The words would chill any trader to the bone – partly because of the message, and partly because of the man speaking. Sitting forward in his chair, arms resting on the desk in front of him, the head of securities at one of the world’s big dealers is talking expansively about the future of the derivatives business, and what it means for the massed ranks of sales and trading staff on the building’s lower floors.
“A lot of them won’t make it,” he says, matter-of-factly. “This is not going to be a cosmetic change.”
The way he sees it, capital and liquidity pressures, coupled with new trading and clearing rules, will turn derivatives market-making into a volume game, with standardised products trading in smaller tickets, cheaply and electronically – and traders themselves receding into the background, their ranks shrinking and being infiltrated by operations and technology specialists.
“The old-school trader is going to fade away. Clients won’t recognise the new-school version – they’ll be asking ‘Are you an ops guy, are you a systems designer?’ But he will be a trader, at least in the new definition of the word,” he says.
Some parts of that future feel a long way off – but others are here already. Today’s traders describe the effects in a variety of ways. Some of these are mundane – a wider cast of characters is involved in trading decisions, including treasury and collateral management experts, as well as the desks responsible for pricing and managing derivatives counterparty risk, known as credit valuation adjustment (CVA). Others are profound – traders need different skill-sets, with problem-solving being emphasised at the expense of risk-taking, while soft management abilities are also becoming more important. And a few of the effects are more personal.
The old-school trader is going to fade away. Clients won’t recognise the new-school version – they’ll be asking ‘Are you an ops guy, are you a systems designer?’
“My wife doesn’t get to see me much anymore,” says a London-based trader at one international bank. “There have been a multitude of changes – anything capital, collateral or clearing house-related, those are the big ones. These things used to be such a small part of the decision-making process but now you can’t escape them. I don’t spend more or less time trading, but I spend far more time doing ancillary things, which basically means I end up working much, much longer hours than before.”
These ancillary things have become a big part of the job for certain transactions and businesses. “It is not just about making good trading decisions any more. It’s more about optimising the customer flow, using the least amount of capital,” says Antoine Miribel, head of CVA trading at Deutsche Bank in London. “The traders have had to adapt.”
Some have been unable to adapt, or have simply chosen not to. One senior interest rate options trader at a US house says working at a bank is “no fun” any more. Many of his colleagues have moved to hedge funds as a result, he says – in theory, a way of escaping the regulatory pressures on the banking industry and getting back to a simpler type of trading (see box). And there are plenty of anecdotes like the one relating to an experienced foreign exchange trader who lost his job at a big US bank two years ago and spent much of the following period looking unsuccessfully for the same kind of role at one of the other dealers – eventually, he gave up and used his savings to spruce up a dilapidated pub on England’s south coast. He is, says a former colleague, “happier than he’s ever been”.
These are the hidden impacts of a very public upheaval in derivatives trading. The component of the price for which a trader has traditionally been responsible – the market risk – is now a relatively trivial part of the equation, with counterparty risk, capital and funding considerations coming to the fore. As an illustration, Risk’s annual US conference last month saw Oliver Jakob, the head of investment banking market risk at UBS, explaining why his institution had taken the decision to exit fixed income and cut around 10,000 jobs – in short, the bank’s existing portfolio attracts roughly seven times more capital than it did under the old regime, a combination of the new trading book capital rules in Basel 2.5, the CVA charge that is part of Basel III, and tougher Swiss equity capital minimums.
“You may look at that and think, ‘No, that can’t be right’, but that is what we’re dealing with. If you do the math, the capital charges for certain assets have gone up by a factor of 10 to 12, so it’s easy to understand that you probably can’t go through life without making severe adjustments to your business model,” he told delegates (see page 12).
Other changes to the business are driven by Basel III’s liquidity rules – which, among other things, require banks to set aside low-yielding liquid assets against any collateral posting obligations that would result from a three-notch downgrade (see pages 28–30). That is happening at a time when banks and other market participants will be required to post far more collateral than before, as a result of the new clearing and bilateral margining regimes that should come to fruition next year. But even without the regulations, the market has been changing.
In the past four years, dealers have been migrating to a new valuation standard, in which trades are discounted using the overnight indexed swap (OIS) rate paid on cash collateral, with the currency of the collateral determining the relevant OIS rate. It means the details of the credit support annex (CSA) governing collateral posting between two counterparties now plays a big part in the value of a trade – each CSA is individually negotiated and may allow collateral to be selected from a menu of options, meaning the appropriate discount rate will also change. The end result is an increase in disputes, as counterparties quibble over collateral posting rights, and constrained liquidity – it can be difficult to novate trades to a new counterparty or load portfolios to a clearing house, because the collateralisation terms, and the net present value of the transactions will change (see page 9 and Risk April 2011, pages 29–31).
