Interest-rate derivatives poll 2009: Post-traumatic stress

INTEREST RATE SWAPS and options were not to blame for the financial market carnage of recent years. But as curves gyrated and bid-offer spreads widened, profits turned to losses and flow business dried up. In 2009, liquidity has come back and banks are making money again in rates. But trading hasn’t fully recovered. Liquidity comes and goes, and dealers are still coping with varying degrees of post-traumatic shock.

The crisis has posed the ultimate test of banks’ ability to meet clients’ demands. Against this backdrop, the Total Derivatives Dealer Rankings attempt to determine who passed the test.

The results

Which banks led the pack? JPMorgan, Deutsche Bank and Barclays Capital all battled over the top-three slots in dollars and euro. However, MUFG came first again in yen interest rate derivatives, with a slightly increased share of the vote. And in sterling, RBS continued to top the tables.

It’s impossible to ignore the fact that JPMorgan was once again the dominant name in fixed-income derivatives. The bank came first overall ahead of Deutsche Bank and Barclays Capital and was also ranked first for dollar swap buckets, dollar options, dollar exotic rates and euro options. JPMorgan also ranked second in a number of categories including euro swaps and yen options.

Swaps liquidity improving

But even JPMorgan is cautious about sounding the all-clear on swap market conditions. Liquidity is "an ongoing challenge," says Chris Willcox, the bank’s global head of rates trading. "We would suggest that the market has not fully recovered." But while liquidity is depressed in the interbank markets, large, well-placed banks "are still able to access better liquidity through diversification of their client base", especially in the lightly structured flow products such as options and inflation, says Willcox.

More positively, bid-offer spreads have compressed a lot from their worst levels and are continuing to tighten. However, liquidity levels are not in line with the spreads, Willcox suggests. "Clients are probably seeing the most competitive offerings, due to the proliferation of e-trading platforms and the ability to aggregate prices which creates a very tight composite two-way market," he says.

Wayne Felson, European head of rates at Deutsche Bank, has a broadly similar view of conditions. "Liquidity has returned in delta-1 and, increasingly, in options," he says. "While bid-offers in Europe remain wider, they have continued to tighten from the post-Lehman period, and business is broadly back to normal."

At the same time, drivers of flow in swaps are shifting. "Much of the de-risking activity has been completed but this has been partially offset by real money looking to diversify their counterparty credit risk exposure and hedging the increase in issuance this year," says JPMorgan’s Willcox. "Clients have started to become more price sensitive" but the interbank market continues to see "very limited depth", he warns. "The market generally still seems to be exhibiting some post-traumatic stress and can be very liquid for a while, but then get quite thin without warning."

Fewer banks, fewer funds

A key factor for all participants is the reduction in the number of players active in the market. Indeed, a general observation from the Dealer Rankings is that the top-three banks in almost every currency and product grabbed an increased share of the total vote in 2009, compared with 2008.

Many banks have experienced a great deal of pain in options and inflation and there are now a lot fewer participants, notes Willcox. "There is a recognition that in these products, more critical mass is required to justify the risk infrastructure and to be able to generate offsetting flows in an illiquid inter-bank market," he believes.

Still, the fall in numbers has tended to be a bigger issue in dollar markets, given the dislocations of Bear Stearns, Lehman, Merrill Lynch and Bank of America, which were "much more significant in that market than in Europe", according to Deutsche Bank’s Felson. However, he confirms that the European options market has been adversely affected by the declining number of hedge fund participants.

The rankings in Total Derivatives’ dollar interest rate league tables were clearly affected by the events of 2008 and 2009. Barclays Capital’s broad-based improvement in the dollar rankings is apparent and provides even more evidence, if it were required, that the bank’s move to take over Lehman’s US operations is bearing fruit. Indeed, Barclays Capital even nudged Bank of America Merrill Lynch out of the top three in some dollar interest rate products. In Europe, the bank fought its way into the top three overall for euro interest rate derivatives and was unchanged at second place for sterling products, marginally behind RBS.

Another strong performer in the rankings over the past year was Deutsche Bank, which retained its first place for euro products and also held on to second place for dollar interest rate derivatives, with an improved share of the vote.

There was substantial movement in the rankings for sterling rates. RBS and Barclays continued to battle for the top two places but Deutsche took third place by a fingertip and Abbey/Santander and HSBC were not far behind. "Many institutions have deleveraged risk levels on the back of reduced risk limits and rate markets are generally quieter in a low-interest-rate environment, all leading to reduced levels of liquidity," says Steve Ashley, RBS’s global head of flow fixed-income trading. "We have started to see a narrowing of bid-offer spreads although it’s still too early to say whether this is long-term reversion to pre-Lehman levels."

