Vol rise boosts activity

Warren Buffett famously called them financial weapons of mass destruction. In the world of derivatives, there has probably never been so much devastation as was evident in the aftermath of the collapses of Fannie Mae, Freddie Mac and Lehman Brothers. The disappearance of one of the most significant players in the derivatives market – Lehman – was never going to be painless. Yet the implications for corporates who had Lehman as a counterparty in their hedges, alongside the chaos in the CDS market triggered by three of the biggest defaults ever, have been felt on a magnitude that, until it occurred, was difficult to envisage. Derivatives have been eyed with suspicion from the early days of their existence, and not just by Buffett. There has always been a suggestion that if a market crisis were to occur, derivatives would be to blame. It will take time to sift through the wreckage of the credit crisis to fully understand the details of what went wrong, but there is little doubt that credit derivatives have contributed to – and fanned the flames of – the current crisis. Well before the crisis began there was no shortage of commentators warning about the dispersion of risk throughout the system. On many occasions it has been argued that credit derivatives in particular made problems so highly contagious that any shock in the system would spread like a plague. The counter-argument was always that a problem shared is a problem halved, and that the more risk was dispersed, the less it would be felt by individual institutions. That argument now looks naïve. But as tempting as it is to some, it would be grossly unfair to apportion all the blame onto derivatives. To return to Buffett’s metaphor, there is only so much blame you can apportion to a weapon: the person firing it, and those who put it into his hands, must also accept their share. Although credit derivatives have hogged the limelight in recent months, it is worth remembering there are derivatives contracts based on plenty of other assets and that remain imperative to the smooth functioning of the modern market. With equity markets being pummelled in October, the ability to hedge has been invaluable to many investors and corporates alike. The same goes for commodities, which have for so long looked like a one-way bet, but which have started to look fallible again as fears of a global recession have increased. Although hedgers will be eyeing their counterparty risk nervously, they will certainly be grateful not to be exposed to the vagaries of price volatility at its most violent. The problem of counterparty exposure has been revealed as one of the main risks within the derivatives industry, but there are already a number of solutions vying for primacy. An increase in exchange-traded instruments will form part of the solution, but perhaps more interesting will be the fate of plans to clear OTC trades through an independent clearing house. The trend has not caught on yet, but prospective providers of this service are in no mood for defeatism, and believe uptake will be better when problems in the markets abate enough for them to give the plan the attention they feel it deserves. Many are predicting that an increase in independently cleared OTC trades will be one of the key themes for 2009.

Europe and the US have grown accustomed to the benign macro economic environment that has prevailed for much of the early part of this century. Double digit inflation and interest rates are a distant memory for many, while many in the West have never even experienced it. At the same time, the market for inflation products is relatively young and illiquid. Participants in the market are vulnerable to structural basis risk because their exposures have typically been hedged with inflation-linked bonds. Rapid unwinding of positions can cause market dislocations. The Lehman factor Since mid-September the inflation market has experienced dramatic dislocations, and around the world breakeven inflation rates have nosedived, in many places wiping out a year’s worth of advances in two weeks. Japan has seen the most spectacular collapse, and the situation there is unique. Up to 80% of the inflation products sold in Japan went offshore, but as hedge funds have deleveraged their portfolios there has been a glut of inflation products coming back to the mainland, causing breakeven inflation of the JGBI to collapse to negative 50bp from 30bp. The numbers suggest the market anticipates negative inflation stretching out over 10 years, but this is probably not an accurate assessment. According to Sebastien Goldenberg, global head of inflation products at Citi, reading too much into the market at such a time of dislocation is misleading. Interest rate swaps form the basis of almost all fixed income hedging products, so stress in this market is quickly exported. In early October the market experienced significant levels of volatility for 10 business days in a row, with bid/offer spreads blowing out by 10 times. Since the collapse of Lehman, the market has been driven principally by a replacement trade. Corporates that had bought hedges from Lehman have been forced to take their business elsewhere, replacing defunct contracts, said Goldenberg. The failure of other institutions following the Lehman debacle has also amplified the problem, and liquidity has disappeared in every single asset class. Liquidity might return in early 2009, but it is unlikely that interest rates products will be seen as commodities for the foreseeable future. Headline inflation rates are higher than they have been for 15 years. In the UK, the consumer price index (CPI) hit 4.7% in August, just below the retail price index (RPI) rate of 4.8%, which factors in house prices. In the US, the CPI was 5.4% in August, while