SWITZERLAND
A EUROMONEY SURVEY – MARCH 1996
A UNIQUE MARKET
Today’s global financial markets are without frontiers. Reading most financial publications, one would think that doing financial business in London, Tokyo or Zurich is merely engineering and selling generic products to local markets.
In reality, fundamental cultural differences exist in the demand and usage of financial products even amongst neighbouring countries. Switzerland is no exception, and analyzing the market for derivatives products in this country is an interesting exercise in order to understand the future of the derivatives business in general.
Although a small country, Switzerland presents a extremely diversified financial profile:
* Swiss corporates include some of the biggest European multinationals alongside big domestic companies;
* Swiss sovereign entities (confederation, cantons, municipalities) have only recently faced significant borrowing needs and this trend is likely to continue;
* The Swiss financial sector has traditionally been very important and diversified: it combines three giant, universal groups, present internationally in every area of finance; a unique collection of private banks; and a strong network of local commercial banks.
Switzerland therefore offers the promising potential of a very diversified market in a limited geographical area; but it is also a country where caution is a national tradition. How do these contradictory factors affect the market for one of the most sophisticated areas of finance, derivatives?
USAGE BY CORPORATE CLIENTS
Liability management
In most countries, derivatives products are primarily used by corporate clients for liability management purposes as they often have significant borrowings. Switzerland is the country of cash-rich corporates. Some of the bigger corporates, and especially the big multinational companies, have some debt financing, denominated in various currencies that could justify the use of derivatives products. This, however, has been fairly limited in the past and has certainly not been comparable in volume and sophistication to the type of business seen in other European countries. This results from a very conservative approach to liability management involving only plain vanilla products such as interest rate and currency swaps, and, in a very limited way, standard options on interest rates.
What can be said of this clear conservatism? On the one hand, it is obvious that a well-managed and controlled but more active use of simple and complex derivatives for liability management purposes could bring substantial savings to Swiss corporates. On the other hand, this conservative approach has prevented the occurrence in Switzerland of any of the excesses that have been experienced by some corporates in other countries such as the US. Therefore, there is no a prioricase in Switzerland against the use of derivatives, but rather a pragmatic and open approach. This sector of the market will slowly develop as active liability management becomes increasingly important for these clients.
Asset management
A large part of the derivatives business executed with corporates is in the field of asset management. The greater liquidity of simple interest rate derivative products such as swaps, compared with that of Swiss bonds, has allowed a substantial volume of business to develop. These instruments are seen as well-suited for the dynamic management of fixed-income assets. In the area of equity, classical tactical strategies such as sale of covered calls or purchase of puts are also relatively common. The simplicity of instruments used is a natural consequence of the conservative bias attached to corporate financial asset management. However, as with liability management, CSFP believes in the virtues of a slow but continuous learning process which will ensure a natural growth for this area of the business.
Foreign exchange risk management
Swiss multinationals in particular, with an extremely significant presence abroad and one of the strongest base currencies in the world, have tremendous exposure to foreign exchange risks. To date, they have focused on basic products for managing these risks (spots, forwards, short-dated plain vanilla options). However, if the Swiss franc remains overvalued in the coming years, it is probable that the competitive pressure brought by currency disparity will encourage Swiss companies to use more sophisticated derivatives in the area of foreign exchange management, a trend already emerging in other geographical markets.
Other applications in the corporate market
Today’s scope for application of derivative products goes far beyond risk management in traditional areas such as interest rate, foreign exchange and equity. First, more underlying risks naturally present in corporate businesses such as commodities price or credit risk can be efficiently managed by derivative products. For example, the past two years have seen a development of credit derivatives used by corporates for hedging credit risks generated by projects or activities in emerging markets. Swiss corporates have been at the forefront of this development.
Additionally, increasingly complex corporate finance transactions, in which a derivative might be only one of the components, are taking place today. These transactions do not belong to the traditional derivatives business executed in the treasury department of the firm. They usually involve its top management or even the board, and tackle fundamental issues for the company. On the bank side, they require the combined efforts of very different departments with different cultures and expertises.
Having a unique derivative service provider with knowledge in all types of underlyings and markets, rather than several scattered derivatives departments, becomes a key success factor for inventing, structuring and executing these transactions.
USAGE BY SOVEREIGN ENTITIES
Sovereign clients across the world have been a traditional source of business for derivatives providers: Numerous derivative transactions have been entered into by these clients, either attached to primary funding transactions aimed at tapping a given investor market, but incorporating unwanted currency or interest rate risk, or as secondary tools for managing financial risks embedded in existing borrowings. Most of these transactions are plain vanilla (interest or currency swaps).
