IFR Derivatives 2005

The listed product sector currently exhibiting the strongest growth is fixed income, primarily short-term interest rate futures and options. Within this segment, the biggest beneficiaries of increasing volumes are the two main Chicago futures exchanges (see chart) – the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) – which have at last embraced electronic trading, a notable contributor to their recent success.Dave Nicholls, head of global finance at Deutsche Bank, observed: “The reduced expense of going electronic has helped the exchanges grow because marginal transactions can be expressed for limited cost. For example, some multi-legged trades used to be too onerous to execute for the small spread you are trying to achieve, whereas now reduced commissions allow more relative value trades to be executed.” Reduced costs and increased flexibility have also helped to attract new users to the exchange-traded derivatives markets. For example, there has been acceleration in arcade-based activity as a direct result of electronic access and, perhaps most significantly, hedge fund use.The growth of the hedge fund industry has impacted all financial markets to a greater or lesser extent, but the evolution of exchange-traded derivatives trading has impacted the hedge funds themselves. Patrick Cirier, chief operating officer, Europe, Fimat International Banque, said: “They are bringing new things to the market, benefiting from the technology improvements. You see hedge funds that were doing limited strategies now turning over a lot more business because the systems now enable them to do so – they give them the ability to adjust trading positions much more precisely and quickly than ever before. That in turn, is contributing to the volume growth on the electronic exchanges as well.”It is unlikely that current year-on-year growth levels will continue to be maintained now that the boost from electronic trading has been factored in to volumes. Exchanges will therefore have to look elsewhere to encourage further growth.One possibility is for exchanges to merge with each other, which has the added benefit of being a quick fix for bottom line, if not headline volume, growth. In doing so, however, there are potential difficulties with competition authorities – and not all exchanges have obvious merger partners.Another method of increasing volume is to attract liquidity from other exchanges. There have been a number of successful attempts to do so over the years; such as the move by Eurex to attract liquidity in the bund contract away from Liffe. But more recent efforts have failed – notably Eurex US and Euronext.Liffe’s forays into the US rates market. The latest moves of this nature – Eurex US and the Philadelphia Exchange going toe-to-toe with the CME’s FX futures and the CBOT’s US Treasury products respectively – have not yet had time for a winner to emerge, but futures dealers suggest that these plans only have a limited chance for success. Consequently, most observers believe that if exchanges are to consistently grow volumes they will have to broaden the scope of the products they offer. This is likely to be a long-term process.Richard Berliand, global head of futures & options and prime brokerage at JPMorgan, said: “It is difficult to identify any new exchange tradable financial instruments that are transformation products – things that will change the face of the listed derivatives world in a couple of years, rather than just being nice to have. Swap futures, for example, have proved to be in this latter category, and have not really taken off. It is the same story with single stock futures – they have not transformed the world, even though I think they will continue to grow and, over time, will become a profitable product offering for exchanges.”The exchanges will continue to look to the OTC market for new product inspiration, according to Nicholls. “The larger OTC markets that do not yet have a full exchange-t

The derivatives industry was already aware of the issue and had been working for some time on addressing default swap confirmation backlogs. Much of the work has been done under the aegis of the International Swaps and Derivatives Association (ISDA).“The association has published a series of documents outlining timetables for tighter end-to-end processing and increased automation of bilaterally negotiated derivatives processing,” said Robert Pickel, executive director and chief executive officer at ISDA. Notably, ISDA published a consultative paper outlining its vision for a shift to full automation for the bulk of OTC products in December 2003. The paper included a target timeline for key elements of the post-trade process, which was augmented when ISDA produced implementation guidance for OTC derivatives processing automation in 2004. “This year,” Pickel said, “a series of high level meetings, sponsored by ISDA, has brought together business, legal and operational staff from buy and sell-side institutions of all sizes to address these issues, focusing on the increasing range of automated solutions, many of which are based on FpML [Financial Products Mark-up Language], the industry data communications standard sponsored by ISDA.”The result of those meetings was a commitment to prioritise the resolution of