The past year has been one of unparalleled discord in the global financial markets. Rising defaults on US subprime mortgages have caused billions of dollars worth of writedowns on collateralised debt obligations of asset-backed securities warehoused by dealers, in turn sparking a crisis of confidence in bank counterparties. With dealers reluctant to lend in the interbank market, liquidity has virtually evaporated, sending the basis between Libor and overnight index swaps surging to record highs on a handful of occasions since August 2007. The crisis triggered the near collapse of Bear Stearns in March - and has since caused Lehman Brothers to file for Chapter 11 bankruptcy protection on September 15, and Merrill Lynch to agree to a $50 billion all-stock acquisition by Bank of America.
Despite the hiatus in global financial markets, South Africa has been more or less shielded from the worst of the storm. While the domestic securitisation market has seen a sharp drop in volumes over the past 12 months as overseas investors have shunned asset-backed securities transactions (see pages 16-18), local financial institutions have been aided by traditionally conservative investment mandates and currency restrictions, causing them to miss out on the most toxic instruments at the heart of the current crisis.
But that is not to say the market has got off the hook completely. Volatility across asset classes has meant local financial institutions have had to weather a tough trading environment over the past year, particularly in fixed income. All eyes have been on the inflation rate, as rising energy and food costs have forced consumer prices to their highest levels since 2002. The key consumer price index excluding rates on mortgage bonds (CPIX) hit 10.1% in March, before rising to 10.4% in April, 10.9% in May, 11.6% in June and a record 13% in July - far above the South Africa Reserve Bank's inflation target of 3%-6%.
This caused speculation that interest rates would rise strongly. The repo rate has increased six times since June 2007 in response to rising inflation, from 9.5% to 12%, most recently rising 50 basis points on June 13. However, an announcement by Statistics South Africa on July 1 that it would make wholesale changes to its CPIX measure caused traders to reassess the outlook for both inflation and interest rates. In response to the litany of changes, due to be implemented in January 2009, analysts estimate the benchmark inflation rate could drop by as much as two percentage points (see pages 20-21).
"The facts are there: inflation will drop from January," notes Johan Roos, head of interest rate derivatives trading at Standard Bank in Johannesburg. "The market is pricing 200bp of cuts for rates starting in April 2009. Participants are starting to look through this spike in inflation, which will continue to have an effect over the next two or three months."
Bond yields have whipsawed around in response. The benchmark R153 South African bond due in 2010 soared from 10.478% on May 19 to reach 11.835% on July 1. The yield then plunged to 9.627% by August 18 and was trading at 9.826% on September 15.
"It has been an extremely volatile time for the rates market, especially over the past two months," says Roos. "The ideal we have is to service clients directly by understanding their needs and hedging strategy. That means when there have been no available prices on some trading days, we strive to be there and quote prices. As new dealers have sought to enter the market, the ability to quote prices and be aware of the liquidity pools is crucial."
Standard Bank topped this year's Risk South Africa derivatives rankings for the fourth successive year, with 15.8% of the overall vote. The bank performed particularly strongly in the interest rates component, taking first place with 18.2%. It also took third place in the currency categories, down from last year's first place, and finished third in the equity categories.
Volatility has not been restricted to the interest rate markets. The South African currency has also had a torrid time, affected by large-scale unwinding of carry trade strategies, fluctuation in commodity prices and interest rate uncertainty. Having started the year at R6.84 to the US dollar, the currency weakened to R8.19 on March 20 before rallying to R7.25 on August 4. The rand was trading at a year high of R8.26 to the dollar on September 11.
"There have been huge swings in the rand this year, particularly against the dollar," says Andrew Selby, head of sales at Absa Capital in Johannesburg. "I think that in such choppy markets, it is important clients do not miss out on potential upside as they hedge their risks, and that applies to both exporters and importers. It is important to take that insurance, but also benefit from some of the potential upside."
Absa Capital retained its second place overall this year, taking 15.2% of the votes - just 0.6 percentage points behind Standard Bank. Absa performed particularly strongly in the currency categories, winning first place with 20.6% of the vote - a rise of one place from last year. The firm also finished second in the equity derivatives segment with 16.8% of the vote.
"We are a young institution and have made tremendous strides to get where we are at the moment," Selby adds. "The volatility has been good for our business in some ways. We have had a good direction and clients have increasingly come to us to manage their risks in both the rates and foreign exchange markets."
Equity traders have also had to deal with unpredictable markets. Having started the year at 29,290.15, the FTSE/Johannesburg Stock Exchange (JSE) All-Share Index dropped to 25,135.13 on January 23 before rising to 33,232.89 on May 22. As of September 15, the index had fallen to 25,642.30.
The market has largely been driven by the fortunes of the mining sector, with the FTSE/JSE Africa Mining Index reaching a year high of 50,553.22 on May 22 before falling to 29,628.58 on September 9, in line with the fall in commodity prices. However, stock prices of the country's financial institutions have moved in the opposite direction, hit by concerns stemming from the credit crisis. The FTSE/JSE Africa Banks Index fell from 36,524.54 on February 26 to 25,646.05 on June 24, before rising to 33,664.88 on September 8.
It has meant investors have had to be a lot cannier in hedging their positions. Rather than hedge using the main index, end-users have been more willing to hedge with those sub-indexes that best match their exposures. "Clients have traditionally hedged using the index. But if your portfolio is weighted towards banks, those hedges would have underperformed or outperformed, depending on movements in the sub-sectors. Clients are now looking to do more sector-specific baskets or stock-specific hedges," explains Crispin Gell, head of equity derivatives in South Africa at Deutsche Bank in Johannesburg.
Given the volatility in the equity market, a growing number of investors - primarily hedge funds - are also looking to trade volatility directly, adds Gell. "Hedge funds can be more nimble and active in the way they manage their derivatives positions. Some are looking to actually trade or take positions on volatility as opposed to pure exposure or protection," he says.
Deutsche Bank maintained its grip in the equity derivatives categories, finishing top with 17.6%. However, that represents a mere 0.8 percentage-point lead over second place Absa Capital. Standard Bank finished third with 14.8%, with JP Morgan and Societe Generale taking fourth and fifth place, respectively.
Commodities, meanwhile, have lost their sheen in recent months, having nudged record highs earlier in the year. Gold futures contracts trading on Comex hit $1,018.5 an ounce on March 18, but had fallen to $787 an ounce as of September 15. Meanwhile, platinum prices were pushed to new highs in the first half of the year after power supplies to South African mines were restricted as a result of energy shortages. Platinum futures on the New York Mercantile Exchange reached a high of $2,214.2 an ounce on May 21, before dropping to $1,175 by September 15. Despite the power shortages that have plagued the country for much of this year, dealers say it has had little effect on the wider financial markets.
"It hasn't really affected the market as much as might have been expected, but clearly the country can't afford to have ongoing electricity issues," says Selby of Absa Capital. "As long as people are more judicious in their use of electricity, and on the whole the country was a bit wasteful before, it shouldn't impact things going forward. In the banking sector, that hasn't had a significant impact at all."
Despite the tricky trading conditions, South African dealers have not had to deal with the huge writedowns faced by many financial institutions in Europe and the US. However, with the crisis showing no signs of abating, the volatile conditions in the country may persist for some time yet.