Swiss sovereign entities’ need for borrowing is only relatively recent, at least in meaningful amounts. However, this situation has naturally implied a fair amount of primary and secondary derivative transactions in the past, and there is no reason to see why this area of the market should not develop significantly in volume over the coming years.
USAGE BY FINANCIAL INSTITUTIONS
Trading and liability management
Switzerland is the country of banks. Therefore one would expect tremendous derivative activity generated by banks in Switzerland. This is the case and one can clearly differentiate this activity into two categories, depending on the banks involved.
In the first category are the big international banks, and mainly the big three. These are extremely sophisticated institutions, present all over the world in all categories of financial business. They obviously use the whole array of derivative products for their own use or to service their clients, including exchange-traded contracts. Interbank business between these entities cannot be classified as Swiss business as a lot of it is generated and transacted in London.
In the second category are the Swiss domestic banks. These include some large national banks as well as cantonal banks of various sizes. Their derivative activity is mainly targeted at asset and liability management of interest rate risk and involves mostly standard products such as swaps and swaptions. However, management of risk generated by non-liquid assets such as mortgages is the source of a need for new complex derivative products. The development of this market is also a reflection of the natural Swiss cautiousness: it has been slow but consistent over the past few years, and, again, this segment should naturally develop in the years to come.
Asset management and private banking
Institutional asset management in Switzerland is not fundamentally different from its counterpart in other countries. It primarily concerns institutional funds of Swiss origin but also incorporates a share of foreign money. The use of derivative products, or of securities embedding derivatives elements, by Swiss institutional managers is therefore comparable to that of their foreign counterparts: underlyings are mainly equity, foreign exchange and interest rates, and, as in other areas, the use of the more sophisticated derivative products is somewhat limited, especially compared to countries like the UK or US.
Private banking really makes Switzerland different. In the early 90s, the use of derivatives by private money managers was concentrated on the purchase of warrants and structure notes. Some of these instruments were highly leveraged, complex and not fully understood by the intermediaries proposing them to the final clients. They were designed to answer a massive demand for leveraged products in an environment of decreasing returns on traditional instruments. This was a recipe for disaster. When the markets turned at the beginning of 1994, so did the leverage embedded in these products, against the investors that had bought them. This mitigated experience gave birth to great cautiousness with regards to derivative products, from both the private bankers and their final clients.
However, the private banking industry is going through two fundamental changes that have started and will continue to contribute to the increase of careful use of derivative products in the future.
The first change is the increase of competition in this industry, both from within and from abroad. The famous bankers’ fees are being substantially reduced and the performance objectives being enhanced. This is especially true in the area of funds under mandate, where the ultimate clients give (some) freedom to the banker in its management against an expected minimum return. In this business, what will make the difference in the future once the investment strategy has been decided is cost efficiency in its implementation. The days are over where churning a client’s portfolio was the name of the game because each sale earned fat commissions. Derivatives products, typically options and all their variations, are the flexible, cost-efficient tools needed for successful and cost-efficient dynamic asset management. This trend is clearly showing up today and will only increase in the future.
The second change is the increase in sophistication of both final clients and bank intermediaries with a change of generation taking place at both levels. Derivatives are very efficient tools when used properly; they are not necessarily complex and obscure to understand. Designing simple-to-understand (although complex to structure), retail-oriented products is an area with a tremendous future for derivatives providers and users, because derivatives allow users to carve out unwanted risk and target desired exposure. A simple example illustrates this perfectly: a dollar-based investor might be bullish on the Japanese stock market, but bearish or uncertain on the dollar/yen exchange rate. What he needs is a dollar-denominated instrument giving 100% participation on the Nikkei 225 in percentage terms, irrelevant of currency fluctuation. This can be achieved easily, and cost efficiently, by a Nikkei 225 certificate quantoed into dollars. Structuring the same results through direct investment and foreign exchange hedging is both complex and very costly.
These reasons explain why, by working closely and transparently with private bankers in order to understand the needs of their clients and to educate them about financial improvements, securities houses can design safe, easy-to-understand and well-adapted products for retail clients.
CONCLUSION
In its approach to new ideas, Switzerland has always been careful, but pragmatically open. This attitude can be felt in the world of derivative products. It has somewhat slackened the speed of usage of these products, but has also allowed Switzerland to avoid some excesses experienced in other markets. This has been and will be a recipe for success, and the tremendously diversified financial profile of this country will continue to make it a fascinating market for new, but well designed, derivatives products. For further information, please contact:
Olivier Sachs
Director
Swiss Representative Office
tel: +41 1 212 6018
fax: +41 1 212 6044
