Being first to market with a new product can benefit a bank in terms of reputation and margin. But is the cost of development really worth it? Natasha de Teran reports
As competition in the derivatives markets heats up, differentiation is becoming more important. Innovation is one way in which banks can distinguish themselves but the process can be costly and, having innovated, there is no guarantee that the bank will maintain exclusivity – or indeed be able to ensure its name is the first associated with the products. Despite this, some of the key industry players are expending considerable effort in new product invention. According to Ted Moynihan, a senior consultant at Mercer Oliver Wyman, this is because innovation is crucial for banks wanting to gain a lead in the structured product market, which is where a lot of the profit is now being made. “It is the banks that can bring clients ideas, as opposed to [those] reacting to client requests, that are moving upstream and making the largest margins in the market,” he says. Publicity drive Some of the larger banks go to great lengths to ensure their new products are widely publicised at an early stage to guarantee their brand name is associated with the intellectual endeavour. Mr Moynihan says the reason behind this courting of media attention is that, because of the opaque nature of the products, competitive information is often purely reliant on industry surveys which, in the case of derivatives, often rank banks according to their perceived ability to innovate. “These surveys are somewhat self-fulfilling because they are also based on polls – and each ranking will reinforce opinions in the minds of those polled,” he says. But other banks choose a seemingly contradictory approach, courting little or no media attention, with the result that they rank disproportionately low down in the surveys. SG CIB’s equity derivatives operation, for example, which employs around 600 people, provides a fifth of the group’s profits and is regarded by the cognoscenti as the industry leader, is often ranked behind its far less powerful competitors. SG reinforced its silent approach by refusing to contribute to this article. The reason for this tactic is an open question, but Mr Moynihan proffers his own explanation: “This may be because they are targeting a different audience and a hefty media profile would not help them to win the business.” A third group of banks appear to expend little effort on the innovation front, depending instead on marketing muscle or loyal clients to lend an advantage when following others’ advances. To innovate or not to innovate? Sean Park, global head of debt syndicate and credit trading at Dresdner Kleinwort Wasserstein (DrKW), believes that for the big players, it often does not make sense to innovate because they have brand presence and can rely on client inertia to a degree; they can simply muscle in, pick all the winners and not take the risk. Smaller banks, meanwhile, can find it tough to position themselves if an innovation has happened without their involvement.
Sean Park: big players can rely on client inertia Besides, says Mr Moynihan, it is easier for the larger banks to innovate precisely because they have the flow business. “For the second-tier players, the pay-off is very different. They don’t naturally have the flow of ideas and the range of clients – the most effective way to innovate is to do it on the job, and these situations don’t arise as often with these firms,” he says. Profit or profile? What is increasingly evident is that different banks rank innovation on widely diverging scales. Niall Cameron, global head of credit markets at ABN Amro, is adamant about its importance. “There are two primary reasons for banks to be leading innovators: profit and profile,” he says, adding that it is not simply a case of looking at the bottom line when evaluating the benefits of innovation, as its value is very difficult to monetise.
Niall Cameron: aggressive marketing is key Rich Herman, European head of rates at Deutsche Bank, agrees: “Sometimes we come up with ideas out of a vacuum, others are client-related, and occasionally they come from the trading side – so it is impossible to quantify the costs involved.” Regardless of cost, Mr Herman says a reputation for innovation is important in recruitment: it helps to differentiate an investment bank from a pure commercial bank. “When hiring senior staff, it is important that they think they will have the chance to do something creative and that there is a history and culture of it within the institution.” He admits that the payback can often be purely in terms of perception. “With the [Dow Jones] iTraxx indices for instance, which banks like ourselves effectively gave to the market, the payback was purely reputational. But these efforts are nonetheless important. The hope is that enough clients see you as an innovative solution provider and come to you for solutions.” ABN was another key player in the development of the iTraxx credit index family, and Mr Cameron says that when the bank set out to create the indices, it did not do it to make short-term profit but to solve a market problem. “One of the side-effects was that it generated a lot of structured product and liability management solutions, which did of course bring in revenues, but our aim was problem solving and profile raising,” he says. “We succeeded in both: the market is now much more liquid and also, having had a low profile in the credit derivatives market before then, we were catapulted into the big league.” First to the margin Another advantage of being ahead in the game is that the first mover extracts a large proportion of the margin, which is inevitably eroded as more banks become involved. Moreover, Mr Moynihan says that the early movers are often able to maintain higher margins on products for longer than the followers because the followers have to undercut fees to try to get the business. Mr Park adds that being first very often wins banks a large proportion of subsequent business in the product – even after the rest of the market has caught up. “There is so little that differentiates us to clients, so things like this are important. Often, it will just come down to who got their first,” he says. Keys to success Speed is key to ensuring that banks capitalise on being first and Mr Moynihan says many are only now recognising that innovation in distribution is just as crucial as product innovation. “[Banks] need to monetise their ideas fast, as they only have a finite period to establish first mover advantage,” he says. “To do this, banks need to be nimble and have good channels of communication, which is where some of the larger banks fall down. They are still working to break down the inter-departmental barriers and institutionalise the idea of communicating.” Mr Cameron says that this urgency is intensified because of the short exclusivity period on new products. “The period of exclusivity depends on the level of complexity, but it’s rare to get more than six months. You therefore have to ensure you have the means to replicate and market [a product] very quickly and aggressively.” One recent high-profile example of product development that underlined the demands inherent in successfully managing innovation was DrKW’s credit spread warrants. The bank had first started work on the product in mid-2002, when it was trying to think of ideas that would enable France Telecom (FT) to mitigate its upcoming financing costs. Bankers at DrKW were studying how the firm could possibly profit from the explosive levels of volatility to which FT was exposed. Although the bank came up with a solution, which was based on FT selling call warrants, at the time, the exercise was academic because the telecoms operator had other priorities. But DrKW’s bankers continued working on the idea in what turned out to be an interactive 18-month process of product development and marketing. This culminated in the French supermarket group, Casino, issuing the warrants in May this year – almost a full two years after the product had first been suggested. In the interim, DrKW says it probably involved a solid two or three-man months of work. After Casino had issued its warrants, many investors told DrKW that they needed to see more of the product emerge – they were not able to make the necessary infrastructural adjustments for just a single trade, so DrKW went on to issue its own covered spread warrants. While the bank then managed to attract a slightly broader investor base, many clients insisted on seeing other banks involved in the market before they too would begin considering using the product. The fine art of judgment Mr Park explains: “For a product like the credit spread warrants, which are ultimately for trading, clients need more than one liquidity provider. The fine art was in judging when to move to try to promote a wider uptake and give up the proprietary angle. It’s a dilemma. Our gameplan was to make sure we had first mover advantage – and we successfully did that with Casino. In June this year, once the deal was completed and we had marketed it to both clients and the press, we also started to speak with other dealers to see how they could co-operate.” The issue that DrKW will now face, and which the original iBoxx and iTraxx consortia faced for some time, is bankers’ pride. Whatever the merits of new products, banks will often pour scorn on them, simply to undermine another bank’s success. “There is a lot of ‘not invented here’ pride among bankers, and it’s very hard for customers to navigate through that. They have to effectively ignore the opinion of what are often the largest banks, as often it is only the opinion of a frustrated specialist who has missed a trick.”