in the EU it was 4.2%. And while inflation rates are universally higher than a year ago, the picture has also grown far murkier regarding expected future inflation. Some reckon that high commodity prices are set to stay and will continue to push the figure upwards, while others point to slowing growth and a possible global recession as evidence that the rate has probably peaked. Emerging markets have had a different set of experiences – from the West and amongst themselves. The BRIC countries of Brazil, Russia, India and China, regarded by many as the most successful – and certainly the largest – emerging markets, have been blighted by relatively high levels of inflation, but in some instances the problem has been at least partially tamed. In Russia the rate is running at 10.8% in 2008. In China inflation is heading down, and in August hit 4.9%, while in India it is still around 12%. Yet in emerging markets, just as in those that are more developed, uncertainty prevails as to where inflation is going. How severe a recession Europe and the US might be about to experience, and how such an event will affect Chinese manufacturing or the economies and sectors of other countries, remain billion-dollar questions. Meanwhile, the evolution of the inflation market has not been uniform throughout the emerging markets. In South Africa and Brazil, for example, the market has developed further than it has in South Korea, though it remains most advanced in developed, G10 econo

The volume of outstanding credit derivatives contracts declined for the first time in the market’s history over the first half of this year. It fell to US$54.6trn at the end of June, down 12% from US$62.3bn at the end of 2007, and a 20% annual drop, according to International Swaps and Derivatives Association (Isda). This decrease primarily reflects the industry's efforts to reduce risk by tearing up economically offsetting transactions, and demonstrates the industry’s ongoing commitment to reduce risk and enhance operational efficiency, said Robert Pickel, Isda executive director and chief executive officer. “We expect to see more effects of this over time,” he added. “There has been a lot of pressure, from regulators and an operational point of view, to reduce the notional volume within banks, resulting in a big focus on compressing trades. Volumes will further reduce if many of the contracts move to a central clearing facility, which could clear many index trades that account for around one-third of the credit derivatives market,” said Michael Hampden-Turner, structured credit strategist at Citi. Volatility has ravaged both single-name and index spreads, pushing them to record levels. The iTraxx Crossover reached a record of 750bp while the iTraxx Main was trading in the 140bp area, below its peak levels in March, on October 10. Sovereign CDS also came under intense pressure due to wholesale government bailouts across Europe, aimed at stabilising the fragile financial sector. One quantitative credit strategist said that though government actions did not provide relief to financial stocks, synthetic credit spreads of the financial sector outperformed the market, evidenced in the spread between the iTraxx Main and Financials Senior indices reaching over 20bp by October 10. Government bailouts were well received by the derivatives markets as the iTraxx main closed at 128/129bp, the Crossover at 686/689bp and the financial indices moved to 93/96bp by October 13. Despite the market’s immense size, analysts estimate that roughly US$15trn of credit default swaps (CDS) are concentrated among the top 20 to 25 banks. This has highlighted counterparty risk concerns among investors, who now have to analyse and understand concentration risk issues. The solvency of institutional counterparties has become a major concern, said Domenico Picone, head of structured credit research at Dresdner Kleinwort. “The concentration of the market among very few players means counterparty risk is huge. There is little information shared with other players, on CDS volumes and counterparties each banks has. The market is very opaque and as a result no player has a clear knowledge of the ramification of a "senior" name defaulting on the credit market overall,” he said. It is not only banks that are being affected. Insurance companies and investors, such as sovereign wealth funds and hedge funds, have written credit protection via CDS, and these institutions could be faced with huge payout amounts or liquidating assets to raise money for the final settlement. Credit derivative product companies have also suffered from recent CDS default events, resulting in Primus Guaranty and Theta Corporation losing their Triple A counterparty rating. Auctions under way The auction season for settling contracts began with Canadian forest products company Tembec on October 2, followed by Fannie Mae and Freddie Mac on October 6 and Lehman on October 10. Washington Mutual is scheduled for October 23 and the auctions for Iceland banks, Landsbanki Islands, Glitnir and Kaupthing Bank for early November. In these settlement auctions, the reference price for the underlying bonds will be set, thus determining the payout levels for cash settled CDS, CDX and iTraxx indices, index tranches and synthetic CDOs. How these auctions fare, and the reaction from regulators, is an important test for the credit derivatives market, said Hampden-Turner. “It will be important how efficiently auc