In other words, trading used to be much simpler in the pre-crisis years. There were no global liquidity rules. Capital requirements were lighter – based on the lower risk-weighted asset (RWA) numbers generated by the Basel I and Basel II rules – and banks could raise fresh capital cheaply anyway. Funding was inexpensive, too.
“Balance-sheet usage and RWAs – those things were rarely an issue for derivatives desks. Also, before the crisis, the bank could fund at almost the risk-free rate. The credit spread on most banks back then was 10 basis points and now most are well above 100bp,” says Deutsche Bank’s Miribel.
It’s the same story elsewhere. “Five years ago, we were agnostic to capital, but we are now much more cognisant of the resources we are using,” says a Toronto-based credit trader at one Canadian bank. “As well as being traders, we’re also managers of these resources – capital, liquidity, balance sheet. It will affect the type of trades we want to put on, because they all consume different amounts – and the cost of those resources is also changing.”
That requires detailed analysis, going some way beyond a trader’s traditional remit. Pricing is now based on complex decision tree analysis. Is the trade going to be cleared? If so, which central counterparty will it be cleared at and how will that affect the dealer’s existing risk position and initial margin requirement? If it isn’t going to be cleared, then will it be collateralised bilaterally and under what terms? What are the capital and liquidity implications? And, crucially, if these questions leave the dealer in a place it’s not comfortable with – or result in a price the counterparty is not willing to pay – how can the terms of the trade be changed to make it more palatable?
As a result, the trader is becoming less important. “The value-add moves away from pulling a market price off a screen to the more structural elements that surround a trade,” says a former head of rates sales at a US bank. “These things are worth more per trade than the differing views on market risk.”
He gives a real-life example: “I was involved in a swap with a big US corporate. Rates moved 40bp and the swap was heavily in their favour, so they wanted to unwind and they thought we owed them $90 million because they were discounting at Libor. We went back and told them we were using a different discount rate – Libor plus our funding spread – and it reduced the amount we owed to $75 million. That is a real conversation I was involved in, but what I just summarised was three weeks of work involving our funding guys, me and my models, and the CVA guys – the trader was nowhere to be seen. All the action was in all this other stuff that the trader had no role in, and the world has now moved even further in that direction,” he says.
The result is a greater diversity of people on bank trading floors, says a New York-based senior risk manager at one large US bank: “What is key is that the people around the trader changes – the level of support changes. You need people on the desk who are able to price funding, counterparty and collateral effects and pass that on.”
These individuals have to be plugged into a broader structure, warns Deutsche Bank’s Miribel. “You cannot do it desk-by-desk or trader-by-trader – that’s why you have a CVA desk and managers who can look at the whole bank. RWA is across the whole bank, so it is hard to say an individual trade is contributing this much RWA because you have millions of individual trades. You have to do proper analysis and that has to be centralised, not at the individual trader level. If someone is a specialist in trading foreign exchange volatility, he needs to focus on that. It’s less the role that has changed and more the organisation itself,” he says.
But it still means the number of things traders have to consider is increasing. To some, this requires a new skill-set – traders need to understand how regulations drive capital and liquidity costs, and help find ways to reduce the impact. That calls for individuals who are analytical problem-solvers, rather than red-blooded risk-takers. It also requires closer co-operation with people inside and outside the bank.
The former head of rates sales at a US bank thinks many of today’s traders will struggle. “The trader probably doesn’t have the skills,” he says. “He also doesn’t necessarily have the time or tools. His job is to make market prices and not think about credit risk, or funding risk or whatever. They are not set up to do it. They are dinosaurs, their brains can’t wrap around it.”
Some banks are changing what they look for when hiring traders, according to recruitment consultants. “They want traders who are more technical, people who can help build curves, rather than just pure market-makers. Some banks also like traders who will be able to go out with the sales team and help push home points about increased pricing,” says Natalie Basiratpour, head of research and fund management at Selby Jennings, a recruitment firm.
This shift can also be seen in the way banks recruit graduates for entry-level trading positions, says Isabel Frazer at the University of London’s career group – playing down the risk-taking, money-making aspect of the role and emphasising other areas instead. “We visited two large banks as part of our annual City course – whereby we take 100 top University of London students on a four-day tour of different City organisations – and both seemed to emphasise the intellectual curiosity, problem-solving ability and desire for a challenge integral to trading, rather than an overt willingness to take risks. This is something we have noticed in the way banks promote themselves to graduates on a wider scale,” she says.
It’s not just about the new complexity of derivatives valuation and the interplay between collateral, clearing, liquidity and capital – traders also need to have the right attitude to thrive in this new world, warns one occupational psychologist, who argues banks should be testing the relationship skills of prospective traders. “Trading is not an isolated activity any more,” says Hugo Pound, managing director at psychometrics testing firm RDI. “You work with other people and you need to have relationships with clients and other traders. It’s a more complex role and traders need to spend more time building relationships than they ever used to.”
