Goldman Sachs reported weak earnings today, following Bank of America Merrill Lynch yesterday. The core problem at each is their dealer businesses, though it is difficult to get at that central function in the lumpy, conglomerated mess that passes for (incomplete) financial statements. Goldman’s FICC “revenue” dropped by almost a third in the second quarter from a Q2 2014 that itself wasn’t all that great. In other words, dealer bank activities haven’t been very profitable for some time.

Net revenue from trading fixed-income securities, currencies and commodities (FICC) fell 28 percent to $1.60 billion.

 

In comparison, JPMorgan Chase & Co’s FICC revenue fell 10 percent during the period on an adjusted basis, while Bank of America’s fell 9.3 percent.

 

The business, which once contributed about 40 percent of Goldman’s revenue, has been under pressure since the financial crisis as new rules discourage banks from trading off their own balance sheet and regulators demand that banks boost capital.

That last paragraph is the tempered version trying (listlessly enough) to understand what is taking place, brought to you by the same people that continuously focus solely on 12 minutes in computer trading as responsible for a major and maybe untenable shift in the whole global financial system. It’s easy to blame regulations, especially when they sound prudent on the surface, but what is taking place in the eurodollar system (and the global “dollar” short) actually seems to hold very little relation to “capital” or Dodd-Frank. This is not to say that those have created no immediate or lasting impacts, only that the trajectories of money dealing far better align with “market” events and trends.

I used the derivative book of JP Morgan to help in illustrating this point, especially as it was a good representation of how balance sheet factors are the primary “currency” under the eurodollar/wholesale framework (just to clarify, the eurodollar system is a wholesale finance system, or shadow system as it has been called, but it is not the only version). Over time, I think it will be helpful to present these balance sheet afterthoughts as they are updated especially to what is happening to the “dollar” more broadly.

ABOOK June 2015 JPM IR SwapsNotionalABOOK June 2015 JPM Credit Notional

Here I am going to use Bank of America Merrill Lynch even though their second quarter balance sheet as part of their 10-Q isn’t yet available. The basis for understanding derivatives as money supply is described, briefly, as:

In the modern, wholesale framework, the true “money supply” is far deeper than currency or even ledger “cash.” Because of the VaR-style framework for balance sheet construction, tied back to capital ratios and regulatory ideas about them, the ability to control risk management calculations amounts, in perfect kind, to a form of money supply; you might even go so far, as I would, as to recognize it as the form of money supply. If you can hedge at a definable price, you can define how much of a particular security or asset class in which to be able to invest. Once invested, that leverage is defined exclusively by the math!

 

If the “market” value of the hedges turns squirrely, that isn’t just a strict P/L problem for the income statement, but rather acts upon VaR, vega and all the rest. In other words, depending on a number of factors, without the ability to add additional hedges at desired prices and terms, leverage composition actually changes. In the case of 2008, because aggregate balance sheets were not attuned to taking on more risk, in the form of writing protection or the “needed” side of IR swaps, nobody could gain additional risk capacity to offset declining hedge effectiveness. The lack of derivative supply meant an exponentially greater decline in overall balance sheet leverage, and thus “money supply” contracted in the wholesale format exactly as it would have in a traditional bank panic.

And so the more general decline in derivative books after the panic, and really starting in the summer of 2011 when the euro/dollar crisis re-ignited, speaks to the overall retrenchment of the “dollar” itself. You see the exact same pattern defined in the TIC flows, where “dollar” behavior immediately after the crisis actually resembles a hopeful restart to the prior system. Then, all of a sudden, it fades out and has continued in a nearly uninterrupted descent since then. The less balance sheet constructions available as traded and chained liabilities, the less “flow” or activity that will result along with a noticeable increase in financial irregularity and even disorder. That has certainly been the experience in the “dollar” system since 2013’s taper events.

ABOOK June 2015 TIC Total Overall Cumulative 6

BofAML’s derivative book, as far as gross notional, looks about as you would expect given the “dollar” setup. The total notional amount of IR swaps, in particular, has declined significantly since the renewed banking difficulties in the middle of 2011; in fact, IR swaps have been cut almost in half, falling from $64 trillion at the end of QE2 to just $36 trillion as of Q1 (remember, notional values do not directly translate into dollars, as they just represent one form of a quantitative measure). That is an enormous amount of balance sheet capacity that has been taken “offline” for adding and nurturing financial leverage and expansion. Given the “dollar” behavior of the past year, it is also not surprising to see IR notionals drop quickly since the end of Q3 2014 (with October 15, January 15 and the rest thereafter).

ABOOK July 2015 BofAML IRsABOOK July 2015 BofAML Credit

On the credit derivative side, it is perhaps of note that total notional exposure was somewhat stable after the panic until Greece and Europe first erupted in 2010. The bank’s credit book was also seemingly smooth in 2012 (LTRO’s, $ swaps and all that?) and into the first quarter of 2013, renewing that decline once the taper selloff in credit and MBS hit.

In both cases, neither IR swaps nor credit seem to have been significantly affected by any of the QE’s, and certainly not more than a temporary bump, which I think accounts for one reason as to why QE has had such little impact on overall financial operation. It just doesn’t translate into the wholesale system as its designers expected, as bank balance sheet factors are far more remote to monetary policy.

The reason I wanted to show BofAML, however, is that the bank’s forex book is quite interesting in this context of on and off QE and the “dollar” thereafter.

ABOOK July 2015 BofAML Forex

Neither Bank of America nor Merrill as a standalone had much forex exposure before or during the panic. That has changed over time in what could be taken as somewhat of an offset to the IR swap and CDS decay, but in a transition that is decidedly not neutral. I find it significant (though this is pure speculation on my part) that the notional “supply” of forex is most intense during some of the more disruptive periods – first in 2011 and then at the end of 2013 and into 2014.

It may be that the global end of the eurodollar system has been using forex derivatives as a replacement or more inefficient substitute for other balance sheet mechanisms that no longer are quite available. That seems to be quite plausible as to what may have occurred in the first half of 2014, which was quite placid in comparison to the six months before it and the year thereafter. In other words, forex derivatives may have been a “dollar” filler which, for a time, allowed the system to exhibit calm as long as there wasn’t any further and immediate pressure. Once applied starting in late June last year, it all fell apart once more and to a greater degree this time vs. 2013.

While again cautioning that this is just another anecdote, I believe the history of BofAML further adds to the theory of the eurodollar system as it erodes; particularly in view of what is transpiring in overall “dollar” behavior in the past year. It makes intuitive sense, after all, that money dealing banks that struggle to be profitable undertaking money dealing activities would, over time, do less and less of it. That is certainly amplified under conditions where it is calculated to be more “risky” to engage in balance sheet supply.

The result is self-reinforcing negative trends where the “answer” seems to be that none of them want much to do with any of this at all. The problem, as we are witnessing now, is who or what picks up the slack. To this point that has been central banks but they neither recognize their own destructive imprints nor the fact that this is even taking place. Central banks are, in fact, a very poor substitute which is why their interventions end up as enormous reconstructions; when you are highly inefficient it takes a massive effort to absorb even the smallest functions. Thinking about eurodollar “supply” along these lines, in terms of aggregated balance sheet capacity, dealer banks are still exiting and central banks are, and have been here and there, trying to follow them. That global disorder might result isn’t that surprising even when the system tries to adjust, with forex derivatives or other future conduits.