UBS, which built up its commodities trading division in the wake of Enron’s collapse, earlier this month announced its exit from commodities businesses other than precious metals. The move is aimed at bringing the bank’s cost base down to a more sustainable level. “The ongoing crisis in the financial markets and dramatically changed industry dynamics require us to recalibrate our business,” explained Jerker Johansson, chairman and CEO of UBS Investment Bank. UBS was not among the banks that companies in Asia, Europe and the US disclosed active over-the-counter (OTC) commodity derivatives relationships with, according to Greenwich Associates 2008 Global Commodities Research Study, published in May. Neither was now defunct Lehman Brothers, which recently saw its US commodities operation become part of Barclays Capital. Companies responding to the Greenwich study cited Goldman Sachs, Morgan Stanley, Barclays Capital, JPMorgan, Citi, Deutsche Bank and Societe Generale as active OTC commodity derivatives counterparties. Goldmans dominated the business among financial investors in OTC commodity derivatives, with nearly 60% – including pension funds, retail banks and hedge funds – indicating they trade with the firm. Morgan Stanley ranked second, both for market penetration and quality ratings. Both firms have had a longstanding commitment to trading OTC commodity derivatives, and both have relatively long histories in energy commodities. This established presence and the credibility it gave – along with the sheer sizes of their respective franchises – helped attract investors and companies seeking to hedge commodity exposures. Around the world, commodities investors are most active in index swaps and plain vanilla non-index commodity swaps. Nearly 45% of investors participating in a Greenwich Associates survey this spring said that they invest in index swaps and 39% said that they use plain vanilla non-index commodity swaps. About a quarter reported using OTC commodity options and 21% said that they use structured notes with commodity underlyings. "In general, fund managers and pension funds are more likely to invest in index options, while banks are more likely to use single-commodity swaps and structured notes," Greenwich Associates consultant Woody Canaday said. A Barclays survey of institutional investors revealed a trend towards mixing passive and active management when investing in commodities. Only 5% of survey respondents said they expect to be investing in commodities via passive long-only indices over the next three years, compared to 12% indicating they currently invest this way. These same respondents said their structured commodities product investment, which they pegged at 43% of their commodities investment in March, will probably come in at about 31% of their investment in commodities three years from now. But growing concerns about counterparty credit risk are also driving changes in investors’ priorities. Limiting the concentration of exposure with a single counterparty is the most common method of reducing counterparty credit risk. Submitting transactions to an OTC clearing service is another approach being embraced by market participants. Total CME Group ClearPort futures and options volumes came in at 9.1m last month – 43% higher than September 2007. While ClearPort futures volumes were up 71% over the same period last year, options volumes on ClearPort were up just over 7%. Among other things, ClearPort lets market participants conduct transactions off-exchange, negotiate their own prices and take advantage of exchange clearing. The New York Mercantile Exchange launched ClearPort before it became part of CME Group. Life after Bear Since Bear Stearns’s collapse, many banks have tightened the margin and collateral requirements imposed on their trading clients. In general, clients have underestimated the costs of collateral to maintain hedges. The fact that more of clients' money can be tied up in larger collatera

At a leverage finance conference in Barcelona just days before Fannie Mae and Freddie Mac were taken into conservatorship by the US government, attendees commented that Lehman Brothers was noticeable by its absence. Alongside Morgan Stanley and Goldman Sachs, it was a major player in the LCDS market in both the US and Europe. Earlier this year, Lehman hired Dresdner Kleinwort’s Tom Johannessen, head of secondary loan sales and trading in London, to develop its LCDS business. Morgan Stanley and Johannessen’s team at Dresdner Kleinwort executed the first inter-dealer senior secured LCDS trade in the European market nearly three years ago. The number of counterparties for LCDS is dwindling, and has been for some time. Deutsche Bank and Dresdner Kleinwort have backed away from the market, as did ABN AMRO once it merged with Royal Bank of Scotland. Bear Stearns was another significant player in LCDS. For the LCDS market, the most positive outcome of JPMorgan’s acquisition of Bear Stearns might be if the acquisition gives LCDS a new lease on life. However, that is looking somewhat unlikely, given the state of the credit markets. Even before the summer of 2007 when the meltdown began, the contraction in the number of counterparties in the LCDS market was already exerting a negative influence over the market. Then, as now, users of the instrument were concerned about concentrating counterparty credit risk with a small number of dealers. Yet now the situation has become far more acute, particularly in Europe. LCDS require a cost base that may not be sustainable with such low volumes. “The challenge is getting more dealers involved,” one official said before global credit markets went off the rails. “[Some] dealers lost money [in LCDS] last year, and it is hard to get the resources and capital to justify a new product.” The LCDS indices, LevX and the LCDX, took a beating last autumn as dealers used it to hedge warehouse risk when the credit crisis began. Those responsible for LCDS trading at the dealers still involved in the LCDS market may have the ear of management now, but if events continue they might need to scale back their operations. Until