IRD debate: There’s demand for derivatives, just no funding

EW, Calyon Capital markets have been in crisis for a year, instigated by the credit crunch. This has affected the whole financial sector. There’s been volatility in currencies. There have been strong fluctuations in commodities, in the appetite for private placements, and we’ve started to see knock-on effects into rates. European Central Bank president Jean-Claude Trichet’s comments triggered dramatic events in the most liquid market in the world: the swaps market in euros. The yield curve was already slighted inverted. The longer end was up. But it became even more inverted because of the announcement. Money rates went up because of the understanding that the ECB would raise rates. But that was contrary to the long-term views and was compounded by the fact that a lot of banks were not positioned that way, so then had to get out of positions, which made things worse.

JN, Nordea Yes, that inversion of the curve caught a lot of exotic desks on the wrong foot.

EW, Calyon We started with a crisis that was credit and funky CDOs. We’re now in a crisis where even the yield curve in the swap market dried up.

KP, LGIM Was the follow-through to impact led by banks cutting capital into trading lines? Some of the unwinding by exotics desks was because they had little risk appetite, or little ability to take risk.

EW, Calyon The market’s ability to absorb risk is much diminished compared with a year ago. Market players are no longer able to weather more risk, whether it’s exotics, commodities or forex.

JF, Euromoney Who’s providing liquidity?

KP, LGIM It’s tough to get business done from my end, which is predominantly in the UK, long-end interest rate and inflation swaps and some cross-currency swaps. The size in which you can transact easily has diminished substantially. It’s hard to get anything done in the inflation swap market in the UK. Banks are no longer willing to commit risk to their books. They don’t know where they can lay that risk off or for what price, because of the volatility and moves between taking on and managing. But there’s also a supply issue. Fewer people are willing to pay inflation or pay long-end rates.

JN, Nordea That’s exactly what we’ve seen. Very few markets can now claim to be liquid.

KP, LGIM It’s not just derivatives. If you want to buy a portfolio of corporate bonds or index-linked gilts, it’s harder to transact.

EW, Calyon If you want to buy a portfolio of CDOs, you’d probably find it quite easy at the moment! But clearly the structured credit market is severely impaired and there’ll probably be a weak market for years. A big question is if rates will follow the same path.

JF, Euromoney How exactly is the standstill in structured credit impinging on the rates business?

KP, LGIM Corporates are not fixing their rates and they’re not paying inflation supply because banks don’t have the appetite to give them lines, or they find it too expensive to raise debt because credit spreads have widened so much. There is still demand for institutions, life insurers and pension schemes to use derivative products, rates products and the simple linear products.

EW, Calyon To provide lines for corporate and institutional clients, banks need their own liquidity. While they are struggling with severely damaged balance sheets, it’s difficult for them to market aggressively to clients. Clients then feel they should focus more on getting that next credit line and less on how they hedge it. The demand is there. But until banks feel more confident in the way they’re funding themselves, derivatives business suffers.

KP, LGIM This will correct itself. There will be a period in which banks have to sort out their balance sheets. When they’ve recovered the markets will move on that, but it’s going to be a while.

JN, Nordea It’s not only getting rid of assets that are impaired or illiquid. Entire business models need to be changed. Large investment banks don’t have a business model where they can store senior risk, on and offloading risky equity, building large, seemingly riskless, positions that they need to fund. That de-leveraging process will take a long time. Even then people will be slow to jump back on the wagon. It may take a business cycle.

EW, Calyon Business model change is the core issue. It will be interesting to see how banks adapt. The financial sector has got carried away with one way of functioning. We’ve had an offset between the suffering financial sector and the corporate economy, which is not doing so badly. The reason the crisis has dragged on, and possibly saved us from systemic meltdown, is that parts of the large diversified institutions are still doing well. HSBC, for example, has had both tremendous losses and tremendous gains. Its Asian franchise is doing extremely well but its US subsidiary has taken very big losses. In their case, the gains outweigh the losses. We’ve been saying for a year that corporates will suffer, and maybe that’s starting to happen, but during that year banks have been restructuring. It’s a fine line between whether corporate defaults will increase to the extent that they bring the banks further down, or if the lack of defaults and the better core business will buoy up the banks.