Banks fight to maintain $22.6 Billion in Derivatives Trading Revenues
The New York Times reports today that bank lobbyists are fighting desperately to save the trading revenues from their derivatives desks. http://nyti.ms/aaGgen. Considering 5 banks (Bank of America, Morgan Stanley, JP Morgan, Goldman Sachs, Citigroup) dominate the derivatives business, that’s $4.5 billion per bank. I’d also fight like hell to save those revenues.
According to the Article, “the financial industry says that derivatives are a valuable product used by more than 95 percent of Fortune 1000 companies to hedge against risks, including price changes.” However, the issue is not whether Fortune 1000 companies view derivatives as a valuable risk management tool, but whether banks which benefit from federal safeguards should provide these products.
Yes, derivatives are a core banking product. And yes, they provide significant profits to banks. The question is: Should this continue?
As I wrote in a prior post, Goldman’s Clients — Caveat Emptor, the largest banks rely upon a significant conflict of interest within their basic business model. No where is this more evident than with trading derivatives. And as the above numbers reflect, huge bucks depend on this.
First, we must be mindful of the fact that derivatives come in all shapes and sizes, from the most simple to the most esoteric. And, as always, when we speak in generalities we must be careful. Nonetheless, it is safe to assume that derivatives are risk reducing tools. These tools can be used to assist clients with managing their own risks, and they can be used among the banks themselves (and other financial institutions) to apportion risk. I am more focused on the former than the later.
As my prior post outlined in greater detail, Goldman explains that its risk business (e.g. derivatives business) grows out of its investment banking relationships with clients. In other words, once Goldman has secured a relationship as an advisor to a client, it then introduces the client to various derivatives strategies.
Upon entering into a derivatives contract with Goldman, the client has evolved from an advisory relationship to an adversarial one. Counter-parties to a contract, by definition are adversaries. If Goldman continues to cultivate the advisory relationship (which of course it will), while at the same time maintains and cultivates additional counter-party relationships with the same client, it has entered into significant conflicts with this client.
On the one hand, where the derivatives are plain vanilla interest rate swaps, there are fewer concerns. That is, many Fortune 1000 companies have expertise within their own treasury departments to make informed decisions about entering into a derivatives contract. However, quite frankly, the banks don’t make a lot of money of these transactions. Instead, it is in the highly “bespoke” arrangements where the banks both earn the most money and undoubtedly where the clients rely upon the bank’s advice the most. This is precisely where the greatest conflicts lie.
Again, I don’t mean to pick on Goldman, this is rampant throughout the industry. Not only is it rampant, but these very conflicts help to turn on the lights every day. For instance, JP Morgan Chase reported $3.3 billion in earnings for Q1 2010 on revenues of $8.3 Billion. Therefore its $4.5 billion share of derivatives revenue, constitutes about 12% of its revenues (assuming Q1 revenue numbers are annualized). We are not talking about insignificant numbers, here. This is worth fighting for.
The other point is that in light of Goldman’s recent challenges concerning the ABACUS deal, many people think of complicated synthetic mortgage backed instruments when the topic of derivatives is raised. However, the term derivatives encompasses many types of instruments which are sprinkled throughout corporate America. They are not some isolated, esoteric, rarely used instrument. They have become a bedrock of the financial industry. That is why the battle is so heated.
Whether the banking lobbyists are successful in retaining the derivatives trading desks within the banks, or whether the desks get pushed out into affiliated entities, in my mind, the most insidious aspects of derivatives trading will continue — the fact that the bank serves both as advisor and counter-party.
Clients, commentators, policy makers, advisors and bankers themselves need to be aware of these conflicts. As Justice Brandeis once said, “sunlight is the best disinfectant”.