credit default swap confirmation backlogs and set even more stringent goals for the industry. For example, a target was established for 70% of plain vanilla CDS trades to be automatically generated by the end of 2005.The target would build upon the progress evidenced by ISDA’s annual operations benchmarking survey. The 2005 survey found that the automated generation of credit derivatives confirmation had increased to an average of 40% from 24% the previous year, while the number of credit derivatives confirmation backlogs dropped from an average of 17.8 business days in the 2004 Survey to 11.6 in 2005. And 68% of respondents that have not yet automated credit derivatives confirmation stated that they plan to do so in the next year.Despite such progress, regulators remain concerned by the issue and, as a result, the US Federal Reserve called a meeting in September to discuss the strains placed on the credit derivatives market by the explosive growth of the instruments. Attended by representatives from regulators around the world and 14 derivatives dealers, one key focus of the meeting was the un-notified assignment or novation of trades.The practice, which is believed by many to be the cause of a significant proportion of unconfirmed deals, is a particular issue with hedge funds, according to dealers. Jeanmarie Davis, a Federal Reserve staffer, said at the meeting that consent should be agreed before assignment of a default swap to a separate counterparty, that third-party deals should not be placed on bank risk management books unless the original counterparty had been notified, and that guidelines for assignment should be agreed and applied.To this end, the dealers present observed that they had all signed up to the novation protocol published by ISDA earlier that week. “Under the terms of the ISDA Master Agreement, the prior written consent of the remaining party is required when its counterparty in a trade wishes to ‘novate’ or ‘assign’ (i.e. transfer) its position in a trade to a third party. The protocol enables the parties to specify a clear process to facilitate a streamlined exchange of electronic communications among the parties involved,” Pickel said.The hedge fund industry appeared reluctant to comply with the dealers’ plans, however. On the day of the novation protocol launch, the Managed Funds Association (MFA) sent a letter to ISDA detailing hedge fund concerns with the proposed new market practice code. MFA president John Gaine said that the liquidity and transparency of interest rate and credit derivatives would suffer due to the ISDA Novation Protocol because the market's ability to price and transfer risk w

Asian structured product growth has come from the opening up of new markets and growing familiarity with new investment techniques. The development of any new market comes with its share of risks, however, as some international banks discovered this year. In global terms, Asia represents a fraction of the financial markets, which is always going to act as an effective revenue cap on any product line in the region; it is no different for structured products. Yet the numbers are already good enough for banks – and head-hunters – to see further opportunities in this area.From a liability management perspective, Asian structured product activity is tiny in worldwide terms. Yet, although the contribution to the overall business from the Asian market is constrained by the size and nature of its companies, the margins are good. "Asian companies tend to have pro-active treasurers," said Mahesh Bulchandani, head of structuring and solutions at JPMorgan. "They are much more accepting of complex structured solutions, whereas in the US, the market is bigger but more commoditised.”Volumes on the investment side constitute a more significant component of world-wide volumes and profitability. Here, the placement of CDOs has been a major factor in Asia's increasing importance, but there has also been healthy interest in structured notes – notably before the flattening in the US interest rate curve. The retail sector is also taking off in the more developed markets of Hong Kong, Singapore, Taiwan and Korea.Great hopes are pinned on regional profits increasing, and these hopes are likely to be fulfilled but it will not necessarily come easy, particularly as the market pushes into new territories. In these frontier markets, supervisors have a lot of catching up to do before there is a level regulatory playing field throughout the region. This is where banks can get caught out.Running foul of the regulator can impact a bank both from a financial and, even more importantly for some, a reputational viewpoint. Incidents in India and Korea this year highlight this threat.India has two financial markets regulators, both admirably protective when it comes to the domestic investor. There is a level of opaqueness when it comes to derivatives in India that periodically leaves room for error – and recrimination. In April, for instance, the Reserve Bank of India (RBI) put a stop to a developing flow of quanto swap deals, while in May UBS was reprimanded by the Securities and Exchange Board of India (SEBI) for equity derivative transactions. While the RBI curtailed the sale of quanto products, it did not enforce unwinding of existing trades and no