Credit Derivatives and Derivatives House

IFR Review of the Year 2012
16 min read
Helen Bartholomew, Christopher Whittall

First-mover advantage: Being the first to leap into a new capital regime was never going to be easy, but one bank turned that into an advantage. For delivering impressive results while aggressively streamlining its business to lead the charge into a new regulatory environment, Credit Suisse is IFR’s Credit Derivatives House and Derivatives House of the Year.

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Post-crisis attempts to restore public confidence in derivatives took a step backwards in a year most memorable for Libor fixing, energy market manipulation, swaps mis-selling and a now infamous US$100bn wrong-way credit derivatives bet.

It was a tough environment in which to shine, and a year that many will be only too happy to forget. But amid the deluge of disasters, some banks made huge strides towards readying themselves for the new regulatory environment intended to eliminate some of the scandals that hit in 2012.

Swiss banks were pushed to the front of the queue for reform with the unenviable task of being the first to be tested under the Basel III regime in January 2013 – up to five years ahead of other jurisdictions.

For Credit Suisse, that could have meant the end of its ambitions as a global derivatives player given the huge capital costs associated with much of the traditional over-the-counter swaps business. Instead, the bank turned the rigorous capital requirements into a competitive advantage, proving what many of its rivals were not able to – that its business model really worked under a framework to which others must eventually adapt.

“We were compelled by our regulators to move faster towards Basel III compliance, but we embraced it and took it a step further to be the first bank in a position where the business is viable in a Basel III world,” said Eraj Shirvani, the firm’s head of fixed income for EMEA.

As a result of a multi-year overhaul that saw the bank slash risk weighted assets and clean up its balance sheet, Credit Suisse emerged as a counterparty of choice with a Tier 1 ratio of 18.5% at the end of the third quarter and one of the lowest CDS levels of its peer group at sub-150bp.

A more streamlined player, the bank was well prepared to navigate the new regime and build market share in the core areas that it deems economical in a new landscape that is still to be finalised.

“We’ve had to really assess which markets make sense in a Basel III world and also look at whether it works in a Volcker, Mifid and Dodd-Frank environment, both at a granular and firm level,” said Shirvani.

Less is more

The less is more approach flies in the face of the traditional financial supermarket model that has historically been the goal of ambitious derivatives players. But Credit Suisse bankers believe that the old model will be unworkable under the new framework.

“We have no appetite to be in the top three across the whole market as the idea of world denomination in rates houses is going to change. We want to be top three to key clients in key products,” said Jon Kinol, global head of rates.

“You have to look at the areas where you have an edge, where you have a competitive advantage, and that’s what you have to focus on.”

Amid the cost-cutting, Credit Suisse generated SFr4.7bn (US$5bn) of fixed-income revenues in the first three quarters of 2012 – 27% up on 2011 levels, while equity revenues, at SFr3.6bn, were just 4% down against a market that saw volume decline around 20%.

“Since 2008, we’ve been through a big transformation, but we’ve always stayed on top of innovation,” said Anthony Pesco, global equity derivatives product head. “Innovation is one of the key determinants of success in this environment, alongside efficiency, control and capital.”

When it came to innovative solutions to manage risk weighted assets, Credit Suisse proved itself to be a thought-leader from the start. One of the hardest-hitting consequences of Basel III is the credit valuation adjustment charge and associated capital requirement. For Credit Suisse, that represents a major contributor to the 30% increase in RWA associated with a shift from Basel 2.5 to Basel III.

At the start of the year, the bank synthetically securitised an US$8bn portion of its CVA portfolio and distributed a mezzanine tranche of the risk to employees as part of the 2011 compensation plan in lieu of what would typically have been deferred stock. The landmark transaction was widely viewed as a template for other banks in aligning employee remuneration with the long-term success of the organisation.

“We are at the centre of excellence for RWA management trades and we’ve done similar transactions with other investors,” said Shirvani. “Mezzanine or equity CVA risk is some of the most attractively priced out there and lots are looking at it as an asset class in its own right.”

Credit overhaul

The make-over of the credit business was emblematic of the wider overhaul of fixed income within Credit Suisse. Risk-weighted assets were halved from a year previously, one-day value-at-risk dropped significantly, expenses and headcount were trimmed, while return on equity under Basel III rocketed.

“The change in our ROE has been eye-popping. Cutting RWA and VaR dramatically and building a very customer-centric model has worked very well,” said Shirvani.

That is not to say the changes have been easy. Off-loading the remnants of its synthetic CDO business to rival banks coincided with the fourth quarter of 2011 and a raging sovereign debt crisis in Continental Europe.

But the benefit of shedding the bank’s correlation book – which would attract capital weightings approaching US$20bn under Basel III – remained compelling. Cutting RWA suddenly seemed like tidy business, largely accounting for RWAs in the credit business as a whole plummeting by half from 2011 to the end of the third quarter.

“Cutting RWA is painful, especially in that environment, but we decided to forgo a quarterly profit for it,” said Shirvani. “Exiting the synthetic CDO business very early has been an enormous advantage: it’s impossible to get this done today for the same cost we did.”

Keeping a lid on RWAs became ingrained into the mentality of every Credit Suisse trader, who had capital costs allocated to them at an individual level. This went hand-in-hand with a thorough clean-up of the market-making books.

The credit team had long shunned off-the-run maturities in favour of the liquid five-year part of the curve, enabling it to recycle its risk far more efficiently as liquidity increasingly drained from more bespoke tenors.

“We’ve concentrated on much more targeted risk-taking, bearing in mind the old adage that 80% of the revenue comes from 20% of the risk. We were the first bank to pull back from off-the-run maturities and concentrate on the five-year point of the curve,” said Jonathan Moore, European head of credit trading at the bank.

