Interest rate derivatives - Modern great: Deutsche Bank

In the first quarter of this year, an Asian sovereign was looking to execute a constant maturity swap (CMS)-linked trade with a notional of around $1 billion. The trade, which in essence allowed the sovereign to bet on non-inversion of the US swaps curve, was roughly equivalent to the total size traded in an average month. Referring to Deutsche Bank, a senior swaps salesman at another firm says of the trade: "They won it because they are very aggressive on price; they often stick out from the pack."

Deutsche Bank's ability to put its balance sheet to work and warehouse complex and large risks has been one of its most distinguishable traits in recent years. A strategic plan that began in mid-2001 has turned the German bank into a dominant force in the interest rate derivatives market. In essence, the firm decided to develop its flow business, while making a concerted attempt to become the pre-eminent house for executing large transactions for clients.

To win this business, especially among US mortgage agencies, banks and investors, it quoted aggressively, and in doing so put more proprietary capital at risk than most of its competitors had the stomach for.

To help realise its goal, the bank reorganised its North American team so that swaptions, swaps and cross-rate desks were unified to facilitate netting off of risks, greater information-sharing and discussion about client needs. Jon Kinol, currently head of global rates in North America, helped spearhead the group's unified effort.

One of its early groundbreaking transactions constituted what at the time was one of the largest over-the-counter derivatives deals, with a notional value of around $40 billion. Following FleetBoston Financial's sale of its mortgage arm, Fleet Mortgage, to Washington Mutual in 2001, FleetBoston wanted to transform the risk inherent in its mortgage servicing rights hedge portfolio into hedges for its balance sheet. In response, Deutsche engineered a $40 billion portfolio of interest rate swaps, swaptions and other derivatives that would meet the needs of FleetBoston, which merged with Bank of America in 2004.

By 2002, Deutsche had emerged as the main dealer in the rapidly growing CMS market, and had also become a favoured seller of volatility to Fannie Mae and Freddie Mac, the two behemoth US government-sponsored entities that, prior to a series of regulatory and accounting probes that stymied their derivatives activity, were major players in the swaptions market.

Meanwhile, its revised focus helped it carve out a new type of business in Europe too. Deutsche Bank caught the start of the wave of client interest in asset-liability management (ALM), and executed a number of large strategic and more tactical trades for pension funds and insurance companies.

In addition to being able to handle extremely large trades, Deutsche Bank has earned a reputation for being able to transact complex and long-dated risk. A case in point was the landmark ALM deal it executed for UK-based insurer Aviva in 2005.

The deal saw Deutsche buy a £3 billion portfolio of receiver swaptions from Aviva, while simultaneously selling the insurer a 49-year cashflow swap. The transaction allowed Aviva to monetise the in-the-money swaptions portfolio and obtain a long-dated hedge for its liabilities.

The dealer's interest rate derivatives business has been consistently ranked the best by insurance companies, alongside asset managers, hedge funds and pension firms, according to Risk's annual institutional investor end-user rankings. Making it the third time in a row, Deutsche Bank again topped the overall derivatives poll in 2007, winning a top-five place in 25 of the 28 interest rate derivatives categories. This dominance was also evident in Risk's 2007 corporate end-user rankings, where the bank topped the interest rate swaps, interest rate swaptions and exotic interest rate products categories.

In some ways, Deutsche Bank's present day interest rate derivatives group follows a business model that resembles one of its legacy companies, Bankers Trust, where innovation and trading savvy was all, combined with that of its current great competitor JP Morgan, where more strategic client relationships are at the fore. Throw in its risk appetite and global presence, and Deutsche Bank has become a formidable player in the interest rate derivatives market.

THE CONTENDERS
- Barclays Capital
- Deutsche Bank
- Goldman Sachs
- JP Morgan
- Morgan Stanley

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