Derivatives: Swinging around the world

Derivatives markets are constantly on the move. Credit products currently feature most prominently in the considerations of derivatives providers and sophisticated users, though there are plenty of other developments contending for attention. These include asset packaging, access products, volatility derivatives, the declining role of exotic products, and the hedging of corporate share-incentive schemes.

Geographically, Europe and the US remain highly active markets for derivatives and Asia is also important, though oversupply may be developing there. Australia is beginning to attract attention, not least because of the special derivative needs of an electricity market in the course of being deregulated.

Product developments

Credit derivatives Most banks now regard credit derivatives as a separate asset class in their own right. From a banking viewpoint they are probably as significant a development as the emergence of the swaps market a decade ago. In the last 12 months the market has reached critical mass; it’s no longer just a case of matching up one-off transactions. Serious potential clients have sorted out their internal policies, legal issues and documentation and so are ready to deal.

There are also encouraging signs on the administrative and regulatory front, with International Swaps and Derivatives Association documentation developed and clear capital guidelines having emerged from the US Federal Reserve and the Office of the Comptroller of the Currency. In the UK the Bank of England is expected to produce similar directives soon.

For many banks perched on the fence, these developments could be enough to propel them into the market. Shaun Rai, director and head of global credit derivatives at CIBC Wood Gundy, reckons volumes could be enormous. “If you broadly define the credit markets to include bonds and loans as well as the credit risk incurred in normal corporate business activities, you’re arguably looking at the largest class of risk in the world,” he says. “Until the last year or so, there were no effective tools for managing that risk. The potential scope for the market is huge. Despite the globalization of financial markets, most credit risk is still held on a regional or national basis: the bulk of US credit risk is still held in the US, for example. Already European institutions are starting to use credit derivatives to take on US investment-grade credit risk. As an alternative to opening an office in the US and trying to enter the loan market directly it’s obviously very attractive.”

Admittedly the state of the markets in recent months has been especially favourable to credit derivative development: global interest rates are at historically low levels. “There are a number of business drivers that are very obvious right now,” says Blythe Masters, global head of credit derivatives at JP Morgan. “One is the fact that the prices of financial assets are at exceptionally high levels; combining that with heady stock markets, tight corporate credit spreads, possible interest rate hikes and a potential turn in the default cycle gives people a strong incentive to get involved in credit derivatives.”

Those observers expecting institutions that have got involved to get their fingers burnt may well be disappointed if Masters’ experience of the developing market is anything to go by. “Most of the business we have seen to date has been in credit default and total-return swaps, which are not complex instruments,” he says. “In a credit swap, the risk-taker receives a stream of basis points and has the potential liability of making a substantial cash payment in the event of a default. That’s a risk profile that banking institutions are by definition comfortable with. At the same time, standards of due diligence and disclosure are also high.”

Apart from general interbank and corporate activity, Masters sees two specific areas in which credit derivatives could play a significant role. “One is the extent to which credit derivatives become used in the syndication process and become a tool of the trade. The other is the way in which they could be used to arbitrage pricing discrepancies in the credit market. Currently a corporate credit will have different prices attached, for example, to a loan and an in-the-money interest rate swap. There is no reason why different prices for the same risk should prevail, once you have created an instrument that allows those discrepancies to be exploited.”

Asset packaging and structured notes With interest rates remaining low, asset packaging has continued to be a growth business globally. The simpler forms of packaging activity may not offer colossal margins, but they do provide a reliable income stream. Mark Blundell, treasurer at Rabobank in London, has noticed the trend. “One thing that has happened over the last year or so has been that everybody has piled into the asset-packaging business. We’re an enormous investor in asset packages and like a lot of other people we’re trading them now as well. As a result the spreads over Libor for these names have shrunk, so that the difference between lesser-rated credits and higher-rated credits has definitely narrowed. It’s the only business that I know in the dealing room that makes money every day, I can set my watch by it. It may not be enormous but it will always be a positive number.”

In the current interest rate environment a lot of the repackaging business is being driven by existing holders throwing debt issues back into the market in search of better credit or yield. In areas like Japan, where fixed-rate sellers tend to be in the majority, there have been opportunities for derivative houses to pick these up cheap to be used in swaps. After repackaging and warehousing them for a while, they can be resold to floating-rate investors looking for loan-replacement products.

Peter Colvin, regional head of marketing and investor products at ABN Amro in Singapore, has seen a lot of this activity. “Repackaging illiquid second-hand debt from the Japanese marketplace such as samurais, dual-currency bonds, reverse dual-currency bonds and forex-linked notes has been a high-volume business. The dual-currency products also create higher swap activity by increasing the flow into yen, US dollar and Australian dollar swap books.”

Structured notes have also been making something of a comeback. “It’s been a predictable consequence of investors hunting for yield in a low interest rate environment,” says Andrew Firth, vice-president of interest rate derivatives for Banque Nationale de Paris in London. “The difference has been that this time around people are staying clear of highly leveraged structures. Volumes are certainly not as high as they were three years ago, but there has been an increasing number of enquiries for lightly structured products, such as callable notes and reverse floaters.”

