Based on the changing regulatory landscape, this is the kind of trading you need to get into now
Brad Hintz, the top ranked analyst at Bernstein Research in the US has produced a report looking at trading businesses in the new regulatory landscape.
It doesn't look good.
According to Hintz, the combined evils of Basel III and Dodd Frank threaten to drive the average return on equity at US banks' trading businesses below, 8% - less than their return on capital.
Specifically, Basel III will mean that common equity capital must increase from 2% to 7% of risk weighted assets. It will also make it difficult for any major bank to maintain leverage ratios in excess of 15%.
Despite various claims that it won't, Hintz is also of the opinion that the Volcker Rule-element of the Dodd Frank Act will have an effect.
'It is reasonable to assume that discretionary, non-client-facing businesses such as risk arbitrage, statistical arbitrage, index option and index futures arbitrage desks will be prohibited. Alternatively, it is clear that pure market making and the proprietary risk taking associated with this activity are exempt from the ban, Hintz writes.
Central clearing of OTC derivatives is also expected to have an adverse impact on trading revenues.
Where to position yourself as a trader
In response to the changing regulatory landscape, Hintz predicts that banks will build up some businesses and wind down others, as follows:
Build up:
· Emerging markets debt and equity (high ROA, rapidly growing, high
regulatory capital businesses)
· Government and sovereign book (low regulatory capital use, low
ROA but rapid growth due to persistent deficits in the USA and the EU)
Wind down:
· Money markets, preferred stock, developed market equities, medium term
notes and investment grade corporate bonds (all low margin areas)
· Correlation books and securitization businesses (high regulatory capital requirement)
Hintz also expects banks to reduce compensation in order to cope with the lower ROE environment, a trend he says has already begun.
