Fixed income derivatives - There must be a betterway

Since derivatives aren't an asset class it surely makes sense to sell them along with the underlying cash instrument rather than market them independently.

Mehmet Dalman

There is an inherent conflict. The more you integrate product areas, the less vigorously individual products are marketed. Selling integrated solutions to customers' risk-management problems sounds good, but turnover suffers.

One derivatives expert recalls the sad history of Paribas, which went for total integration in around 1993. "I think it was a mistake: it killed derivatives at Paribas," he says - although there was a later attempt to recreate an independent derivatives operation.

The ideal, for fixed-income products, is that the bond salesman is derivatives-literate but that if the client needs a custom-made derivative such as a structured note he calls in a specialist to explain the risk/reward and to close the sale.

But this doesn't work for all types of client. Some, such as hedge funds, want to talk to a polymath who can present any solution the bank has to offer: they prefer to be treated almost as another dealer. A sophisticated buyer of structured notes might respond best to a multi-person structuring team making a slick Powerpoint presentation. By contrast, a less-sophisticated buyer of structured notes might be happier with one salesman to whom he's not ashamed to show his ignorance.

The bank aims to be flexible and sensitive to the client's needs. Also, however unintegrated the product areas are, it tries to present a totally integrated face to its customer. The credit derivatives department may be in a separate building or in a separate country, but the salesman will strive to give the impression that they're sitting at the same desk.

If this is the ideal, the reality among even the top derivatives firms is a mish-mash of solutions and fudges.

Jean Dominjon, formerly at Société Générale, believes that integration and deintegration goes in cycles: a move towards integration works for a time until conflicts of interest drive the product groups apart again. "If you have a marketer selling equity and FX derivatives, he would sell only 95% of the derivatives he could sell," says Dominjon. "Every three years you discover you're weak." Société Générale would prefer to have individual teams, for example one selling equity derivatives and the other interest rate derivatives.

At the other extreme, however, are the "total solution" firms, such as Chase or ABN Amro, according to their own description. "The primary driver," says David Brown, head of derivatives and forex marketing for Chase in London, "is to integrate product delivery - so that the client sees one team, and we can contemplate the full risk-management needs of the customer."

Simon Rogers, head of derivatives marketing and structuring at ABN Amro, says his aim is to "get in at an early stage" before the origination and his own swaps people have bombarded a client with products. The message to the client is: "We can add value if you give us your portfolio." The solution might be to unwind a swap rather than to add another.

Specialist firms, such as Morgan Stanley and Goldman Sachs, have the same marketing strategy. In fact it would be foolish for firms not to try to convey this message.

But there is also the challenge to achieve volume, deal flow, and margin. "The margin on commodity trades is 2% to 3%," says one marketer, "so there's big pressure to press for commodity derivatives."

JP Morgan recognizes that in the government bond business, volume and "flow" are vital for market information and the ability to provide customers with a narrow bid-offer spread. "Flow product is important to us," says Eric Bertrand, co-head of interest markets in Europe, "as a tactical business and for the ability to recycle our client-originated risk positions." Government bond sales are no longer in the hands of generalists but specialists who are also rewarded by volume of sales.

JP Morgan, like many top firms, has put more and more derivatives people into its salesforce. Even though the bond salesman isn't transacting derivatives himself he is actively involved in the selling process, in identifying clients' needs and calling in structuring specialists. Credit Suisse First Boston likes to have one person covering the overall relationship with the customer, "but he will bring in others," says John Zafiriou, head of European coverage for fixed income and derivatives at CSFB. And he must be quick to respond to such a need, says Zafiriou: "he realizes that if he doesn't bring in the high-yield specialist straightaway, a competitor will."

Limited flexibility

It would be nice to think firms have the versatility to jump easily from one product possibility to another. But in reality they have their own biases, based on the quality of salesmen, the historical product split in particular firms, and inevitable turf wars.

