PTION

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The scarcity of innovations
cooked that counts, but the
has led to product similarity,
way it's presented,
so it's not the way it's
DRESSI}IG
UP,
wlTHouI
A l0lLlltc
Players in the swaps and
options game all agree that the
heady days of innovation are
gone. What they're less clear
about is how best to adapt
within what has become a
low-margin commodities
market.
Simon Brady reports
j ompetition in the derivatives market
is hotting up. Swaps and options
have become commodities. the pace
i of innovation has slowed dram-
aticallv. and the market leaders are tinding it
increasingly difficult ro differentiate
themselves tiom each other. Three strategies
have emerged: concentrate on the high-
r'olume. low-mar_qin products and rnake
monev on the bid-otf'er spread: move into
consultancv: or turn to the retail market. The
competition in each area is t'ierce. and domin-
atetl bv a handful of institutions. But everyone
agrees that the days when swaps and options
could be treated separatelv are over.
Pft)iirrcrs are no longci ln issue in the traded
swap and option markets. Mark Tristram.
second vice-president at Chase Manhattan
Bank in London, says:
"As
far as available
products are concerned, there are not many
new ones. All the mathematical exploration
has been done, and there is no more rocket-
scientist production of new products. New
products centre on the amalgamation of two
or three risk
-
forex-cornrnodity and forex-
equiry warrans, anci options on more than one
variable." Banks with thrs view have two
choices: they can either seli the existing
products more cheaply ihan everyone else
(which means having the bcsi systems, the
best internal risk managemenr, and the best
pricing models), or rnarket therr in new ways.
Alexander von Ungern Sternberg, managing
director at Deutsche Bank Capital Markets,
summarises the lirst approach: "What
differentiates banks in this rnarket now is not
products
-
but the abilitv to handle risk so
that you can price an'/ structure, at any size,
quickly and competitively.'
Banks that choose the fir:st strategy
specialise in making colr:inuous two-way
markets in as wide a range of iostruments as
possible and concentrate on h,.isine.ss with
other financial instirutions. Giveir thr: itructure
of the swap and opticn markets. tlris makes
sense. Per Sekse, asso.:rate director at
Manufacturers Hanover, sa_vs: 'lllllese are
educated guesses but I woulo say that leaving
aside problems of double counring, about
85% of trades
[in
the swap market] are
between financial instinrtions, aad. L5Vo are
corporate. Of the total abctrt 25% are inter-
bank trades between rrarket-makers
-
arbitrage and positiort-closing .{ big chunk
of trading is laying-otf risk irr rhe maiket. and
65% are real end-users
-
ba:rks using swaps
to hedge their balancr she.:r:r
'or
r-(r
match
swaps sold to their clients
"
A bank with more fixed..rar.: liabilities than
assets can use a swap, irr u,nich it pays floating
and receives fixed, as a Sond or loan sub-
stitute. If it has more fixed-rate arssets rhan
liabilities it can use a fixed-to-floating swap
instead of issuing a fixai-rate bond. Pre-crash,
bank treasuries also used the swap market
extensively to take views on interest rates.
According to Sekse. this activiry has dimin-
ished, and treasuries prefer the government
bond markets or futures for their flufters. Says
Tristram: "We do not use cur sv/ap books to
alter the up- and downside olthe bank's P&L,
even though we are authorised to take huge
positions."
Demand lrom non-f,rnancia( institutions
remains thin, despite three years of intensive
marketing. "Corporate demand is irregular,"
says Gilles de Chant6rac. second vice-
president at Chase Manhanan Bank in
London. "It does not consist cfa stead',, stream
of smaller players but a few large
organisations with demand frorn smaller
companies dictated by market conditions."
The majority of companies are unsuitable
counterparties anyway because of credit.
Says one swaps chief: "I would probably
be killed for.saying that we are not interested
Euromoney April 1990 71
Growth rates of swaps,
bonds and
equities
750
Total s*"p"
O
Total aquhies
Jrotal
bonds
in corporate business
-
and ofcourse we care
deeply about our corporate customers
-
but
a swaps group cannot survive bv concen-
trating on companies." Banks which take the
view that the market is now marure and that
demand patterns are unlikely to change sig-
nificantly in the medium-terrn are now
concentrating on providing a commodiry
service to the financial end-users.
