Macaskill on markets: FICC downturn drives bonus woes at Goldman Sachs
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Macaskill on markets: FICC downturn drives bonus woes at Goldman Sachs

Ashok Varadhan might well be the most unpopular man at Goldman Sachs as bonus time approaches. The global head of macro trading at the firm oversaw a third-quarter collapse in revenues in his product lines – which include foreign exchange and rates – that was dramatic enough to threaten lower annual compensation levels for everyone else at Goldman Sachs.

The fall in third-quarter revenue in fixed income, currency and commodities at Goldman was the sharpest slump since the 2008 credit crisis.

The fixed-income backdrop in the quarter was far from ideal, as participants braced themselves for a tapering in quantitative easing by the Federal Reserve that then failed to emerge, leaving investors confused about the likely direction of interest rates.

But the scale of Goldman’s revenue plunge was exceptional. Fixed-income revenue of $1.25 billion was down 49% on the same quarter in 2012 – a much sharper dip than the average fall of less than 20% at competitors Bank of America, Citi and JPMorgan.

Goldman noted in its earnings release that revenues were much lower in mortgages, interest rate products and currencies. The fall in mortgages was not a surprise, given lower securities prices and demand.

Goldman’s bonus killer?
Goldman’s bonus killer?

The apparent scale of the slump in currencies perplexed rivals and stock analysts alike, however. Goldman Sachs is not a big player in the market for foreign exchange dealing with clients, which is dominated by four universal banks: Deutsche Bank and Citi, followed by Barclays and UBS. Goldman fell out of the top-10 FX dealers in this year’s Euromoney poll of customer volume and was replaced by Bank of America Merrill Lynch at number 10, in the only change in ranking for a top dealer.

Goldman has been able to take a bigger share of the FX revenue pool than its customer volume ranking would suggest, which implies that its appetite for risk-taking is higher than that of its competitors and might also explain why it saw an income slump in a quarter when currency volatility was subdued.

Goldman had a 2.75% share of the FX marketin Euromoney’s most recent poll of over 16,000 currency end users published in May, a level that was less than a fifth of top-ranked Deutsche Bank’s 15.18% customer share.

But Goldman’s FX revenue for 2013 was expected to be close to 50% of Deutsche Bank’s income, at least until its recent trading mishap. A breakdown of estimated product-line income published by JPMorgan bank stock analyst Kian Abouhossein on October 2 (before Goldman released its third-quarter results) had predicted that full-year 2013 FX revenue at Goldman would be $1.1 billion, compared with a $2.6 billion estimate for Deutsche Bank.

That prediction for a Goldman total of over $1 billion now seems to be wide of the mark, which highlights the continuing difficulty that analysts and investors have in understanding how much risk is being taken in fixed-income sales and trading by banks, even after standalone proprietary dealing desks have been shut.

Goldman’s disclosed average value at risk for currencies in the quarter that ended on September 30 was $17 million, which was slightly higher than the $12 million VAR for the same quarter in 2012, but lower than the $23 million for the second quarter this year.

Those numbers give very little insight into what went wrong with Goldman’s FX business during the third quarter, and senior management at the firm declined to shed any further light on the issue.

Chief financial officer Harvey Schwartz characterized the currency slump as "difficulty managing inventory" that was "virtually all driven by risk reduction" during Goldman’s third-quarter earnings call and rebuffed requests by analysts to explain what this meant.

Abouhossein, perhaps feeling piqued at having accepted a misleading earlier steer from Goldman insiders about its FX business, asked why Goldman would be holding any inventory in foreign exchange, which is the most liquid and short dated of fixed-income markets, but Schwartz dodged the question.

The answer might lie in the way Goldman is addressing the dilemma of how to deploy staff like Ashok Varadhan. The career path of Varadhan tracks Wall Street’s money trail over the past 15 years, but with some Goldman-specific twists that highlight how the firm was able to outperform its peers in the past and why that might become harder in the future.

Varadhan was marked out for the fast track at Goldman from his start as an interest rate swap trader in 1998. When credit products boomed in the years after 2000, many banks shifted their fixed-income focus towards CDOs and credit derivatives, and placed less emphasis on rates trading and FX, on the assumption that margins would decline as liquidity increased.

Goldman took a different tack. It joined the rush into credit trading, but also maintained a policy of allowing its rates traders to put on big risk positions in the pursuit of outsized profits. With other dealers pulling back, Varadhan in New York and his counterpart Ed Eisler in London developed a reputation as the most aggressive bank traders of interest rate derivatives and kept turning in profits and collecting big bonuses.

Varadhan was rapidly promoted: to head of US dollar derivatives trading in 2000, head of North American rates in 2001, global head of foreign exchange in 2007 and head of FICC emerging markets in 2008. He is currently global head of macro trading, which includes interest rates and FX, and sits on Goldman’s management committee.

Liquid market revenues cannot consistently outpace client share without the assumption of risk, whether it is called proprietary dealing or given an industry euphemism such as ‘positioning’ or ‘inventory management’. And that is bound to create periodic upsets, even for the best traders.

Outsiders are puzzling over what went wrong with Varadhan’s macro group in a quarter when rates were not especially volatile and major currency pairs were steady. Emerging market currencies are a potential source of the weakness, especially if Goldman was positioned for a decline in exchange rates to the dollar instead of the recovery that came when the Fed backed away from its tapering plans.

Insiders at Goldman will be more focused on whether Varadhan and other managers can turn around performance fast enough to rescue full-year bonus levels that were threatened when the firm cut its compensation accrual to cover the third quarter fixed income revenue slump.

Gary Cohn, Goldman’s intimidating president and COO, warned in late October that bonuses would be down unless the firm has a good fourth quarter and remarked ominously that "we are replenishing our trader supply".

That should serve as warning enough for Varadhan, if he needed any, but Goldman Sachs itself faces a difficult transition period for its fixed income franchise, regardless of who sits in the trading hot seat.

Goldman is now unlikely to generate $9 billion of FICC revenue in 2013, which itself would be well under half the recent peak in 2009. The firm is even facing a threat to its top-five status in fixed income, which would have seemed unthinkable a few years ago. Equities, investment banking and asset management are making up some of the slack, but it is unlikely that top managers at the firm envisaged a collapse in fixed income as the route to a more balanced business mix at Goldman Sachs.

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