The top brass at Citigroup gathered early this summer at their annual off-site meeting to discuss the fortunes of the US bank. The presentations covered a wide range of topics, not least Citi’s stubbornly low share price. But one, by credit strategist Matt King, stood out: “Who Stole the Market’s Mojo?”

In front of executives including Suni Harford, head of US markets, the strategist attempted to explain why the fat profits the bank once made from trading bonds and other types of securities had evaporated, and when they might come back. “Without volatility, dealers are struggling,” Mr King wrote bluntly in the presentation, to the dismay of some of his colleagues from the trading side of the business.

Citi is not alone in asking if the good times will ever return to the division that bankers refer to as “FICC”, for “fixed income, currencies and commodities”. These bond-trading units were once among the most powerful businesses at Wall Street banks — home to the star bond, commodities and derivatives traders who made big money making big bets. In the years leading up to the financial crisis, these traders helped push the industry’s profits to record levels.

Those days are long gone, thanks in part to the regulatory response to a global financial crisis that was triggered by risky trading. Banks are on track this year to record their lowest revenues from FICC since 2005, according to Boston Consulting Group. Across Wall Street, the future of FICC has become a hot topic — not just within banks but also at the investment companies that do business with them.

US Fed policy and a regulatory crackdown have humbled banks’ once-mighty trading businesses. Will a return of volatility to the markets revive them?

The question facing Citi and other big banks is whether the slump is a permanent change brought about by post-crisis regulation, or a temporary trend that will pass as the US Federal Reserve ends its policy of quantitative easing in October and begins to raise borrowing costs next year.

The Fed’s extraordinary crisis-fighting policies have suppressed market volatility, the lifeblood of trading. Many say FICC business will return — but only when the Fed and other central banks change tack. “When will normal service resume? Not until central banks stop stifling markets,” Mr King told his colleagues.

Some banks are not waiting for that to happen. UBS, the Swiss bank, decided in 2012 to wind down its fixed income business. Others have followed, leaving only Citi and a few others, including JPMorgan and Goldman Sachs, resisting the urge to dramatically reduce their fixed income presence. A spike in volatility in recent weeks may be giving them hope that this strategy will pay off soon, though they would still have to live with new regulations on trading.

“Banks are being discouraged or prohibited from trading, which drives down volumes, while on the other side, central bank policies have depressed market volatility,” says Bradley Golding, managing director at the hedge fund Christofferson, Robb & Co. “This is completely suboptimal for traders, sales staff and investors.”

On a recent afternoon, a trader at a Boston-based asset manager received an unusual call from a counterpart at a bank. The bank wanted to let the asset manager know that they were quoting the same ‘bid’ and ‘offer’ price on a mooted transaction — a highly unusual situation given that the price at which people are willing to sell a security is usually expected to be different to the price that others are willing to pay for it.

It was a misunderstanding. The bank’s trading software did not have enough decimal places to reflect the minute difference between the bid and offer price being set by the asset manager amid sleepy summer markets.

That difference in prices — known as the ‘spread’ — is how banks make money. With such tiny spreads, there can be no profits.

“Welcome to the world of FICC in zero volatility,” a person at the asset manager observed.

It is a far cry from the pre-crisis days when banks became accustomed to pocketing chunky spreads in return for brokering transactions. Then, banks were able to load their balance sheets with risky investments; all they had to do was wait to sell the securities for a profit.

In the five years since the crisis, central banks around the world have flooded the system with easy money — forcing asset prices to record highs but also introducing a gentle torpor into markets.

Low market volatility mitigates the need for investors to use products to ‘hedge’ their portfolios against sudden and unexpected changes in interest rates, currencies and commodities, and thereby cuts into the amount of money banks can make from arranging trades.

“Low volumes bring low volatility and then you have a feedback loop,” says Fred Ponzo, founder of Greyspark Partners, a capital markets consultancy. “If there’s low volatility there’s no reason to go in and out of positions.”

But even if volatility does come back, banks’ FICC divisions still face a danger. With higher capital requirements and tougher regulatory oversight, FICC may not be suffering from a cyclical downdraft but from a secular shift, brought about by new rules such as the incoming Basel III regime.

The Volcker rule, implemented this year, has also taken a bite out of FICC. The rule bans in-house trading operations that specialised in speculating on markets, or proprietary trading. The “prop desks” bolstered FICC revenues by placing large bets on currencies, bonds and derivatives.

“The previous economic model on which most of the big FICC players were predicated is gone,” says Mr Ponzo. “That’s by design. The risk-taking part of the banks’ activity has been pushed out by Basel III. I don’t see, in my lifetime, capital requirements coming down ever again.”

Banks began to lean heavily on revenues from FICC operations in the early years of the 21st century. Reeling from the bursting of the internet bubble and accompanied by a stall in mergers and acquisitions, large banks struggled for direction.

But as the Federal Reserve began aggressively cutting borrowing costs at the start of 2001 — igniting house prices as mortgage rates tumbled — trading volumes, or ‘flows’, across banks’ FICC divisions took off.

Bear Stearns and Lehman Brothers, the traditional fixed-income investment banks, led the charge. It did not take long for others, including Morgan Stanley, Merrill Lynch and Goldman Sachs, to pump more resources into their their FICC businesses.

The good times for FICC ended after the bursting of the mortgage bubble, bringing about the demise of Bear and Lehman. Tough new regulations on trading were drafted.

Many banks have retrenched to adapt to the new landscape. Some, such as Credit Suisse and UBS, have become “agency” players, focused on helping customers execute trades in mostly-electronic venues, rather than directly assuming the transactions as they once did.

Royal Bank of Scotland, which built one of the largest trading floors in the US, announced in May that it would cut hundreds of trading jobs in the country.

At Morgan Stanley, the focus has shifted from fixed-income to the business of wealth management, whose steady stream of fees looks attractive under new capital rules.

“When you look at how much lower leverage is, we have a big chunk out of the industry,” says Ruth Porat, Morgan Stanley’s chief financial officer. “That’s a permanent state.”

Others, such as Citi, Goldman and JPMorgan, have so far resisted dramatic change, preferring instead to wait for market volatility to stage a comeback. Many expect this to happen as central banks ease up on their crisis-fighting monetary policies. But few expect the central banks to allow interest rates to rise quickly.

“We are sticking to what we know best. We’re confident volatility will return — as will investors’ needs to re-balance their portfolios more frequently,” says Jim Esposito, co-head of the global financing at Goldman. “It is a question of when, not if. It is irresponsible to assume otherwise.”

Late last month — mere weeks after Citi had asked where the mojo had gone — volatility briefly returned to Wall Street.

Fears over when the Fed might raise interest rates sparked a bond sell-off. But, instead of banks being lured back into the market as prices dropped, dealers disappeared, some market participants say.

“That’s how it felt,” said Vishal Khanduja, a portfolio manager at Calvert Investments, which manages $13bn worth of assets. He noted “how little the banks want to stick their neck out” to facilitate riskier trades.

While the trading of bonds and other securities in the secondary market has stagnated, the primary markets where the securities are first sold have been booming. While FICC income in the second quarter of the year was anaemic by historical standards it was better than expected thanks partly to these sales.

Published in Dawn, Economic & Business, August 18th, 2014