Derivatives House of the Year - Merrill Lynch

To its critics, Merrill Lynch is the fair-weather shop of the derivatives market: bolstering resources when the market is hot, cutting back when the cycle turns. Certainly, the US investment bank has been aggressively building its business recently, hiring more than 700 people globally over the past two years to work in derivatives, all at a time when the markets are booming.

However, this is not just an opportunistic response to cyclical trends, senior officials at the firm stress. While Merrill concedes that it had fallen behind its competitors in derivatives earlier this decade - a fact Osman Semerci, global head of fixed income, currencies and commodities, attributes to losing key people in 2000-01 (see Q&A, page 25) - it strongly disputes that the bank is not committed to the business. Instead, the hiring spree has been part of a strategic initiative to make derivatives a core focus for the firm.

"The senior management, all the way up to Stan O'Neal, chief executive and president of the bank, made a commitment to this business, and the decision was made two years ago to make derivatives a core part of the bank's strategy," says Dimitrios Psyllidis, London-based co-head of fixed income, currencies and commodities (FICC) for Europe, the Middle East and Africa (EMEA).

It seems to be working. Merrill is not yet the biggest or most profitable derivatives dealer on the Street, nor does it offer the scale of product that some of its competitors do. However, the bank has made giant strides in its derivatives business over the past year across virtually all asset classes. Derivatives revenues have increased quickly, rising from $2.3 billion in 2004 to an anticipated $4.5 billion in 2006. If achieved, the 2006 figure would represent a 50% increase in just 12 months - and the dealer expects even greater gains next year.

Key to this improvement has been recognising gaps in product offering, client coverage and geographic location, and filling those through acquisitions or new appointments. For instance, realising it needed to strengthen its commodities business, Merrill acquired the energy trading businesses of Entergy-Koch, a joint venture between New Orleans-based energy company Entergy Corporation and Wichita, Kansas-based Koch Industries, in November 2004. The integration of this business into Merrill's global markets division has enabled the dealer to extend its coverage to include natural gas, power and weather derivatives, and has contributed to triple-digit growth in commodities revenues.

Elsewhere, recognising that its coverage of corporate and public-sector clients needed to be improved, the bank nabbed a 20-plus derivatives marketing team from JP Morgan in 2005, led by Antonio Polverino, now co-head of Merrill's client solutions group for EMEA. The results have been quick in coming this year - the team has executed deals for 260 corporates and 70 public-sector entities.

And the build-up doesn't stop there. The bank has hired some of the biggest names on the Street across structured credit, equity and foreign exchange, and covering different client segments and geographies. "We identified where our gaps were and looked to address them," says David Gu, global head of rates and foreign exchange, and the other co-head of FICC in EMEA. "Clearly, we have added a lot of fire power in terms of people, and have expanded our asset class coverage."

Another key change has been to reorganise the firm's derivatives coverage to create an integrated, cross-asset platform. Clients now have a single point of contact within the bank, and while specialists remain on the structuring side, the sales teams are able to cover the full gamut of products. While many banks have loose joint ventures in place across asset classes, the organisational structure at Merrill Lynch has been formalised through the appointment of a single head of fixed-income and equity - in Europe, this is Semerci. This allows the dealer to avoid any squabbling between desks over profit and loss, and focus on the delivery of bespoke, cross-asset solutions for customers, says Semerci (see Q&A).

It's an approach that clients appreciate. "I have found Merrill to be quite creative and innovative in structuring specific products for our business needs," says one treasurer at a UK-based investment company. "I see that as the difference between them and some of the other price-driven banks. If I have a problem, I will call Merrill first."

Arguably one of the biggest successes has come in the credit market. While Merrill already had a strong franchise in cash collateralised debt obligations (CDOs), it was virtually non-existent in structured credit derivatives. In 2005, however, the bank decided to build up its capabilities in synthetic CDOs, hiring Paul Horvath from JP Morgan as global head of synthetic product marketing and Paul Levy from Deutsche Bank as head of exotic credit structuring for the EMEA region.

