Wall Street traders for years complained that they couldn’t make money in calm markets. They haven’t fared any better in wild ones. Bank traders stumbled in the fourth quarter of 2018, when the stock market lurched and strange things happened in the bond market. The five largest Wall Street firms reported this week that combined quarterly trading revenue was down 6% from a year earlier, further draining a once-reliable stream of profits.
Rising interest rates, trade tensions and signs of China’s slowing economy stoked investor fears. Exacerbating the swings: the widespread use of algorithms, which sold stocks in tandem and bought when pummeled shares looked cheap enough. The S&P 500 swung at least 2% on more than half of the trading days during the fourth quarter, the most in any three-month period since 2011, when the U.S. credit rating was downgraded.
“When things move a little bit up or down every day, that’s good,” Morgan Stanley Chief Financial Officer Jon Pruzan said in an interview. “When they go up 600 points one day and down 600 points the next, that’s bad.”
Bank traders serve a key function, matching buyers and sellers in relatively opaque markets. They can make money predicting steady price moves in either direction, like a baseball outfielder shifting into position for batters who reliably hit the same spot. Scattered moves are harder to defend.
“It’s not necessarily whether interest rates are moving up or down. You can certainly [make money] in either of those cases,” said Michael Corbat, chief executive at Citigroup Inc., where revenue from currency and rates trading tumbled 26% in the quarter.
“It’s where the market appears somewhat directionless or people aren’t quite sure exactly how far something is going….Bad volatility, that’s what we saw in the fourth quarter,” he said.
Wall Street banks used to be more resilient. Years ago, banks were permitted to hold a large number of securities for months at a time. That allowed traders to ride out price swings.
Since the financial crisis, banks have shrunk their portfolios and put strict time limits on certain positions. Holdings of the riskiest and most illiquid assets are down 85% since 2008, according to the Office of the Comptroller of the Currency. In some situations, traders must flip their inventory by day’s end, which left them exposed to the market’s stunning intraday swings last month.
“Banks act much more like market makers, and less like large proprietary position takers, than they did precrisis,” said James Masserio, head of Americas equity-derivatives trading at Société Générale SA . The volatility changed how clients acted, too. Some retreated altogether. “People didn’t know when to jump in,” Mr. Corbat said, “so everybody just stayed on the sidelines.”
Some money managers shifted away from products that generate big fees for banks into less lucrative ones. Mildly concerned investors often use derivatives to guard against losses, but the truly scared tend to sell outright, traders said. That generates commissions, typically a fraction of a penny, instead of bigger fees associated with derivative instruments.
Indeed, while equity derivatives were a bright spot early in 2018, when volatility briefly spiked, they were weaker in the fourth quarter. The result was a December slump that turned a mediocre quarter into a bad one.
At Goldman Sachs Group Inc., executives between Christmas and New Year’s pulled tens of millions of dollars out of the bonus pool that had been set aside a month earlier for fixed-income traders, according to people familiar with the matter. In stock trading, where revenue rose in the quarter and for the year, pay was up as much as 15%, traders said.
To some executives, the chance to squeeze out a few pennies didn’t justify the risk of getting stuck on the wrong side of a market move. Citigroup trimmed $26 billion worth of risky assets, the bulk of which came from its trading business, in the fourth quarter, CFO John Gerspach said.
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Further confounding traders, many long-held market truths crumbled. Investments that have historically moved in different directions traded in lockstep. Treasurys maturing in five years were briefly yielding less than two-year notes. The Japanese yen, which often rises significantly in times of market stress, appreciated only modestly for most of the late-year turmoil.
That meant that the bets traders used to hedge their risk were less effective. “Historical relationships broke down,” Mr. Pruzan said, though they are coming back this year.