Derivatives go back to the drawing board
Simplicity and risk control are paramount
When the most powerful man in the world says he does not “want every single college grad with mathematical aptitude to become a derivatives trader”, it is a clear signal that the industry is out of favour.
US President Barack Obama’s verdict on derivatives, in an interview with the New York Times Magazine last month, follows a year during which derivatives have been portrayed as weapons of mass financial destruction. The collapse of Lehman Brothers, the AIG affair, and the high volume of losses through corporate hedging programmes have led participants to eschew complex derivatives products and put a renewed emphasis on simplicity and risk control.
At the same time, derivatives volumes have fallen as many big banks cut back on their proprietary trading and sought to remove leveraged exposure from their balance sheets.
Credit derivatives have received the most negative publicity. Volumes in synthetic collateralised debt obligations and structured asset-backed securitisation have fallen off a cliff and look unlikely to bounce back in the short term.
Gary Jenkins, head of research at boutique bank Evolution Securities, said: “While credit default swaps will continue to be used by credit investors, more complex products will not return for quite a while and some areas may not return at all.”
But through the doom and gloom, there are areas where derivatives are making a comeback. According to the International Swaps and Derivatives Association, the volume of notional outstanding contracts on credit default swaps fell by 29% in the second half of last year, yet despite the fall in structured credit, the vanilla CDS business continues to hold up well.
Jenkins said: “Credit derivatives have all been lumped together by politicians and regulators to include structured credit, but, unless they make a specific change, politicians don’t affect the volumes of business carried out by market players.”
Although credit has suffered, vanilla equity derivatives have remained surprisingly robust this year, according to Garry Jones, group executive vice-president and head of global derivatives at derivatives exchange Liffe.
There has been strong trading in options and index futures on the exchange, driven by algorithmic traders. Average daily volumes for the exchange’s individual equity products increased by 40.9% in April this year compared to April 2008 and 67.7% compared to March this year.
This should continue as the market stabilises, according to Jones, although he intimated that the more structured over-the-counter equity derivatives business would be unlikely to revive in the short term.
He said: “One of the changes we are seeing is the increasing influence of algo and black-box traders, whose trading volumes have remained stable. However OTC volumes are down more than exchange [volumes]. Any equity derivatives desk that used to make money by structuring products will have seen this business dissolve.”
The credit crisis has also led to a shift in the use of derivatives by corporates. Several businesses that used derivatives to hedge against record commodity prices or that leveraged themselves to bet on foreign exchange rates saw their derivatives positions underwater as prices dropped and the markets moved against them last autumn. Their negative experience means that many companies have been slow to get back into the derivatives business.
Activity has been further reduced by the reluctance of banks to extend derivatives lines with the same freedom they have done in the past. Banks say they have seen lower volumes, particularly in corporate use of interest rate and foreign exchange derivatives – which constitute the biggest portion of the OTC market – and this is likely to continue in the short term.
Kara Lemont, head of interest rate and foreign exchange structuring for Europe, the Middle East and Asia at BNP Paribas, said: “Corporates have been doing a lot of hedging on liabilities when rates are high. But when rates are near zero, less hedging is required. Some corporate clients are also doing less foreign exchange hedging because they are doing less business overseas and have lower offshore revenues.”
However, the drop in corporate hedging has to some extent been balanced out by a greater demand from investors looking to use derivatives to place speculative views on the market. Foreign exchange is a particularly strong draw in this respect. Lemont said: “Among investors, FX is quite sexy now. Certainly the investor business is seeing more volumes than the corporate business, which hasn’t been the case for a while.”
Interest in commodity derivatives has also increased this year. Volumes declined in the commodity market, which forms 2% of the global derivatives business, according to financial research firm Celent, as corporates and investors unwound trades in the face of falling commodity prices last year.
However, with renewed investor confidence since last summer and with much of the sector still trading at relatively cheap levels, investors have been looking to benefit through derivatives trades.
Tim Owens, head of global commodity investor structuring at JP Morgan, said: “Flows into commodities remain strong on the investor side. Few have shied away from this market though the approach to investing has changed.
We have seen increased interest in exchange-traded products and a move towards one-to-one tracking instruments, both of which are experiencing strong inflows.”
Commodity exchange-traded products have been the dominant feature of commodity investment this year. Inflows into commodity-linked exchange-traded products totalled $17.2bn (€12.7bn) for the first quarter, compared with $6.7bn in the same period last year, according to research from Barclays Capital.
Gold has been the prime beneficiary of these fresh inflows, with $14bn of investment into gold-linked exchange-traded products in the first quarter, more than three times the previous record set in the third quarter of last year.
Furthermore, participants suggest the corporate hedging hiatus may be only temporary and that many are moving back into hedging their commodity risk against a recent surge in prices.
Another derivative asset class in which interest has revived is inflation. The inflation derivatives market was crushed earlier in the year as bid/offer spreads widened to record levels on the back of poor liquidity and increased market volatility.
But quantitative easing and the cutting of interest rates by governments across the world has led to concerns over long-term inflation risk, which many are seeking to hedge through inflation swaps.
Alberto Brondolo, director and inflation product manager at Barclays Capital in New York, said: “Corporates and investors were very focused on hedging inflation in early 2008. But with the financial crisis, attention shifted rapidly to liquidity and funding. As the dust settles, we are increasingly witnessing a re-emergence of inflationary concerns – and inflation derivatives are appropriate instruments to address these risks.”
Economics aside, the other big influence on the derivatives business will be regulation. One derivative class in the UK that will be affected this year is the contract for difference. These give their holders an exposure to the change in price of a specific share.
They have typically been used by hedge funds to take positions on the movement of a stock at a small fraction of the cost of investing directly in the shares.
Contracts for difference have been popular, but this could change following a new ruling by the UK Financial Services Authority that will require users of such contracts to disclose their positions in the products from June 1.
The ruling is likely to dissuade many participants, particularly hedge funds, which prize trade secrecy, from dealing in these derivative products, according to Andrew Shrimpton of asset management consultancy Kinetic Partners.
Further regulatory moves are likely as long as misunderstanding and distrust cloud the derivatives market. Evolution’s Jenkins believes regulators may be waiting for the market to settle down before they commit to specific actions. He said: “Regulation is needed but not at the moment when the market is at its most vulnerable. As the St Augustine quote goes: ‘Give me chastity Lord, but not just yet.’”
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