Interest rates derivatives survey 2010: Banks adapt to changing structure of rates market

Methodology

IT’S MORE THAN three years since cracks began to appear in the US mortgage market and almost two years since Lehman Brothers filed for bankruptcy. But interest rate markets are still wrestling with the consequences of the crisis. Liquidity is no longer taken for granted, government debt comes with a default premium and counterparty risk has started to drive OTC derivatives pricing. And while profitability in banks’ rates divisions remains strong, regulatory pressure plus a new appreciation of risk has quickened the pace of change in OTC derivatives trading.

Banks and end-users are preparing to meet the new regulatory challenges but many still harbour doubts about the strength of the recovery. A sovereign debt crisis has underlined risky assets’ vulnerability and forced reluctant central banks and cash-strapped governments to take extraordinary measures to support economic growth, once again.

Interest-rate derivatives poll results


In this environment of cautious banks and battle-hardened end-users, the latest Total Derivatives poll tracks the changes at the top of interest rate derivatives trading. Looking by currency, Barclays Capital and Deutsche Bank both moved up smartly in the latest global rankings to first and second respectively, even as JPMorgan firmly held on to the top slot for US dollar derivatives trading.

Across interest rate derivative products globally, Deutsche Bank grabbed the number one position for both swap buckets, while Barclays Capital led the pack in inflation. JPMorgan retained its lead for vanilla options and exotic rates trading, as well as holding the top slot for most dollar categories ahead of Deutsche Bank and Bank of America Merrill Lynch. Deutsche Bank kept its lead across euro swaps, inflation and options from rivals Barclays Capital and JPMorgan, while yen swaps and options saw a tussle between Nomura, Mitsubishi UFJ Morgan Stanley Securities and JPMorgan. RBS held the lead in all the sterling rates categories but Barclays Capital was a very close second in swaps and options.

Regulation speculation

The dealer rankings reflect banks’ assessment of their peers’ performance over the year. But the push for reform of OTC derivatives trading might mean that the rankings shift again over the coming 12 months, if regulators follow the US example and consider pushing out certain kinds of derivatives trading to non-bank affiliates.

Consequently for Thomas Hartnett, Deutsche Bank’s head of rates North America, regulatory reform is likely to be the seismic event for fixed-income derivatives markets over the next year. "Much remains highly speculative as to what will eventually happen" and at this stage, it is still "too early to say what the impact will be on liquidity and market depth," Hartnett believes, adding that Deutsche is nonetheless building out product-driven initiatives and platforms to help its clients manage execution in the new environment.

Mayank Chamadia, head of US dollar interest rate options trading at Barclays Capital, broadly agrees. "We think the market will focus on regulatory changes for the next few quarters. In my opinion the [Dodd-Frank] bill has the potential to change the fabric of derivatives trading over the next few years," he says.

Despite the changes, Deutsche’s Hartnett remains positive. The dollar rates market has "strong liquidity" which is "positive for clients given the high level of macroeconomic volatility," Hartnett says. Indeed in his view, for delta one products liquidity is almost at pre-crisis levels while for non-linear products liquidity is only a shade under pre-crisis levels. Still, Hartnett acknowledges that interest rate volatility and recent events in the eurozone have made some dealers more risk averse.

Volatility flows mixed

Barclays Capital’s Chamadia describes conditions in dollar volatility markets. "In general, liquidity in the options market has been shrinking and will continue to shrink as hedge funds have largely walked away from selling options," he says. At the same time GSEs’ needs are declining and structured note issuance has gone down because of low rates and lack of appetite.

In euro options, end-users are "definitely coming back to the interest rate options market," says Mathieu Gaveau, head of interest rate options and exotics at BNP Paribas. He cites the examples of pension funds offering predefined returns to their clients looking to cover the risk of lower rates, and corporates that fear the return of inflation and want to hedge against the risk of higher rates. "Compared with plain-vanilla swaps, options can be very attractive – either in terms of outright cost or risk-reward," Gaveau contends.