punishment was meted out. But SEBI banned UBS for one year from selling offshore derivative instruments with Indian securities as the underlying instrument.Clarity, or the lack of it, was an issue in both cases. Without explicit guidelines as to what is expressly permitted, retrograde action is inevitable but worrying. The Indian Securities Appellate Tribunal itself highlighted a lack of clarity in SEBI's "know your client" requirement in its September ruling in favour of UBS's appeal against its ban.Even in the more developed markets, banks are open to regulatory risk. In Korea, for instance, Deutsche Bank and BNP Paribas were rapped on the knuckles by the regulator for supposedly mis-selling derivative products to quasi-sovereign companies. "That decision has made it difficult for foreign banks, but it will hurt the development of the market in Korea more," said one structurer. Following the reprimand, bankers say that deals with government-linked companies require several banks to price the deal."Having 10 banks bidding on a deal is OK in normal markets, but that is not Korea," said a banker. "What is the point of doing loads of work for only a 10% chance of getting the business?" The rewards from structuring in Asia are evident but the risks less tangible, yet with the market leaning towards further deregulati

According to some estimates, the first quarter of this year saw more commodity-linked hybrid products sold than all of last year. “The returns [for the commodity sector] are excellent and there is a believable and coherent story for why that should continue. It is not like 1973 and 1979, where [the oil market] was supplying the lead. This is about demand and growth,” said Kevin Rodgers, global head of energy trading at Deutsche Bank (see chart). Most commodity-linked transactions are oil-focused. The optimal allocation to commodities is widely seen as 5% of a portfolio, but the reality is that many investors have no commodity allocation at all, said Arun Assumall, executive director and head of European commodity investor sales at Goldman Sachs. While the commodity index market is a US$70bn market, the commodity-linked structured products market is estimated to be a US$15-20bn sector. When it comes to getting exposure in commodities structuring is key. “You have to consider that a lot of investors cannot buy 1,000 lots of WTI futures - that risk would be well outside their mandate,” said Wayne Harburn, global head of commodity derivatives at ABN AMRO. Because the price of energy as measured by oil in recent years has more than doubled, fixed income payouts have grown in popularity, he noted.The general trend in commodity-linked products is for more complexity and greater use of the barrier technology that is already widespread in the foreign exchange and equity markets. Goldman Sachs has been in the market with bonus bonds - a structured commodity index product that guarantees a return as long as the underlying does not touch certain barrier – while JPMorgan has turned the oil buffer certificates that it launched 18 months ago into butterfly certificates. "Many investors are becoming nervous at current oil price levels. While they are still confident that oil will appreciate, they believe the price level is capped at US$85-90 per barrel, so they are prepared to cap their participation at 30% above current levels in return for higher participation and some protection if the oil price falls," said Tim Owens, global head of currency and commodity solutions at JPMorgan. "It is a popular product because it offers a geared return and an enhanced return protection if oil range trades for a while," Owens added, noting that typical tenors are three to four years. According to some market participants, the amount of barrier option trades recently executed is worth keeping an eye on. “If we do go near to the barrier level where a lot of barriers have been structured we potentially could get sucked into a liquidity hole - much like we did with large FX barriers in the spring of 1995. The lack of liquidity in the underlying market could make it tricky for dealers to hedge,” said Deutsche Bank’s Rodgers. As these products have barrier levels on the downside that have been left far behind by the rally in crude, this is viewed as a concern that is unlikely to materialise any time soon, however. Relative to traditional asset classes, like fixed income or equity, commodities are often viewed as risky. In light of this, applying constant proportion portfolio insurance (CPPI) technology on commodities is an idea that has been floating around the dealer community. CPPI products can offer a way to achieve principal protection by investing in a risky asset class. The gap risk on CPPIs on commodities can be harder to handle than on CPPIs in other asset classes, however, as the commodity markets can spend years in the doldrums or at plateaus. "This behaviour makes most CPPI strategies look poor performers when they are back tested," Rodgers said. While the stunning returns of commodities in the last two years produce attractive back-testing, the Asian crisis in 1998 and the market downturn in 2001 dampen results. CPPIs with commodity underlyings are widely regarded as a developing phenomenon. Commodity CPPIs would look no different from other CPPIs