Willi Hemetsberger, chief executive of CA IB Investment Bank (CAIB), is quite cynical about the reasons for this: "It's a clear power game. Why in most firms are short-term swaps traded in the treasury and the rest elsewhere? People defend their jobs; these are political and social issues." At CAIB, Bank Austria's investment bank, cash and derivatives are fully integrated, although admittedly just for equity products. Only in Budapest does CAIB trade debt products too. But Hemetsberger believes that all traders should have a derivatives background, as his do. "All cash and derivatives instruments are just discounted cashflow," he says. "A bond is an option on interest rates. All derivatives are doing is making asset trading more specific. With corporate bonds this is even more relevant, being split into the risk-free element and the credit spread. The old cash traders simply couldn't do the mathematics," he adds.

But most firms are careful to say that there is still room for the traditional bond salesman. "In specific markets such as the UK," says Bertrand at JP Morgan, "you need to be focused to be successful. Only accomplished salesmen can tell a credit story well."

JP Morgan's internal segmentation, says Bertrand, is between the interest-rate market and the credit market. Many other firms aspire to the same split. But there are difficulties about where to fit equity derivatives, and government bonds, which are distributed to the same clients.

"We've put a lot of derivatives people into our salesforce," says Bertrand. In fact many regional and divisional managers at JP Morgan, Deutsche Bank and CSFB in particular, have a derivatives pedigree - starting at the top with Allen Wheat, CSFB's chairman and CEO who built up derivatives at Bankers Trust, and Edson Mitchell, head of global markets at Deutsche, who did somewhat the same at Merrill Lynch.

The different ways in which these three firms organize their marketing says a lot about their history.

JP Morgan is probably the most integrated, although the others are heading that way. Bertrand vaunts his salesmen's "ability to manage ambiguity, with products and with clients". There is no best way to deal with a client since each has different needs and a different level of understanding. But JP Morgan has specialist teams for leveraged funds, corporates, sovereigns, institutional investors, users of flow products (liquid government bonds and flow derivatives), leveraged finance and M&A, and tax-based transactions. Since you can't ignore geography there is also a regional matrix.

The firm is building what it calls a "client knowledge engine" which means there is a record of all JP Morgan's relations with one client, available to any person dealing with that client.

The question facing JP Morgan and others, says Bertrand, is "how much of the structuring side of the business (designing structured notes, custom-made credit derivatives, etc) do you put with the client and how much with your own trading desk?" At some firms, such as the former Bankers Trust and Credit Suisse Financial Products, the trader would structure and the market sell. Bertrand's marketing team tends to tailor the structure to the client. But "it's more costly than having traders responsible for the structuring," he warns.

Credit Suisse Financial Products (CSFP), a pure derivatives house, was merged with CSFB a year ago. "We were very specialized at CSFP," says Zafiriou, "and we weren't reaching the clients we wanted to reach." CSFB's bond-buying clients were developing an appetite for structured products. "So the route is to combine distribution of cash and derivatives." That doesn't mean, Zafiriou hastens to add, "that our cash salesmen have become derivatives experts." They're not structuring asset swaps or credit-linked notes themselves, but they're talking about what a client's needs are and bringing in specialists. The salesmen and specialists share the same P&L, he says.

"Historically, equity derivatives have been a big part of our business," says Zafiriou. "Recently equity derivatives trading has moved closer to the trading of underlying cash equities as the two have become more interdependent. However, equity derivatives are still marketed alongside derivatives on other asset classes as well as securities."

In the past CSFP's equity business was in index products. "That has changed," says Zafiriou, "as clients have become more interested in basket and single-stock products that have addressed the changing needs of our client base."

A derivatives literacy campaign

At Deutsche Bank, the fundamental change wrought by the coming of Edson Mitchell in 1995 included a closer integration of derivatives with all areas of the global markets division. Saman Majd arrived the same year to head interest rate derivatives and later credit derivatives. In early 1998 he also took responsibility for government bonds. Majd believes Deutsche stands out for the way "derivatives literacy has permeated the global markets division". The acquisition of Bankers Trust, completed last year, brought in a firm which, like CSFP, had been derivatives-driven. "They were organized quite differently, with a business not built on cash products," says Majd. But they have certainly added to Deutsche's derivatives expertise.

"I try to make sure my traders are derivatives athletes," he says. Moreover, the selling of sophisticated products still need specialists not generalists. "We have specialists selling structured products," says Majd. And within credit derivatives there is a "repackaging unit" that creates such things as special-purpose vehicles. There is also a separate group that focuses on money-market products, such as overnight interest-rate swaps, which reports both to Majd and the money-markets division.