Basis swaps and issuance trends

A big development over the past year has been the growing importance of basis-swap markets. Hartnett sets out some of the reasons for this: "Cross-currency basis swaps have been very active due to the increase in yankee bond issuance. Libor basis swaps have also seen more interest from real-money and relative-value players looking to take a view on funding levels and funding spread plays in OIS versus Libor," he explains.

As a consequence, arbitrage through the basis-swap markets has been a key factor behind bond issuance this year – against the backdrop of gyrations in sovereign debt markets. Issuers are now "more nimble" in response to continued macroeconomic volatility according to Deutsche Bank’s Hartnett. "There is a strong pipeline, but the funding window is more volatile," he explains. "As a result, issuance volumes can be more concentrated and issuers, on balance, are more sensitive about their ability to seize opportunities." Although corporates in general are well funded, historically low rate levels are driving "more pre-hedging and rate-locking."

Libor versus OIS

Funding and liquidity continue to be critical issues. In particular the OTC interest rate derivatives market has involved banks changing dramatically the way they price credit and liquidity risk. "The move away from Libor and towards Eonia funding is a clear example," reckons Kara Lemont-Sportelli, head of fixed-income structuring at BNP Paribas in London.

However, Deutsche’s Hartnett does not necessarily see OIS replacing Libor. "Not in the immediate future," he suggests. "Although OIS is growing in importance, given the outstanding universe of Libor swaps, any move toward OIS is incremental and has to be measured over a span of several years."

In the past, structured note hedging has been a key driver for flow business in rates. However, appetite for rates-linked structured notes has been driven by "profit-taking and restructuring of existing transactions on the back of market moves," notes BNP Paribas’ Lemont-Sportelli. However, she reports an increase in the use of lightly structured products following the narrowing of credit spreads. "The key influence on structured note issuance will be the outright level of rates and credit spreads," Lemont-Sportelli stresses. "If rates remain low, and credit spreads continue to tighten, there will be more and more demand for light structures to enhance yield for end-investors."

Yen rates cheat death

In yen interest rate derivatives, the market saw both domestic and foreign clients busy putting on large-sized flattening trades. "We have executed many interest rate swap flatteners, as well as conditional flatteners," says Hiroyoshi Sakamoto, general manager of Mitsubishi UFJ Morgan Stanley Securities’ rates trading and sales division. "Various exotics desks have been consistent receivers of 10-year to 30-year swaps while our hedge fund clients have preferred to use swaptions, JGB options and CMS spread options." The rationale for the trades is fairly consistent, according to Sakamoto, and is based on the view that "the BOJ is on hold and the market will extend duration in this risk-off environment."

Generally, banks describe the growth in domestic use of yen derivatives as encouraging. "Swaps, swaptions and asset swaps have become mainstream for our domestic client base," says Sakamoto. "Recently we introduced asset swap options so that risk can be taken independent of overall market direction. In two months, we will begin to provide liquidity in options on forward swaps."

Lingering in the background are Japan ‘death spiral’ trades from macro accounts. Sakamoto explains: "We have all heard the arguments for yen rates exploding: a debt to GDP ratio over 200%; an ageing and shrinking population; a declining savings rate; an expansion of quantitative easing, etc." Accounts expressed this view through payer swaptions and CMS caps – both in yen and but also quantoed into dollars, according to Sakamoto. "We offered accounts pricing in these types of strategies. However, we strongly advised against them, as we were not and are not a believer in the Death Spiral story." Crucially, the domestic client base was comfortable in adding JGB exposure.

An inflation paradox

Global inflation markets suffered badly from deleveraging at the height of the crisis but there have been rising levels of issuance over the past year. Benoit Chriqui, head of European inflation trading at Barclays Capital, summarizes the state of the market. "The opportunities that emerged when the markets deleveraged are not there anymore," Chriqui suggests. "Issuers are waiting for the credit markets while pension fund end-users see the level of real rates as very low. Hedge funds will be back but they want liquidity." There’s also "very little conviction around" about where markets are heading, which is holding back activity, he contends.