Financial market participants are often confused by patents. “The thing about patents is that once a patent is granted, you need to show that it is not novel and that it should not have been granted. [Patent law] doesn’t operate on a balance of probability like a normal suit,” said Paul Forrester, an attorney at Mayer, Brown and Rowe in Chicago. Discovery of a patent covering distressed collateralised debt obligations (CDOs) triggered Forrester’s interest in patents on securitisation technology. Patriarch Partners principal Lynn Tilton was granted US intellectual property rights on collateralised debt obligations (CDOs) with 30% in distressed assets. The distressed CLO market is not an active market one, but that it not the point. The success of the securitisation market is that market participants all regard innovations as common goods. A move away from this stance and towards securitisation technology ownership poses a serious threat to synthetic CDO innovation. “It could have a chilling effect and that is more troubling than who is right and who is wrong,” Forrester said. It is difficult to imagine what the mortgage-backed security (MBS) market would look like today if a patent on computing MBS had been granted years ago. The fact that patent royalties typically carry a roughly 10% charge is both a concern for market participants and a reason for securing patents. Mainstream securitisation technology does not appear to have been captured in any patents granted by the US Patent and Trademark Office (PTO). To head off such a situation, the Bond Market Association’s American Securitisation Forum earlier this year started providing the US PTO with the information and resources to help it distinguish which securitisation patent claims are novel. It is debatable whether the over-the-counter (OTC) derivatives market requires a similar approach. The patent grab that is underway in the listed derivatives market and that is starting to attract attention in the securitisation market is not as apparent in the OTC derivatives market. JPMorgan’s move to patent an employee stock option programme that it arranged for Microsoft in late 2003 ranks among the most recent, high-profile patent moves coming out of the OTC market. For JPMorgan, the programme, which let Microsoft employees trade in underwater options, did not pan out as hoped: it involved taking roughlyUS$8.8bn of notional exposure to Microsoft just before option volatility collapsed. More than anything else the difficulty in enforcing patents in the OTC derivatives space is what has curbed OTC patent proliferation, market participants say. Since Merrill Lynch became the first major firm to add in-house patent attorneys several years ago, all of the other major Wall Street firm with substantial derivatives businesses have followed suit. “It is very much a sleeper issue,” Forrester said. “The problem is that there are financial institutions on both sides of the equation,” he added. Even though the burden of proving that a patent should not have been granted or that it is not being violated rests with the patent challenger in court, lawyers for the major Wall Street firms for the most part are filing patents rather than thinking defensively about patents, some officials say. Litigating a patent normally takes at least a year and costs about US$2m for the first patent and US$1m for each additional patent. Compared with the OTC market, the listed derivatives market offers more fertile ground for patent pursuit. Exchange volumes are more transparent, providing greater ease of tracking potential infringement. Furthermore, exchange volumes are soaring. According to the latest Bank for International Settlement statistics, global turnover in listed derivatives increased by 11% to US$372trn in the second quarter (see chart). Some industry officials say that financial business method patents and proprietary product patents encourage innovation. Without patented or trademarked products, the m

Through 2007, 12% per annum growth is anticipated in global equity derivatives business, according to Boston Consulting Group (see graphic). Product innovation, increased demand for equity derivatives products from institutional investors, hedge funds and high-net-worth investors will play key roles in the global equity derivatives industry’s growth story. Lower trading costs, due to greater liquidity, and further equity market improvements will also factor into the business line’s positive outlook. Among investors the hunt for yield and increased demand for portfolio diversification are fuelling interest in new underlyings and pay-out features. For investors who anticipate continued range bound equity markets, the current volatility setting is a boon. It facilitates creating structured trades in which they can benefit from the upside and downside of the equity market through straddles, swings linked to a basket of stocks, ladder options and look-back options. The current mix of low volatility and high correlation in equity underlyings is also piquing high-net-worth investors' interest in what are commonly called dispersion trades, in which payouts are based on the relative performance of different economic sectors versus a benchmark, such as the Eurostoxx 50, said Hassan Houari, head of equity derivatives structuring at Barclays Capital in London.In the past investors were involved in products with significant sensitivities to volatility and correlation, but historically their exposure was less explicit than with the new generation of structures in the market. “In the dispersion-based investment instruments, one can easily understand that the higher volatilities and the lower correlations realise in the future, the higher the payout will be,” he added.