Europe’s interest rate dealers have been cursing two foes this year – Mario Draghi, and Mifid II, the region’s new trading and transparency regime.
The European Central Bank chief did his bit to rile traders in June, with a pledge to keep ECB rates at their present levels “at least through the summer of 2019” – a remark that essentially told fixed income investors to find other shores, and hedgers they could keep their powder dry.
Mifid II arrived earlier, spurring rates clients to use electronic platforms for more of their trading, where they can put more dealers in competition and show they are trying to satisfy the regime’s strictures on best execution.
Between them, Mario and Mifid have managed to dramatically shrink the European pool of rates business – a blow for the region’s dealers, including BNP Paribas. Third-quarter revenues for its fixed income, currencies and commodities business were down 15.1% compared with the same period in 2017.
Joe Squires, deputy head of G10 rates for Europe, the Middle East and Africa at BNP Paribas, accepts the results were disappointing, but says they were not completely out of line with the Street – industry benchmark data shows the European revenue pool for G10 rates is down around 40% this year for government bonds and 30% for swaps.
“When you are a heavyweight in Europe, the significant change in the revenue pool then has a gearing impact on your overall business. What that doesn’t mean, though, is that our relative position has deteriorated – in fact it’s increased, particularly in solutions business,” says Squires.
And it could have been worse. The bank had already been investing in its US business as a counterweight, seeking to build on its existing, strong position in the country’s repo market. It started in 2016 by hiring David Moore as its head of US G10 rates.
The mission for the former Morgan Stanley and Bank of America Merrill Lynch (BAML) US rates head was to make the bank more relevant to US clients for both flow and structured rates. This year, US rates revenues were up around 20% year-on-year – despite the US wallet shrinking as well – becoming a larger proportion of the bank’s global G10 pool.
The push started with the most basic instrument – US Treasuries. In November 2017, the bank announced a tie-up with principal trading firm Global Trading Systems. According to Moore, GTS provides the bank with better pricing than is available in the interdealer market, and allows the firm to leave a smaller footprint when executing client trades: “That’s a big advantage when you’re try to make money on thin margin,” he says.
A year ago, BNP Paribas had a 1.5% market share in Treasuries, an inquiries share of 8.1%, and was the best price 25% of the time. Today, Dan Malone, head of US G10 sales says the bank has a 4.7% market share, inquiries share of 15% and a best-price ratio of more than 40%.
The more impressive claim is that the bank is making money – Malone insists BNP Paribas is not buying market share.
Because Treasuries are the bedrock of the US rates market, improved liquidity and pricing offers knock-on benefits elsewhere. For instance, as the US dollar derivatives market is largely priced as a spread over Treasuries, the bank claims it can more accurately price swaps. And as Treasuries are a common hedge for these products, there is a higher probability of being able to lay off risk internally, rather than going out to the market.
“We manage our risk in a multi-product way, it’s not just Treasuries versus Treasuries, it’s Treasuries, futures, swaps and options. So it enables us to keep a smaller footprint or have a lower impact in the market, as we have multiple outlets for risk,” says Moore.
BNP Paribas has also sought to bolster its US options desk, hiring a new US non-linear trading head, Alvin Loshak, from BAML earlier this year. One resulting change was to let the traders provide more client-specific prices, helping the bank quintuple the number of trades done with its top 30 customers this year, he says.
Loshak argues BNP Paribas has had to work harder than some of its rivals in recent years, which have been able to capitalise on a steady supply of cheap volatility from the issuance of callable US dollar-denominated bonds in Taiwan – the Formosa market. According to one buy-side trader’s estimates, individual banks have been making as much as $100 million a year in revenues from these flows, in which the bond issuers sell US dollar swaptions that match the optionality embedded in the bond.
But not BNP Paribas. The French bank’s higher credit rating meant it was not a big player in the Formosa market, forcing it to dig out other opportunities while its competitors feasted on the low-hanging fruit. As Formosa flows dry up following regulatory change in Taiwan, other US options desks will have to find a way to replace business that is said to account for 80% of some firms’ revenues.
Again – not BNP Paribas – and Loshak expects that to give the bank an edge.