With hefty capital charges under Basel III for exposures to central clearing default funds – making the cost of running open positions very expensive – managing down counterparty exposures became more important than ever.

To this end, the bank also halved its total gross CDS outstanding over the year by tearing up trades with counterparties. The result was a huge decrease in the credit business’ one-day VaR, which tumbled 45% since 2011 to US$21m.

“Our VaR is down enormously, but our liquidity provision is not down in proportion. It’s a more disciplined attitude to risk,” said Moore. “Our books are in very good shape, and that’s reflected in the way clients engage with us.

The bank’s flow trading numbers backed this up: as well as scoring highly in benchmark industry surveys in terms of CDS market share, Credit Suisse’s single-name CDS trading volumes more than doubled from 2011 to the third quarter of 2012.

“We’ve been there for clients, we’re consistent. Clients know the business model has changed and that banks can’t be everything to everyone anymore,” said Shirvani.

Part of Credit Suisse’s success with clients remains its prowess in structuring bespoke solutions. As well as securitising counterparty risk, the bank has been at the forefront of using CDS to reduce RWA on loan books.

One such example was a synthetic securitisation of a US$1.88bn loan portfolio, with Credit Suisse buying protection on a junior tranche of the portfolio from an SPV, which in turn issued notes to investors embedding the credit protection. This allowed the bank to partially hedge a portfolio of mostly illiquid loans reducing capital requirements, while retaining flexibility with substitution rights in the portfolio.

“Because we’ve had to be innovative with our capital, we take those products and use them to structure trades for our clients,” said Moore.

The bank has also been at the forefront of calls to overhaul CDS documentation in what has been a tumultuous year for the instrument, which was put to the test by the largest sovereign credit event in history in the shape of Greece.

“We were a definite outlier when we started lobbying for changes two years ago in the ISDA definitions,” said Moore. “After Greece, dealers now agree on the need for a re-wording. If someone buys CDS it needs to pay out if it’s to be fit for purpose or the natural user of CDS will disappear.”

Rates growth

Representing the bulk of derivatives flows, rates proved to be a tough business in 2012 with the global wallet down some 6% on 2011 levels. Against that backdrop, Credit Suisse increased its revenues, outperforming the market across all three main products – flow, repo and structured. The improvement went hand-in-hand with big market share gains across all investor groups, led by a surge in hedge fund clients.

“We made very strong gains across the different areas of our business and built a globally influential business. We are more active across the swap end of government markets and in structured exotics as well as the options business,” said Kinol.

A radical overhaul saw the business slash Basel 2.5 RWA from US$32bn in the third quarter of 2011 to US$10.6bn a year later, with expectations of a steady US$25bn under full Basel III treatment by the end of 2012.

“Credit Suisse is the first bank to emerge with a fully fledged business model under Basel III, at least one year ahead our peers,” said Carlos Rodriguez, global head of rates structuring in London.

“It wasn’t always clear whether it would be possible, profitable, or even a desirable exercise, but we’re proud to have been able to do it as it has given us a credible and lasting competitive advantage as we can help guide clients who haven’t gone through the process through that transition.”

As part of its client-focused strategy to best adapt to the new business and regulatory framework, electronic trading capabilities have been paramount.

The bank expanded its multi-dealer platform presence and delivered solid increases across all major product categories with 200%-plus growth in electronically traded US dollar interest rate swaps versus a sub-20% increase for the market as a whole.

Through its Plus Rates Algo system, the bank extended its ultra-low latency pooling technology and algorithmic strategies, providing clients with access to a broader range of products, including cash yield curves, futures pairs, duration neutral calendar rolls and custom weighted butterflies.

The bank was also able to offer innovative solutions. For example, helping French insurers hedge the interest rate risk on their OAT assets while they also faced the threat of investors withdrawing investment contracts without penalty under higher yielding environments.

Credit Suisse was able to structure an alternative to the traditional hedge of buying caps on the 10-year swap rate. “With rates so low, CMS is cheap but the skew is monstrous, so we replicated CMS caps with swaptions, introducing a new factor to translate the payoff from convex to linear,” said Rodriguez.

The bank executed around US$4bn of such trades with a variety of clients.

Global equity presence

In the equity derivatives space, Credit Suisse continued to operate one of the most globally diverse businesses in the market, while maintaining a strong focus on key themes of yield enhancement, tail hedge strategies, efficient execution and trade management for retail distribution, and capital commitment for strategic corporate transactions.

The bank’s strong balance sheet and relatively low risk profile enabled it to provide cutting-edge solutions for clients.

Protection strategies proved to be an important growth area and the bank saw more than US$750m of assets flow into its CS Equity Dynamic Tail Hedge Index in the first nine months of the year.

“It is designed to address the additional problem of being long volatility, such as premium erosion and market timing,” said Cameron Hedger, head of European equity derivatives. “The dynamic mechanism invests in cash in very stable markets and uses CDS and skew signals to switch into vol and minimise the premium erosion.”

In the US, the bank enjoyed success offering cheaper protection to investors through puts with a European knock-out on volatility. It also created a Liquid Alternative Beta and Liquid Alpha suites in response to demand for liquidity and transparency in alternative investments.

And in Asia, Credit Suisse continued to extend its footprint, moving up the rankings in the retail structured products and warrants markets in Hong Kong and Singapore.

If the bank did suffer one hiccup during the year, it came from leveraged volatility tracker TVIX. Credit Suisse was forced to suspend issuance on the ETN in late February as inflows exploded, leading to hedging concerns for the issuer. Issuance resumed in a matter of weeks, with new rules allowing the bank to require market-makers to offer swaps consistent with its hedging strategy in return for the sale of new ETNs.

First-mover advantage