Trendless currency markets have dented banks' returns from foreign exchange proprietary trading, prompting some of them to close their prop desks. The Royal Bank of Scotland this week said it is shutting its foreign exchange proprietary trading desk - where traders use the bank's money to speculate in the market rather than execute orders for clients.
This follows similar announcements from several other banks, such as Dresdner Kleinwort and Commerzbank in recent months. "As life becomes more difficult you could see other players, who have through the very benign years shown a lot of volatility in prop trading, reducing their commitment to this business," said Kinner Lakhani, equity research analyst at ABN Amro.
But that does not mean there is no longer scope to make money. "If you talk about the big boys, I think prop trading is part and parcel of their business," Lakhani added.
Returns from prop trading can be very volatile, leading to losses if the bank makes a wrong call on the direction of US monetary policy, for example, and thus the dollar.
Low volatility and lack of clear direction in the currency market this year have also made it harder to make money. "It's been a very difficult year for anyone who is involved in the foreign exchange market on a speculative basis," said Steven Pearson, chief currency strategist at HBOS Treasury Services.
"If you look at simple, popular strategies like trend following or carry all of these strategies have lost money this year and this is the third year in three when currency funds have struggled."
Tighter regulation of the banking sector could also make banks less willing to take on the risks associated with prop trading. The Basel II accords, which are to be phased in between 2008 and 2011, are designed to reward banks for safe lending and impose charges on risky practices.
If the new rules place restrictions on prop traders, it could become easier to make money in currency speculation at a hedge fund where there are fewer restrictions than at a bank. Justyn Trenner, chief executive officer at client strategy firm ClientKnowledge, said the increase of electronic trading and introduction of new technology has made it easier for banks to analyse which trading areas they make most money from and those that are less profitable. "Some banks will use those means at their disposal to take more trading risk not less, but they will learn to be very specific about the trading risk they take," he said.
For those who got it right this year, or who are prepared to sit it out until volatility picks up in the currency market, there is still potential for high returns - a key attraction in a market where ever-narrowing margins and competitive commission rates are making it harder to turn a profit.
"(Prop trading) ties up quite a lot of capital but it can still be a very high (returns) business... The larger houses who have their compensation pools to hire the very best people and have the very best risk management ... can make an awful lot of money, so I don't see it is a broad trend (to shut prop trading desks)," said Jon Peace, equity analyst at Fox-Pitt, Kelton.
ABN's Lakhani estimated that on average at least 20 to 30 percent of banks' sales revenues come from proprietary trading. Deutsche Bank and UBS, the two biggest FX banks through which more than 30 percent of the market's $2 trillion daily turnover flows, declined to comment on their proprietary trading operations.
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