The problem with this end of the market
is that there is little value-added. The banks
simply shop around for a price.
"In
the plain
interest rate markets more and more end-users
are doing their own structures." sighs
Tristram. Inevitably, margins have eroded.
According to Liz Merica, executive director
at Deutsche Bank Capital Markets in London,
this has been most noticeable in the US dollar:
but spreads have tightened in all currencies.
The primary debt market is also an impor-
tant souce of business. Not onll' does it
provide the most opponunities to write big
tickets (Chase quoted on both Sl.5 billion
Republic ofltaly issues). but new issues often
suit banks'swap books. Says Craig Kersey,
director, risk management/technical product's.
at Mitsubishi Finance International:
"Some-
78 Euromoney April 1990
times they are the only way to establish or
close a position. Ifyou tried to close a Ecu200
million position in one maturity, you might
move the market against you, anywhere bet-
ween 5 and, on a bad day,20 points. Buying
the offer rate against a new issue is
often cheaper." This, too. is low-margin sruff.
"This is a difficult business," says Duncan
Goldie-Morrison,
head of capital markets and
swaps at Westpac Banking Corporation'
"Although we will pay more if deals are not
put out to bid, a lot are."
Some institutions will not be consoled by
a co-lead manager slot for providing the swap.
"Our senior management is not interested in
lines that don't pay, and that means being anti-
bonds. I think it is a fact that you don't make
much on new issues
-
it is tough to get large-
size quotes out of the market," says one swaP-
per. i3anks which reject punting
-
usually
According to Deutsche Bank's Liz
Merica, margins have eroded, most
noticeably in the US dollar.
defined as running positions to alfect the
bank's bonom-line eamings
-
get their protlts
from the bid-otTer spread and a few highly
controlled net positions which cannot be
avoided.
A smaller group of institutions has taken
a different view. Although they provide a
commodity service. they still believe in the
value-added approach. These houses
-
prim-
arily Banque Paribas. Security Pacitlc.
Salomon. Citicorp and JP Morgan
-
otler
clients risk-management consultancy on a no-
fee basis. Nick Carter. executive director at
SecPac in London. sums up the approach:
-lCs
not enough simply to otfer the products any
more: vou have to be creative about selling:
you have to advise people when to use what
product and so vou need to give people intbr-
mation with which to make that choice and
decision."
For JP Morgan. this has meant providing
its clients with a software package which.
when programmed with their positions and
views on interest and currencv rates, recom-
mends the use of the relevant derivative
products.
The other houses like to emphasise the
accompanying problems. "lf you set yourself
up as a software supplier then you have to do
everything that a software supplier does. You
have to provide education for the users;
maintain systems: get rid of bugs tiom the
programmes. And if you have cliens pushing
bunons and being told to buy x. y and z, and
they have done it wrong or they do not under-
stand the system. you are going to have a
dissatisfied customer on your hands," says one
swaps chief.
A popular horror story concems the system
developed by a leading London bank. Recalls
one swapper: "They sold
just
one of their
systems. Unforrunately they sold it to a rather
demanding client rather a long way away.
Every three weeks or so they have to fly out
to explain the results or correct flaults. I've
heard people there saying they wish they'd
never sold it."
Paribas and SecPac have developed a series
of in-house computer systems on which entire
debt and asset portfolios can be modelled.
Rather than sell these packages, they perform
the analysis themselves. Using the client's
views on currency and interest rates, or the
markets' as indicated by forward curves, the
banks produce advice on the ratios of fixed
to floating debt/assets and the optimum
currency combination these views imply. This
concept has been refined Ly both instirutions
and both now olfer a range of analyses for
which they make impressive claims.
"We are changing the way people look at
their existing as well as new issue debt," says
John Mussachia. executive director at Securiry
Pacific in London.
"At
the moment chief
financial officers might do scenario analysis
-
looking at what happens when rates go up,
stay the same or go down
-
and then they
might choose the alternative with the lowest
average cost. what we try to do is show that
hedging using expected rates can lead to
positions that you never would have gotten
into if you had realised the possibiliry, We
do a probability analysis of all possible
outcomes so that clients can see what would
happen if something outside their expectations
occurs. This is expressed as a probability
-
so that a client might be told that if he used
a swap then there is a l0% chance that his
rates will rise above 11.25%. The client then
has to decide whether he can accept that risk.-
One way of working out this probabiliry is
to use the implied forward curves (the
markets' view of where. say three-month
Libor will be in three months' time) and add
an expected dispersion by incorporating the
markets' view on how accurate this curve is.
