The intense regulatory scrutiny that put credit derivatives in the limelight in 2008 and 2009 has not affected interest rate derivatives to the same degree, keeping such securities largely out of the news. But while product innovation may have fallen by the wayside for the time being, further distancing the asset class from the spotlight, activity has been booming. For many banks, interest rate derivatives have become the bread-and-butter business of their derivatives efforts over the last 12 months.
"This is a market where two or three houses have benefited. A lot of banks got out of the business as it's not viable if you're not seeing the whole flow. But the players who are really committed have benefited the most. We came into this year very worried about how the business would fare, but now our worries are that we won't be able to repeat this kind of success again," said Jezri Mohideen, head of interest rate trading at RBS.
According to a mid-year 2009 survey by the International Swaps and Derivatives Association, the total notional amount outstanding of interest rate derivatives, including interest rate swaps and options, as well as cross currency swaps, grew by 3% to US$414trn in the first six months of 2009. Over the same period, credit derivative notional amounts decreased by 19% to US$31.2trn.
But like many asset classes, rates have witnessed a dramatic shift in product usage. “There has been a shift away from structured products and towards flow products,” said Nat Tyce, head of interest rate derivatives trading at Barclays Capital. “Part of the reason is an increased focus on liquidity risk and the simpler the product, the more comfortable end users are.”
Although volumes have held up well, despite declines across other classes of derivatives, the market has adopted a more vanilla flavour. Straightforward swaps account for the bulk of activity. Complex products have fallen by the wayside, at least for the time being
“Over the last two years we have seen a simplification of the derivatives market but volumes have been enormous in rates, primarily in interest rate swaps,” said Kara Lemont, European head of FX and rates structuring at BNP Paribas. “Most of the volume has been new issue swaps relating to the dramatic increase in bond issuance."
For corporates with predictable cashflows such as infrastructure and oil companies, the bond markets have been wide open since late 2008. Many have looked to the dollar and sterling markets, where they have been able to find longer-term funding than would be possible in euro currency markets. This has created an unprecedented demand for dollar and sterling hedges among corporates.
“There has been a surge in the use of rates, driven by increased DCM activity,” explained Pascale Moreau, global co-head of interest rate and forex derivatives at SG in Paris. “Lots of issuers previously prevented from issuance due to a lack of liquidity, flooded into the bond market when it opened. The increase that we have seen in our business over the first half of the year has put volumes above our target for the whole year.”
Although the DCM-driven interest rate swap activity could easily subside if the new issue window proves fleeting, derivative professionals believe the renewed corporate focus on liability management will prove its longevity. Against historically low rates and a steep yield curve, corporates have been forced to take a more prudent approach to liability management over the last 12 months. Many have switched from fixed to floating exposure.
“The financial crisis has allowed corporates and banks to consider best practice in terms of risk management,” said Moreau. “The management of carry will continue to be at the top of the agenda as corporates are keen to properly manage their capital charges and benefit from the carry.”
While rates suffered initially from the liquidity crunch during the peak of the crisis, soaring volumes have quickly changed that picture. “The proportion of leverage accounts has reduced dramatically, first leading to a reduction of liquidity,” said Clement Perrette, euro fixed income linear trading at Barclays Capital. “Overall activity with strong growth of real money clients is actually higher. On swaps notably, striking that we are now back to the same type of bid/offers that we saw pre-crisis.”
Spreads look to be returning to pre-crisis levels for smaller clips. For larger trades, wider spreads continue to be a feature of the market. For some, this is good news. "In plain vanilla products, some of the biggest opportunities and margins have been available. Bid/offer spreads have been very tight in the past, making it very difficult to make money out of rates business, but with spreads pushing wider, there are some very good opportunities on offer," said RBS’ Mohideen.