01 Sep 2008, Georgina Lee, Risk magazine
The downturn of the equity markets since November, a current weakening of the Australian dollar against a resurgent greenback and a likely shift to a softening interest rate environment have created significant challenges for an array of derivatives end-users in Australia.
Dealers, meanwhile, have faced issues in terms of funding and large increases in writedowns related to structured credit instruments. And that is creating something of a squeeze. Bank lending to business grew by a meagre 0.3% per month in the second quarter of this year, down from an average of 1.8% per month a year ago, according to a quarterly review by the Reserve Bank of Australia (RBA).
These developments have eroded initial confidence among financial market participants that the country might be able to withstand a knock-on economic slowdown stemming from the turmoil in the global financial markets, which kicked off in the middle of last year.
Jump forwards 12 months and gloomier economic forecasts from the RBA, and a wide expectation that weaker growth is in store for the next year, has set the scene for the central bank to cut interest rates for the first time in seven years, with the first cut potentially coming as early as September.
The result is choppier markets across asset classes, be they commodities, equities, foreign exchange, interest rates or credit - a market that has seen banks moving from writing protection for transactions like collateralised debt obligations to buying protection as many old structured deals are unwound.
But higher volatility has also created opportunities. Derivatives desks in Australia, for example, are now looking to offer instruments to investors that allow them to express macro views on Australian interest rates, corporate fundamentals and the overall economy.
A resurgent US dollar, against which the Australian dollar had fallen by 12.7% in mid-August since hitting a 25-year high of $0.9849 on July 15, has caused fund managers to rapidly reassess previous allocation strategies as they put on new hedges against a weakening local currency. Steeper yield curves, meanwhile, have resulted in pension funds struggling to handle the long end of the curve for liability hedging.
The appetite for simpler products is also notable, especially on the credit side. "There has been a strong preference for vanilla products, a move away from structured credit and an absolute flight to relatively safer credits," says Grant Bush, Sydney-based head of debt capital markets at Deutsche Bank, which won top spot in Risk Australia's 2008 derivatives survey for the second year running. "We expect investors to increasingly engage in well-rated corporates from their preferred sectors. However, they will be much more name-specific than in the past," he adds.
Ranked first by end-users and the interdealer community, Deutsche Bank secured 12.1% of the total vote, ahead of second- placed National Australia Bank (NAB) with 11.8%. ANZ followed in third place with 11.2%. The German bank also secured second places in the equity and credit derivatives categories, and third places in the interest rate and currency derivatives categories. It performed particularly strongly in US dollar/Australian dollar currency forwards, exotic currency products and cross-currency swaps. In the interest rate derivatives segment, Deutsche Bank ranked number one in US dollar repurchase agreements with 19.3% of the vote.
"We have a strong local business with international reach," says Bush. "As such, we don't think of ourselves as a branch of an international bank, but rather as a local bank with a foreign network, and then it comes down to remaining focused on providing value and solutions to clients."
Ian Martin, head of global rates at Deutsche Bank in Sydney, also reckons the bank's global footprint enabled it to deliver exotic interest rates trades quicker than its competitors. "Our core competence is our ability to deliver complex derivatives solutions for our clients, and we have the balance sheet to transfer risks for them," he says.
The apparent change in the RBA's monetary policy stance began to be priced in from late July and this is attracting more macro players into the market, says Martin. "When rates were less volatile, a lot of capital was employed in transactions such as butterflies and other trades taking a view on yield curve anomalies. But the greater influence now is from those investors who want natural exposure to the Australian market-place due to their macro views on rates," he explains.
The expected turn of the rate cycle is also good news for NAB, with the bank climbing to second place overall, up from last year's fourth position. Indeed, Australian banks performed strongly in the interest rates derivatives categories, with NAB dislodging last year's leader, Deutsche Bank, and ANZ climbing to second from its fifth place of last year.
John Feeney, Sydney-based global head of rates and credit at nabCapital, the investment banking arm of NAB, says increased volatility over the past 12 months has given nabCapital increased business volume due to a rise in the number of users of interest rate derivatives. Much of the volatility at the short end of the curves is due to banks' funding constraints in Australia, New Zealand and globally. And he expects these conditions to "stay for some time".
"With increased volume over the past two years in short-end derivatives instruments, we certainly put more emphasis on them," Feeney says. "Meanwhile, we try to be more visible on the long end. Due to our increased presence, particularly in the interbank market, we try to become increasingly a provider of price and liquidity across a whole spectrum of interest rate derivatives."
The expectation of a steeper yield curve will bring in different types of clients to the market, Feeney reckons, as financial institutions such as hedge funds will begin to engage more in carry trades based on the shape of curves.
As for asset managers more generally, volatility in the foreign exchange market and, in particular, the current strength of the US dollar versus the Australian dollar, means active managers are rapidly reassessing tactical asset allocation having previously been aggressively overweight cash and underweight global equities.
