Volatility surge: too much of a good thing for traders

By Lionel Laurent

LONDON (Reuters) - Market volatility is traditionally a boon for brokers and banks hungry for client activity. But the latest bout may signal growing unease about a six-year-old bull market that owes much to repeated central bank largesse.

For much of the year, ultra-cheap cash and faith in a recovering global economy has kept equities on the rebound. In the first half of 2015, trading volumes jumped 36 percent worldwide, according to the World Federation of Exchanges, though the rise was a far more modest 5 percent after stripping out mainland China's rollercoaster stock market.

That in turn has helped banks squeeze out more trading revenue despite pressure on all sides from increased automation, intense competition and post-crisis regulation. First-half equities revenue grew 18 percent at the top 10 investment banks, to $25 billion, according to data from research firm Coalition.

But after last month's China-fueled spike in the VIX volatility gauge <.VIX> to its highest since 2008-2009, flows are drying up and major indexes like Japan's Nikkei <.N225> or the S&P 500 <.SPX> are making daily moves of 3 to 8 percent.

"Volatility is generally good for trading desks but when you see Japan up 8 percent overnight, or Wall Street down 400 points ... The risk is just too much," said Mark Ward, head of execution trading at Sanlam Securities in London.

"Volatility like this is horrendous. It's volatility on steroids."

It may already have inflicted some pain, albeit manageable, on investment banks. While curbs on risk-taking have reduced banks' exposure to proprietary trading, J.P.Morgan analysts warned last week that August's bruising sell-off may have led to losses and dented future trading and deal flows.

"Investment banks are not immune to the market movements," they wrote in a note to clients. Beyond hits to profitability, the analysts forecast double-digit falls in equities and fixed-income revenue for the third quarter.

The surge in the market's fear gauge is blamed on fundamental and technical factors alike. China's slowdown is alarming markets at the very time when the U.S. Federal Reserve is weighing its first interest-rate hike since the 2008 meltdown, while trend-following algorithms exacerbate losses.

Whatever the cause, global equities fund flows are now in negative territory year-to-date, according to BofA-Merrill Lynch research on Friday. Investors are complaining of "untradable" markets and a perceived lack of liquidity, strategists said, even if a big shock to the system has yet to materialize.

"The increased volatility and (Fed-related) uncertainty ... has reduced flow to a trickle, with both the single-stock traders and derivative sales reporting a paucity of directional volumes," Deutsche Bank Managing Director Nick Lawson wrote in a note to clients on Friday.

It is still too early to say whether the current turmoil will derail a recovery in trading revenues.

"It's not a hugely positive sign for volumes to pull back so quickly after such volatility ... But this might be a slight pause as opposed to a reversion in the trend," said Craig Viani, Vice President at consultancy Greenwich Associates.

Industry watchers say losses are likely to have been in the manageable range of $50 million to $60 million. The jury is still out on whether the most active hedge funds will retrench, said George Kuznetsov, head of research at Coalition.

In many ways, the safest bet is on volatility itself. Crossbridge Capital's Manish Singh said he was using volatility-linked derivatives to trade on the Fed's policy meeting next week.

"Whether the decision from the Fed is to hold or tighten policy ... expect volatility to remain elevated," said Deutsche Bank's Lawson.

(Reporting by Lionel Laurent; Additional reporting by Atul Prakash; Editing by Ruth Pitchford)

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