Risk South Africa Rankings 2014

While South Africa’s macroeconomic struggles have led to reduced levels of trading in the interdealer markets, institutional investors and corporate hedgers have helped fill the gap.

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South Africa’s derivatives dealers have a lot on their plates. Lower risk appetite and fewer participants have drained liquidity from the markets, while pending regulatory reforms threaten to further depress activity and add to costs. Furthermore, many fear the looming threat of monetary tightening by the US Federal Reserve could trigger a stampede out of emerging market assets.

But, despite the macro concerns, dealers point to healthy demand for hedging products among domestic corporates, potential growth in demand among investors for credit derivatives and bright prospects for the wider region that bode well for Johannesburg’s future as a regional financial centre.

“Corporate demand for hedging products is strong,” says Garth Klintworth, head of Africa markets trading at Barclays, which was ranked number one overall dealer in this year’s Risk South Africa rankings. “With all the project finance deals in South Africa and the infrastructure investment throughout Africa, corporates are very interested in finding out what risk management products are out there.”

The year didn’t start off in the most promising fashion, though. An unexpected rise in interest rates in January, when the South African Reserve Bank (Sarb) increased its benchmark repo rate by half a percentage point to 5.5%, caught many market participants unawares.

“The Reserve Bank governor really threw a curve ball into the market,” says one broker. “A lot of the major banks took punishment on the rate hike.” This wasn’t the last rate movement – in July, the Sarb put up rates by another 0.5%.

Despite the rate rises, brokers say the asset class has struggled to build liquidity. “It has been a testing year for many rand-denominated products,” says Clint Valjalo, a director at interdealer broker Icap in Johannesburg.

Barclays’ Klintworth says liquidity in interest rate swaps is 60% of what it was two years ago, and 85% of what it was in 2013. “We’re finding liquidity quite a lot more challenging than in prior years,” he says. 

Unexpected losses early in the year did not help risk appetite in the interest rate derivatives space, which was already declining given the regulatory and capital pressures on bank trading desks worldwide.

There are also fewer clients active in the rates space on an intraday basis in the country, says Icap’s Valjalo. One year ago, they had 12 international clients very active on that basis, and now that number is as low as six.

This has also hit trade sizes: “You’d have 12 players doing a yard [$1 billion] each on a daily basis… now, there are four to six doing a yard, with the rest doing bits and pieces,” he says. “A year ago, we’d have no problem doing a 10-year swap in a yard. Now, $200 million– $250 million would be a big ticket.”

Similarly, the interbank forex derivatives markets are somewhat quiet, participants say. The rand has been gradually sliding against the dollar, falling from ZAR9.76 to the dollar on 24 October, 2013 to ZAR11.17 on 23 September, 2014. Brokers say general negativity about growth in South Africa, combined with a lack of volatility, has kept volumes down on recent years.

However, with much emerging markets growth coming from cheap money stemming from loose monetary policy from the US in recent years, traders are watching the Federal Reserve to gain a sense for how South Africa’s market will react once those funds start to dry up.

“The next move will be when there’s a withdrawal of these funds,” says Jay Ramjanum, head, FX rand forwards at Icap in Johannesburg.. “The big question is the timing and method of that withdrawal. If it’s not controlled, it could create a lot of volatility,” he adds.

The end of quantitative easing (QE) and rising interest rates will be the tonic South Africa’s interest rate swaps market will need, says Neil Standen, a Switzerland-based managing director at broker GFI. 

“We’ll see more volatility come in as QE ends at the end of the year. From a rates point of view, we’ll be US-led,” says Standen.

Credit shock
While South Africa’s economy narrowly avoided slipping into recession in the second quarter, sentiment took a further knock in August with the near-collapse of African Bank, a local lender that the Sarb was forced to provide with a $1.6 billion bailout. That rescue came at a cost to creditors, as the central bank imposed a 10% haircut on the senior debt issued by African Bank.

“This was the first major default that inflicted broad-based pain across the market,” says Steve Barnes, global head of structured sales and distribution in the global markets team at Standard Bank in Johannesburg. Most of the market was involved somewhere in the capital structure, whether in equity, debt or subordinated debt, he says.

Theo Thomas, co-head of global markets trading at Rand Merchant Bank (RMB) in Johannesburg, says a combination of a general lack of credit supply in the domestic market and growing demand among local asset owners meant that debt was expensively priced. Since the African Bank default, however, that has changed.“It has definitely made institutional investors think about the price at which they’re prepared to take on credit,” says Thomas.

Barclays’ Klintworth says some local investors may have underestimated the jump-to-default risk – that is, the risk that a credit will default in the short term, which can be implied by the prices of credit products such as credit-linked notes.

This event may yet prove a boon for South Africa’s credit derivatives market, according to Quintus Kilbourn, head, institutional distribution and research – Africa, at Barclays. He notes there has been a tendency for investors to simply use credit derivatives to take on exposure, rather than to hedge.

“It used to be very much a primary market, but that’s definitely changing – we’re seeing the development of the credit default swap market on a secondary basis,” he says.

