Banks will struggle to recoup the fat returns they grew used to by trading anything from complex bond derivatives to gold and currencies, as a clampdown on their riskiest activities bites.

Europe's escalating debt crisis and uncertainty over the U.S. debt ceiling are being blamed for a double-digit dip in bank trading and sales activities in the last quarter, with clients wary of taking trading positions.

But the threat of a more permanent structural downturn looms over the Fixed Income, Currencies and Commodities (FICC) business, the black box of investment banking, whose lucrative trades have been the industry's main revenue driver.

Investment banks are normally associated with the high-profile advisory business, but it has been the less glamorous trading floors which have often make the bulk of revenue. And it is the traders who regulators have firmly in their sights.

FICC desks generate somewhere between 40 and 60 of investment banking revenues at Credit Suisse , Deutsche Bank , UBS , HSBC and Barclays , according to a recent Morgan Stanley estimate.

But the once-lucrative business is not raking in the money like it used to.

In fact, a cross-section of 7 large investment banks saw revenues from core fixed income sales and trading fall by 33 percent in the second quarter on average, according to Credit Suisse, a total decline of roughly $8.8 billion.

Goldman Sachs was the worst hit with a 64 percent drop, Morgan Stanley was down 36 percent, and J.P. Morgan fell 20 percent, the smallest on the list. The numbers were compared to the first quarter of 2011.

Nobody is predicting the death of the fixed income market, given the borrowing needs of companies and countries both in developed and fast-growing emerging economies. But some are forecasting a permanent fall in both size and accompanying jobs.

The business will come back, but it will be 20 to 30 percent smaller than it was. In 18 months time, investment banking headcount will be 20 percent smaller than it is now, said Anthony Peters, a strategist at Swissinvest.

The total stock of debt outstanding - in bond and loans, for companies and governments - reached $157 trillion in 2010, according to a study by consultancy firm McKinsey, far larger than the total global stock market, worth $54 trillion.

LOWER GEAR

Some of the shrinkage is due to wary clients. Hedge funds have sharply cut back their bets, according to prime brokers -- the bankers who provide them with services from loans to office space. Many, hurt by the whirlwind of the past months, fear second-guessing politicians who are dealing with the crisis.

That business could come back. However, the slow death of proprietary trading -- the positioning of a bank's own money to make trading gains that is banned under the new U.S. Dodd-Frank rules -- means sales and trading may not recover fully.

Many banks have closed their prop trading desks in anticipation of the new rules coming into force. Even European investment banks, which may be less directly hit by the U.S. law, are in retreat. But the full impact may have yet to show.

Visibility on banks' proprietary trading performances is poor. It is difficult for an outsider to determine where the client business stops and proprietary trading begins, Credit Suisse said in a recent research note.

One banker, who works in the fixed income market, said he believed prop trading was still widespread, signaled by the undiminished volumes in interest rate swaps trading.

The volumes haven't really changed... If prop trading was significant before, and now it's gone, then wouldn't the volumes have come down?, the banker said. A further clampdown on prop trading could mean permanently lower volumes.

At the same time, financial watchdogs are putting an end to the behind-closed-doors trading of derivatives, a practice that earned itself a bad reputation in the credit crisis, when arcane derivatives blew up without forewarning.

U.S. and European regulators want these instruments to be traded on exchanges, rather than bilaterally over the phone as is now the case. That would shed light on this secretive business they say, and make it less risky.

It would also mean far lower margins for banks, who now charge fees for structuring a derivative instrument to the demands of individual clients, for the operational risk that comes with the deal, and for market risk.

All three fee components will be under severe pressure under the new plans. Exchanges will offer standard products, so there is no need to structure them. The operational risk will be minimal, and the market risk much less.

In the current world, the sell-side has pretty much all the leverage. It is their contract, it is their terms. (Under the new rules), the risk premium that the trader makes on an interest rate swap should disappear, the person familiar with fixed income markets said.

Lower income will inevitably mean job cuts. Much of a recent round of job losses may already reflect the outlook for a more modest business, where salaries were once gold-plated to reflect the booming business. [ID:nL6E7HU0G8]

Cost management will be critical, with both UBS and Credit Suisse initiating a cost save plan (joining Barclays, Deutsche Bank, HSBC, etc.) Cost-cutting will need to be deepest in FICC, Morgan Stanley said in a note.

(Additional reporting by Laurence Fletcher; Editing by Alexander Smith)

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