Getting in on the hedging and pre-hedging for a deal used to be a game changer for DCM banks. Some swaps are more lucrative than others, but with long-dated cross-currency swaps, for example, they could often make many multiples of their underwriting fee.
More competition and new regulation have, however, made fee generation from the derivative far more of a challenge. "The swap business used to have a much higher margin built into the bid-ask," says one banker. "If the bid-ask was 34/32 you would trade one side of it. But now everyone expects mid-execution. Everyone trades at 33." And the persistently low interest rate environment doesn’t help either. "In the US it is very tough to make money in this business," says another. "Interest rates are so low it is tough to get anyone to hedge treasuries: if the interest rate goes up by 20bp who cares?"
But it is the impending Basle III collateral requirements that might require both parties to the swap to post collateral against it that really worry the banks. "Traditionally the biggest source of alpha in DCM was the derivative written on top of the trade," says one swap specialist.