A brighter year for equity traders
While fixed-income investors might have taken a hit on African Bank exposure and the rate rises, equity investors have fared better. This year, the benchmark Johannesburg Stock Exchange (JSE) Top 40 equity index is up 9.34% in the year to September 30, and up 15.44% over the past 12 months.

Although this may seem counterintuitive, given the local economy’s issues, Gavin Betty, a director at Peregrine Securities, says the index’s composition is increasingly less representative of the South African market.

International technology, telecoms, consumer and luxury goods, and resources businesses – all with strong US dollar earnings – now dominate the upper reaches of the JSE Top 40. “Rand weakness and foreign turnaround has been a catalyst for the index to go higher,” says Betty.

However, the market’s rise has not necessarily been good news for equity derivatives desks. Volatility has been relatively low, and, in common with forex and rates trading, brokers report a continuing decline in interbank activity.

According to figures from the JSE’s equity derivatives trading market, the cumulative volume of equity index options was down 44% year-on-year to August. Brokers point the finger at incoming proprietary trading restrictions.

“We’ve certainly seen the equivalent of Volcker rules filter through the London banks, and we’ve seen less prop trading and risk-taking. That same trend has washed through to the local banks as they grapple with new regulations,” says one broker.

Tinus Rautenbach, head of the equity derivatives desk at Investec, also notes end-users may be growing weary of hedging downside risk.

“They’ve been buying protection all the way from 2008, 2009, and you’ve had four or five years where buying protection didn’t pay, which has been a drag on their results. End-users are less likely to keep on just rolling those protection strategies,” says Rautenbach.

That said, Peregrine Securities’ Betty says interest from international investors in South African equities is growing. “We’ve definitely come off the lows of the 2011–2012 phase. We’re seeing more foreign interest in trading in South Africa. It’s part of the process of the country continuing to globalise, Africa’s emergence in the emerging markets basket and the continent’s growth story, which is on more people’s radar screens,” he says.

There has also been interest from investors in using equity derivatives to hedge or overlay positions, whether in indexes or single stocks, Betty says. He adds that activity is growing in so-called Can Do futures and options offered by the JSE. These allow professional investors to choose a basket of futures and options contracts, and customise elements such as the expiry date. The JSE says these products give the flexibility of over-the-counter products with the low counterparty risk of margined listed contracts. “This is part of the general migration we’re seeing from OTC to listed products,” says Betty.

However, while the JSE Top 40 has been on a steady rise, it has left those investors seeking downside protection struggling to find risk-takers on the other side, say dealers.

“Most directionality is one way,” says Standard Bank’s Barnes. “A lot of the people are looking for downside protection, and there are very few sellers. The banks have been absorbing a huge amount of that directionality but, at some point, you run out of road.”

While liquidity is still there, he says it is becoming more expensive to cover downside equity risk. As a result, market participants are increasingly relying on international banks.

“In some cases, they’ll have big emerging markets books that can absorb more than you necessarily can with a rand-dominated book,” says Barnes.

Corporate hedging on the rise
While the financials may have pulled back, dealers are reporting strong interest from the corporate market.

“It has been a pretty good year from a corporate hedging perspective,” says Craig Williamson, co-head of global markets structuring at RMB.

The Sarb interest rates move in January was the catalyst, as corporates started to revisit their views on rates. Williamson says RMB has had success in back-testing the effect of interest rate, forex or commodity price moves on clients’ net income margins, and suggesting improved hedging strategies accordingly.

“They often say ‘we’ve got a natural hedge’ but, nine times out of ten, we find there is a mismatch between that natural hedge and their actual exposures. We’ve incentivised quite a few people to consider hedges that they otherwise might not,” he says.

However, like many banks, the Basel III capital charges are beginning to have an effect on pricing. But, for better-rated clients, Williamson says those costs can be minimised.

For one, the charge for counterparty risk – the credit valuation adjustment – is reduced for counterparties with better credit quality. But if, on closer inspection, the trade also offsets existing positions in a bank’s portfolio, for instance, it can dramatically affect the charge required to be paid.

“We recently did a long-dated corporate trade with a full Basel charge of just 2.5 basis points,” he says. “If you understand your own book, and can get a level of benefit out of it that you can pass on to your clients, it makes you more competitive and makes the premium less of a problem.”

The story is less bright on the forex side, says RMB’s Thomas. Demand for forex hedging from some exporters has been hit by the trend over recent years of “dollarising the balance sheets”, where local corporates with US dollar revenues don’t immediately convert to local currency.

“They used to be far more active in selling their proceeds [and buying rand]. Now, they don’t repatriate as quickly, and all they really do is manage their local cost base. Because their balance sheets are dollarised, they tend to keep their turnover from their products in dollars,” says Barclays’s Klintworth.


How the poll was conducted

314 votes were received from dealers, brokers, corporates and asset managers in South Africa. Participants were asked to vote for their top three derivatives dealers in order of preference in products they had traded over the course of the past year. The survey covered derivatives categories, divided into interest rates, currency, equity, structured products and risk advisory. The votes were weighted, with three points assigned for first place, two points for second and one for third. Only categories with a sufficient number of votes have been included in the final results. The survey includes a series of overall product leaderboards, calculated by aggregating the total number of weighted votes across individual categories.

Download/view the full results of the Risk South Africa 2014 rankings

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