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.
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"The market needs new flow and business – how, when and to whom this manifests itself will be key"
Neil Weatherall, RBS |
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.
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"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"
Kara Lemont-Sportelli, BNP Paribas |
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."
