Ronan O’Neill spoke to senior rates professionals.
|Interest rate derivatives poll|
In association with Total Derivatives
|Global Winners||US Dollar|
Interest rate derivatives: Rates - a year in the market
The interest rates business is the single-biggest revenue source in the investment banking industry. Rates revenues exceeded those of the credit business even during the credit bubble years. But now that credit revenues have collapsed – indeed have turned negative at many large banks – the rates business is all the more critical. For under-capitalized banks that over-invested in the structured credit business, the performance of their rates business is the key to survival.
When the credit crisis first hit, rates revenues held up remarkably well, supported by increased volatility, wider bid-offer spreads and the structural curve steepening that was prevalent across the industry. But in March 2008, after the Bear Stearns rescue, the market became much more challenging.
Trading conditions in rates have become increasingly illiquid, dealers have widened bid-offer spreads further and clients have become increasingly wary.
In all, 2008 has been the most challenging year for the rates business since fixed-income derivatives rose to prominence in the late 1980s.
Profitability in the rates business has not been wiped out as it has been in credit. But banks are reeling under the pressures of lower risk appetite, reduced leverage and dwindling capital.
Amidst the carnage, there are opportunities – and success stories.
Against this background, Total Derivatives, in association with Euromoney, conducted its global fixed-income derivatives rankings.
The poll is the largest and most comprehensive peer review of investment bank performance in interest rate derivatives. There were 831 individual responses to the survey, registering a total of almost 2,500 votes. Senior professionals involved in trading, sales and marketing, structuring and strategy at investment banks formed the largest group of respondents, with portfolio managers at hedge funds and traditional asset managers also taking part.
The results show that the leading market-makers with best access to two-way flows from a wide range of clients, and those that can manage risk most effectively in an extreme environment, have capitalized on the experience of 2008 to strengthen their dominance. The most prominent underperformers in this survey are the independent US investment banks: only Goldman Sachs made it into the top 10 overall, in seventh position.
The main winners
JPMorgan was the standout winner of the poll. The bank came in first overall by a significant margin and was the only bank to appear in the top three in all five global product categories. By currency, JPMorgan was first in US dollars, second in euros behind Deutsche Bank and second in yen behind MUFG.
"Investors in exotic products are well aware of the risks that such products entail, and while some areas of the structured product market have slowed, other products have taken their place"
He adds: "The past year has demonstrated that clients see consistent liquidity provision to be absolutely vital. A number of dealers have responded by withdrawing their liquidity from their clients and the inter-bank market. But JPMorgan believes that one of its core strengths is the ability to determine an appropriate market level and provide liquidity to the market, even in very challenging conditions."
JPMorgan sees 2008 as an opportunity to extend its franchise. "As and when the market normalizes," says Willcox, "we expect to have significantly extended our client base, market share and reputation as the top rates derivatives house."
With regard to the Bear Stearns acquisition, Willcox notes that the investment bank "had penetrated a number of markets very successfully". By incorporating Bear’s relationships into the JPMorgan franchise, the bank has "further extended our client base both in terms of sectors and geographic coverage." He adds, however, that, "the most valuable asset is the Bear Stearns talent".
Deutsche Bank, increasingly JPMorgan’s only rival for the position of leader of the global rates business, came second in this survey but dominates the euro results.
Wayne Felson, European head of rates at Deutsche, notes that the bank "has always maintained a good balance between vanilla and structured products with a focus on e-commerce and client solutions" and that this approach has worked "particularly well in this market environment". He adds that "the requirements of our clients may be quite different than before the crisis," and that the "product focus has shifted towards the more liquid spectrum".
"Market access and liquidity provision is clearly becoming much more important," he says. "Especially as several dealers pull back due to internal issues."
MUFG was voted overall number one in yen rates in the poll and was the only bank to appear in the top three in all five yen product categories.
It has been a banner year for yen rates derivatives in 2008, says Hiroyoshi Sakamoto, Tokyo-based head of rates trading at MUFG. "We had updated our risk architecture, pricing systems and analytics before the crisis hit," says Sakamoto. "MUFG is one of the firms that possesses world-class derivatives capabilities, coupled with a massive domestic franchise in Japan."
MUFG is now working to "introduce more sophisticated derivative solutions to our clients," Sakamoto notes. "Deeper pockets and larger risk appetite than the US and European investment banks will allow us to further capitalize on higher-margin derivative products."
