Derivatives house of the year: Bank of America

Risk Awards 2020: New home in Paris has brought more European clients to the Street’s most consistent markets franchise

Bernard Mensah
Bernard Mensah

On November 13, a special visitor showed up at Bank of America’s new Paris office: Édouard Philippe, the prime minister of France.

Philippe walked the trading floor and gave his verdict on one element of the firm’s European strategy. “Excellent choice,” he said, of the decision to open a trading hub in the heart of Paris, close to the Élysée Palace and Arc de Triomphe.

On the other side of the Atlantic, Tom Montag isn’t arguing. Bank of America’s chief operating officer and president of global banking and markets says the difference of being on the ground in Europe “has been palpable as far as the intensity of client coverage. It was a change born out of necessity, but one that has turned into a real competitive advantage”.

As one concrete example, since announcing the move in 2017, BofA’s share of client inquiries in euro swaps has trebled – it now sees one in four trades on electronic platforms. The firm’s euro swaps market share has doubled from 4% to over 8% on Tradeweb platforms.

Among global banks, the Brexit referendum in 2016 was met with a mixture of disbelief and dismay – it threatened longstanding operating models in which Europe was served from subsidiaries or branches in London. Some banks prayed it wouldn’t happen. Others talked of moving to the continent with all the enthusiasm of an agoraphobe.

For BofA, it was a moment of clarity. “We saw Brexit coming. We prepared for Brexit,” says Bernard Mensah, co-head of global fixed income, currencies and commodities (FICC) trading at Bank of America. “And we thought, why don’t we use this to really establish a broader EU base and get closer to clients?”

BofA was clear-eyed from the outset about what Brexit meant for financial services. The UK government had made leaving the single market a ‘red line’ and financial services were never part of the negotiations for a withdrawal agreement. As long as that was the case, BofA would need a presence on the continent to serve EU clients.

While many dealers approached it as a repapering exercise, amending swaps documents to face new or existing European legal entities, BofA decided to open a fully staffed, fully functioning trading hub in Paris, chosen over Frankfurt for its size and deeper pool of qualified employees.

BofA’s new Paris office, a converted postal office in the eighth arrondissement, opened in the first quarter. It already has around 400 employees, roughly half them in front office sales and trading roles across FICC and equities.

This was an opportunity for us to make a statement about our commitment to the region. It has helped us get closer to our clients, and that’s paying back in a good way
Bernard Mensah, Bank of America

“We have a full trading floor in Paris,” says Mensah. “There’s a real buzz about it.”

Several senior bankers formerly based in London have made the move, including Sanaz Zaimi, head of global FICC sales, who was named chief executive of the bank’s EU broker-dealer entity, BofA Securities Europe. Zaimi is leading the effort to expand the firm’s EU footprint (Mensah is president of BofA’s operations in the UK, Central and Eastern Europe, Middle East and Africa). Among those joining her are Vanessa Holtz, who was appointed head of EU FICC trading in addition to her existing roles in foreign exchange trading, and Othman Kabbaj, co-head of Europe, the Middle East and Africa (Emea) FICC sales.

The move served two main purposes. “This was an opportunity for us to make a statement about our commitment to the region. It has helped us get closer to our clients, and that’s paying back in a good way,” says Mensah. “Our European strategy is clear. We want to be here. We want to be local.”

Sanaz Zaimi
Sanaz Zaimi

It has also helped to strengthen what has generally been a weak link in the chain of global fixed income flows. For the past several years, cash has flowed from Asia into European fixed income, and from Europe into the US market. Being closer to European clients has made it easier for BofA to satisfy the demands of Asian investors, and has already resulted in some important deals.

This year, BofA issued its first Swedish krona callable bonds – a sovereign, supranational and agency (SSA) deal followed by a self-issue. “Krona still gives you a steeper curve and a better local currency yield for investors in Asia even after the cross-currency hedge,” says Snigdha Singh, head of Emea flow derivatives trading at BofA.

It also ramped up its program of local law structured notes offerings, such as Schuldschein loans in NSV format. Notionals have more than tripled year-on-year.

“Being closer to our clients on the continent, we have a better understanding of what their needs and requirements are,” says Singh. “That’s one of the reasons we were able to add this to our product suite.”

Selling the notes also gave the bank a healthy supply of rates euro volatility, which it was able to use to increase its market share in the region’s swaptions market. Clients tell the firm has taken “big strides” and made “a strong push” in euro swaptions this year.

As global yields have declined, the US market – whether that’s government securities, corporate bonds or mortgages – has become more attractive to foreign investors
Jim De Mare, Bank of America

BofA has also increased its share of cross-currency flows from Europe to the US. The bank handles a large, and growing, share of US debt issuance – investment banking revenues rose 27% in the third quarter – a chunk of which is increasingly swapped into euros.

