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Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks |
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The trading mishap should instead serve as a warning of how little the present global regulatory overhaul is likely to affect the behaviour of all the main dealers.
Goldman’s problems must be put in context. The firm certainly had a bad quarter by its own standard of almost constant outperformance of its peer group. Revenue from its main business line of trading and principal investments was down 39% from the second quarter of 2009 to $6.55 billion, a level that also marked a dip of 36% from the first quarter of 2010. Firm-wide profit was a disappointing $613 million after a charge of $600 million to cover the UK bank tax and $550 million to settle with the SEC over charges of CDO fraud.
But the relatively resilient net trading and principal revenues underscored the strength of the bank’s core franchise. Fixed income, currency and commodities (FICC) revenues of $4.4 billion were 35% lower than during the second quarter of 2009, when Goldman confounded its critics by extending the bull run that was created by government guarantees of lower interest rates and bond market support, combined with a temporary dearth of competition.
Goldman’s FICC dip in the most recent quarter was comparable to the fall in revenues at competitors such as JPMorgan, however. And the total FICC revenue number left Goldman with its leadership position intact in the business line that is still the biggest single contributor to global investment banking profits.
The big problem for Goldman in the second quarter – and the reason for hasty speculation that the firm has lost its mojo – was the slump in its equity trading revenues.
Goldman tried to obscure the trading disaster it suffered in the second quarter by highlighting in its headline earnings announcement that the dip in its overall equities revenue to $1.21 billion marked a 62% fall from the total in the comparable period in 2009. It also stressed that equities commissions – the vanilla revenues from trade execution – were down on the same period last year, as global equity markets stuttered.
Equities commissions fell by only a nominal amount, however. In the second quarter of 2009 Goldman recorded $1.02 billion of commissions, compared with $977 million in the second quarter of this year. The numbers were close to flat.
The headline 62% fall in overall equities revenues also served to mask the extent of the trading upset.
Pure equities trading revenues, at $235 million in the second quarter of this year, were down a hefty 89% from the same period in 2009 and 84% from the first quarter of 2010. The gap in actual revenues was also substantial – the total in the second quarter of 2010 was almost $2 billion lower than in the same period in 2009 and more than $1.2 billion below the level in the first quarter of 2010.
Goldman attributed the slump to losses in equity derivatives and CFO David Viniar pinpointed a failure to hedge short client volatility positions as the main problem in an earnings call with analysts.
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As is often the case with Goldman’s carefully judged pronouncements on touchy subjects, this explanation raised other questions.
The key issue is how the bank makes its decisions on the timing of offsetting of client positions in the main trading markets.
When equity option volatility spiked in the wake of the flash crash in US stocks on May 6 and a global slide on sovereign debt and economic growth concerns, rumours immediately spread that Goldman had been one of the main losers among banks.
A headline loss number of $250 million on option volatility began to do the rounds at rival dealers and hedge funds. However, from Goldman’s eventual results it appears that the number could have been substantially higher. Goldman, like other dealers, does not break out trading gains and losses by instrument type, so the extent of the equity derivatives losses will not be formally disclosed.
The spike in equity volatility in May was certainly dramatic. The benchmark Vix jumped from 25 on May 5 to 40 points two days later, and skew – the difference between implied volatility for out-of-the-money put and call options – hit levels higher than in the immediate aftermath of the bankruptcy of Lehman.
Despite the violent move in prices, Goldman must still have been running very substantial short positions to suffer such a hefty slump in its equity trading revenues.
Goldman’s second-quarter results reminded observers that the firm’s own analysts had picked a short forward starting variance swap position as their number one recommended trade for 2010.
This led to suggestions that Goldman had decided to go short option volatility for the year on a proprietary basis and was simply caught out by the movement in May.
The reality is likely to have been more complicated. There was clearly an institutional bias at Goldman towards running short volatility positions during 2010 – as there had been during 2009. There is no reason to doubt Viniar’s statement that mishandling of offsets of client trades was the main problem, however.
The decision to leave client short volatility trades unhedged was a timely reminder of how little the US financial reform bill and other global regulatory changes will affect the core sales and trading operations at the big investment banks.
Goldman did not need to direct proprietary trading firepower and the associated capital to make a big bet on volatility direction, even though it might well have done that too. All that was required for a substantial directional gamble was a decision to ramp up client trades in the form of variance swaps and structured product sales (which leave dealers short volatility) and then to hold off on associated hedges. Other dealers, such as Bank of America Merrill Lynch, suffered from a similar approach in the second quarter.
The tinkering with sales and trading regulation that was to be found in the final version of the Dodd-Frank bill in the US will leave decisions about hedging of client flows almost entirely at the discretion of investment bank trading heads.
It is possible that regulators in the US and Europe will suddenly discover an appetite for monitoring the daily decisions of trading managers, then arguing with them about whether a partial hedge is actually a bet.
History would teach that this is highly unlikely, though, both because of supervisory funding constraints and the degree of regulatory capture that almost always comes with close association.
Investors and taxpayer guarantors of the big banks are instead likely to be left at the mercy of the trading decisions made by dealers for the foreseeable future.