Chriqui says that this lack of conviction is leading to less risk being taken. At the same time, end-user activity in inflation markets over the coming year might remain in thrall to the macroeconomic outlook. There is a growing acknowledgement among clients about the need for structures to hedge inflation exposure, Chriqui believes, with government budget deficits and quantitative easing both stoking fears of inflation. But recently many end-users have become more concerned with the risk of a double dip than with high inflation, leading to a slowdown in end-user hedging despite attractive levels.

Indeed, the paradox of simultaneous deflation and inflation fear is leading to increasingly divergent views among market participants, according to Deutsche Bank’s head of US dollar inflation trading, Allan Levin.

"Inflation markets globally are currently pricing a fairly benign outlook for inflation but the forward curve masks the extent of the divergence of views," Levin says. "The options market tells us that although the average expectation is for inflation to be around central bank targets, very few people actually expect this outcome" over the medium term. Thus the forward inflation curve is essentially an average of two very different views: "prolonged deflation due to weak demand and austere fiscal policy versus very high inflation due to sovereign deficits and unprecedented monetary policy actions".

This has led to more participants seeing opportunities in the inflation market and the emergence of new players, Levin believes. "Linkers are perceived as expensive from a real yield point of view but cheap from a breakeven standpoint and the difference of opinion generates good two-way flows," he says.

As for supply/demand dynamics, Deutsche Bank’s head of inflation trading, Paul Canty, explains the situation. "Sovereign issuance of inflation-linked bonds has increased and traditional asset swappers such as banks and hedge funds have retreated. But now real-money investors are able to generate their own supply of swaps, either by freeing up cash to invest in physical linkers rather than LDI swap overlays, or by re-couponing in-the-money derivative positions and investing the proceeds in linkers," he suggests.

"The use of linker asset swaps as the sole measure of inflation swap supply has been one of the major stories of recent times," agrees Neil Weatherall, senior sterling inflation trader at RBS. However, with sterling inflation supply potentially diminishing it becomes "more important that private supply can be found and accessed," Weatherall believes. The bank’s clients have been restructuring their hedging programmes but there is only so much that can be restructured. "The market needs new flow and business – how, when and to whom this manifests itself will be key," reckons Weatherall.

Other banks tell a similar story for euro inflation. Franck Triolaire, head of inflation trading at BNP Paribas, believes that the key concerns for the market at the moment are liquidity and the recycling of risk. "Conditions have definitely changed, with wider bid-offer spreads, balance sheet constraints and increased focus on cost of capital," says Triolaire.

Jim Hough, head of euro inflation trading at RBS, notes that the Greek saga initially offered some good trading opportunities. However, as the crisis got severer and liquidity evaporated, inflation market makers "suddenly found themselves trading credit in a way they had never envisaged before, and ignoring the inflation component to these bonds entirely," Hough says.

Despite a recovery in volumes, the asset swap market remains "depleted", Hough confirms, with the absence of hedge fund and real money players still noticeable. Across the inflation curve, long-end swaps have seen continued demand from pension funds, especially with the lack of the much-anticipated German 30-year linker. As such, most bond supply in euro has focused on the 10-year area, which remains the most liquid and active sector of the curve, he notes.

Deutsche Bank’s head of euro inflation trading, Sakse Orstavik, sees the market finding ways to deal with lower liquidity. "The key concern for issuers is how to place a large amount of inflation risk into a difficult market. Syndication has been a useful tool in this respect and has been a benefit to both issuers and investors."

In the US, Barclays Capital’s head of US dollar inflation trading, Chris McReynolds, is positive about the prospects for the product. "I think one of the key drivers has been the broad acceptance of the asset class among dollar-based investors," he says. "Many investors still aren’t sure what the right percentage of real return bonds is in their asset mix, but they now know that zero is clearly wrong."

In the inflation volatility markets, despite reduced appetite for structured notes, interbank options volumes are at a peak in euros, with estimates suggesting that €10 billion of options traded in the first and second quarters of 2010. "Heightened inflation uncertainty and volatile curve moves have spurred bids for inflation vol out to 10 years," explains Mark Greenwood, head of inflation volatility trading at RBS. Dealers fearful of a repeat of the late 2008 gamma trap have been "trying to sell caps to buy floors". But, as Greenwood points out: "There’s been only limited client interest to buy caps on the hyperinflation story, so the inflation smile has tended to become more negatively skewed."

