The largest investment banks reported a tenfold annual increase in losses related to derivatives trades in the first quarter, a foretaste of how these activities are likely to curb profitability in trading units this year and may even force some to reassess their presence in these markets.
Losses from credit and funding charges on derivatives positions at the top 12 investment banks totalled more than US$4bn in the first three months of the year, according to Amrit Shahani, research director at analytics firm Coalition, a tenfold increase compared with the previous year. That took the shine off a bumper quarter for most banks’ trading units, whose annual revenue gains of more than 32% declined to 14% when including the losses.
The scale of the losses – which mainly relate to provisions against a potential rise in client defaults as well as an increase in banks’ funding rates – lay bare the eye-watering costs banks can incur on these complex products when market volatility rises.
Analysts say the charges will remain a major focus in the quarters to come, not least because of discrepancies in the size of provisions different banks have made.
"It will be significant given how much these charges impact their performance. It changes their market share, it changes their rankings and it changes the return on equity for shareholders,” said Shahani.
“Some banks that have been conservative in booking these charges could start looking better as the quarters go by, while those who were more optimistic could end up looking much worse.”
Paul Hamill, global head of FICC distribution at Citadel Securities, which competes with banks trading products including bonds and cleared derivatives, suggested the losses could even cause some banks to reassess their activities.
"What we always see after these types of crises is that certain banks reconsider their positions in these markets because they either lost more money than expected or they just realise that the capital commitment to being involved isn’t commensurate with the opportunity," he said.
Trading derivatives, while usually a lucrative activity for banks, is also fraught with risks that go far beyond whether the value of a position rises or falls. Chief among these is counterparty risk, the danger that the entity on the other side of the trade goes bust.
Derivatives contracts are often lengthy, tying a bank to its client for years or even decades. Most trades pass through middlemen known as clearing houses to combat counterparty risk, but many clients such as corporate treasurers deal directly with banks to avoid having to post large sums of margin if a trade moves against them.
Not receiving margin poses a significant problem for the bank, leaving it open to losses when markets nosedive, as they did earlier this year.
Instead, the bank must judge how likely a client is to default over the life of a trade and bake that into how it accounts for the position, via a so-called credit valuation adjustment.
The bank also adds a funding valuation adjustment to account for times when it effectively lends to (or borrows from) the client during the life of a trade – a common feature of long-dated derivatives.
“CVA and FVA numbers tend to be large for any banks that have a big derivatives business,” said Jon Gregory, a senior adviser at consultancy Solum Financial, who has written extensively on the subject.
“It’s a business that, in very abnormal market conditions when volatility is high, is very sensitive to basis risks and second order risks that can suddenly look really substantial."
March’s slump in financial markets proved a potent cocktail for desks handling banks' derivatives trades. Interest rates plummeted, altering the value of contracts struck at higher levels, while company borrowing costs rocketed.
Consider a corporate treasurer with an interest-rate swap in which it regularly pays a bank a fixed sum in exchange for an amount pegged to a floating interest rate – a common trade for those looking to hedge against an increase in borrowing costs. March's decline in interest rates caused the bank’s floating payments to decrease markedly, putting it “in the money” on the swap.
But even though the value of the bank’s position rose, it can only realise those gains if its client remains solvent and keeps making its swaps payments. As the corporate treasurer doesn’t post margin, the bank now has a greater exposure to its client and must increase its CVA to reflect that.
If the crisis has also made the client more likely to default, as measured by wider credit spreads, the bank will have to raise credit provisions still further.
“The fact that banks are being cautious in terms of provisions is to be expected,” said a senior bank trader. “No one knows what the actual data look like in terms of bankruptcies. The only thing you can do is to be cautious.”
There is a also funding component to consider, as the bank may have to meet margin calls on trades it had entered in the cleared, interbank swaps market to offset its client position. Financing those margin calls may become costlier still if the bank's own borrowing rate has increased. As a result, the bank's FVA on the trade rises.
JP Morgan reported the heaviest losses related to derivatives charges in the first quarter – US$951m - which it said was predominantly driven by a widening in funding spreads. Bank of America and Goldman Sachs recorded losses in the region of US$500m.
JP Morgan has the largest derivatives book of all US banks, according to the Office of the Comptroller of the Currency, at nearly US$70trn, 63% of which aren’t centrally cleared.
A lack of transparency around how banks calculate and disclose their numbers makes it hard to predict how the situation will evolve in the coming quarters.
One central takeaway is that funding losses appear to have been the dominant force so far. UBS reported a US$378m loss on FVA and US$92m on CVA in the first quarter, a breakdown experts say is broadly indicative of the wider industry.
That may be, in part, because there is no simple way for banks to guard against an increase in FVA. By contrast, they can hedge counterparty risk at the outset of trades by buying instruments such as credit-default swaps.
“FVA is something that can’t be hedged ... so it tends to be more volatile,” said a second senior bank trader.
The fact that there is no industry standard for calculating FVA muddies the waters still further. Some banks may use internal funding curves; others may decide an aggregated industry borrowing rate is more appropriate. Some may even ignore a rise in borrowing rates if they think it will be temporary.
Whatever the approach, there's no getting around the fact that these enormous costs exist for banks and will have to be absorbed at some point.
Exiting these trading activities is also easier said than done, not least because the losses are mainly driven by popular client products such as interest-rate and cross-currency swaps.
“That’s bread and butter for most banks alongside offering loans," said Gregory. "There’s a general acceptance among banks that this is a difficult and sometimes low return-on-capital business to be in – and a volatile one as well."