Derivatives house of the year: HSBC

Derivatives house of the year: HSBC

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Samir Assaf, HSBC

Rival dealers sometimes dismiss HSBC as a big, slow-moving commercial bank with a bolt-on markets franchise that exists largely to serve its corporate borrowers. It’s a caricature that has become increasingly hard to recognise in recent years, as before-tax profits for the Global Banking & Markets (GB&M) division climbed 47% from $5.8 billion in 2006 – the third-largest contributor to the group’s bottom line – to $8.5 billion in 2012, representing the biggest share of a total $16.4 billion in profits.

The derivatives business has been a big part of that, and 2013 gave the bank a chance to show off the breadth and ambition of its over-the-counter capabilities – from the equity and foreign exchange options trades that demonstrate new-found traction with big hedge funds, to the key role it played in the drawn-out and complex restructuring of submerged hedges at UK telecoms company Arqiva.

Samir Assaf, London-based chief executive for GB&M, says the division has made strides in the past couple of years, partly because rivals have been retrenching to cope with Basel III rules on capital, leverage and liquidity, which start to be implemented in Europe and the US this year. HSBC’s relative credit strength and high common equity ratio – 10.6% as of the third quarter last year – shield it from some of these pressures.

“Our market share is growing, our clients are more satisfied with what we’re doing, and as a result, our profits are increasing – on a five-year average, our compound growth is substantial when you compare it to the competition. That has been made easier by the fact that a lot of our competitors had to revisit their business model and decide what kind of products they would continue to do,” he says.

For many institutions, the strategic rethink only happened in 2010 and 2011, at which point the capital and liquidity rules appeared to be the main threats to the business. The emergence of the leverage ratio in 2013 is now forcing a second round of changes at some banks, as dealers refocus on gross exposure as a constraining factor. “For European banks in particular, where business models were most concentrated, the transformation has been huge and will continue,” says Assaf.

We basically decided not to waste our time – the market was not going back to where it was

HSBC is not trying to step into its rivals’ shoes, though. It retains its characteristic focus on emerging markets and is paranoid about risks, such as contingent funding obligations, which some banks have treated with breezy disdain. More controversially for a dealer, it is also advising some clients to abandon traditional OTC products, arguing the new regulatory environment makes them too expensive, or creates hidden risks – certain pension fund clients, for example, are now replacing swaps with bonds as a liability hedge. For Assaf, that is one of the natural conclusions of a course set by the bank in 2007, when it decided to focus on liquid products with observable market values. The crisis only strengthened that resolve. “We basically decided not to waste our time – the market was not going back to where it was. The important thing was to focus on simple products that directly satisfy the needs of the client. For us, and for others that reached the same conclusions, we couldn’t know the detail of the regulations in advance, but it wasn’t accidental – we made a call, and it proved to be the right one,” he says.

As of the end of September, GB&M was on track for a third consecutive year of growth, recording before-tax profits of $7.6 billion – up 10% year-on-year. By way of comparison, pre-tax profits for roughly analogous divisions at Barclays and Deutsche Bank stood at £2.9 billion and €3 billion, respectively, down 11% and 17%. None of the banks break out earnings for the OTC business specifically – they disclose revenues only, and wrap up cash and derivatives in a single figure. Across credit, rates and foreign exchange, HSBC raked in $5.2 billion, up 41% from $3.7 billion in 2006.

Despite its success, however, HSBC still faces a challenge. While simplicity may now be the watchword for clients, complexity is often unavoidable for market-makers. The industry has accepted that a derivative should be discounted at a rate determined by its associated collateral, making the detail of bilateral credit support annexes (CSAs) a vital part of the valuation process. These agreements often allow a counterparty to select from a range of agreed collateral types and became a battleground for dealers from 2008 onwards, as the new discounting orthodoxy spread – as an example, an aggressive dealer might have persuaded a client to assign it an existing trade, meaning it would step into the transaction, facing the customer on one side and its former counterparty on the other. That might have been done in the knowledge that the bilateral CSA between the two banks would allow the aggressor to post cheap collateral, while receiving more valuable assets. HSBC has long been rumoured to have ended up on the wrong side of some of these trades.

Some institutions now ascribe a value to collateral posting options, which they may want to be compensated for if their counterparty seeks to change the terms of the trade – to clear the portfolio, for example, or to replace the old CSA with the new standardised agreement that was drawn up to help avoid collateral disputes (Risk December 2012, page 9). Both steps would wipe out the collateral option.

Thibaut de Roux, HSBC’s deputy head of market and head of global markets for Europe, the Middle East and Africa, says the situation is complicated by the fact its peers in some cases want to be paid for the loss of the option, which he says is “ridiculous” within the new derivatives regulatory environment. The issue has risen to Assaf’s attention too. He argues the bank has a right to negotiate with its counterparties on these details, and has advised HSBC’s traders and lawyers to do so. “There are two aspects to this. The first is legal and contractual – so, what’s the contract, what are the terms? After that, though, there is room for negotiation – there is a contract, but there should be a bilateral negotiation beyond that, where people make their own judgements about where their interests lie,” he says.