This is done by incorporating the implied
volatility of the relevant interest rate or
i
l>
-
Now at Paribas, Jim Durrant says he's
improved on the portfolio models he
originated at SecPac.
currency derivative.
Paribas' approach is very similar. This
comes as no surprise since the same man
-
Jim Durrant, now head of research at Paribas
Capital iVlarkets in London
-
is behind both
systems. Understandably, Durrant thiirks that
his new package is superior.
-Whenever
you
put together a system, you look back and think
about how you would have done it ditferentlv
if you had ihe chance ro start again. Well. i
have had the chance to start again, and lve
incorporated a number of improvements."
Neither institution charges fbr this analysis,
hoping that it will supply any swap or
option products purchased by the clients as
a result.
"We
do not do anything tbr free
-
if I said that it would be untrue." says John
Stomber. head of SecPac's origination ettort
for the eastem US.
-We
expect compensation.
If we get within a basis point we expecr ro
be given the deal. Ifwe kept getting shut our
of deals over half a basis point rhen we would
be priced out of the market."
Although clients which make a habit of
gening the analysis done and going elsewhere
for the fixes soon find that their queries are
answered more slowly, the banks do seem
prepared to run these services as loss-leaders
if necessarv. "It
is not fbr us to decide who
to do business with and who not to do bus-
iness rvith." savs Durrant.
-Our
clients mav
have relationships with other parts of the bank
and this is
.lust
pan of an overall service.-
The banks do expect that clients will at least
cover their expenses if an analysis turns out
to be panicularly long and complicated.
SecPac is in the middle of a rhree-monrh
breakdown ol the debt porriblio of a large
Italian state-owned corporation. This kind ol
service has to be paid tbr.
The main clients are sovereigns and
govenment entitic-s. major international
companies and some large frnancial insti-
tutions. Paribas deals almost exlusively ivirh
triple-A and double-A credits. and its
consultancv service fiequently advises
borrowers tbr rvhom it has lead-managed
Eurobond issues such as the Kingdom of
80 Eurornonev .\pril 1990
ESWAPS & OPTIONSI
Denmark and SEK. Even corporations with
in-house finance arms. such as UK oil giant
BP, have had analyses done. SecPac reckons
that as a result of its strategy, 50% of its
business is with end-users. New issue-driven
swaps are now only a minor part of its
activity, especially since the bank withdrew
from the primary Eurobond market. This
emphasis may be detected in SecPac's trading
profile. Says one trader:
*They
used to be in
the market all the time. Now we don't see
them so much.'
However, the more complex retail-orien-
ted products are growing fastest. Institutions
responding to the latest Intemational Swap
Dealers Association survey wrote M67 billion
of swap contracts, measured on notional
principal amount, in the first six months of
1989, compared to the $690 billion in the
whole of 1988. Caps, collars and swap-
options contributed another $187 billion
-
swaption notional principal growing by 16370
over 1988's semi-annual Erte; c:ps, collars and
floors grew by over 70Vo.
Those houses which concentrate on trading
are sceptical about consultancy. 'We have not
set ourselves up as a risk management
advisory service, and it does not make sense
for a bank to do this. It does not require
capital, so it is better done by an investment
bank or boutique. Ifyou don't charge, you are
not guaranteed a deal because the user will
put the deals out to bid anyway. We would
rather use our resources on the trading side,"
says Westpac's Goldie-Morrison.
The service has a long way to evolve, and
some banks, while remaining trading houses,
offer an informal advisory service. "I would
not say that we offer consultancy," says Sekse.
*We
are a trading house with over l0 currency
swaps books off which we also sell options
products. We sell these products to corporates
and other financial instititions which they then
offer on to their own retail customers. Our
sales approach is to offer a problem-solving
service to both corporate and financial
institutions." In the same way, Citicorp and
BanMmerica make markets in the full range
of vanilla derivative products, as well as
putting together tailor-made packages on a
deal-by-deal basis. These houses. though.
have not yet made available the multiple
models on which entire portfolios can be
analysed.