The results have come quicker than many at the bank expected, with the business growing by more than 100% in 2006. While it has ramped up its single-name credit default swaps (CDSs) and index market-making activities, the dealer has also pulled off some notable structured credit deals in 2006 - something that has been appreciated by end-users.

"Merrill Lynch has come up very quickly. They've always been quite strong on the cashflow CDO side, but they've brought a team in on the synthetic side too and they are doing a lot of business," says one Singapore head of structured credit at a global asset management company. "They are really good on the credit side for us - not so much on the plain vanilla, as everybody does that, but on the more innovative stuff. They are playing across the spectrum that we like to look at, so I would put them up there as number one in that respect."

Perhaps the most significant transaction structured in 2006 was the $3 billion Jazz III CDO managed by France's Axa Investment Managers. Launched in July, Jazz III was aimed at addressing credit investor concerns that spreads were too tight and could widen, and that by investing in a CDO they could become overexposed to credit spread volatility over time. "What other people see as very hard markets, we see as market opportunities," says Horvath.

The transaction effectively comprises two components: a main corporate credit portfolio (accounting for around 97% of the deal) and a structured finance bucket (making up 3% of the overall portfolio). The main corporate portfolio contains 137 mostly investment-grade credits with an average rating of BBB+, and the manager has the flexibility to invest in CDSs, loans, bonds, asset swaps and total return swaps. Axa can also invest across different maturities, take short positions (up to a maximum of 10% of the overall portfolio) and exploit arbitrage opportunities between the price of cash and synthetic instruments - essentially giving it the flexibility to put on different strategies in various market conditions.

The French investment manager also has a liquidity facility of $1.67 billion that allows it to invest a total of $4.67 billion in credit instruments - provided that $1.67 billion of those investments are effectively hedged. This will allow Axa to put on $1.67 billion in negative basis strategies ahead of its expectation of a deterioration in the credit markets. If spreads widen quicker in synthetic instruments compared with cash, as they did in 2002, then the negative basis trades will realise mark-to-market gains. Otherwise, they can be held to maturity to realise positive carry.

The structured finance bucket, meanwhile, comprises a 0.5-2.5% single tranche of a corporate portfolio managed separately by Axa. This portfolio was aimed at taking advantage of the shift in value to the equity and junior mezzanine parts of the CDO capital structure following the dislocation in the correlation markets in May 2005, therefore compensating for tight spreads in the main corporate portfolio.

Merrill Lynch and co-arranger Ixis Corporate and Investment Banking offered seven benchmark classes of notes worth a total of $664.5 million, ranging from AAA to equity. The equity tranche comprised 5.75%, or $176.5 million, of the total portfolio and on closing was projected to have a 14.6% return (in dollars) assuming no defaults and no trading gains or losses in the portfolio.

Merrill Lynch says the popularity of the Jazz III structure has led it to create a similar instrument managed by another major money manager. But it cited US regulatory concerns about providing further details of the transaction as Risk went to press.

The firm has also proven innovative in helping European insurers and pension funds to increase their investment yields by developing credit-contingent, capital-protected inflation and interest rate trades. "Ideally, insurance firms would like to preserve capital, so principal protection is important, and they would like to hedge against rises in inflation, either because they have policies linked to it or implicitly have made promises that mean they get hurt if inflation goes up," says Horvath.

While traditional capital-protected structures have typically offered high initial coupons for the first few years, subsequent payouts can be lower than those required by insurance companies, says Horvath. In response, Merrill Lynch developed a principal structure that is able to pay high coupons throughout the product's life by making the payout contingent on the performance of a junior mezzanine CDO tranche (typically 2-4% or 3-5%) for a certain period.