“As global yields have declined, the US market – whether that’s government securities, corporate bonds or mortgages – has become more attractive to foreign investors,” says Jim De Mare, co-head of global FICC trading at Bank of America. “There have been big flows from Europe over the past two years, and the last year in particular. Increasing our presence with clients in the region has been very meaningful.”

If the focus in rates was on building out the geographic and product footprint, in equity derivatives the bank made its mark via innovation, solving problems with two popular products.

Notably, demand remains strong for short-volatility trades, but investors have become more worried about a repeat of the ‘Vixplosion’ in February 2018 that wiped out some products.

James DeMare
James DeMare

This tail risk has proven hard to hedge. Short volatility strategies have an implicit positive beta to the equity market, which cannot be neutralised by delta hedging.

BofA tackled the problem by constructing the Synthetic Uncorrelated Volatility (SUV) index, which is short volatility but decorrelates from the equity market at times of stress. By design, the strategy should outperform during steep market sell-offs, when volatility sellers typically incur the largest losses, instead leaving them exposed to losses during aggressive market rallies.

It’s a trade-off investors seem happy to make – the SUV strategy raised more than $1 billion in its first 10 months.

SUV has allowed investors “to diversify the volatility risk premium sleeve of their risk premia portfolios, to tilt their yield-generation programmes more defensively and to boost the Sharpe ratio of their overall portfolio”, says Hichem Souli, global head of equity derivatives structuring at BofA.

The extended sell-off in US stocks at the end of 2018 also left dealers reluctant to sell options on volatility-controlled indexes, which underpin the $70 billion US fixed-index annuity (FIA) market. BofA found a way to smooth out the gap risk linked to the daily rebalancing of the underlying indexes, using a technique called fast convergence, allowing it to sell cliquets more cheaply to FIA carriers.

The fast convergence technology dampens the two-way transaction costs present in options on volatility-controlled indexes, giving the firm “the confidence to issue larger volumes of options for annuities while staying within stringent risk limitations”, says Souli.

Flying a helicopter

BofA hit a low point in 2011. After a raft of sub-prime mortgage settlements and fines, Moody’s downgraded its credit rating by two notches. The cost of insuring its debt blew out to more than 400 basis points and its stock price fell 62% that year, to below $5.

That year, Montag was appointed co-COO and head of BofA’s corporate and institutional banking operation. As the firm embarked on a rebuild, Montag saw a chance to make a push in the derivatives business, where it had fallen behind rivals.

“We had a gap that was an achievable gap,” says Montag. “We made a lot of effort – both in equities and fixed income – to improve the quality of our systems, the consistency of our market-making, our coverage of clients. It’s been a multi-year effort.”

The plan called for a laser focus on clients, research and technology, coupled with a judicious approach to risk-taking and capital management.

Tom Montag
Tom Montag

It has contributed to a string of impressively consistent results for the bank’s markets business. Every year since 2013, sales and trading revenues have been between $12.9 billion and $13.6 billion. In 2018, net income was $4 billion – up 21% on the prior year. The judging period for the awards also encompasses the first half of 2019, when the business booked net income of $2 billion on revenues of $6.7 billion.

That consistency may have something to do with the bank’s insistence that traders make the most of the capital they’ve been allocated.

“Before the crisis, you didn’t ask a trading desk how much capital they were using. That wasn’t part of the conversation. It was how much revenue you were generating. We have made it abundantly clear that we want traders to be conscious of the capital associated with their activities,” says De Mare.

Given the plethora of capital metrics, ratios and buffers now in play, that is no easy task. “If you were running a markets business pre-2008, you simply had an accelerator and a brake pedal,” says Mensah. “Now, it’s like flying a helicopter. There are many different capital measures, liquidity measures and regulatory measures that you have to keep in mind.”

The stability of the firm’s sales and trading revenues speaks to the management team’s piloting skills. The standard deviation of the quarterly year-over-year change in the firm’s sales and trading revenue stands at just 11%, the lowest of any major global bank. This compares with 13% for Citi and 15% for JP Morgan.

This partly reflects the nature of BofA’s business, Montag argues. “One of our advantages is that we’re a customer-driven shop. Our earnings are among the most stable because we’re a customer-driven business.”

Those customers in turn praise the firm for its consistency and steadiness – something Montag values and that he attributes to its prudent approach to capital and risk management.

“We want to be known as a firm that is consistently there for clients,” he says. “We are a firm you can trust, somebody that is going to be around even when the markets are stressed. The quality of our balance sheet and our risk management means we’re going to be there through the cycle.”