"It takes at least a year to get an effective strategy derivatives platform up and running"
BNP Paribas performed well across the survey and came out top in exotics globally, nudging JPMorgan into second place. BNP Paribas was also ranked first in euro inflation products.
Kara Lemont, head of rates and FX structuring, EMEA, says that in recent years the bank has worked hard to build its business "not only in exotic inflation products where we have traditionally been a market leader, but also in the flow inflation derivatives business".
Given headline CPI data of 4% in the eurozone and 5% in the US, it is no surprise that clients are increasingly focusing on inflation-linked products to take positions and manage their risk. The combination of strength in flow and exotic inflation business means BNP Paribas is very well positioned to offer clients "comprehensive derivatives solutions to meet the demands of the inflationary environment," says Lemont.
She acknowledges that the inversion of the euro curve has been tough for the large number of investors in the steepening positions via CMS steepeners, range accruals and similar products. Still, "the steepener was the rational position to put on ahead of an economic slowdown," Lemont says, adding that many investors – especially in Asia – participated in the sustained steepening of the US dollar curve in late 2007 and early 2008.
Mixed fortunes in exotics
Interest in exotic rates remains relatively healthy, says Lemont, and the exotics sector has not suffered a blow to its reputation as it did during the sell-off of 1994. Lemont highlights the fact that investor losses in 1994 were "not only because of market conditions but also because of mis-selling on the part of banks". Some investors had risked and subsequently lost all of their capital. But in 2008, exotic rate structures are, almost without exception, principal-protected to maturity.
Deutsche’s Felson believes the reputation of certain exotics desks has been damaged "due to the magnitude of the rumoured losses in a product that typically had stable risk management". However, Deutsche Bank’s exotics desk "escaped virtually unscathed from this," Felson says, while "our flow desks were major providers of liquidity to the market."
JPMorgan’s Willcox adds: "Investors in exotic products are well aware of the risks that such products entail, and while some areas of the structured product market have slowed, other products have taken their place."
One potential challenger to the top tier is the combined Royal Bank of Scotland and ABN Amro.
"A wider and wider range of clients is turning to inflation products for their hedging needs"
The combined RBS/ABN has a strong starting position: it was voted top sterling derivatives house, with BarCap its only serious rival in the poll.
"RBS sees a real opportunity to build its market share through the integration of ABN," says Ashley. Combining the franchises "means clients will have access to an even greater pool of expertise," he notes. "We have achieved wider geographic coverage thanks to our acquisition of ABN Amro’s wholesale banking business, and, naturally, as a result of this, have access to a broader client base worldwide".
Ashley believes the bank can apply sterling-related expertise to the euro markets, including how to take advantage of an inverted curve. "RBS has been dealing with an inverted sterling yield curve for some time," he says "and so we feel confident we have the experience and tools required to help our eurozone customers exploit opportunities in an inverted yield curve environment."
The migration to inflation
Clients are migrating to inflation products to protect themselves in the present environment – and the banks are competing to provide liquidity and the best hedging solutions.
Barclays Capital came out on top in the inflation products section of the Total Derivatives dealer rankings. The bank was voted number one in dollar inflation products, number two in euro and sterling inflation and came fourth in yen inflation.
"Barclays has a true commitment; inflation is at the foundation of our firm," says Ralph Segreti, inflation-linked and rates total return product manager.
"The UK market presents a unique challenge, as interdealer volumes are down 50% from last year’s levels"
That said, he adds: "Given the rise in inflation expectations, and the broad-based fears that come with that, interest from both individual and institutional investors is way up." But banks are still innovating and "opportunities remain for those, like us, who have been able to adapt."
In particular, there are great opportunities in emerging market inflation, Segreti notes. On the issuer side especially, "it is obvious that growth will come from emerging market countries," he says.
In the developed markets, Segreti talks of BarCap executing "significant non-linear trades for hedging purposes", as well as "large European basis trades". The bank has "facilitated large UK trades in these very difficult times, was at the centre of the hedge fund deleveraging in the US, and helped launch the first ever CPI deposit account program for a Japanese bank".