September, credit structurers in New York were focused on developing ways to get funding. The LCDS tranche market seemed stable. “The trouble with cash CLOs is that there are no Triple A buyers anymore,” a New York-based structured credit desk head said in late August. LCDS tranches were holding up largely because they do not require the whole capital structure. At that time, market participants were saying that the great thing about the synthetic tranche market is that LCDS tranches offer superior returns to the cash product. In Europe, at least one dealer was optimistic that a LevX tranche market might take root. Yet even before last month there were several other market participants questioning the rationale of introducing a complex tranche market before the underlying was trading with any vitality. By some estimates, a total of about 360 names have traded in the US and European LCDS markets since its inception. About 30 names were trading regularly in Europe during the summer. In the US around 50-75 single name LCDS could be described as liquid. “You see good two-way volume on LCDS [in the US] because the credit hedge fund investor base still exists. In Europe, it was hurt [last autumn],” a market participant in London noted, noted in early September. How the credit hedge fund investor base will fare in the current crisis will therefore play an important role in the US LCDS market’s future. The future is non-cancellable This summer the US LCDS market was excited about the prospect of non-cancellable documentation. Loan CDS dealers designed the non-cancellable single-name LCDS contract to enhance liquidity, by eliminating uncertainty linked to the cancellability of the current market standard contract. Before the credit crisis flared up last month, some dealers stopped providing liquidity a

The dislocation in the credit markets may have sounded the death knell for structured credit, but any slowdown in business on that side was more than made up for in other asset classes. As early as March 2008, interest rate and foreign exchange traders in Asia were boasting that they had made their budgets for the year. Volatility in the US dollar interest rate yield curve and in the US dollar itself had completely reversed. It soared from the very low base that had been set over the previous couple of years. During the last reaches of the credit rally, asset prices were universally expensive and volatility excessively low as structured products became increasingly leveraged in order to eek out that last drop of return for investors. It all changed over the course of the last year as volatility moved dramatically higher. Equities Up until the end of the fourth quarter 2007, equity structured product desks continued to benefit from a long bull rally in Asia that had seen huge volumes of structured notes being placed. “It was the best ever year for equity structured products [in Asia],” said Min Park, head of the risk management products group at UBS. “Both retail and private banks were very busy buyers of these deals.” Up to 10%–15% of total private banking assets were said to be held in structured equity products, according to Park, and more than 80% of the structured products markets was equity based. Retail preferred the more common correlation products such as range-accruals, doubles and triplets, wrapped round the security blanket of principal protection. Private banking clients, meanwhile, on the look out for high-risk/high-return investments found accumulators more of an attraction. These deals work well in a rising market, but as the year turned, share markets became both more volatile, and more correlated. As markets swung sharply up and down, all shares moved in the same direction at once, thereby increasing correlation. Stocks that would otherwise be completely unrelated were suddenly reacting to the same mass buying and selling pressures. The conditions did not favour the “accumulator” and auto-callable products that had been sold in their billions. Accumulators played on a seemingly straightforward pitch: if you like a stock at certain target level, then you should be happy to accumulate those shares at a discount. The investor is effectively short a put in the instrument – he is obliged to buy shares at a set price, should the stock fall below that threshold. In a bull market, the product works wonders. In a bear market, the investor is obliged to take shares if they fall under a specified bar, usually 80%–90% of the market price at the start of the contract. According to a report by ABN AMRO issued at the beginning of the year, private banks had sold a total of US$43.2bn accumulators, many of which were leveraged. Auto-callables provide investors with exposure to tail risk: a basket of shares where the pay-out is based on the price of the worst performer in the basket being above a set barrier after a set period of time. If this is achieved, the structure knocks out and the investor receives a coupon. An auto-callable investor is buying correlation and selling volatility. The best-case scenario for investors is that the basket of stocks is highly correlated and trades with low volatility. The issuer is short correlation and long volatility. The worst-case scenario for the issuer of such products is that they knock out quickly. In such situations, the issuer is left with a hedge on a deal that no longer exists, leaving issuers needing to buy back volatility. On the other hand, when the spot prices on the basket dropped, they needed to sell more volatility in the market in order to increase their hedges. Dramatic and highly correlated market movements sent issuers rushing to sell volatility as markets tanked, or to buy volatility en masse as markets spiked to hedge. It added a peculiarly Asian twist to the Asian eq