Luke Marriott, global head of foreign exchange options at ANZ in Melbourne, says that, as the Australian dollar falls and dovish rates sentiment grows, it has become increasingly difficult for asset managers to manage their portfolio drift. Most asset managers still do not regard equities as too cheap and remain sceptical on earnings, he claims.
ANZ grabbed the top spot in currency derivatives with 13.8% of the vote and landed in second place in interest rate derivatives with 12.8%, trailing NAB's 13.2%.
Marriott, however, believes foreign exchange market volatility should fall as a result of US dollar strength. "The broadly based US dollar weakness resulted in multi-decade highs being achieved across numerous currency pairs along with rising volatility levels," says Marriott. "That turnaround in the US dollar has seen volatility levels fall rapidly, and prompted increased activity in short-dated defensive strategies and lower-cost directional plays such as one touches." A one touch is a digital option where the buyer receives a specified payout amount if the spot touches a specified barrier level before expiry.
Foreign exchange has increasingly gained recognition as an asset class in its own right, due in part to its lower levels of correlation with other traditional asset classes within a portfolio. And, moving forwards, Marriott expects uncorrelated products with higher returns and lower volatility to continue to be in demand.
Ben McMillan, head of foreign exchange at Commonwealth Bank of Australia, sees no reason for volatility to calm down anytime soon. He believes corporates should examine how their businesses would be affected by 20% or even larger moves in currencies in both directions and hedge that risk appropriately. Option strategies can be used to tailor solutions to particular views or provide protection, and McMillan says the bank is gaining share from clients that are moving away from US and European banks to diversify their counterparty risk. "Foreign exchange derivatives usage will grow as corporates search for more efficient and tailored ways to hedge their exposures, and investors look for alternative and uncorrelated investment opportunities," he adds.
Meanwhile, David Hawkings, Sydney-based head of credit trading at JP Morgan for Australia, says the focus in the credit default swaps (CDSs) market this year has been on banks' correlation desks, where demand has being geared towards managing current exposure and restructuring existing trades rather than printing new deals. "Negative gamma has been a problem for correlation desks, so when we saw spreads continue to push wider, these desks continue to be buyers of protection," Hawkins says. "There has been heavy turnover from correlation desks."
JP Morgan extended last year's leading position in single-name investment-grade and single-name high-yield CDSs and iTraxx Australia tranches into this year, capturing a solid 23.8% of the credit vote with a significant lead over second-placed Deutsche Bank, which won 15.5%.
The ability to trade actively and in large sizes has been one of the important areas that differentiates the US bank from other counterparties, according to Russell Taylor, Sydney-based head of institutional sales at JP Morgan in Australia. "JP Morgan's credit hybrid book relies on single-name flow derivatives," says Taylor. "Our position as a significant player in Australian single-name CDSs puts us at an advantage globally due to our ability to fulfil demand from clients generally."
In equities, a 29% fall in the benchmark ASX 200 index since November last year - the largest drop in the past 20 years - has been accompanied by a significant shrinkage in warrant market turnover. Daily volatility in the equity market had seen share price movements averaging 1.2%, doubling the average of the past 20 years, according to the RBA quarterly review.
Overall warrant turnover has dropped as much as 20% from a year ago, according to Paul Darwell, former head of equity derivatives at Citi in Australia, who retired in August. Despite this market trend, Citi's turnover has increased significantly, Darwell claims. Its strength in single-stock options and options on the ASX 200 index helped it to win first place in the equity derivatives category this year, dislodging UBS from top spot.
"There has been greater interest in cross-asset class hybrids, such as outperformance notes, which we market in a suite of retail products called Optimiser," Darwell says. "So, over the past year, investors have changed from more equity payoff-focused products to multi-asset products."
For institutional investors, John Moore, Sydney-based head of derivative sales for Citi in Australia, says hedge funds are looking at trading volatility within the region as they are increasingly interested in trading inter-country spreads.
"It's a trend that will continue to grow over the next few months while higher levels of volatility persist," says Moore. "Examples of trades executed using variance swaps include Australia versus the Nikkei 225 index, Australia versus the Kospi 200 index and Australia versus US. We also continue to see heavy use of derivatives for playing fundamental ideas, not just pure volatility."
Click here to view the rankings results in PDF format
How the survey was conducted
Risk Australia's derivatives survey was completed by 184 dealers, brokers, corporates and asset managers in Australia and New Zealand.
Participants were asked to vote for their top three derivatives dealers in order of preference in derivatives categories in which they had traded over the course of the year. The survey covered 36 categories, divided into interest rate, currency, equity, credit and commodity. The votes were weighted, with three points for first place, two points for second and one for third. Only categories with a sufficient number of votes are included in the final poll.
The survey included a series of overall product leader boards, calculated by aggregating the total number of weighted votes across individual categories.
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