Another challenge for HSBC is the new regulatory environment. Anything that hurts another dealer will hurt GB&M too, but the bank’s high credit rating and capital ratio gives it a higher pain threshold. However, as a UK bank, it is also in the firing line of the so-called Vickers reforms, which are set to force retail banking activities to be ring-fenced from riskier businesses. It’s not a prospect Assaf welcomes.

“We continue to believe there are better ways of protecting depositors in one country without doing anything as drastic as this, but we will have to adapt. Operationally, it’s going to take a lot of time and a lot of resources to make this split happen in the next five years. It’s going to divert the efforts of a lot of our staff away from working in the interests of clients and shareholders – and it’s going to be a long, painful process,” he says.

It might be less painful if HSBC were to relocate its headquarters from London to Hong Kong, but Assaf dismisses the idea. “It’s not a question we’re putting on the table. We have a big balance sheet in the UK. We have a big client base in the UK and we’re happy with the setup,” he says.

Elsewhere, regulation is acting as a tailwind. HSBC’s 2012 annual report lists 28 principal subsidiaries – from HSBC Bank (China) Company Limited to HSBC Bank Brasil SA – which gives the group a lot of local market know-how. That could prove a big advantage if clashing, extraterritorial regulations on clearing, execution and reporting result in some market participants choosing to trade within national borders – as a rule, subsidiaries will be subject to local supervision.

The same kind of outcome – a focus on local markets, and less cross-border activity – can already be seen in corporate financing, where many multi-national companies used to raise funds for their far-flung offshoots in their home currency and then convert it into synthetic local currency borrowing via the cross-currency swap market. These swaps have become far more expensive as a result of Basel III’s capital charge for credit valuation adjustment – which penalises long-dated, uncollateralised trades in particular – and the response from many companies has been to use local equity and debt capital markets instead.

“It has become more difficult to do cross-currency swaps, but we’re product-agnostic and it’s translating into very strong demand for local-currency financing. The evolution of this business over the past two or three years has been tremendous, and clients really want to see all of this packaged up – local-currency financing, derivatives and local risk management and regulatory advice. I think we lead the market on this,” says de Roux.

In total, non-group-of-four currencies accounted for 7% of all syndicated bond financing globally in 2006, but have since jumped to 25% in 2013, says Spencer Lake, HSBC’s global head of capital financing. That could hit 35% in the next three to four years, in line with the growth in emerging economies and their respective capital markets, he adds.

“We accelerated our local-currency build-out to accommodate this trend several years ago – we felt it was going to be significant. We have been taking a similar view on infrastructure and real-estate financing, preparing for less bank financing availability in these areas, and an environment where the appetite for duration, yield and such underlying credit exposure continues to grow – and where the ability to create that exposure using derivatives is more expensive.  We’re not the only bank to have recognised this, but we didn’t recognise it yesterday morning. It’s something we’ve been working on for a while,” says Lake.

One of the biggest markets in years to come will be China. Again, HSBC is poised to capitalise. Although China-related business is booked globally, GB&M in China reported profits before tax of $606 million in 2012, up from $240 million for 2010. “Nobody has any doubt now that the renminbi will internationalise and that a larger part of China’s trade will be done in its domestic currency. We expect to see other countries – maybe emerging, southern hemisphere nations – will also use it more as an international currency, generating growing cash management needs and renminbi financing demands. Companies will need to have bigger renminbi balance sheets, and will seek more access to Chinese capital markets. We’ll be a big beneficiary of all this, because among international banks we have one of the biggest footprints there,” he says.

There are early signs of these developments already. In 2013, HSBC executed its first sterling/renminbi target redemption forward for a UK corporate client that had started using the local currency to pay Chinese suppliers rather than US dollars, and wanted to apply the same kind of hedging strategy to the new currency pairing it had used for the old one.

And it was in Asian markets that the bank’s options desks stood out last year. A broad spectrum of international investors wanted upside exposure to Japanese stocks, beginning with hedge funds in the last quarter of 2012, then filtering through to big asset managers, insurers and other market participants as prime minister Shinzo Abe’s economic policies became clearer. Market-makers describe it as a once-in-a-generation flow of business, with volumes leaping dramatically – OTC Nikkei index options activity increased by about five times in 2013 compared with the previous year, according to some estimates. HSBC surprised a number of investors with its ability to take down large trades during this period.

“HSBC has made a huge push and is doing very well. It was one of our top three counterparties last year, whereas we hardly used the bank a couple of years ago,” says a portfolio manager at one big European pension fund.

