US ready for increase in OTC derivatives appetite

Although the US is widely credited with being the birthplace of over-the-counter (OTC) derivatives, much of the volume and innovation in this sector of the market is now being driven by Europe.

Pointing out the exception of the plain vanilla interest rate segment, American bankers freely admit that the European OTC markets are now ahead of their US counterparts in terms of sophistication and turnover.

Oliver Frankel, head of economic derivatives at Goldman Sachs in New York, says: “The US OTC markets are behind those in Europe. Necessity has been the mother of invention in Europe where fragmented markets have encouraged innovation. FASB [Financial Accounting Standard Board] accounting rules have also discouraged some potential US users of derivatives.”

When Deutsche Bank and Goldman Sachs decided to launch a set of innovative inflation auctions, the two banks opted to do so in Europe first. Launched with interdealer broker Icap in May 2003, the auctions enable participants to hedge against short-term inflation risk by trading one and three-month options against the European Harmonised Index of Consumer Prices. According to Mr Frankel, this was precisely because the European market for inflation protection is more highly developed.

The divergence between the two regions extends across asset classes. Matthew Carrara, US head of global equity derivatives at Deutsche Bank in New York, says that the US institutional market has “unquestionably” seen less adoption of OTC equity derivatives than the European market

Mr Carrara adds: “There hasn’t yet been the sweeping mindset change to truly adopt derivatives strategies in the US that I think there has been among institutional investors in Europe.”

Now that the risk management and transparency of these instruments is showing considerable signs of improvement, and there are fewer issues for them to overcome Mr Carrara believes that the share of business they do in the OTC markets will begin to grow. He adds: “It is perhaps just a lack of familiarity that has held them back,” he says.

While the fast-growing fund derivatives markets are reportedly as busy in the US as they are in Europe, Stephane Liot, global head of fund derivatives at BNP Paribas, says that European and offshore investors are generally “much more comfortable” purchasing these sort of OTC derivatives than their US counterparts. Like Mr Frankel, he points to the accounting and fiscal issues which he says are “clouding the market”. He says: “Some fund products are viewed as derivatives in the US, while others are not, and because lawyers and tax advisers often hesitate to give an opinion, investors hold back. In Europe the treatment of derivatives products from a legal and fiscal point of view is much more straightforward.”

Credit market size

One of the most notable oddities is on the credit side – the US credit markets are far larger and more liquid than their European counterparts, and yet even here the pace of innovation is being set in Europe.

Chip Stevens, senior credit derivatives flow trader at Deutsche Bank in New York, explains the inconsistency. He says: “Here in the US there are many more idiosyncrasies in the credit markets, which is much larger and has much greater depth. In Europe many dealers have combined the various vehicles for trading credit risk, whereas in the US, trader mandates – while deeper – are usually more narrow in scope. Thus the corporate bond and credit derivative market making functions are still often run separately. As a result Europe has been quicker to develop the more exotic product types.”

Thomas Benison, head of North American flow credit derivatives marketing at JP Morgan, says it is also because the credit derivatives market has developed faster in Europe to compensate for the lack of available credit products in an easily transferable form.

“In the US there are plenty of bonds for investors to buy, while the European bond market doesn’t have such depth. Also not all European investors are able to participate in the loan market, so they have to look at structured products and international credits to gain credit exposure,” he says.

Strengthening business

But despite the relative slow-footedness of the US client base, banks are now adamant that a strong appetite for OTC products will take hold throughout the US markets. Far from witnessing an outflow of talent and expertise towards Europe, several European and US investment banks have been building up their structuring and sales franchises in a bid to meet what they hope will be a strongly escalating level of demand.

In July this year BNP Paribas acquired Zurich Capital Markets’ operations, in a move that will place the French bank in a leading position in the fund derivatives markets globally. The agreement saw BNP take over ZCM’s derivatives transactions and structured products, as well its credit facilities and related assets. BNP took on 60 of ZCM’s 260 staff, all of which work in fund derivatives in the US. Mr Liot estimates that, despite the uneven split in his business today, approximately 50% of BNP’s fund derivatives business will be done in the US by the end of 2004.

Commerzbank Securities, which was hit by an exodus of senior talent in early 2003, regrouped during the year, taking on an equal number of qualified staff. Omar Bayoumi, head of the Americas, at Commerzbank in New York, is adamant the bet will pay off. He says: “Appetite is potentially as big in the US as it is in Europe. There is a gap at the moment – and it is one we are interested in exploiting.”

In the credit derivatives market, Mr Benison believes the US will soon catch up. As investors face ever-tightening spreads and struggle to find yields, he expects the growth of the market in the US to continue accelerating. “The relative value of credit derivatives is becoming more apparent, and investors will respond to this. Over time I would expect the US market to become larger,” he says.

During 2003 Bear Stearns added a total of 20 staff to its credit derivatives team, including Credit Suisse First Boston veteran, Mark Davies, who became global head of credit derivatives at the bank. Compared to Europe, Mr Davies believes the creative application of derivatives for trading purposes is now becoming more advanced in the US, where there is more of an active trading culture – and less of the buy-and-hold approach in Europe.

Product placement

Alex Reyfman, who joined Bear Stearns as global head of credit derivatives research from rival firm Goldman Sachs in November, points to how some of the newer, highly liquid and transparent products – such as the tranched iBoxx indices – have taken off in the US better than they have in Europe. He adds: “The mark-to-market discipline, and the demand for liquidity here is much stronger than in Europe. While that has held things back until recently, it has meant that this sort of product has seen more traction here.”

On the more complex, structured side of the credit derivatives markets, Mickey Bhatia, co-head of US exotic credit derivatives, and correlation trading, at Deutsche, believes the US will catch up fast. He says: “Appetite for collateralised debt obligations (CDOs) and basket trades is definitely more developed in Europe. There is, though, a fast-growing appetite here for the equity tranches of synthetic CDO deals – which is mostly coming from the growing numbers of hedge funds in the US that want to invest in the structured product market.”

Market leaders

Those banks that will succeed in gaining a strong proportion of the growing business in the US, are perhaps most likely to be the US houses along with those international banks that have strong franchises in other regions. Deutsche Bank, which has been heavily building up its derivatives business in the US over the last few years, and which has a strong presence in Europe and Asia, is one non-US bank that is well placed to succeed.

Jon Kinol, head of rates for North America at Deutsche, believes that banks can’t have a real presence in the structured products business without being big in the flow side. He adds: “The structured products area is very competitive, not least because most of the activity is in a handful of structures: if you are buying or off-laying volatility, and have to do it through the interbank market, it necessarily becomes less profitable. You need to have solid risk management and an alternative outlet for offsetting the risk as we do, through mortgage accounts, and convexity players.”

Even so, other non-US banks such as Société Générale and BNP, which have built sophisticated and respected franchises in niche markets, may also do well. And Commerzbank, which has developed a small but fully integrated platform serving all sides of the derivatives market, is likely to find some advantages in its nimble set-up. Either way, the US houses are likely to see increasing competition on their doorstep.