On May 22, Britain’s Financial Conduct Authority fined Barclays Capital £26 million ($44 million) after finding a Barclays trader had manipulated the 'London fix' for gold prices, a benchmark used for pricing billions of dollars’ worth of derivative contracts.
Such actions are now commonplace wherever prices are determined by consortiums of bilateral market makers, rather than by public price discovery. Governments around the world have levied nearly $6 billion in fines over manipulating Libor prices, and in Singapore an investigation continues regarding non-deliverable forwards for regional currencies.
This is likely to end with almost all fixed income and currency trading abandoning the current patchwork infrastructure, which is dominated by the major banks with sufficient liquidity to make efficient markets, in favour of moving trades onto exchanges or via entities offering central clearing.
This is a direct threat to all of the world’s major banks, who are already seeing falling revenues from fixed income, currency and commodities (FICC): margins have dropped four years in a row, with the first quarter of this year especially painful. Shrinking revenues as fees compress are one reason: also to blame are increased regulation – especially increased capital charges – and litigation costs.
Banks are not the only ones feeling the squeeze: according to Michael Petrick, managing director at Carlyle Group, global credit markets expanded from $5 trillion in outstanding issuance around 2000 to $20 trillion today – but broker-dealer balance sheets have been pared back to $50 billion. (He was speaking earlier this year at an AsianInvestor conference.)
This lack of liquidity is of huge concern not just to banks, but also to their real-money clients. Some major Asian investors have privately indicated nervousness around the ability to trade assets such as high-yield bonds should market conditions turn negative.
Regulation such as America’s Dodd-Frank law is already forcing derivatives to move to central clearing. Electronic trading on multilateral platforms is now clearly the future for FICC. Just as equities trading has gone almost entirely electronic, so too will bonds. Last month BlackRock announced a tie-up with TradeWeb, an electronic trading hub for bonds and derivatives, as one response to the growing counterparty risk on the sell side.
Asian institutional investors may not yet be ready to sign up directly to such platforms. They will need to be convinced that the governance is strong: front-running is not, in theory, the vice solely of broker-dealers.
But the Barclays fine is another step forcing the banks to relinquish their centrality in FICC trading. The question is who will become the new intermediary.
When equities went electronic, wily new electronic players convinced US authorities to pass Regulation NMS, blowing up the clubby old world of human-traded exchanges. But the fragmentation this created (by making speed more important than service) also paved the way for the emergence of a new set of intermediaries: the high-frequency traders.
These proprietary trading groups (Renaissance Technologies, DE Shaw, Getco, Optiver, Citadel – to name just a few) became the new middlemen of high-volume stocks.
Such players added liquidity to the market, but as the May 2010 'flash crash' demonstrated, when the algorithms instructed them to retreat, there was no liquidity without them.
These experiences will become increasingly relevant to the trading of rates, FX and credit. Moving to exchange-traded instruments and central clearing may cut out some of the existing strata of intermediaries, but others will take their place.
Bonds and currencies are going to move to new electronic hubs. The advantages are that they will now be cleared by multilateral platforms. This is an obvious area for banks to target.
Those with either strong custody and transaction banking operations, or who have built up prime broking operations with a heavy emphasis on clearing and trade facilitation (notably Goldman Sachs and JP Morgan), can reinvent themselves as central clearing counterparties. And they will pass on the costs of this infrastructure (including reporting, collateral services, and whatever becomes the bond version of smart-order routing) to investors.
The banks aren’t going to vanish in the FICC world; whether such activities compensate for the lost revenues on their bond trading desks remains to be seen. As for investors, for whom this trend is meant to convey transparency, the cost of enlightenment is likely to be high.