As for clients, "we will continue to see new entrants to the inflation markets going forward," he predicts. On the investor side, "people have realized that they can’t always chase high returns, without putting some layer of insurance in their portfolio. Inflation enhances diversification and protects the real value of accumulated wealth. We will see more interest from high-net-worth individuals, as well as increased investment from retail savers." On the borrower side, BarCap expects to see "an increase in interest from corporate treasurers looking to hedge exposures on their balance sheets".
Deutsche’s Felson agrees that the rise of inflation suggests a migration to inflation-linked products. "There is clearly much greater focus on inflation risk across the client spectrum" he says, adding, however, that "much inflation activity is closely tied to the credit markets and has been impacted in 2008". Specifically, "inflation has been sourced in part from project finance deals where the underlying credit was typically wrapped by a monoline". With the monolines beset by ratings downgrades and other problems, the wrapping business has effectively ground to a halt.
"Inevitably, we will see more demand for index-linked bonds, inflation swaps, and inflation derivative structures," says JPMorgan’s Willcox. "The challenge will be to find issuers of inflation-linked products." However, "the growth of visible, liquid and tradeable inflation markets have enhanced the inflation asset class. The growth of observability in the asset class allows the beneficiaries of higher inflation to be more responsive to moves higher in inflation expectations. This will help provide a better balance to the supply demand dynamic."
Ashley at RBS notes that in previous periods of heightened inflation, "the ability to hedge was extremely limited. Global index-linked markets have since been developing in a period of relatively benign inflation. For the first time now we have a situation where inflation protection is at a premium, the product is available and demand is high and the market’s ability to deliver is being fully tested. A wider and wider range of clients is turning to inflation products for their hedging needs," he adds. "Whereas it was once the preserve of a handful of industries, dominated by utilities, we now see opportunities for a breadth of sectors."
In Japan, the inflation derivatives market is relatively new but the banks are expecting rapid development. "Hedge funds were the initial drivers of the inflation market," says MUFG’s Sakamoto, adding that "we focused considerable resources towards assisting our domestic client base enter this market". The domestic clients (many of whom were already investing in US Tips and euro-linkers) have entered the JGB inflation market "in full force", Sakamoto says, "and turnover with domestics is on a par with that of hedge funds and proprietary trading desks".
MUFG undertakes the most comprehensive survey of long-term inflation expectations in Japan. "This year’s survey [yet to be released] indicates long-term inflation expectations to be 1.57%," notes Sakamoto. "These heightened expectations have led us to market tailor-made inflation solutions to our retail and institutional client base. This will lead to growth in non-governmental inflation-linked issuance and will further develop and mature the inflation derivatives market in Japan."
Strategy derivatives – a new generation product
How can investors profit if the trading environment evolves in unpredictable ways, as has happened in 2008?
Lemont says the answer lies in what BNP Paribas calls "strategy derivatives". These are a new generation of products that bear some resemblance to hedge fund replication tools and are sometimes referred to as strategic algorithms, proprietary algorithms or index algorithms.
Strategy derivatives reflect rule-based trading strategies, either generic or specifically tailored to investors’ requirements. They help investors to "diversify and to achieve uncorrelated returns," says Lemont, and the risk-reward characteristics are superior to classic structured products. They are more flexible than classic exotic products, according to Lemont, "and take account of directions changes, momentum and so on".
The dynamic nature of strategy derivatives returns brings a new dimension to the market, says Lemont, enabling clients to be more nimble and automatically reverse positions if they turn sour. The "recent inversion of the curve is a good example", she adds, noting that the proprietary model that BNP Paribas uses for euro curve trading strategies "sent a signal to switch from a steepening to a flattening position" just before the sharp inversion move.
Lemont estimates that, "it takes at least a year to get an effective strategy derivatives platform up and running".
Consolidation to come
The dislocation in the markets over the past 12 months has reduced risk appetite, weakened competition and led to a remarkable cheapening of established franchises. In the rates derivatives industry, weaker players are being forced to exit certain businesses, leaving the way open for the strongest banks to benefit from higher margins and the opportunities that will inevitably arise.
Those market-makers with best access to two-way flows from a wide range of clients and those that can manage risk most effectively in an extreme environment can capitalize on the situation by capturing wider bid-offer.
The leading banks that combine capital, sales and trading expertise and market-making technology to strengthen their dominance will prosper. The shakeout is likely to result in a further concentration of power among the top-tier banks.