Yen interest rate swaps were dominated by four banks, with MUFG winning first position at the front of the swap curve, while Nomura took the honours for swaps in the 10-year to 50-year bucket. Hiroyoshi Sakamoto, general manager, rates trading and sales, with MUFG in Tokyo, notes demands from clients for enhanced liquidity. Sakamoto explains that while clients feel that the bid-offers on plain-vanilla products should be reduced to pre-Lehman levels, the liquidity in the interbank market cannot support these demands. Consequently, Sakamoto contends: "The significance of a deep domestic and international franchise has increased exponentially." In MUFG’s case, its franchise has allowed it to provide enhanced liquidity to clients and afforded the bank greater ability to offset and hedge risk.

From here, MUFG’s Sakamoto expects further consolidation in the banking industry. "Clients will now demand that banks and securities houses provide liquidity in an at-risk situation – and not simply on an agency-broking basis. One must provide the full gamut of services to survive – in both on- and off-balance-sheet products. Not many players can do that now – there will be even fewer in two to three years," he believes.

A new reality

Spreads in options have also come back a lot, although they "are still not anywhere near as tight as 2007 levels," says JPMorgan’s Willcox. In 2008, he says, options spreads had just "got too wide in many cases for option-driven structures to work for some clients, so they just had to deal with their risk with first-order delta hedges. Now that spreads are more normal we are seeing a lot of that residual second-order risk-restructuring coming through."

But the departure of the leveraged funds has particularly affected the options markets. Deutsche’s Felson agrees that hedge funds are far less important to the options market now. "Leveraged funds are coming back to a degree but activity remains well below pre-crisis levels. This may be one of the longer-lasting outcomes of the crisis," he suggests.

How have business models changed for exotics and structured notes? BNP Paribas took first place in the rankings for euro exotic rates. Kara Lemont, head of interest rate and FX structuring, EMEA, says BNP Paribas’ model hasn’t changed dramatically but she accepts that "as ever, when markets shift, people shift their focus slightly". For example, "structurers are more client-facing than five years ago, and spend more time working on tailor-made products for specific client solutions," she says.

On the exotics side, Eric Etienne, global co-head of interest rates exotics at BNP Paribas, reckons that although it is fair to say that banks still have appetite for exotic risk, there are fewer players. "Those who entered the business recently, but maybe didn’t invest enough in IT systems, quantitative research, structuring and trading, have pulled back. There are a few solid players, such as BNP Paribas, still in the market," he contends.

Fewer deals have printed in the structured notes business but "the real question is whether clients still have appetite for exotic risk," says Lemont. She says that clients’ declining appetite for very exotic and highly leveraged payouts has been evident over the past nine months. "Don’t forget that on the rates side, in contrast to the credit business, we very rarely do deals which are not principal-protected, so the business is normally less risky, but the rates business was also affected."

However, BNP Paribas has of late seen "a lot more appetite" for flow exotics with more straightforward payouts. Moreover, "if the market for more exotic risks comes back, we will still be well positioned to accommodate that demand, our platform is very flexible," Lemont says. She takes the view that simple structures will remain popular for the time being. However, towards the end of the year, if there is no new shock to the market, and credit spreads start to come in again, she foresees a rise in demand for more structured business, "as a necessity to generating yield".

JPMorgan’s Willcox also expects the return of a search for yield. "The low-return environment will inevitably lead a select group of clients to start to seek higher returns via structured products. The key question is if and when this appetite takes to return in any scalable form and what products will be deemed acceptable."

Lemont also stresses the continuing demand for strategy derivatives (proprietary algorithms). "Some of the indices in the market did not perform as well as expected during the turbulence in the market post Lehman, but they still outperformed most other benchmark indices and there is still a preference for transparent but managed product," she suggests.

In their defence, interest rate exotics have been a very profitable asset class for clients, points out Mathieu Gaveau, global head of interest rates options and exotics at BNP Paribas. Callable range accruals and non-inversion notes, for example, have been delivering a nice return to those investors or liability hedgers with a medium-term to long-term time horizon.

Inflation risk to the fore

Inflation markets, after a rough patch following Lehman’s demise, have rebounded as the focus has turned away from deflation. In the Dealer Rankings for inflation, Barclays Capital just managed to hold off a strong challenge from Deutsche Bank to take the global top spot, led by a first-place performance by Barclays Capital in dollar inflation and a second place in both euro and sterling inflation. But Deutsche was ranked first in euro inflation this year, from third in 2008. RBS managed to hold on to its first place in sterling inflation and rose to fourth in euro inflation behind BNP Paribas – last year’s winner. MUFG was ranked first in the troubled yen inflation market, with Nomura surging to take second place in yen.

"Inflation has been especially impacted [by the crisis], as it was always a warehousing market," according to Ralph Segreti, managing director, inflation-linked and fixed-income index derivative product manager, at Barclays Capital. "Inflation would be sourced from corporate supply – typically asset-swapped issuance – and held by dealers until an LDI came along. The supply chain has been severely hampered, and few are willing to hold risk – rather choosing to push it out the door as quickly as possible," he explains.

