Two worlds

The dichotomy between the derivatives markets in North America and Europe appears to be getting more pronounced with each passing year. While dealers in London and on the Continent can point to a robust pipeline of new products and distribution channels, in the US, post-Enron legislative and accounting initiatives have combined with the hangover from FAS 133 to cast a pall over many types of structured derivatives business.

Enron’s collapse has not been completely bad for the US derivatives markets – it demonstrated the resilience of the credit and energy derivatives markets, for example. But the market now operates under the renewed threat – however far-fetched – of expanded regulatory oversight, with its adverse effect on product innovation and marketing.

Meanwhile, post-Enron accounting proposals in the US relating to special-purpose entities have, in effect, brought one of the fastest-growing areas in credit – the collateralised debt obligation market – to a halt.

One major derivatives dealer reports that its structured business in the US only accounts for 15% of its total – the vast majority is in Europe, with a small proportion in Asia. In Europe, inflation-linked products, European sovereigns’ hedging programmes and index-linked products all offer potentially lucrative business.

Retail-orientated structured equity derivatives products are also far more advanced in Europe than in the US. This is partly a result of the ‘culture of equity’ in the US, where investors have a long history of investing directly in equities rather than equity-linked vehicles.

Of course, dealers are still making money in the US. Vanilla interest rate business has remained robust due to new bond issuance-related swapping and investors’ embrace of interest rate derivatives as hedges since Treasuries became ineffective hedges in the late 1990s. Dealers also earned a good living last year by exploiting the historically low costs of funds and high levels of volatility. Whether those market conditions will survive in light of the US Federal Reserve’s move last month to a neutral interest rate stance remains to be seen.

Dealers also had a profitable business from unwinding highly structured hedges – which did not pass muster under FAS 133 – for US corporate clients over the past two years. They then put on new, simpler hedges for these companies. But much of that business is already done. And the revenues from that work have to be set against FAS 133’s longer-term fallout for dealers, such as its devastating effect on product lines such as constant maturity swaps.

The derivatives markets have always rebounded from bad publicity and regulatory problems in the past. It would be unfortunate if some dealers now began to think that opportunities in the US were simply not worth the trouble.