Italian dealers hope tide will turn after tricky 2015

It has been another tough year for Italy’s derivatives houses. Once again, low and stable interest rates, excess liquidity from the European Central Bank, and the dampening effects of regulation have made life difficult for derivatives desks. But, with the US Federal Reserve finally moving to tighten monetary policy, and with Milan-based dealers working hard to marry new regulatory realities with client needs, they are hopeful of a more successful year in 2016

Banca IMI was voted number one overall in the 2015 Risk Italia Rankings, on the back of strong placings across all asset classes. Massimo Mocio, IMI’s head of global markets, says: “In interest rate derivatives, we’ve seen reduced activity, particularly from banks and insurance companies. The expectation has been for continuing low interest rates, and demand has been for very simple products.”

But Mocio hopes the tide is set to turn: “Now, with a more hawkish Fed, the perception is changing. We expect to see more demand from banks and insurance companies to pay fixed to hedge their available-for-sale books. Generally speaking, we think there will be an increase in activity, on the plain vanilla side at least.”

One driver has been regulatory pressure on Italian banks to diversify their bond holdings away from Italian government debt, says Massimo Cattaneo, head of Italy distribution at Barclays in Milan, voted number one dealer for interest rate derivatives. The sector has been turning to credit products and other eurozone sovereign paper and, with European Central Bank (ECB) bond purchases depressing yields, there has been increased demand for seven- to 10-year paper, and inflation-linked BTPei asset swaps.

The good news for interest rate derivatives desks is that clients have also been tapping swaps. “Contrary to the past couple of years, when purchases of bonds tended to be outright, clients are hedging interest rates,” he says. Clients swap out the fixed for floating rate exposure on the assumption that the risk/reward of outright long duration exposure may no longer be favourable.

But other regulatory pressures have been less welcome. “All the new regulation is going in the direction of less activity from the dealing community, larger spreads because of the leverage ratio and Basel III’s liquidity ratios,” says Mocio at Banca IMI. “These are increasing illiquidity and increasing spreads, even in plain vanilla products.”

For example, the net stable funding ratio (NSFR) is expected to drive up derivatives costs, as the balance of variation margin payments (if negative) and initial margin for centrally cleared transactions attract, respectively, 100% and 85% required stable funding. This will affect the pricing of uncollateralised transactions with corporate customers, for example, as hedging the resulting market risk with a bank counterparty creates an asymmetric funding position – one trade is collateralised and the other is not, potentially resulting in a net margin requirement and an NSFR hit.

In addition, the move towards over-the-counter derivatives clearing, as required by the European Market Infrastructure Regulation, is having an impact on the Italian market, say dealers. “There is a clear distinction between banks and real money players,” says Cattaneo at Barclays. The former have been ready to clear interest rate and inflation swaps “from day one”, while many of the latter are less equipped, particularly those that use derivatives in a limited fashion. “We’ve been having discussions with them and providing support and advice on how we see the evolution of clearing vehicles around Europe.”

He acknowledges that, for less active derivatives users, there are “organisational and operational issues” in putting the mechanisms in place to use OTC clearing. But investors that are taking their time will increasingly suffer in terms of pricing and liquidity, he warns: “There are differences emerging in pricing derivatives bilaterally and on a cleared basis.”

“We are advising clients to get organised and move towards clearing, because we feel there is a very liquid market for interest rate [derivatives] that are cleared, as opposed to the bilateral market, especially in longer maturities,” Cattaneo says. While rates have been low and stable, the foreign exchange market generated more action for dealers and investors. The euro/US dollar rate started the year at 1.20 but rapidly slid to 1.0495 in March, driven by continued ECB easing and signs of tightening monetary policy in the US. After hitting 1.15 in September, the exchange rate was close to its low of the year at around 1.05 in late November.

Forex plays reward risk-takers

Volatility in emerging market crosses has also been relatively high, prompting Italian corporates to become more active buyers of forex hedges in 2015, says Carlotta Martoglio, Milan-based senior forex derivatives salesperson at BNP Paribas, voted top dealer in forex derivatives in the rankings.

Clients are looking to hedge both overseas cashflows, and the effects on their balance sheets of their operations based in emerging markets, where currency volatility can dramatically change their value in euros. “Given that hedging solutions can be very, very expensive in emerging markets, it’s a question of finding tailor-made solutions,” she says.