“We are in a unique position of having spent years already building a strategy and putting the pieces of that strategy in place to make money without relying on Formosas. So for us it ends up being an advantage,” says Loshak.
The firm was particularly active in curve options in the US this year, which pay out the difference between two points on the curve, versus a strike point. While not a new product, the business has picked up this year due to expectations the curve will steepen – in part as a result of the dwindling supply of Formosa volatility, but also because of other changing structural forces.
For instance, the bank executed two clips of $5 billion notional curve trades with one pension fund on different parts of the curve. It also sold three $5 billion clips of a contingent version of the trade with one- to three-year maturities, which are cheaper as they only become live when certain conditions are met.
“In the US, for vol products they’re number one,” says a trader at one North American pension fund, who uses the bank for swaptions and curve options. “Their pricing is tight and always tight – it doesn’t really vary through time.”
The French bank’s non-US roots and strong equity franchise also allowed it to be one of the first to spot the widening of the basis between US forward rate agreements and overnight indexed swaps, an indicator of the Libor-OIS basis that is one measure of bank funding stress – if term rates climb away from overnight, it’s a sign the market is demanding more to lend to banks.
The bank is active in the US dollar funding market, and Moore says the rates business noticed funding stresses in early January that looked set to produce a wider basis. Their equity derivatives colleagues also highlighted the widening of S&P 500 index repo prices later that month – a further indication of funding challenges in the US dollar market.
It was quick to help clients capitalise. In February, BNP Paribas traded packages pairing Libor FRAs and OIS, in sizes going up to $500,000 of DV01 – the sensitivity to a one-basis point move in interest rates. The FRA-OIS spread ultimately went from around 25 basis points in February to a peak of 64bp in April.
“We realised the oversupply coming in from the US Treasury in February, as well as the need for US dollar cash, and the tension in the equity repo market, would create a big widening. So we were able to get our clients involved in the trade early,” says Moore.
The bank also built on its strong position in the repo market, extending a number of committed lines with pre-agreed terms and pricing for a range of scenarios. For instance, one client was looking for bridge finance for merger and acquisition activity, while another insurance company needed certainty during the US hurricane season.
The bank also executed contingent versions of these trades, which would come into force at a given interest rate or foreign exchange level – for instance, at the point the client was required to make a cash variation margin call on derivatives positions. In total, the bank entered $4 billion notional of committed and contingent repos in the past year.
“BNP Paribas was a great partner in structuring this. It’s not easy to trade committed repos, they don’t happen often because of the uncertainties involved. But they managed to come through and we really appreciated their help,” says a treasury source at one US insurer.
In Europe, while the interest rate environment is not ideal for flow business, the low-yield environment meant many clients were looking to enhance their net interest margins (NIMs), creating opportunities for the bank’s structuring team.
One highlight saw it helping a UK bank to sell sterling interest rate floors – embedded in its loan books – in a hedge accounting-friendly way. Hedge accounting is generally frowned on for sold options, as control over the exercise sits with the buyer. But BNP Paribas made use of an exception that allows sold options to hedge a bought position, and purchased several clips of sterling floors from the client through the year – totalling around £1 billion notional – while volatility levels were favourable.
It also found a way to have the premium recognised in the P&L over the lifetime of the trade – a tricky task, especially given it was a macro hedge.
“What we brought to the strategy was highlighting that this is a methodology that exists under the rules that allows you to apply hedge accounting to these written options for both the intrinsic and the time value, which will boost your NIM enhancement profile,” says Brad Anderson, head of accounting solutions at BNP Paribas in London.
The bank also helped European asset management clients move swap books from LCH to Eurex, due to fears the UK central counterparty would become unavailable to EU-regulated firms following Brexit – and to benefit from the basis between the two clearing houses.
In particular, it helped one asset manager move €15 million DV01 of receive-fixed swaps from LCH to Eurex – where those trades would receive a higher fixed rate – in €250,000 clips. It achieved this by hedging some of the exiting flow with a sovereign that was backloading pay-fixed positions into LCH, and the rest through CCP switch trades in the interdealer broker market.