A third approach is to avoid the wholesale
swap and options business and to concentrate
on developing new products for the retail
markets. These are the currency. interest rate,
commodity and equity-linked warrants that
have been launched as both public issues and
private placements in the UK, US, Switzer-
land, Germany and on the Euromarkets. Since
the beginning of 1989 there have been over
150 such issues and a further 500 issues of
covered warrants. Investors have been able
to hedge (or gamble on) movements in the
stock indices of Germany. France. the UK.
the US. Italy. Switzerland and Japan,
tluctuations in the yen. Deutschmark, sterling
and Australian dollars against the US dollar:
Advising on risk management doesn't
guarantee deals, says westpac's
Duncan Goldie-Morrison.
and movements in interest rates via warrants
on a range of government bonds and bond
furures (French OATs, German Bundes-
obligations and Bundesanleihe. and JGBs).
These instruments are the one area ol the
derivatives market where domestic insrirutions
stand a fighting chance. They have fbund.ir
difficult to make an impression in the swap
and option markets because, as commodiry
markets, they are systems and int'rastructure-
intensive. The most efficient books are run
globally to maximise the number of possible
offsening positions, to allow the minor books
to clear through the main book. to make risk-
monitoring easier, and to increase the book's
liquidity by allowing bigger limits.
The warrant business offers local insti-
tutions one way into the derivatives business.
Sociite G6ndrale. Trinkaus und Burkhardt.
Commerzbank. VItvl Warburg-Brinckman
and Westdeutsche Landesbank Giroz, rle
are all in the top l5 lead-managers of p..,lic
warrant issues (excluding covered warrants)
since the start of' 1989. il covered warrants
are included. local houses t-eature even more
prominently.
These instruments have been criticised fbr
the excessive premiums charged on the
warrants. and an alleged concentration on
shon-term protits at the expense of olient
satisthclion. Says one banker cryptically:
*These
markets cenainlv oifer banks the
margins of products in the early stages of
development."
Befbre he left the chairman's job ar Bankers
Trust International. Allen Wheat told
Euromoner- that he saw the warrant markets
swiftlv going the way of the other derivatives
markets
-
becoming low-margin commodiry
markets. His strategy would be to stay in rhe
market until that happened, and then move on
to a nerv product ranee. leeving the domestic
houses to tight each other tbr the business.
While the banks ponder and pursue their
strategies. it's clear that the heady days oitrue
innovation are gone. Success in the derivatives
market will increasingly depend on presenr-
ing the same old products in new
guises.l
,
Swaps and options gave
the
Eurobond market a new lease
of life in the 1980s. Deriv-
ative-driven private placements
and the increasing use of
swaps and options as asset
management tools could
undermine the public
bond
_markets
in the 1990s.
y Simon Brady
or the past seven years the swap
markets have grown on the back
of an underlying liquid public
bond market. The primary Euro-
bond market has been transformed first bv the
application of swaps and then options to new
issues. The Ecu market is almost entirely
swap-driven as is the Euro-srerling sectoi.
The Euro-yen sector relies on the vield
enhancement provided by embedded Nikkei
put options and the growth ofcallable bonds
has been spurred by the development ofa $60
billion swaption marker.
As the benefits of using derivatives to tailor
products to the needs of"individual i^;;;;
or investor groups
became understood, the
structured private placement
began to compete
with public markets. In some areas, most
'lnificantly
Japan. swap- and oprion-driven
_
.lvate placement
business has become more
important than the public Euromarket.
The major invesrors in Japan are the life
companies. Nippon Lifle has over $165 billion
of assets; Dai-Ichi Life around $l l5 billion
and even tenth-ranked Toho Life has over S25
billion. These companies are limited to
making dividend pay-ours to policy holders
from current coupon income, which means
that they are in the marker for high coupon
instruments and are prepared to take on some
principal risk. The companies' tarqet coupon
level is the Japanese Long-Term Frime d.ate
(LTPR). In periods rvhen there has been a
substantial dilfbrence between borrowers'
target funding levels and the LTpR. the
insurers have tried ro t'ill the gap by
purchasing
bonds in high-coupon currencies
such as rhe Australian dollar. The rapid
appreciation of the yen against these
currencies led to heavy loreign exchanse
losses on the tbreign bond froldin-gs and tbrcld
the insurers to lo"ok tbr other wavs to meet
their targets. The most tlexible source of
suitable investments
has been the private
placement market.
