There are two ways to grow a derivatives business: commit capital, or go for partnership, explains Denis McHugh.
The derivatives sector is one of the fastest growing segments of the financial industry.
According to the Bank for International Settlements (BIS), the combined value of trading in exchange-listed interest rate, equity index and currency contracts had risen to be worth over $333 trillion during the first quarter of this year, up from just over $150 trillion in the same period three years earlier.
In the global over-the-counter (OTC) derivatives market, the most recent data from the BIS showed that notional amounts outstanding totalled another $248 trillion at the end of December 2004 – up from below $100 trillion at the end of 2001.
Interest rate-based products dominate in both markets – accounting for 75% of overall volumes of the OTC market, and over 90% of exchange-traded volumes.
The market opportunity
Liquidity in these segments is thus clearly not an issue, but the market’s fragmentation can be confusing for potential participants. Trading is split between major derivatives exchanges and regional and sectoral rivals, as well as between emerging electronic platforms, while most of the OTC business is done on a private bilateral basis. Support processes are ever more critical and include market, credit and operational risk management monitored by risk professionals and scrutinised by regulators. At the same time, documentation, systems, settlements and daily valuations are onerous in the OTC world. Credit risk concerns have driven the widespread use of collateralisation techniques which, while providing additional surety, demand more support functions of their own. So, in summary, barriers to entry are higher than ever.
From the client perspective, financial institutions and corporate clients are continuing to expand derivatives for their own risk management, hedging future borrowing costs or foreign exchange exposures. Pension funds and other investment managers are managing their asset and liability portfolios with derivatives, including inflation, equity and credit risks. High net worth and private banking clients now have derivatives regularly in their investment portfolios, and even retail customers are now purchasing investment products structured on derivative instruments.
Moreover, as even the largest national and global commercial and investment banks begin to move into the small and mid-tier corporate segment, smaller entities can find themselves competing more fiercely than ever to retain their traditional franchise.
The partnership opportunity
For financial institutions that are involved in these target sectors of the markets, the investment required to service this growing community of derivatives users can be uneconomic at best – and very often unaffordable. However, the risk of staying out of the market altogether is that clients will move core financing to banks that provide a solution-oriented approach to their needs that can only come with the use of derivatives. Without the product set, the institutions ultimately risk the loss of entire relationships. Banks delivering derivatives products to their clients are finding that they improve client retention.
Financial institutions that are now looking to enter or enlarge the scope of their derivatives activity have two alternatives: either they can commit extensive amounts of capital to the business, draining scant resources and putting additional pressures on other banking areas, or they can outsource elements of the business to reliable partners.
Coupled with the mounting operational expenses involved, the growing commoditisation of derivative markets and the inevitable pressure that is put on margins, the outsourcing option has become an increasingly attractive one. Such partners can help companies remain at the forefront of the market, ensuring they are able to offer the full range of rapidly changing derivative products and structures. Smaller institutions that find themselves marketing OTC transactions can benefit from such partnerships by bundling their offerings with a partner who is able to deliver a larger arsenal of products. Even entities that already use derivatives extensively for their own portfolio management purposes can find that rolling out the products to clients can challenge their existing resources, and that they can benefit from outsourcing to partner banks to meet capacity and reporting demands. Yet again potential entrants face an array of choices – ranging from IT solutions and market connectivity providers, to broker-dealerships or wholesale banks.
Front-to-back partnering
ABN AMRO is one of a handful of wholesale banking groups that offer clients front-to-back partnering arrangements across the full array of derivative markets. The bank extends a white-labelling service to those interested in selling on derivatives or derivative-based products, as well as an operational outsourcing service for those already engaged in derivatives trading, or that wish to upgrade or enhance their capabilities.
These services can be handpicked and tailor-made to fit individual requirements. Financial institutions looking to partner with entities such as ABN AMRO can choose between the services on offer, leveraging their existing capabilities in areas where they are already strong, and working together with the partnering firm in areas where greater investment might be necessary.
For example, one of ABN AMRO’s outsourcing partners is seeking to deliver a commercial derivatives web-pricing tool, with full transaction processing and portfolio management capabilities. Through outsourcing, this bank will be able to redirect valuable in-house resources to concentrate on the client-facing side of its business, and expects to increase its related revenue stream by an additional $10 million within one year.
In a developing market, ABN AMRO is also working with a national retail and commercial bank that realised it would benefit from developing a derivatives trading and marketing capability, but had little experience or available resources. Here, the bank will take on a middle-to-back office advisory role, developing operational, risk and accounting frameworks to underpin the new business area.
By doing this the bank can debut in the market a good two years earlier than it would otherwise have been able to, thereby establishing a valuable lead over rival firms.
Aiming for profit
The benefits of outsourcing to an established firm with a strong derivatives capability and stringent risk management and operational infrastructure are clear. ABN AMRO’s clients have ranged from large and sophisticated entities that have been looking to streamline their own operations, to small, regional banks; and our services have varied from bespoke advisory-based options to off-the-peg web-based solutions.
With a global reach and worldwide derivatives trading activity, supported by extensive research facilities, top-tier staff and one of the most sophisticated collateral management operations in the world, ABN AMRO has a long-term commitment to such partnership arrangements.
Denis McHugh, Head of Derivatives Sales and Solutions Group, Americas, ABN AMRO. denis.mchugh@abnamro.com
WHY THE EIB CHOSE TO OUTSOURCE
In 2001 the European Investment Bank (EIB) mandated ABN AMRO to take over the management of its collateral operations and related custody activities. ABN AMRO now acts as the EIB’s collateral agent and takes responsibility for valuing the collateral, making and agreeing all margin calls with EIB’s swap counterparties, as well as for all related settlement and custody activity.
The collateral market has grown rapidly over the past five years with over 50% of OTC transactions now collateralised by $1,210bn assets (2005 ISDA Margin Survey). Most active derivative market participants have collateral programmes to benefit from reduced counterparty risk, lower capital costs, and greater access to the derivative markets on more favourable terms.
But supporting a collateral management function requires expertise, systems and resources, and the incremental costs involved can be prohibitive especially for new market entrants. ABN AMRO’s Collateral Management Service can supplement an existing derivative operations or risk department, or form part of a more comprehensive outsourcing solution.
“With collateral now standard for all participants in the derivatives market, we were approached by our clients to support their collateral operations,” says Robert McWilliam, head of counterparty exposure management at ABN AMRO and former chair of the ISDA Collateral Committee. “Now you have a genuine choice between building and staffing your own collateral programme, or outsourcing.”