Even so, Segreti believes there is huge growth potential in the coming year. "More investors are moving into the asset class for both diversification and hedging reasons," he says. "Sourcing swap supply remains a challenge but as the asset swap markets normalize, flow has been resuming. Fears over the effects of quantitative easing and the prospect for EM-driven commodity price inflation will be a major driving factor for the coming year." He believes that quantitative easing is prompting many long-term investors to re-evaluate their asset allocation mix. "Fears of future inflation abound, with investors seeking to defease associated risks as much as possible," he suggests. Meanwhile, the bank is starting to see a slight return of leveraged money and relative-value players.

Paul Canty, head of Europe inflation trading at Deutsche Bank, confirms the improvement in market conditions, especially in inflation swaps. "They are now quoted with similar bid-offer as before last summer," he notes, agreeing with Segreti that end-user buying of linker asset swaps has helped to restore liquidity. But inflation-linked bonds "still have some liquidity issues, particularly at the end of each quarter, due to market participants’ balance sheet constraints," he says.

What kinds of inflation products are Deutsche’s US clients demanding? "Two clear themes have emerged," finds Allan Levin, the bank’s head of inflation derivatives trading in the US, "fear of potential inflation, with clients wanting to buy inflation in swap or note format, and demand for Tips on asset swap, where investors have been taking advantage of the significant pick-up over treasuries."

Regulatory pressures

The new regulatory regime "has yet to fully play out," judges JPMorgan’s Willcox. In his view: "There appears to be an increasing acceptance that OTC derivatives, especially rates, play an important part in enabling end-users to hedge in the real economy." For its part, JPMorgan supports the introduction of clearing for the OTC derivative inter-dealer market and for "a subset of clients who value the benefits of clearing sufficiently to offset the increased cost". However, for the likes of corporates, the mandation of clearing would represent "an aggressive tightening of credit terms that would manifest itself either in less effective hedges or redirection of capital to support margin calls both initial and variation," he contends.

Since Lehman’s demise, nearly all eligible inter-dealer transactions are now cleared to SwapClear intra-day. The key will be to "extend this clearing concept to end-users over the coming months," Willcox believes.

But will all OTC derivatives be centrally cleared, eventually? And what structural changes will higher capital charges force on to the markets? "It makes sense to clear the OTC derivative inter-dealer market and transactions for certain segments of the non-dealer trading counterparties, such as hedge funds and asset managers," reckons Willcox. But he also argues: "It is not possible or prudent to attempt to clear rate derivatives for corporates, or non-standard transactions where there is insufficient liquidity to enable effective price discovery or portfolio liquidation in the event of a default."

"Anything that improves liquidity and helps options clearing is welcome," says BNP Paribas’ Lemont. But she warns that the OTC market is crucial for hedging counterparties and structured-note investors. "Being able to develop tailor-made solutions for counterparties to manage their diverse risks is an essential part of the financial markets. In any case, we will most likely end up with standardized products being cleared and OTC products remaining alongside – so no major change."

Other than regulation, JPMorgan’s Willcox sets out what he sees as the key issue for fixed-income derivative markets over the coming year. "Clients will continue to diversify their counterparty risk – especially on uncleared products or before the introduction of clearing. E-commerce offerings will be increasingly leveraged by clients in line with the directive for more market transparency and efficiency," he says. Hence he believes that the market will continue to move in a direction "that makes size and economies of scale crucial for effective operations in the flow markets".

BNP Paribas’ Lemont takes a more historical view. "The market moves in cycles, and there has been a lot of talk about structured products being finished," she says. "That is a misconception. Being able to transform one client’s risk into a risk that another client wants to take is what derivatives business is all about. That can be packaged as a super-leveraged exotic product with a lot of risk, or a simple structure. If we were to revert back to a world where swaps didn’t exist and people could only buy centrally cleared securities there would actually be a lot more risk in the market."

Liquidity, balance sheet and counterparty risk costs were priced far too tightly in the past, and most of the wider bid-offer spreads on swaps and other vanilla instruments seen now are a direct result of people pricing this risk correctly, according to Lemont. "In future, people will pay more attention to the credit risk they are taking when they buy an MTN, for example, rather than just assuming all financials pose the same risk. Liquidity and balance sheet is harder to come by now, so people will price it properly, whereas in the past, some counterparties priced those things, and some just ignored them."

Finally, Deutsche Bank’s Felson notes the massive macro risks for rate markets. "The key issue is around the ultimate terminal level of rates, whether we fall into a Japan scenario environment of extremely low rates or some form of inflation-driven, high-rate environment not seen since the late 1980s. Markets have operated in a comfort zone for the past two decades and a move to either extreme would likely be significant."