Citizen dev

BofA has also made a big push to electronify much of its market-making, especially in fixed income.

“We have tried to bridge the gap between fixed income and equities on the electronic part by putting people in charge across the platform,” says Montag. “That has benefitted the flow product in derivatives.”

BofA is auto-quoting and auto-hedging the bulk of its flow in foreign exchange and rates. “We’re sophisticated on that,” says Mensah.

The bank’s technologists are now working on increasing the streaming of prices, not only in rates and forex, but also “in credit derivatives, in some of the index trading there”, says Mensah, as well as for emerging market products.

“We’re currently putting considerable energy into doing that in a sophisticated way,” he says. “It’s really important to have the technology to be able to differentiate, client by client, and be flexible in terms of the platforms that are out there.”

As a rule, any large dealer will share these goals, but the firm is now looking to push the envelope on innovation. Last year, it created a data and innovation group (DIG) – led by Brice Rosenzweig, the former global co-head of quantitative strategies – to turbocharge those efforts.

It’s really important to have the technology to be able to differentiate, client by client, and be flexible in terms of the platforms that are out there
Bernard Mensah, Bank of America

Rather than centralise all development under its aegis, the group is striving to democratise access to data and tools, such as machine learning, making them “available to what we call ‘a citizen dev’ in the businesses”, says Rosenzweig.

Those ‘citizen devs’ are working with DIG on a number of promising projects, which include efforts to “incorporate machine learning and data-driven approaches in the less electronic, less flow, more illiquid parts of the business”.

Others are looking at using data and machine learning to improve the way derivatives are hedged, and the way liquidity is measured.

Resource allocation is also getting the DIG treatment – another team of developers is using similar techniques to try and predict the demand for collateral and balance sheet in different business lines.

The goal is to find “patterns in how demand evolves over time and try to react to it faster”, says Rosenzweig.

He declines to specify when these projects will go live, although at least some are understood to be close to fruition.

Libor reform? It’s complicated

BofA’s stance on Libor reform has become a matter of some intrigue this year, at least among other dealers and some big buy-side firms.

On the one hand, the firm has been heavily involved in the reform efforts, especially in the UK. Mensah sits on the Financial Conduct Authority’s markets practitioners panel and was invited to join the working group on sterling risk-free reference rates. BofA is one of only six banks, and three non-UK banks, represented on the 26-member working group.

But it has also emerged as a gadfly in those meetings, sometimes asking awkward questions about the risks of using the new risk-free rates for loans and credit lines.

That has prompted some to question whether the firm is dragging its feet, or even fully behind the reform effort.

Mensah says those charges are unfounded. BofA is doing everything necessary to prepare for the transition to new risk-free rates, he says. “No ifs, no buts.”

In the UK, where the migration is already well underway, the firm has been involved in some of the biggest transition trades to date – including a key co-ordinating role in last year’s move by ABP to switch £500 million ($633 million) of interest rate and cross-currency swap exposure from sterling Libor to the secured overnight index average, or Sonia. It has been a top counterparty to UK pension funds, which Singh estimates have moved the vast majority of their liability hedges to Sonia.

If you have a reference rate that doesn’t move when bank funding is moving, you could introduce systemic risk into the banking sector
Bernard Mensah, Bank of America

BofA has “probably seen around 25% of those migration flows, across this year and last year”, she says.

In the US, where movement has been slower, BofA is an active market-maker in swaps and futures linked to the US dollar Libor replacement, the secured overnight funding rate, or SOFR. The firm expects SOFR swap volumes to pick up after the so-called ‘big bang’ next October, when CME and LCH are set to adopt SOFR as the discounting rate for cleared swaps.

BofA may be preparing for the switch to new risk-free rates, but Mensah says the firm does have concerns about using them as the reference rate for loans and credit lines, given the lack of a credit spread and forward-looking term rate.

“We’ve really been thinking this thing through. And what we’re saying is, there are some real issues around the new reference rates,” says Mensah. “In the UK, we now have this possibility of a term structure and we’ve been asked to contribute to that effort. Globally, the other thing that we’ve been sensitive about is the lack of a credit spread in the new risk-free rates.”

The big worry is that, unlike with Libor, assets linked to new risk-free rates may not move in tandem with the liability side of a bank’s balance sheet in times of stress. “And we think we should talk about that, because if you have a reference rate that doesn’t move when bank funding is moving, you could introduce systemic risk into the banking sector,” says Mensah.

BofA’s only interest, he adds, is to get Libor reform right. “It’s a really important benchmark. We want to land in the right place.”

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