Three basic swap- and option-driven struc-
HOW IO TAI1OR YOUR ASSTTS
With over $ 160 billion of assets
placement market illustrates the
to invest, Nippon Life's use of the private
popularity of derivative-driven instruments.
tures have been popular: callable yen bonds:
dual-currency instruments; and Nikkei-linkcd
instruments. The straight
)'en
placement is
simply a loan with bullet repayntent on
maturitv. The cash flolvs can be swapped to
provide competitive funding in another
currencv.
Callable ven bonds are typicallyr purchased
by insurance companres. Thev van' in rnat-
urity but a common structure is ibr the
insurance companv to extend the loan tbr ten
years at a trxed ven rate rvith an option tbr
the borrorver to cancel any tinte atier three
years. The borrorver. usuaiiv an AA- or
AAA-rated Europeen bank. s,'vaps the trxed-
rate ven into the currency t>i its choice at a
sub-Libor level. The swap counterpany has
therefbre entered an ottmarket srvap in
r""hich
it pavs out the highcr-than-rnarket-rate uoupon
demanded bv the insurance companv. rnd rec-
eives a sub-Libor tlow in return. To make up
fbr this discreoancy the borrorver
,.v't
ites I
callable swap {an option to cance'l the srvap)
in lvhich the srvap counterpartv has the right
to cancel the swap alter three vears. Il ven
rates fall. the srvap is called and rhe borrorver
cancels the Ioan. The srvap counterpan\'sclis
this option dorvn and uses the prentiunt to sub-
sidise the oft'-market swap.
Dual-currencl- structrlres involre
instrumenls whose principal is paid and repaid
in yen. but rvhose coupons are in a high-
coupon currencv. Loans are made b.u- the ins-
urance companv either direct. or rhrouqh a
leasing companr, intermediary. This choice rs
dictated bv the rvpe of borrower as the leasine
companies are eiiorved to lend to a rvider
range of credits. The ieasins companies
typically lend on a subordinated basis to
borrowers oi BBB or berter credit-rarins.
The.v- take r spread ol 15--10 basis points i5r
acting as an intermediarv but are stiil able to
provide competitivelr-priced funds taround
Libor less l0) because oi their relarionships
rvith the insurance comoanres. The end-user
rrreiv
"vants
1en
rundine. and so the principal
is su,apped into tloarinc-rate US doilars.
This market has slow'ed recentl.,, because
rhe .upplv ot iherp runds trom rhe lire com-
panies has dried up as rher., reach rheir lrmits
on exposure ro leasing companies. This sque-
ezc has meanl that the Ielsing corrpanies'cost
of ftrnds has risen irom around Libor less i0
to Libor ilat or even hieher. A recent issue
bv rhe Banco di \apoli resulted ln a cost of
tunds to rhe end borrow'er oi Libor plus 55.
The third srrucrurL-. Nikkei-linkcd deals.
started in rhe private placentenrs sector but is
now'comtron in the public ntarkers. Like cal-
Iable bonds. the borro*'er pavs an above-
nrarket coupon tnd reccives :ub-Lrbor fund-
ins in the currencv rri its choice. The swao
I:trrrrnrorter
j,Orrl
1q9() 3.1
SWAPS &
Fixed
Rate
7%
Creating synthetic "bear assets"
@
Libor
For examole, take an investment portfolio of DM 10m with a
5-year avirage life, To take advan'tage of a projmrcd 0 5oo
riie in S-yeai rates, the portfolio manager
iuts
on a DM20m,
S-year swap: this works as follows:
Ircss on bonds: Price at 7 .1Vo rates
-
Price at 7qo rat'es
=
DM10m x
(97.977
-
100)/100
=
-DM202,294.
Gain on swap: Present value (PV\
of 0.54o on DM2Om over
5 yeaE at 7.3%
=Pv
15,7.57o, DM100,000)
=
DM404,588.50.
(Libor is assumed to have remained constant)
Net gain on bear position: DM202,294.50
Source: SecuritY Pacific Hoare Go\
Source: Security Pacific Hoare Govett
Hedging against adverse interest rate movements
w
Fixed
rate
10%
SecPac's Chris Botsford advocates
swaps, not bond switches, as the
logical way to modify exposure.
is subsidised by the sale of Nikkei put options
by the investor to the arranging bank. These
are then sold on to the OTC market and the
premium received is factored into the swap
rates.
