Credit traders didn’t have a good first quarter. While banks like Goldman Sachs which are focused on macro trading (rates and FX) had a good start to the year, banks like Citi and BAML which are more focused on so-called ‘spread products’ (credit), didn’t. And the situation for credit traders could be about to get worse.
In a report out today, Deutsche Bank’s analysts predict credit traders will be hit especially hard by the Fundamental Review of the Trading Book (FRTB). As a result of FRTB, Deutsche thinks the value of risk weighted assets attributed to the credit trading book will increase by 100%, as per the chart below.
Increase in risk weighted assets by category under the FRTB:
Source: Deutsche Bank
The big issue for credit traders is the change in ‘liquidity horizons’ (defined as ‘“the time required to execute transactions that extinguish an exposure to a risk factor, without moving the price of the hedging instruments, in stressed market conditions”). under the FRTB. Back in the day, before Basel 2.5, it was assumed that trading book positions were all liquid and could be exited, if necessary, in 10 days or less. This was proven very wrong during the financial crisis.
Regulators are now forcing banks to extend their liquidity horizons by different time periods according to the different products they trade. The Basel Committee on Banking Supervision plans to compel banks to incorporate this new liquidity horizons into risk calculations related to their trading books. As shown in the chart below, credit products have the longest liquidity horizons under the new rules. Hence, they experience the biggest increase in risk weighted assets (RWAs). As RWAs increase, banks will either need to commit a lot more capital to credit trading, or pull back from the area…
Liquidity horizons under the FRTB:
Source: Deutsche Bank
In the text accompanying the chart above. Deutsche points out that structured credit products (for which liquidity horizons might be 250 days) will be worst impacted by the new rules. Single name CDS, for which some funds have been calling for a renaissance, are expected to, ‘fall away almost completely.’ Worse, Deutsche points out that the latest ‘quantitative impact study’ from the Basel Committee completely ignores the even higher liquidity requirements of high yield and emerging markets.
Deutsche isn’t the only bank to be sounding the alarm on credit traders’ careers. In a report earlier this year, Morgan Stanley predicted that banks will shrink their credit-related balance sheets by 15% this year as they prepare for the FRTB. Credit trading revenues are expected to fall by 5% in the process. Further cuts may follow.