claim to be broadening their product range in order to better serve clients.

This has prompted some to embark on an expansion drive. Barclays Capital, for example, has grown to be a top-3 European rates player alongside J P Morgan and Deutsche Bank, but wishes to expand still further.

For those who already have commanding positions in these markets there is some logic behind these moves. There are large advantages to being one of the biggest players. This is both because of advantage of spreading fixed costs over larger volumes and the ability to match buyers and sellers.

But according to Dirk Hoffmann-Becking at Bernstein, spreads have already come in sharply over the past few months and are set to revert to pre-crisis levels. And the level of investment required is roughly the same regardless of the volumes traded.

Even for the biggest players, this will only ever be a good rather than a stellar business. For the wannabes, it looks like being a money-loser.

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