“The really interesting and innovative trends this year are those new indices based on innovative and systematic alpha generating strategies that add a lot of value to institutional investors - lower costs than active asset management, total transparency and liquidity and no risk of style drift,” said David Escoffier, head of equity derivatives at SG CIB in London."If we identify a strategy that we think has potential - like a hedge fund strategy - then we create a derivative on that," said Areski Iberrakene, head of equity derivatives at Dresdner Kleinwort Wasserstein in London, noting that DrKW is creating custom-made underlyings for distribution in its network.According to Deutsche Bank’s Johan Groothaert, global head of the investment products group, among the innovations that clients are looking for are tailored indices that are delivering higher returns than the traditional equity indices. Against this backdrop, Deutsche Bank has created the CROCI, which stands for cash return on capital invested index. CROCI is an investable index that only contains stocks that seem the most undervalued, according to the bank’s equity research division’s quantitative models. “CROCI turns Deutsche Bank’s research into an investable index,” Groothaert said. In the last 12 months Deutsche Bank has sold more than €2bn in products based on the CROCI family of indices, he said, noting that investors have been buying the index outright and in structured products and constant proportion portfolio insurance (CPPI) form. In a similar vein, SG has had success in the institutional market creating systematic investment strategies aimed at replicating alpha generating market neutral investment style in a transparent fashion. In its Palladium product, investors receive the return of an index composed of international blue chip stocks. The Palladium index automatically goes long the best performers and short the worst performers for a given period of time. “This creates a very interesting investment which is linked to the dispersion of the returns of each stocks and thus their individual volatility versus the market volatility; as a result the Palladium shows very low correlation to traditional asset cla

The conundrum on which the Fed chairman has been musing over the past year – falling long yields – is not only an issue for US dollar swap dealers; it has been a global one. There were some signs of a long-awaited steepening of the curve in the sterling market in early October, but the flattening trend looks set to continue elsewhere.In the euro market the forward path of 30-year rates for the next seven years, as reflected by the forward swap market, is more or less the same as current levels, according to Meyrick Chapman head of derivatives strategy at UBS.“Furthermore,” he added, “current market conditions, taking into account current swaption volatilities, predict there is a reasonable chance that euro 30-year rates fall below 3% within 4 years – currently there is a 17% chance of that occurring – whereas in September 2004 the probability of 30-year rates falling below 3% within four years was 0.4%, i.e. vanishingly small.” (See chart)“A flat curve makes everybody’s life more challenging,” said Jon Kinol, head of rates for the Americas at Deutsche Bank. “One of the easiest ways to make money in the swap market is through positive carry and traders have made large sums of money over the last few years just by being long the front end. Coupled with that, banks were able to hold significant amounts of mortgages financed at relatively low rates in the deposit market and lock in relatively large margins. The flatness of the curve, especially at the front end, has put a dent in those strategies and made it much more difficult to generate this type of revenue.”Jan Loeys, global market strategist at JPMorgan, observed that markets are being held in very tight ranges, which reduces trading opportunities for market participants. “The global economy is pretty much growing at a straight line with the stimulative impact of low yields being offset by the negative impact of high oil prices. The result is depressed volatility, which in turn reduces the compensation for risk at the shorter end of the swap curve,” he said.Normally, traders expect short-end swaps to provide a premium in excess of consensus projections for central bank interest rate movements to compensate for the lack of certainty over those projections. Historically one-year three-month Libor forwards offered a premium of around 25bp and two-year onwards about 50bp. But currently both forwards are flat to projections if not below what most observers and economists expect central banks in major economies are going to do.As a result, Loeys said: “Not only do you currently get little carry, any anticipation of hanging on to one- or two-year receivers for the risk