The key to the succcss of these deals has
been the swap and option books of the arran-
ging banks. The avaiiabiliw of rhe appropnate
derivatives dissociates investor pret'erence
fiom that ol the borrower. Investors get the
cash tlorvs thev rcquire. borro,'vers get cheap
t'inancing. The lvailabilitv oi ln increlsing
number ol liquid and sophisticated derivatives
has altered the balance of power between the
public and private markets. More and more
issuance. which r.vould
have been done
publicly two
years
ago. is being done pri-
vatelv. Large numbers of ostensibly public
deals have been targeted and pre-sold. Ofthe
60-plus Eurobond issues by Bankers Trust iast
year. less than ten rvere straightibrward debt
issues. The rest lvere highly structured and
had been discussed and refined rvith the larget
institutions tbr tlays il not weeks belbre issue.
However. the private placement market
has. until norv. been hampered by its one
over-riding disadvantage: illiquiditv. This has
alrvrvs overshadorvcd the manv udvantages ot
thd rnarket. rvhich include a kxver cost ol
funds bccuuse r)l rltvrolIS on printing. ilgcncv.
legal und undenvritins expenses: flexibility ol
structurc because oniv a small number of
investors have to be satistled: speed of
arrangement bccause no svndiclte has to be
arranged: no public disckrsure: lnd the
building rrf close rciationships
'.vith
rnajor
institutionul in'u'estors.
Thc traditionul ri*v rvas that institutional
invcstors such ls pcnsion funds
-
tvhich hold
For example, for a US$10m 10-yeu bond with a 10-yeu
swap and a 0.5% increase in lGyear yields to 10.5%,
the hedge works as follows:
Loss on bond: Price at L0.57o rats
-
Price at 107o rates
=
$10m x
(96.993
-
100y100
=
-$300,700.
Gain on swap: Present value (PV)
of0.57o on $10m over
10 years at 10.5%
=
PV
(
10, 10.57o, $50,000) =
3300,738.
(Libor
is assumed to have remained constant)
longer-term assets than liabilities to obtain a
higher yield iiom a positively sloping yield
curve
-
are sensitive to interest rate changes.
and so unwilling to commit to a hold-to-
maturity philosophy. They theretbre avoid
heavy investment in illiquid bonds because.
should their currencv or interest rate views
change. the-v- want to be able to alter the pro-
portions of lixed- and floating-rate
investments and the currency mix of their
porttblios bv switching bonds. To do this'
they need a liquid bond market. The swaps
and derivatives markets challenge this
orthodoxy.
The argunrcnt runs like this: institutional
investors' appetite tbr private placements has
proved that tariured products overcome their
liquidiw rvorries. By buying such instruments,
the institutions have got to grips with the
complexities trl derivative-linked products. It
is a shon step ti()m here to recognising that
the same derir.atives can be applied to an
existing rsset porttolio to alter its
characteristics regardless oi the liquidity of
the instrumcnts it contains: so there is less
need tbr a iiquid public bond market.
The illiquidity of manv government and
Eurobond markets relative to their corres-
ponding swap markets only strengthens the
argument for using swaps. rather than bond
switching, lor porttblio management. Try to
move f25 million of gilts or S20 million of
a Sl00 million AAA-rated Eurodollar bond
issue and see what happens to the price," says
Craig Kersey, director of risk manage-
ment/technical products at Mitsubishi Finance
International. "But you can easily do similar-
sized tickets in the swap markets without
moving the price." There is now over 52
trillion outstanding in the swap markets. and
the business is still growing.
-The
Tokyo market offered solutions for the
insurance companies in response to foreign
exchange regulations and the insurance com-
pany code." says Kersey.
"The
next area of
growth will be European pension funds. The
deregulation of 1992 will benefit European
insurance companies: their problem will be
where to get enough flxed-rate assets in each
currency. The answer is the swap market
-
the largest and most liquid tixed-rate market
in Europe: so liquid that in currencies like the
I
i>
Euromoney Aprrl i990 85
Ecu. which lack a good spread of maturities
and issues. the swap rate is already being used
as a benchmark of value."
In other words, asset managers will use
swaps, not trading, to adjust their portfolios
to changing interest rate and currency views.