A trader at one of the world’s biggest hedge funds echoes those comments. “When dealing with Asia, we like to use banks that are experienced in that area, and for trading Asian indexes we relied heavily on HSBC in 2013.”

Franck Lacour, HSBC’s London-based global head of equity derivatives trading, says the bank has made a deliberate effort to build flow relationships with buy-side firms in the past couple of years, but has also tried to strike a balance. “It’s a tough business, and there’s always a trade-off – you want to be recognised by clients, you want market share, but you also want to remain profitable. We’ve made a decision not to sacrifice profitability for volume, which is an easier balance to strike when markets are volatile and there’s a lot of trading, as is the case currently in Asia.”

Hedge funds also played a key role in helping the bank manage the structurally long renminbi volatility position that builds up each year as a result of popular hedging transactions with corporates in China, in which clients sell options as a way of cheapening the hedge. In one case, the bank executed an eye-popping forex option trade with a notional of $10 billion, allowing it to flatten its vega exposure in one fell swoop.

Other dealers are also present in this market, but tend to have a concentration of business on one side or the other – strong ties with corporates, which leave them long volatility; or strong ties with hedge funds that want to buy the volatility. Rival dealers acknowledge HSBC is one of the few banks able to match these two customer groups off against each other, which is vital for any dealer under the post-crisis capital and leverage regime, says de Roux. “We have tried to intermediate more risk transfer between corporates and institutional clients because there is so much pressure on banks not to hold big risks any more. It’s important to have this ability to offload exposure with different customers, and that is something we perhaps lacked in the past,” he says.

But the emergence of HSBC as a genuine force in OTC markets is not a story of dog-eat-dog opportunism. While rivals may be retreating and retrenching, HSBC is not advancing blindly.

The perfect example comes from the rates business and its work with pension fund clients. The staple transactions here are chunky, long-dated interest rate and inflation swaps, which are used to hedge a fund’s future obligations and can have huge per-basis-point sensitivity, known as DV01 and IE01, respectively. This gives rise to very different funding implications for clients and dealers – in part, as a result of new rules on clearing and collateralisation.

From the client’s perspective, if the trades are subject to a clearing obligation, it means variation margin will need to be posted in cash to cover any negative DV01. As fixed-rate receivers, that would not be a big problem in the current environment, but as rates rise, funds could find themselves having to raise huge sums. Analysis HSBC carried out in late 2012 suggests total margin requirements could reach as much as 38% of the notional value of a fund’s swap overlay.

The obvious solution is to repo out the fund’s non-cash assets, but these would also have declined in value as rates rise. In a worst-case scenario, HSBC estimates roughly half of a fund’s assets would need to be allocated to low-yielding, AAA-rated government bonds to satisfy margin posting needs for its hedges – an intolerable drag on performance.

From the dealer’s perspective, the big DV01 on these trades is a danger because of clauses embedded in existing collateral agreements, which require a bank to provide an extra buffer of assets if downgraded below a first threshold, and then to pay a replacement to step in if downgraded below a second trigger level. The same ratings triggers are also standard in swaps executed as part of a securitisation. In HSBC’s eyes, these contingent funding obligations are a big danger. “Regulation is revealing the systemic nature of certain markets. When we did the analysis on what the impact could be for the industry, the numbers are so frighteningly high that it is very clear funding is the game changer – it’s not capital, it’s funding. That’s why we’re now centring everything on funding and are trying to strike a better balance,” says Guido Hebert, global head of rates structuring at HSBC in London.

That means a number of things – it has been taking these arguments to regulators and rating agencies, for example. In the inflation space, the bank aims to have a balanced business, combining outright and asset swap flow, with collateral agreements in place wherever possible. With some pension funds, it has been able to negotiate the ratings triggers in existing CSAs, or change the governance process around them. And it argues funds may be better off holding bonds than using swaps in some situations.

The bank presented its analysis to clients in a series of roadshows during the second quarter of last year – in Amsterdam, Edinburgh, London, Milan, Paris, Rome and The Hague – which began to translate into actual work during the third quarter. In some cases, pension funds have replaced a portion of their existing swap overlay with bonds, cutting both their future funding risks  and those of HSBC as well.

“We still want to play a part in this market, but we want to transform the business – put it on a healthier footing. That means moving to more physical-related business and avoiding ultra-long derivatives exposure and big disruptive DV01s. That requires a mentality shift, so it’s not going to happen overnight, but we do see clients making some changes,” says Hebert. 

Clients welcome the different perspective HSBC has been offering, says Simon Hotchin, head of the bank’s strategic solutions group for Europe, the Middle East and Africa. “We’ve had a lot of very positive feedback from clients on this, because we’d been pretty candid about where we saw the market going and what the impact would be – and maybe not all banks have been quite so transparent.”

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