Major bank dealers are seeing continued erosion of profits since the Great Financial Crisis. There is no more proprietary trading with the Dodd-Frank rules. Volatility is down and trading volumes have declined. It is just hard to hit ROE targets in traditional, fixed income, commodity and currency trading in the current environment.
Many investors will argue that this is a good thing. Banks have been making money from clients for decades so let them suffer. Nothing like seeing Wall Street titans taken down a notch. But, if you are interested in systemic risk, you want to think through the implications from this profit decline.
Dealers make markets in strategic asset classes. The bond market is the place for safety in a crisis. Currencies are the biggest trading markets in the world. Commodities are a critical input to the real economy. The trades that can go through these markets can be very large and they need immediate liquidity. If there are no dealers, and make no mistake, banks are the only intermediaries with the balance sheets to provide liquidity, there will be limited liquidity in these markets. Futures traders, HFT traders, and hedge fund speculators do not have the capital to provide liquidity in the short-run. They do not have the relationships that will allow them to take trading risks that will be paid back in other ways.
If banks start to streamline operations, cut head count, and reduce trading capital, there will be a liquidity impact and this will lead to true systemic risk. This market readjustment is happening now. A liquidity crisis is exactly what the Fed wants to avoid, yet the system may have gotten riskier.
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