'The
logical way of modifying exposures in
these areas is swaps," says Chris Botsford. at
Security Pacitlc Hoare Govett in London.
"and if vou use swaps. you need not invest
in liquid bonds. So you might as well get the
additional benefits of cheaper funds and tailor-
made structures of the private placement
market." The time will come, according to this
theory. when the only bond markets will be
efficient government bond markets and the
derivative-driven private markets.
The popularity of active debt management
using derivatives makes asset-swap supponers
optimistic. From a deal-by-deal use of swaps
and options to manage their debt, institutions
are steadily moving towards active debt port-
fblio management. With the help of banks'
consultancy departments. sovereigns, sup-
ranationals and government entities are using
swaps to alter ratios of fixed to floating debt,
and also currency mixes. They are using caps
and floors to control their rate exposures. And
central banks are using the swap markets to
alter their positions rather than bond and forex
markets. One head of risk management says:
"If
a government was seen to be moving out
of its own currency, it could cause instabiliry.
For reasons of anonymiry they are now using
the swap markets."
As a result, the advantages ofusing deriv-
atives are becoming obvious on the asset side:
the swap markets allow the investment man-
ager to "buy" or
"sell"
a yield without an
underlying principal credit risk. By de-
coupling market-rate decisions from credit
decisions. swaps increase an investment
manager's tlexibility, opening up a much
wider range of investment opponunities to
meet an investor's particular requirements.
And swaps enable accurate comparison of
asset values in different currencies with
different structures.
Asset managers have already started to use
swaps in this way via the synthetic securities
market. With a synthetic securiry. an arranger
buys an underlying bond and is principal to
a swap which creates the investors' required
cash flow (for example bunds swapped into
sterling to create a synthetic gil0. The investor
purchases only the bond principal and the
tailored cash flow. The arranger takes care
ofthe original coupon on the underlying bond.
deals with the swap cash flows and pays the
investor the requisite coupon. The synthetics
can be tailored on a one-ofTbasis, or a special
purpose vehicle can be created which buys the
underlying bonds. modifies their currency and
interest rate characteristics and issues new
paper against them. These synthetics. like
private placements. would tbrm the illiquid
basis tbr a swap-managed pontblio. The
similarity of synthetics to asset swaps is
demonstrating the benet'its of active swap
management to the investors.
86 Euromoney April 1990
Creating synthetic fixed rate assets
Fixed rate,
G + 1.0%
Sterling
Libor
+0.5%
Floating Asset Yield. Libor + 0.5%
Investment Mansger pays on swap:
(Libor)
I.M. reeives on swap: gilts + 1.07o
Yield on repackaged bonds: gilts + 1.5%
Source: S*urity Pacific Hoare Govett
Per Sekse of Manufacturers Hanover:
asset managers will start to use
swaps in the next three years.
But the lcap to full_,--tled-sed asset swappine
is large. In an asset swap. the investor is the
central tlgure: he buvs rr suitable bond and
then goes to the swap market to modity
coupon and currency. Even if an alTanger
advises the investor on the instruments to be
used. the inve:tor is still responsible tbr
managing and accountrng lbr the cash tlows
of the transaction. He owns the underlying
bond. and he is u principal to the swap.
The disadvantages of the approach are the
administrati"'e costs ol handling these cash
tlows. and in particular the need to value the
swap tbr accounting purposes. Asset swap
supponers believe that large institutional
investors lre elreadv clpable of pertbrming
both these tasks. lnd that scveral large US
institutions are alreadv actively managing
swaps porttblios. Suys Nlark Tristram. second
vice-president at Chase Manhattan in [,ondon:
*It
goes without saying that people are looking
at these instruments for active managemenl.
Profits are taken, swaps are unwound." The
populariry of yield-curve swaps which exploit
spread and yield-curve anomalies shows that
investors will use complex derivatives to lock
in profits.
The illiquidity of both private placements
and synthetic securities becomes an issue only
if the fund manager has to move quickly into
cash. In this case the investor has rwo choices.
Sell the instnrment back to the arranger, or
sell it on in the market. It would be up to the
investor to make sure that the first alternative
remained possible until maturityt the second
alternative will become easier as a formal
secondary market for private placements is
developed. In the US, a private placements
market designed for ofiering, trading, clearing
and settling these securities will come on
stream when Rule l44a is approved. Called
PORTAL. it is run by NASDAQ and will be
the first trading market for privately placed
securities.