Triolaire at BNP Paribas also sees the inflation volatility market growing gradually, with more and more players getting involved. "We’ve built efficient tools and strategies to play the shape of the smiles and level of volatility," he adds.

In other markets, according to Greenwood, dollar CPI has seen "leveraged fund client flows come back to their peaks" with macro funds putting on some fairly sophisticated options structures. Liquidity is still a concern, though, so maturities are often limited to five years. As for sterling RPI, apart from some flow from pension buy-out firms, the supply side "continues to be clogged up due to low commercial property financing capacity," reckons Greenwood.

BNP Paribas’ Triolaire also highlights the ways in which inflation end-users’ swap and options needs are shifting. "We printed cumulative inflation swaps floored at zero with pension funds and sold some year-on-year floors through structures. Real money are looking at inflation volatility more carefully as a way to enhance their return or protect themselves in a deflation scenario," he believes.

Central clearing gaining ground

Changes in the regulatory regimes will have implications for inflation trading. Barclays Capital’s Chriqui says that the proliferation of Credit Support Annexes is becoming a headache for dealers, and inflation swap pricing is being affected by counterparty risk issues.

Central clearing "is under discussion for inflation swaps but will not be in the immediate future," reckons RBS’s Weatherall. "It would be reasonable to assume that banks will move to it in the first instance, client interest however is harder to gauge given the nature of the clearing agreement and the need to provide both initial and variation margin – the net effect of which represent a sizeable difference and cost as compared to their current collateral arrangements." Still, "central clearing for inflation swaps is inevitable at some point in the future," believes Deutsche Bank’s Canty.

"On average, the sell side is beginning to give more focus to centralized clearing but the operational complexities are very high," warns Deutsche’s Hartnett. Barclays Capital’s Chamadia agrees that many desks are focused on interpreting legislation but reckons that the key question that market participants are trying to figure out is whether banks and end-users will have to come up with more collateral. "There are some studies which suggest up to $2 trillion may be needed. We don’t agree," he suggests. "While the collateral requirement would go up, it would be an order of magnitude lower, about $200 billion to $300 billion, and mostly from end-users. Banks won’t have to post any more collateral than they already do."

RBS’s Weatherall highlights the example of linker asset swap levels quoted in the broker market. "The asset swap is essentially a long-dated funding trade and as banks have become more savvy as to what discount curve is appropriate the quoted prices have moved from being Libor-based towards OIS-based," Weatherall explains. "Valuations of all trades are/will be affected by this change in discounting policy, if they have not been already. Opportunities have therefore existed for banks and clients to take advantage of this during this switchover period to maximize (or minimize) the effect of the change." He adds that RBS has been working with clients across both collateralized and uncollateralized positions to identify their risks and how best to hedge them.

Traders stress that Japan has a very different regulatory structure. "Banks and securities firms are already separated, so there will be no need to undergo a painful separation and capitalization process that some legislators in the US have been calling for," explains Mitsubishi UFJ Morgan Stanley Securities’ Sakamoto. "Of course, if and when central clearing becomes the norm for yen derivatives, then we will become an integral part of the process," he pledged. However, for now, Sakamoto believes that exchange clearing will be confined to standardized contracts while many structured ­derivatives trades will remain outside the province of the clearing houses.

Other fears

Encouraged by regulators, banks’ use of central clearing continues to rise. However policymakers in the US and the EU are also pressing for more trading to take place on exchange/exchange-like facilities, alongside increased dissemination of OTC trade information. As regulatory frameworks continue to evolve, derivatives dealers warn that central clearing is no panacea. Critical, continuing issues include the need to ensure the highest risk management standards at the clearing houses, along with proper rules for public dissemination of trade information. The latter, if not done properly could make market making in derivatives challenging and lead to illiquidity and a cost eventually passed on to consumers and the economy, some desks warn.

The impact of regulation on the direction of rates and volatility will depend on how the rules are written. "It’s likely that certain products like swaps benefit by these changes in terms of liquidity and bid-offer, but products like options end up costing more bid-offer," one trader believes.