September 11, 2013 7:49 pm

Derivatives move from banks into the shadows

Shadow financial institutions have taken advantage of the wave of new regulation to steal the lion’s share of the derivatives business from the major banks in a blow to those institutions’ profitability, according to traders.

Bankers fear the trend, underpinned by tougher capital rules for the banks, can only increase as regulations come into force encouraging bilateral over-the-counter deals on to exchanges, where pricing is more transparent. The obligatory clearing of trades, theoretically in place since the end of last year, will further erode margins.

“There’s been a substantial increase in the number of small banks and hedge funds operating in this space,” said one investment bank boss. “That has helped to narrow spreads, which is good news for clients but less good for [profits].”

For now, the OTC market remains dominant in the two areas of the derivatives market that continue to grow – foreign exchange and interest rates.

But even here banks are under attack, with shadow banks, such as hedge funds and other non-bank financial institutions now taking more than 50 per cent of both interest rates and FX trading for the first time, according to data by the Bank for International Settlements.

That data also revealed that interest rate volumes are up by more than a third since April 2007, just before the global crisis took hold, and by 10 per cent since April 2010. FX trading rose by nearly a third over the past three years and by more than 60 per cent since 2007.

Yet banks’ revenues from those businesses have declined. According to Coalition, the research firm, interest rate trading revenues at the 10 largest global investment banks have fallen 30 per cent in the past three years from $16.5bn in the first half of 2010 to $11.5bn between January and June this year. Rates trading is traditionally a core profit driver for investment banks and even last year still accounted for a fifth of overall investment bank revenues globally.

The banks’ FX aggregate trading revenues also declined – by 18 per cent to $4.2bn – over the period, according to Coalition.

Not all non-banks are cheering. Don Wilson, head of independent trading house DRW, said: “Forcing risk capital out of the system means we are seeing markets go to extreme valuations much faster than they should, due to less support from dealers. That means investors have to change the way they manage risk and trade and it could negatively influence volumes in over-the-counter and listed derivatives.”

The shift in market share comes against a background of the City of London tightening its grip as the world’s main centre for both foreign exchange and off-exchange derivatives trading. The BIS said 40-50 per cent of all global trades now went through London.

That lead is likely to be maintained in coming years, as the owners of the world’s largest swaps houses – LCH.Clearnet and US duo CME Group and IntercontinentalExchange – are either based in the UK capital, or are planning to expand their London operations. CME Group is set to open its futures exchange in coming weeks, starting with FX derivatives.

Additional reporting by Michael Mackenzie in New York and Philip Stafford in London

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