These rely on leveraging BNP Paribas’ local presence in markets such as Brazil and Russia – not least in market intelligence, Martoglio says. “For emerging markets, we focus on models, trying to give our clients advice to help them choose the best market timing [based on analysis of likely currency moves],” she says. “Our early warning signal model is extremely popular with corporates.” 

Institutions are also turning to forex to overcome challenges in expressing views in other asset classes, says Nariman Salvatori, southern Europe forex sales at BNP Paribas. “Currency plays have been used by active risk-takers because it often presented the best risk/reward profile across different asset classes to implement macro views [rather than equities or fixed income] and also because of the liquidity advantage it offers,” he says.

He gives the example of the market turmoil around the Greek referendum in June. “By monitoring implied volatility surfaces, we spotted asymmetries across specific events, such as ECB or Fed meetings, or the Greek referendum in June. Clients have used options to take advantage, for example, by trading bearish one-touch calendar spreads – which pay out if a certain level is traded over the life of the option – over the event, or digital options with a double knock-out valid for the first part of the option’s life.”

Alternatively, clients concerned about an emerging market meltdown – which investors fretted might have been caused by the tightening monetary policy in the US – bought calls on the dollar against a basket of emerging market currencies, Salvatori says. “One single product gave them a very good replication of the underlying risk,” based on the correlations between the emerging market currencies.

“We’ve also been able to structure some more sophisticated products, such as warrants in which the payout is linked to the worst performer in a basket of options, such as worst-of US dollar calls against other currencies,” he adds. “This is another example where you can use implied correlations to express a macro view. If things go bad, typically the correlation spikes; you are likely to see a US dollar appreciation and a spike of the implied correlations. Chances are that, even with the worst performer of a basket of options, you are likely to have a profitable trade on your books.”

Regulatory capital charges faced by some clients have also encouraged them to use the currency markets to get exposure to an underlying asset. “We’ve seen trades where the client could buy a security denominated in an emerging market currency, but has instead traded the non-deliverable forward to achieve the same yield,” says BNP Paribas’ Salvatori.

But, while institutional investors may have turned their sights on the forex markets, Italy’s stock market generated enough excitement to pull in retail clients, with a particularly strong run-up in the first six months. Between 1 January and 15 April, the benchmark FTSE MIB index climbed 26.4%. Since then, the market has ranged between the 24,000 level and 20,450, with some dramatic swings. The strong returns the market delivered in the first quarter – especially when contrasted with the dismal yields on offer in fixed-income investments – have tempted Italian retail investors away from their traditional focus on government bond products.

“On the retail side of the derivatives business, it has been almost impossible to sell interest rate linked products this year,” says Mocio at Banca IMI. “The equity market, however, is very interesting to retail investors.” Some 80% of the structured products Banca IMI sold to retail customers this year are equity-linked, he says, compared with 60% in a typical year. The remainder were linked to currency risk or commodities. “There is a risk-on mood,” Mocio says.

Regulation breeding opportunity

That mood was somewhat dampened by Consob, the market regulator, which issued long-awaited rules in June on structured notes sold to retail investors, requiring considerably more transparency about their likely performance, and banning the sale of “complex financial products”, including asset-backed securities, convertibles, and credit-linked products.

Roberto Pecora, head of global market sales for Italy, at Societe Generale Corporate & Investment Bank (SG CIB) in Milan, says the volume of structured products issued in Italy in 2015 is likely to have fallen 80% from 2010 – from €50 billion to €10 billion.

The most immediate impact is that the new regulation has effectively banned the issue of credit-linked structured notes to retail investors. “From the second half of 2013, through 2014, these were very interesting products that a series of Italian and international banks brought to the market. They were successful in terms of volume, but were essentially stopped from the end of 2014, with the publication of the draft regulation,” he says. “The innovation that the industry was bringing to clients was blocked by this new regulation. It limits substantially what you can bring to the market.”

Other factors have weighed on the business, says Vincenzo Saccente, co-head of cross asset distribution at SG CIB in Milan. While some distributors are working to put in place procedures required by the new regulations, market volatility in August and September also served to discourage issuance of new structured products, he says: “In that market context, it’s not so easy to distribute products.”