It’s a similar story with regards to career progression. A former gilts trader tells the story of a star trader at one of his former employers, who started off in government bonds, was gradually given freedom to trade across a range of asset classes and ended up with a coveted corner office that was bigger than that of the managing director who was ostensibly his boss.
“In the end, he had three or four people working for him and they made oodles of money. You can see why people liked that – it made his manager look good, and the bank made money, so it made the bank look good. Which is fine as long as you make money, but when that stops, people think again. This was back in the late 1990s. I can’t imagine any bank giving someone that freedom now,” he says.
These are the proprietary traders of Wall Street legend – and there is no home for them at banks that are supposed to execute and hedge client trades only. But the moral of the story is relevant in others ways, too. It’s not just that banks are shutting the door on prop trading – they are also looking to encourage and reward traders for reasons other than fat profits. “Before, if you were a very good trader, then you would become head of the desk and that would be it. Now it’s not enough to be a money maker – you have to understand all these other factors as well,” says a senior London-based trader at one European bank.
RDI’s Pound says he has seen this as well. “There certainly has been a change with internal promotions. A number of banks are looking far more carefully and cautiously at the skills within their talent pool and are reconsidering how they promote internally – and a lot of that is driven by regulation or by reputational issues. They want all-round leaders, and people who are squeaky-clean. We’ve seen one of our clients developing an in-house testing regime to assess whether people have the ability to lead – and that includes trading,” he says.
This could be a permanent or a temporary shift. As banks become more adept at understanding and automating the various elements of derivatives valuation, power that has slipped away from the trading desks may be handed back – something the US bank’s risk manager is working on. In the past, the bank’s trading systems gave users one output – a market value – for each new trade, he says. Now, they receive the market value as well as counterparty risk and CVA information and a funding charge. “The systems are being revamped to automatically perform these things so you only have to go to people for complex transactions. For a vanilla trade, you wouldn’t have to go to 10 people because it would be done by models on screen,” he says.
But this could prove a double-edged sword. Some argue that automated pricing will eventually make the traditional desk trader obsolete. As banks try to cut costs and regulation encourages greater use of electronic trading venues, it may be that traders are forced to take on new roles or become extinct. Clients will no longer call their dealers to get a price or even to structure a transaction – instead it will all be done on screen, with execution algorithms managing a customer’s actual trading needs.
Either way, the role of a trader is changing. To some, that is a good thing. “This is the way trading should have been done in the first place,” says Bill Templer, former co-head of listed derivatives at Morgan Stanley, who left at the start of this year to start his own consulting firm. “You should never have been able to trade without consideration of balance-sheet usage, CVA and other issues. That ridiculous freedom, to me, is what caused a lot of the banks’ problems. There is a discipline in banks now that wasn’t there previously. It should have been like this all the time.”
BOX: Where have all the traders gone?
The big casualty of post-crisis regulatory reform, from a derivatives trader’s point of view, is autonomy. They can’t price a trade on their own any more, risk appetite has declined and they are bound by new constraints on capital and liquidity usage. In addition, anything defined as proprietary trading is out, primarily as a result of the Volcker rule contained in the US Dodd-Frank Act – although analogous rules in the UK and Europe may produce a similar effect.
“If you are someone who wants to just come in, take risk and get paid for it, then you don’t want to be at a bank – you want to be at a hedge fund,” says a euro interest rate swap trader at one European bank.
Many sell-side traders have come to that conclusion. “My motivation was career progression,” says one former proprietary trader at a US bank who has left to start his own hedge fund. “Some of that was down to regulation and the Volcker rule. There is legislation in the US that prevents prop trading in investment banks. That’s the reality.”
But it isn’t just proprietary traders who are leaving. As banks pull back, trading head counts are down across the board, for market-makers as well as prop traders. Recruitment consultants say they have been placing more people into buy-side firms than ever before.
“The majority of the business now is sales on the brokerage side rather than trading in the banks, but three years ago the opposite was true,” says Natalie Basiratpour, head of research and fund management at Selby Jennings, a recruitment firm. “The majority of the business now comes to us from the buy side.”
Another recruiter says the same. “Our hedge fund activity this year has been at its highest since the inception of the firm,” says Mike Karp, chief executive of Options Group in New York. “We are covering more hedge funds than ever. We have increased our hedge fund base by 25% this year.”
As well as autonomy, a big part of the reason for the exodus is pay, he says. While bank traders can still earn vast sums, it is less likely to come in the form of simple, year-end bonuses – there are more strings attached. “US, UK and European banks continue to refine their compensation structures to be more aligned with the long-term interests of shareholders. This has resulted in more employees receiving a portion of compensation in deferred stock or cash, and for senior employees to have even more of their compensation in stock that vests over two, three or even five years in some instances,” Karp says.
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