Banks stand to lose as much as $4.5 billion in annual revenue as regulations aimed at improving financial stability alter how interest-rate swaps are bought and sold, according to a report from McKinsey & Co.
That’s equal to 35 percent of the $13 billion in revenue banks worldwide earn each year from rate derivatives and comes at a time when their fixed-income, currencies and commodities businesses are flagging, McKinsey’s Roger Rudisuli and Doran Schifter said. The driving force is the requirement that most swaps trade on electronic systems rather than over the phone, with more price transparency and competition eating profits.
Swaps are the largest part of the $710 trillion over-the-counter derivatives market, which has come under U.S. oversight for the first time in its 30-year history after the trades fueled the financial crisis and worsened its aftermath. While banks dominated the market before and after the crisis, the new rules shine a light on trades that were always done in private.
“If they don’t do anything, their profitability goes away,” Rudisuli, a partner and co-leader of McKinsey’s corporate and investment banking practice in the Americas, said during a phone interview. To counter the revenue hit, dealers must cut costs, realign their sales and trading teams and focus attention on fewer customers, he added.
The swaps revolution mandated by regulators puts further pressure on bank profits, which have suffered because of less price volatility. McKinsey said global sales from fixed income, currencies and commodities trades fell 16 percent in the first quarter from a year earlier.
JPMorgan Chase & Co., Citigroup Inc., Bank of America Corp., Goldman Sachs Group Inc. and Morgan Stanley were the five largest U.S. swaps dealers as of Dec. 31, according to the Office of the Comptroller of the Currency.
The shift to trading swaps on regulated platforms, known as swap-execution facilities, or SEFs, while potentially killing profits for the banks that used to negotiate the transactions privately, is aimed at bolstering financial markets and preventing another crisis.
The 2010 Dodd-Frank Act in the U.S. required most of the trades to be guaranteed by clearinghouses to lessen the risk of a user default and executed on SEFs to inject competition into the bank-dominated industry. It also mandated that all contracts be recorded in data repositories so regulators could monitor risk within the financial system.
More than 20 SEFs are authorized by the U.S. Commodity Futures Trading Commission. Of those, Rudisuli said, fewer than 10, and maybe just five, will survive. Companies with established dealer-to-customer trading systems have a good chance of staying in business, as do many of the inter-dealer brokers that banks use to conduct trades among themselves, he said. Rudisuli declined to name firms he thought would last.
The largest SEFs by volume of transactions include ones owned by ICAP Plc, Tullett Prebon Plc, Cie. Financiere Tradition SA, BGC Partners Inc. and Bloomberg News parent Bloomberg LP, according to data compiled by Clarus Financial Technology.
Dealers have several chances to stem the revenue loss by cutting costs, according to the McKinsey paper. Sales and trading, now often separate positions within dealers, should be combined into one job, Rudisuli said. And banks need to look at their customers and decide which are the biggest and most important to keep, he said.
The firms should also consider adopting an agency-trading model where they seek to put buyers and sellers together on SEFs, he said.
The bank losses may range from $2.5 billion to $4.5 billion around the world depending on which of two SEF models becomes dominant, Rudisuli said. The first type is an electronic auction system known as request-for-quote, or RFQ. The second is the type of trading used in futures markets, known as a central limit order book.
Revenue losses would be minimized with RFQ systems, in which dealers know their trading partners and can price swaps accordingly, he said. Trading on order books is anonymous, with dealers competing solely on price. Rudisuli said he expects the RFQ system to be dominant for several years, adding that not many SEFs will be around to withstand the shift.
“No well-functioning market requires this many platforms,” according to the paper. “The SEF landscape is too fragmented, complex and costly for efficient trading.”