"But sometimes the specialization in derivatives must be combined with other product expertise," says Majd. For example, Deutsche has a special hedge fund group within sales: "Hedge funds want one guy who can show them a range of products," says Majd. He reels off the derivatives pedigree of many of Deutsche's senior managers. But he asks whether "at the logical extreme derivatives will become a virtual business: I don't think it will ever get there." The firm's business is so broad "we'll always have clientele who are derivatives-specific."

For most firms there is the challenge of fitting credit derivatives into an existing framework. At Deutsche they are put with other derivative products, but separate from credit trading (the trading of corporate bonds).

Credit derivatives take off

In time, the credit derivatives business of most firms is destined to expand into all credit-sensitive areas. "Credit derivatives have only really been around since June 1999," says Mike Christieson, managing director for credit derivatives at Warburg Dillon Read. That was when the industry produced a robust definition that would satisfy most participants that a payout would be triggered properly by a credit event. Since then the demand from high-yield desks has become enormous, Christieson says.

The market for credit derivatives "has expanded dramatically" says Zafiriou at CSFB. "We can expand business with counterparties where before we had credit line problems."

Chase divides its derivatives business between the global trading division, which handles interest-rate, equity and commodity derivatives and foreign exchange, and the securities division, which handles securities and credit derivatives. "A lot of my time," says derivatives and forex marketing head Brown, "is spent on integrating FX and derivatives with other parts of Chase: FX products for the custody division; structured notes for the securities division; structures for M&A and other big-ticket financings." Even though credit derivatives reside with securities "I have certain salespeople," says Brown, "whose clients are buyers of credit derivatives. We try to make our clients unaware of the organizational divide."

The global players are facing increasing competition in Europe from what they like to call the "second tier". These are the large regional banks with a big domestic customer base, including banks and fund managers beginning to use credit derivatives and structured notes big-time. Italy, for example, was a huge market last year for structured notes with an interest-rate or equity yield far above the paltry risk-free euro rate. Italian investors had been used to lira rates. Likewise the smaller banks were hungry for asset swaps that would provide an enhanced floating rate. But it's not only the big players - the CSFBs and JP Morgans - that can provide this. Anyone with good retail distribution can play this game.

So WestLB, for example, with its German savings bank relationships, established a structured assets team last summer and is selling more hybrid products than ever. In London, WestLB last year merged its fixed-income derivatives and cash-bond operations. "Global derivatives and fixed income will be merged with global treasury and money markets this year," says Fred Danneman, head of global derivatives and fixed income in London.

DG Bank and Rabobank are merging to pool their major clients, the farming and cooperative banks in Germany and the Netherlands. In fixed income it's a good fit because Rabobank had specialized in structured derivative sales and DG Bank is stronger in government bonds and credit. But how best to present this to the client is a difficult question. What should be left to the generalist, and when should the specialist come in? DG Bank has set up a separate credit and credit derivatives sales team. "The credit world has become so huge," says Willi Ufer, head of bonds and financial engineering at DG Bank, "that no market-risk salesman could cover credit as well."

No single paradigm

Dresdner Bank divides its global markets division under two co-heads, one, TJ Lim, running derivatives, the other, Erich Pohl, running fixed income. Although it would make sense to include equities and equity derivatives, they happen to be in a different London building.

Commerzbank is undergoing the most vigorous integration among the German banks. Mehmet Dalman, a derivatives specialist formerly with Deutsche Bank, has spent a year building up an international equities department, and in October took over fixed income too.

ING Barings is adapting its approach, believing that the G7 and emerging markets are increasingly focused on similar types of products. "We've always been very integrated in our emerging-markets business," says Gavin Moule, joint global head of derivatives at ING Barings. "Now markets are demanding that we become more specialized along product lines." ING's G7 and emerging markets divisions are "being amalgamated as we speak", says Moule. Specialized emerging market funds business is in decline "but there is much more cross-over business from the G7 world," he adds.

This snapshot of how banks market and trade their derivatives shows that there is no single paradigm. The credit and credit derivatives market is growing rapidly, putting pressure on the banks to change the way they parcel out credit risk to others, and the way they manage their own exposures.

Some banks are further down the road to integration. But, if the process is cyclical, they may be the first to deintegrate again.