premium has been eliminated, meaning you are just going to break even. So, it makes it very hard for banks to purely make money on swaps from typical carry-and-slide strategies. To combat this they have tried to earn returns from more active trading. Some have been decent at it, some have not – there is quite a bifurcation among the banks in terms of trading results this year.”Asset managers are having an equally hard time according to Loeys. “Those with fixed income portfolios have been more on the short duration side because yields are much lower than is typical in a tightening cycle. But they have stayed that way and so they have underperformed their index and they are continuing to be blown apart by the flows coming into the interest rate markets, which are emanating from a reallocation of global savings towards investors who have a strong preference for fixed income – central banks, commercial banks receiving cash inflows from corporates – that depresses the return you get from going out along the curve.”Market participants have been looking to take on alternative risks to compensate for the flat curve. Kinol said: “Most notable has been a move to short gamma. In normal circumstances with a steep curve, banks might be concerned about a rates back up or other potentially hurtful scenarios, but there is enough marg

With May in mind, dealers are waiting to see what impact Delphi’s bankruptcy filing has in terms of tranche downgrades. Rising raw material and labour costs prompted Delphi, the largest US auto supplier, to file for bankruptcy on October 8. Delphi has the potential to rock the markets in a similar fashion as the GM and Ford downgrades did this spring. Fitch says that Delphi featured in 35% of its bespoke synthetic collateralised debt obligations (CDOs) and Standard & Poor’s estimates that Delphi is in 50% of its European deals. At default, Delphi could have significant repercussions for tranche markets.If a default does indeed cause a wave of two and three notch downgrades, as S&P’s report suggests, some dealers think selling mezzanine and senior tranches might be at least as intense as in equity. S&P noted that a single default in one of the most commonly referenced names would cause nearly half of all outstanding synthetic CDOs to be downgraded by an average of two and a half notches. What happened this May was an aberration, dealers say, when supply and demand was simply out of whack. “Unfortunately, models do not say how the market will move and our business is driven by supply and demand [in different traches],” said Mark Stainton, head of credit correlation at Deutsche Bank in London. Deutsche Bank is using the same models for valuing correlation as it was this spring. “Some people say models were wrong and that they could not handle [the repricing], but you have to remember that models are only as good as their inputs,” said Torben Botts, senior correlation trader at ABN AMRO in London. Although there has been much discussion about the problems with the models - or even the inputs to the models - much of this is misplaced, said Matt King, a credit strategist at Citigroup. “The observation that people are starting from is that equity sold off much more than the model said it ought to, and mezzanine rallied much more than the model said it ought to. But the reason for this is that everyone in the market was hugely long equity and hugely short mezzanine. Had the positions been reversed, then equity would have outperformed and mezzanine underperformed,” King said.Therefore, the problem is neither with the model nor with the inputs to the model, but with correlation traders' overreliance on models, he added. “It is the golden lesson of strategy. No trade is a good trade when 150 people have got it on before you. Valuation, or what the model tells you, is only one part of the puzzle,” King said. Ultimately, models will change, but not because of May, dealers say, noting that the approach to pricing and hedging correlation has been evolving for some time now. Gaussian Copula models are still used, but in recent years models have changed from an implied correlation to a base correlation framework. Base correlation is the implied correlation of bootstrapped equity tranches on credit portfolios. Effectively, it is a common language for talking about correlation skew, and its big selling point is its consistency across the capital structure. Banks have been using base correlation approaches in-house for years. Increasingly, they have been sharing their valuation techniques with investors. JP Morgan in March 2004 made public its approach to calculating implied correlations from standardised tranche spreads. According to dealers, the change from an implied correlation to a base correlation framework altered the way market participants hedge and look at risk. Unlike implied correlations, base correlations are constant when measuring credit spread deltas. When the credit correlation market took root in mid-2000, the correlation numbers that were used were estimates and it was not clear how different dealers were looking at correlation. By demanding more transparency in the correlation market, accountants precipitated the changes that set in motion the creation of individual tranche markets. US accounting standard EITF 02-3, which t