For instance, the firm structured a 15-year capital guaranteed product that pays 5% in years one to three, followed by the 10-year constant maturity swap rate plus 150bp - floored at 5% and capped at 10% - as long as the junior mezzanine tranche is not affected by defaults in a reference credit portfolio during the first seven years. "An asset manager aims to minimise credit losses on the portfolio both through its initial portfolio selection and through ongoing trading. Additionally, there is subordination to the tranche that provides a first loss cushion against credit deterioration," says Horvath.

Credit derivatives have also been combined with commodities to tailor an innovative financing solution for a non-investment-grade Indonesian coal producer. The company was looking to borrow money to fund the acquisition of a coal mine in Indonesia, but leveraged loan investors weren't too keen on taking exposure to the country. What's more, leveraged loans are not ideal for a commodity producer - as the borrower's revenues are highly dependent on the price of the commodity, a relatively small drop in prices could trigger covenants on a highly leveraged loan fairly quickly, forcing the company to refinance.

In response, Merrill developed a solution that enabled it to make a $60 million loan and accept repayment in physical coal. The bank essentially entered into a prepaid forward delivery contract, in which it lent the money upfront and the company agreed to deliver coal in the future. The dealer then hedged its commodity exposure through swaps, and found a buyer for the physical coal.

However, that still left Merrill with credit exposure to the Indonesian company. The dealer hedged this risk by buying credit default protection from emerging market hedge funds, project-financing funds and reinsurers. The bank also sold commodity and credit-linked notes to real-money investors, asset swapping them out of the commodity risk into a Libor-plus payout.

The attraction for these investors was that the risk profile is different from that of a standard high-yield loan, translating into lower potential losses. In a low coal price environment, the mining company would be more likely to default, but the investor's losses would be offset by the positive mark-to-market of the commodity swap. Conversely, in a high coal price environment, the losses to the investor would be greater than that of a standard amortising loan, but the probability of a mining company defaulting is actually lower.

"It's a different risk profile, and we found a lot of investors interested in getting paid a similar spread to what they would get on leveraged or high-yield loans, but with lower risk," explains Theo Constantinidis, London-based head of the FICC structuring group, who joined Merrill from Deutsche Bank last year. "By tranching up the risk into its components - commodity for the commodity investors and credit for the credit investors - we are able to lend more money to these investors."

Merrill is looking to extend this type of solution to other commodity producers, and is currently working on a number of similar deals across a variety of products. "We are able to do this wherever we have a physical commodity trading presence. The physical trading aspect is very important because we're taking performance risk on these mines being able to produce the commodity," says Constantinidis. "So, we're focusing on aluminium, coal, electricity, crude oil, gas, copper and gold in countries such as Indonesia, Russia, Kazakhstan and South Africa."

However, not all the bank's innovations have involved complex structures. In July, Merrill was sole lead manager and bookrunner on a 10-year EUR1 billion inflation-linked bond on behalf of the European Investment Bank (EIB). The structure itself was relatively simple - the notes paid a 5% coupon for the first year, followed by 1.48 times the year-on-year change in the non-revised harmonised index of consumer prices, excluding tobacco, for the eurozone, with a floor of 0%.

The difficulty came in simultaneously launching the bond in 12 European countries using multiple distributor banks - one for each jurisdiction - in an attempt to extend the distribution of EIB notes to a broader universe of investors. The bonds, issued under the supranational's new European Public Offering of Securities programme, were listed in all 12 countries and were the first EIB notes to be compliant with the European Union prospectus directive, which allows an issuer to distribute securities in multiple European markets as long as the prospectus for the offering has been approved by one EU regulator.

"The structure of the bond was quite straightforward and it was not complex to hedge, but to ensure the bond appealed to institutional accounts it was important to ensure that the paper was placed very broadly, not just by client type by also by geography ," explains Merrill Lynch's Polverino. "A lot of work went into the syndication and legal documentation to ensure that we managed to launch the bond at the same time in 12 countries is not easy. This was a very complex process involving multiple regulatory filings and a large multi-national distribution syndicate, which we handled very efficiently. In the end, everybody was happy with the transaction."