Access trades With international investors trawling the emerging markets in search of opportunities, liquidity and market impact have become major concerns. So access and allocation trades have proved fruitful business for equity derivative desks. “Asia has obviously been a particularly fertile region for access trades, it’s now a steady flow of business that should continue,” says Andrzej Rojek, senior managing director of global equity products at Bankers Trust. “As barriers come down, interest will start to shift into asset allocation products.”

In some eastern European markets the problems of direct equity investment go beyond simple liquidity issues. In countries such as Poland and the Czech Republic it is estimated that more than 80% of equity trades go OTC rather than through exchanges. At the same time stock substitutes have become increasingly popular with managers that are administering rapidly growing portfolios or have relatively few staff.

Eric Slighton, head of global relative value at Deutsche Morgan Grenfell’s Hong Kong office, has seen two further variations on this theme. “In some regions, market-access derivatives have been as much in demand from local investors as from offshore funds. We have also been tailoring products for particular segments of some markets, as well as the whole of the more difficult to reach ones.”

Volatility derivatives Volatility derivatives have been around for a while as a concept and there are at last signs that they are ready to hit the market. The potential demand is there ­ one investor (believed to be a hedge fund) recently made a huge pure volatility play on the UK’s FT-SE 100 index by buying and selling 70,000 option contracts on Liffe.

Although volatility derivatives may never attain the volumes that can be expected of credit derivatives, the clearest sign that they have arrived is the listing of volatility futures on London derivatives exchange OMLX. Three contracts will be available: on British, German and Swedish equity indices. “Given the way that equity markets have been trending, most derivative houses have a huge amount of out-of-the money exposure which is causing concern; these are an excellent tool for handling that exposure,” says Simon Ruddick of Albourne Partners. “Another application is that while many houses find it comparatively easy to sell long-term options expensively, it’s incredibly inefficient to hedge those with short-term options. The volatility future is a far more elegant solution.”

The decline of exotics and the rise of the informed user Another current trend in the derivatives markets is the general decline in “exotics for exotics’ sake” activities. The original logic behind the development of increasingly complex structures by derivative houses was the hope of individual houses that they would be the only firm able to price them accurately and would thus benefit from relatively wide spreads. Mark Byrne, international head of arbitrage and fixed income at CSFB in Tokyo, considers that those days are gone. “The Chinese restaurant menu of exotics has been written, the emphasis now is on consistent quality of pricing to customers. The cycle on pricing new products has compressed from maybe six months to more like four hours.”

For some banks the swing away from the more convoluted exotics is related to the growth of knowledge among clients. Many of them now have the skills and technology to understand and price products themselves.

Mark Preston, head of trading for financial products at CIBC Wood Gundy, has seen this reflected in the level of activity at the firm’s school of financial products. “Clients now want to understand the scenarios that cross their desks. They may still expect you to be able to provide structured solutions, but they expect to pay wholesale, not retail, prices.” Michael Bresges, CIBC’s head of structured marketing, agrees. “The regulatory benefit of all this is undeniable. You are showing the regulator that you’re doing everything to push the client up the learning curve.”

Geographical trends

US In the US, credit derivatives are still the dominant theme, but firm-wide risk management has come a close second. A common theme is that both credit derivatives and value at risk (VAR) have such a wide application, from corporates to financial institutions. Chase Manhattan has been introducing clients to new risk techniques offered under its Charisma suite of risk analytics. “The application can be phenomenally varied,” says Fred Chapey, Chase’s global derivatives executive. “For a bank the VAR horizon could be 24 hours with a singular focus on a trading portfolio’s market-value risk, for a corporate it could be a year or more and focus on pension-funding risk, and a lot more in between. Many regional and international banks are now interested in the different risk methodologies that exist and how to apply them to their businesses and incorporate them into their systems and infrastructures. Nevertheless there’s still a considerable amount of confusion over VAR; people still sometimes call you up and ask: ‘Can I have the disk?’ The proper question should be: ‘These are my goals and objectives, what approach and tools should I use to manage the risk in my business?'”

Other firms have seen an increase in risk management activity on the back of Securities and Exchange Commission disclosure requirements. “It’s an issue that’s currently taking up a great deal of US corporates’ time,” says Leslie Grant, global head of risk management advisers at SBC Warburg. “An issue that has emerged from that has been that of client connectivity via the internet/intranet for valuation and risk management purposes. US corporate derivative activity is stalling because of the uncertainty surrounding SEC disclosure requirements. Such activity as there is has been due to currency hedging now that the dollar seems to have bottomed out.”

Europe European banks are understandably concerned with Emu. Apart from the obvious issue of redeployment, there is also considerably activity in helping clients to prepare for the changes. The political considerations that determine how hard or soft the euro will be have induced fund managers to make a considerable number of relative value trades. Of the FX derivatives being dealt, a high proportion are still barriers, though there has been growing activity in basket trades.