To some degree, the regulation has done what Consob intended, in that the market has responded with more basic investment products. For example, SG GIB came to market with straightforward SG bonds, paying a fixed coupon, but denominated in emerging market currencies, such as Indian rupee and Indonesian rupiah, to offer yield, currency exposure and, hopefully, some upside.

Other dealers have seen much less impact. “We never sold products like credit-linked notes or credit-linked certificates,” says Mocio at Banca IMI. “Our issuance [of retail structured products] has been sustained, but we have increased the level of protection embedded in our products, in line with the new regulation.” The notes sold by Banca IMI typically have embedded capital protection, with at least 85% of the principal guaranteed, he says.

Elsewhere, January 1 sees the entry into force of Europe’s much-delayed risk and capital rules for insurers, Solvency II. “For insurance companies, all discussions around allocation, whatever the asset class, you need to bring the Solvency II angle … everything is considered not only from a financial perspective, of course, but also from a regulatory perspective,” says Pecora at SG CIB.

In equities, for example, insurance companies are putting on hedges to reduce the capital absorption of their equity exposure, says Paolo Iurcotta, managing director and head of equity and fixed income flow business at SG CIB, which was voted best dealer in equity derivatives in the rankings. To this end, he says, most insurance company clients favour hedges of at least one year in duration, either buying plain vanilla out-of-the-money puts on a liquid index, such as the EuroStoxx 50, or entering into put spreads, where the client buys options struck at-the-money, while selling puts struck 60% out-of-the-money.

In fixed income, Iurcotta at SG CIB notes the relatively high yields offered by Italian government debt compared to other core European sovereigns have meant Italian investors have been “quite bullish, and quite active,” compared with other markets. Nonetheless, the perennial search for yield in the current low rate environment has sent clients further down the yield curve or looking to lower-rated corporate issuers, he adds.

The ever-lower yield on Italian government debt is creating some opportunity for derivatives desks, as both institutional and retail investors look for alternative sources of returns, says Cattaneo at Barclays. “Traditionally, Italian government debt has provided a home for Italian savings, but falling yields have pushed investors and asset management firms to look at a more diversified range of fund products.”

In credit, there has been strong demand on the cash side, and for private placement, but activity in certain areas of credit derivatives has been down this year. “Everything is compressed in the rates and credit space as a result of quantitative easing,” says Cattaneo at Barclays, while the difference in pricing between credit derivatives indexes and the component credit default swaps has been very stable.  “There needs to be a single-name story to find an opportunity,” he adds.

Pecora at SG CIB says the low interest rate environment is encouraging some Italian institutions to look at credit derivatives as a source of yield, with increased allocations to the asset class expressed through options on the iTraxx index. He notes volatility in the credit markets is also encouraging them to hedge. “We saw big idiosyncratic risks,” he says, on individual names, such as Glencore and Volkswagen. “In the credit space, investors need to be selective and quite active in managing portfolios and hedging exposures.”

Other dealers, however, report less liquidity in the Italian credit derivative markets. “It’s an international issue – a lot of banks are closing desks or no longer market-making because capital and liquidity constraints are big and growing,” says Mocio at Banca IMI.  

However, these constraints also provide an opportunity for banks such as Banca IMI, he adds. “There is a perception that market risk is becoming a residual issue and, for banks like us, management of capital and liquidity is becoming more and more important, particularly for the derivatives business.” While this is an important focus internally, it also provides a way for Banca IMI to help banking and insurance clients navigate the new market realities, Mocio notes.

Meanwhile, some dealers warn the search for yield could be storing up problems for both institutional and retail clients. “There is a risk for investors of going further down the liquidity spectrum just to get some yield,” says Salvatori at BNP Paribas. “The problem you might get is that we’ll end up with clients holding less and less liquid assets. If everyone tries to get out at the same time, it can create some issues.”

Read/download Risk Italia 2015 rankings in PDF format
 

How the poll was conducted

354 votes were received from dealers, brokers, corporates and asset managers in Italy. Participants were asked to vote for their top three derivatives dealers in order of preference in products they had traded over the course of the past year. The survey covered derivatives categories, divided into interest rates, currency, credit, equity, structured products and risk advisory. The votes were weighted, with three points assigned for first place, two points for second and one for third. Only categories with a sufficient number of votes have been included in the final results. The survey includes a series of overall product leaderboards, calculated by aggregating the total number of weighted votes across individual categories.