Unexpected cash demands would tend to
affect unit trusts and. in exceptional circum-
stances. insurance companies. Mainstream lile
companies and pension funds
-
the major
inveslors
-
predicr their cash flows years in
advance and should not be worried about
illiquidity.
It will still take time to overcome the innare
conservatism ol institutional investors, and
in some countries, including the UK. the
regulators need tinre to catch up with the
t'inancial engineers. The proponents of
derivative-based asset management admit that
it will be a slow process. Says one swapper:
"l
have devoted a lot of my time. (though not
my stafls because this does not make much
money) into showing fund managers asset
swaps. I say:
'lf
you had invested in bunds
and swapped them into sterling last year you
would have got 80 basis points over gilts.'and
they do not buy it. You ask yourself how to
get these things t-unher up their list of
priorities. and you realise that pension tund
(-,'ilililtr\l,\t
l\t\t
ilg
APS & OPTIONS
Anilnu&l /itilil
pugc tJ6
managers are actuaries and that someone like
me going in and showing them a lancy swap
does not impress them very much."
"That's why we just
recruited an actuary,"
retorts Willy Simon, at Citicorp.
"We
figured
if you can't beat them, join
them." SecPac
employs fwo actuaries, but even in the US the
process is only just
beginning. Says John
Stomber, head of SecPac's origination effort
for the eastern US:
'Because
the US has been
such a dollar market we are only just beg-
inning to see the mutual funds and pension
funds doing this. Even swap-driven private
placements are still a relatively small part of
the total private placement market here. We
hope to be a leading institution in helping
murual funds, pension funds and insurance
companies create assets in any currency and
we are gearing up our operations to do this."
Manufacturers Hanover's Sekse believes that
the process will take off in the next three
years:
*Swaps
took eight years because they
were a new product. Now they are not new
-
the hurdle is
just
a new application."
Of course, investors will still need under-
lying bonds in which to invest, but these will
be the synthetics and structured private place-
ments. As the public markets shrink, so this
market will grow. And it will not just be the
European market that follows Tokyo's lead.
Approval is imminent for Securities & Ex-
change Commission Rule l44a which prov-
ides exemption ior the registration
requirements of the 1933 Securities Act for
re-sales of restricted securities to
*qualified
institutional buyers". Approval will allow
foreign issuers to sell debt or equiry private
CSFB's reputed $5 million lure
to Allen Wheat emphasises the
importance.it places on
derivatives
placements in the US without having to go
through the cumbersome process of SEC reg-
istration; without having to comply with US
accounting regulations; and without the two-
to three year holding period that applies at
present to unregistered securities. This will
make the US market attractive to companies
from countries such as Germany and Switz-
erland which had previously been unwilling
to make the necessary disclosures. Smaller
companies from European countries with
similar disclosure requirements to the US,
such as the UK, have already found the US
private placement market a cheaper and more
convenient source of fu4ds than the public
markets, according to IanPeacock, at Klein-
wort Benson in London.
The etfects on the banks are difficult to
predict. Few houses make significant profits
from primary public Eurobond issuance. The
erosion of this market will not hurt them. and
they are already making money from private
placements anywav. Fixed-income trading
operations are being scaled back or closed in
many institutions now, and a reduction in the
supply of new benchmark issues will simplv
accelerate this process. And those banks with
the largest swaps and options capabilities, the
big commercial banks, will be better pos-
itioned to take advantage of this process than
the investment banks which have traditionally
dominated the primary bond markets.
The strategic necessiry of derivatives was
highlighted recently by the evident delight of
CSFB's Hans-Joerg Rudloff in having lured
Allen Wheat and some of his most accom-
plished lieutenants to head up a new s ;
and derivatives company within CSFB.
-,e
fact that CSFB was prepared to pay a reputed
$5 million for Wheat and a further 51 million
each.for selected other staff emphasises the
importance one leading house puts upon
derivatives in the bond markets in the i990s.
At the time Rudloff commented:
*CSFB
has
never taken swaps positions. . . We are filling
a hole that CSFB had. The market has dev-
eloped to the point where you have to be able
to ofler clients not only your services but your
balance sheet as well." T
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