The Swiss franc and sterling, cast in the role of safe havens, have figured heavily, though Vincent Lauwick, head of marketing and sales at Sociéte Générale in Paris, has seen a lot of French franc/Deutschmark business. “End users have mainly focused on yield curve strategies and products including two or more currencies which would be in or out of the euro, such as diff [differential] swaps. The bulk of deals have concentrated on the convergence between French franc and Deutschmark.”

Some feel that the assumption that there will be a single European yield curve post-Emu is wide of the mark. “It’s a common misconception”, says CIBC’s Preston. “Some of the recent decisions regarding convergence criteria mean that there will be many yield curves within the euro, in terms of sovereign trading. Countries within Europe will borrow at different levels. There may be one Libor/Interbank curve but it will still be possible to trade multiple sovereign curves. We are heavily involved in trading credits and still expect to have an active book after Emu.”

Equity derivatives have been making significant advances. This has been partly driven by insurance and pension legislation, such that downside fluctuations in investment portfolio values are less tolerable, so that there is now a clear need to hedge equity exposure. With UK institutions in particular being generally long equities, derivative activity has been further enhanced. Stephen Smith, head of equity derivative products at SBC Warburg, has also seen two particular areas of corporate activity in equity derivatives. “Firstly, changes in enterprise valuation practice have meant that companies are now only valued on core assets; cross shareholdings often do not fall into this category. Using derivative solutions to unwind these positions while minimizing market impact has been popular. Secondly, the hedging of companies’ employee share incentive schemes, in order to reduce balance sheet risk, has also been a major source of business.”

Japan With substantial deregulation likely in Japan next year, the market is preparing for major changes. Although the unleveraged structured-note business has been recovering, some of the activity has arisen because of legislation that prevents Japanese investors buying exotic options onshore unless they are embedded in a structure. If this regulation is removed, a lot of business will move into OTC and exchange-traded options.

Selling premium (particularly on puts) is at historically high levels. This is also vulnerable to regulatory changes since shorting premium currently enjoys attractive accounting treatment. Low interest rates have prompted an expansion of dual-currency issues, mostly Australian dollars, but also US dollars, New Zealand dollars and even sterling. The appetite has been enormous (even Mrs Watanabe is buying), with a knock-on effect on swaps business, as well as fixed-income and foreign exchange derivatives.

When it comes to exchange-traded products, Japan is looking increasingly vulnerable to the Singapore Internatonal Monetary Exchange. The cost disparity is enormous: high fixed commissions and exchange fees in Japan mean that a contract on Simex can be traded for as little as 20% of the cost in Tokyo. Large international players are already starting to vote with their feet; CSFB has already bought a seat on Simex and is planning to build a floor team there.

Asia ex-Japan As in Japan, asset swaps and repackaging have blossomed in the rest of Asia on the back of low interest rates. With Japanese banks having forced down the price of syndicated loans to an uncompetitive level, Asian regional banks that would traditionally look to this area for corporate credit exposure are going elsewhere. They are finding what they need in swapped or repackaged debt. As most of the names on paper being issued in Japan at present are AA or AAA, buyers are getting better quality as well.

A similar tightness is prevailing in traditionally higher-yield lending to joint venture and industrial Asian companies. In order to enhance yield in these circumstances, the regional banks are looking in the Eurodollar markets for even unrated names repackaged into Libor spreads of 100 plus. They can then do a straightforward dollar interest rate swap into 190-200 over Libor in the two-year to four-year bracket.

For the largest banks, asset swapping convertible bonds from Asian corporates is a major activity. It is system- and credit-intensive, and is thus restricted to a handful of players. Those involved in the market need the facilities to handle the equity risk, either to warehouse it or broker it off to another party that wants that component. Its exclusiveness means that it tends to get overlooked, but it is lucrative both for investors and the repackagers.

Australia Deregulation of the electricity-generating and distribution industry worldwide is an area of enormous potential growth for derivatives that is attracting a lot of attention. This has been especially keen in the Australian market, where the process is already well advanced. At present most of the derivative transactions are between distributors and generators. The Sydney Futures Exchange is aiming to provide a facilitation service for generators and distributors by January 1997, but it will not be guaranteed by the clearing house. Russel Armstrong, the global head of derivatives at Westpac, is upbeat. “The next stage will be distributors and major customers hedging spot risk, which is likely to take off when all major customers become contestable next year. After that, the next step will be the development of a longer-term swap market.” The whole east coast of Australia will effectively be one market with homogenous contracts, which will probably mean that the product will have a short life cycle before it becomes commoditized.

With a significant amount of Australian government debt having been issued in inflation-linked instruments, the outlook for inflation-indexed derivatives is also good. Many key infrastructure products involve consumer price index bond issues with maturities of between 27 and 30 years. Although many fund managers like the term of the asset, they are not keen on the consumer price index risk.

Several banks, including Westpac, have been active in swapping these into floating rate to provide managers with a long-term asset that gives a margin over bills.