Indeed, Aldo Romani, deputy head of euro funding at the EIB in Luxembourg, points to Merrill's co-ordination of the deal and its willingness to underwrite much of the issue - to the tune of EUR520 million - as key to the deal's success.

"There are so many different parties involved, the kind of effort you have to put into the negotiations as an arranger of the transaction and also as the major underwriter of this transaction is enormous," he says. "So you have to be able to negotiate the economics and find a common interest with so many different counterparties that it really becomes an enormous effort and a very complex one."

And while the structure itself was fairly simple, Merrill's ability to pick an inflation-linked payout that was attractive to investors in multiple jurisdictions was also important, says Romani. "The inflation-linked market has so far been extremely fragmented in Europe, and what this transaction has done is to find a common denominator across a number of countries where investor preferences and distribution networks are different. So, the capacity to identify a structure that could be of interest throughout the eurozone was also very important."

Elsewhere, the dealer has been building up its equity derivatives business, increasing its head count by around 50% over the past 18 months. The firm hired Alvise Munari from Goldman Sachs as London-based head of the equity structured solutions group for the EMEA region, and also snared a trading team from Credit Suisse led by Michael Pringle, now head of EMEA flow derivatives and equity risk.

Central to the push in equity derivatives is creating products based on the firm's equity and derivatives research. "When I arrived at Merrill Lynch, I realised the bank had a truly unique and excellent franchise in equity and derivatives research," says Munari. "Research wasn't being used efficiently by other houses for developing structured products. I believed we should be the first one to achieve such a success with a family of structured investment products really driven by fundamental equity research."

One of the first steps was to turn ML Europe 1, Merrill's flagship European research product based on the research team's best ideas, into an investable index and then offer products on it. One simple early example was the ML Europe 1 certificate. In this case, the investor receives the initial capital invested multiplied by one plus the participation rate times the change in the index. If the ML Europe 1 index falls, the participation rate is 100%; if the index rises, the participation rate rises to 135%.

"We observed that over the past six years, the ML Europe 1 index has consistently outperformed the Dow Jones Stoxx 50 by 16.9 % year-on-year," says Munari. "Behind the product, there is a lot of brain power in selecting the names. What we offer is something whereby there is clearly value between the perceived expected outperformance and the fair-value cost of the outperformance in real terms." The bank has sold more than $1 billion notional of products linked to the ML Europe 1 index so far.

Meanwhile, Merrill has devoted considerable resources to one of the hottest areas in structured products today - hedge fund replication strategies. The dealer was one of the first out of the gates with an investable hedge fund index called the ML Factor index. Currently, the product is being road-showed to investors and is being offered through multiple investment vehicles.

"Our choice of factors is explicit, transparent and rules based," explains Munari. "We completed extensive analytic work before we set down the framework we have launched, and realise that the factors we selected are pretty stable. This is supposed to be hedge fund beta. We're trying to offer investors an alternative to funds of funds that we believe often don't offer much out-performance, charge multiple layers of fees and are illiquid and opaque."

Despite this investment in structured credit, equity derivatives and corporate solutions, the bank intends to continue its investment into 2007. Top of the agenda are emerging markets, fund-of-funds products, correlation trading and foreign exchange.

"One area where we will hire more people and continue to invest is foreign exchange," says Gu. "Merrill has traditionally been focused on the exotic business, and clearly you cannot just do the exotic business anymore - you have to do the flow and e-commerce business too. We are launching our forex e-trading platform, and we'll be hiring more flow traders in 2007."

While Merrill Lynch steadily slipped down the derivatives rankings in the early part of the decade, the dealer seems determined to cement itself as top derivatives house. The real test, though, will come in the next down market. Merrill's Psyllidis for one, is confident the dealer will remain a formidable force in the derivatives markets: "When you do provide a solution to a problem, the client does come back. Clients don't like working with banks that are there for the quick buck - you need to be there for the long term, and that makes a difference."