Derivatives house of the year: BNP Paribas

At the end of 2021, Olivier Osty took a long, hard look at the global markets division he runs at BNP Paribas. It needed an overhaul. In some places, the structure didn’t make sense – prime services were being run out of the rates business, for example, which was siloed from foreign exchange and commodities. In others, he wanted to get different teams working together more effectively.

A year on, Osty is more than happy with the new-look division – with good reason.

“We have gained more market share than I could have dreamed of at the beginning of the year,” he says. “It’s a 10% to 15% increase compared to our peers.”

In revenue terms, global markets was up nearly 28% through the third quarter of 2022, compared with the same period in 2021. The fixed income, currencies and commodities businesses led the way, with revenue growth of nearly 30%, helped by a surge in derivatives trading as clients rushed to hedge their exposure to rising interest rates and energy prices. Revenues from equities, which were flat or down at most other banks, grew 25%.

How did they do it? The short answer is, through a mix of good management, good execution and some good fortune.

The second half of 2021 saw BNP Paribas complete the acquisition of Deutsche Bank’s prime services business and take full ownership of its research and cash equities joint venture with Exane. A new global equities unit was created to house the acquisitions alongside its prized equity derivatives arm. Then in January, Osty announced internally that rates trading would be combined with foreign exchange and commodities – which were already being jointly run – and emerging markets in a new global macro unit.

No sooner were the changes made than all hell broke loose. Russia’s invasion of Ukraine on February 24 unleashed a frenzy of trading in global markets. Russian assets nosedived, energy prices soared along with inflation and interest rate expectations.

“Thank God we did it,” says Osty of the decision to merge rates with FX, emerging markets and commodities. “Putting in place an organisation where people work together more closely has really helped us in this very macro environment. There was so much disruption, the teams really had to communicate – sometimes the market driver was rates and other times it was foreign exchange or commodities. The macro structure meant we could be more reactive in terms of understanding what was happening in one asset class versus the others.”

We have gained more market share than I could have dreamed of at the beginning of the year. It’s a 10% to 15% increase compared to our peers

Olivier Osty, BNP Paribas

The re-org also presented a perfect opportunity to cleanse legacy books of toxic and illiquid positions. Expecting that central banks would have to take more aggressive steps to combat inflation, BNP Paribas cut back leveraged rates exposures, such as asset swaps and basis trades.

“Before the invasion [of Ukraine], the level of risk in the trading business was probably the lowest ever,” says Osty. The bank’s one-day value-at-risk stood at €27 million ($29.4 million) as 2021 drew to a close – down from €47 million a year earlier – with rates VAR at €18 million ($19.6 million), from €28 million at the end of 2020. “That allowed us to provide more liquidity and do more market-making afterward, because we were not in a defensive mode.”

The macro unit hit the ground running, providing liquidity in large size and at tight spreads across currencies, commodities and rates products – including options – when it was most needed.

“In volatility, BNP Paribas has been there throughout,” says one client that uses options to hedge its balance sheet. “There was no time in the market where they haven’t been there. They were always quoting without limitation, always well within market bid/offers.”

A portfolio manager at a large European pension fund says: “In a very volatile year when bid/offer spreads in the market were sometimes five-to-10 times wider, BNP Paribas stood out and provided good execution levels.”

The equities unit wasn’t left out – in March, BNP Paribas’s market share in European dividend futures hit 16%, and 36% for contracts linked to banks, which some other market makers were reluctant to trade for fear that regulators might restrict payouts to shareholders, as they did in 2020.

“In March, we committed capital to clients at the worst possible time,” says Emmanuel Dray, the bank’s global head of hedge fund and asset manager sales for global equities. “We were really trying to help clients and we were recognised for that.”

Macro diet

BNP Paribas’s global macro unit is a child of inflation.

“We already had a view that inflation would pick up – though perhaps not to the extremes we have seen – and that the world would become more macro than micro,” says Osty.

Francisco Oliveira, the bank’s co-head of global macro and global credit, felt the same way. He started his career as a rates trader in Brazil in the 1990s, when the country was experiencing hyperinflation, and short-term interest rates hit 45%. So, when Brazil led the way in raising rates in May 2021, in a preemptive bid to curtail rising prices, it struck a chord with Oliveira. And he had a pretty good idea what would happen next.

“When I saw leading emerging market central banks, such as Brazil, starting the hiking cycle decisively – as emerging markets do have the luxury to wait – I was confident that other central banks would follow soon,” he says.

In March, we committed capital to clients at the worst possible time, We were really trying to help clients and we were recognised for that.”

Emmanuel Dray, BNP Paribas

Higher rates would mean more volatility and tighter correlations between asset classes. To operate in this environment, the bank’s trading businesses would need to be more nimble, collaborative and communicative, both internally and externally.

The bank was already moving in this direction. The FX and commodities businesses were combined in 2017. But bringing rates into the fold to create a fully-fledged global macro operation required a complete rethink of how the trading businesses were organised.

“We didn’t want to create a macro holding company where the businesses still operate as verticals,” says Oliveira. “We wanted to really integrate them.”

The bank’s global macro unit consists of five ‘pods’ that cut across conventional asset classes. One specialises in electronic trading of liquid products, such as G10 and spot FX, while another trades volatility as an asset class, across rates and FX. The developed and emerging markets pods have shared co-heads. Non-linear trading is led by the former head of commodities and sits in a separate pod. Oliveira himself co-heads global macro and global credit with Arne Groes.

To an outsider, some of those dividing lines might look blurry, but the matrix structure was a deliberate attempt to limit internal barriers and bring traditionally separate teams together, says Osty.

“Where banks are inefficient is at the borders of businesses – between fixed income and equities, rates and FX, rates and credit. If you can put in place an organisation where these borders are thinner, you can get revenue others leave on the table.”

That idea transformed the way BNP Paribas responded to the various shocks and crises that enveloped markets in 2022.

“The vision we had was to create a governance around global macro that would make commodity traders think about rates, so they can really understand how the gas markets can affect inflation,” says Oliveira. “And lucky for us, we did that at the right time, and we were ready.”

During the energy crisis in Europe, the bank’s commodity and rates traders were in constant communication, sharing intel in daily calls. When European gas prices more than doubled in early March, the rates desk had advance warning that energy firms would need emergency repo funding to meet the ensuing margin calls.

“As a relevant player in the European energy markets, we could see the magnitude of the pricing dislocation creating liquidity issues among some players,” says Oliveira.

Clients also benefited from this connectivity between desks. “The information flow was fantastic,” says Oliveira. “An institutional client trading euro options could be immediately put in touch with an energy trader to discuss what is happening in the power market.”

Combining the businesses had other benefits, too. “When you have a more diversified portfolio, with flow, structured and complex products under one macro umbrella, it allows you to have a more resilient business,” says Oliveira. “In some shocks, the flow desks benefit from increased client activity, which can compensate for some illiquid market-making inventories.”

Some flow business lines posted blockbuster numbers, with the non-linear desk nearly doubling its revenues year-over-year, while the bank’s Cortex FX execution platform saw average daily volumes triple and market share almost double.

BNP Paribas was ranked first and second for sterling and euro interest rate swaps, respectively, on Bloomberg and Tradeweb, with a market share in the mid-to-high teens. In the US, where the bank is expanding its trading operations, market share in US Treasuries and interest rate swaps topped 5%.

We didn’t want to create a macro holding company where the businesses still operate as verticals, We wanted to really integrate them

Francisco Oliveira, BNP Paribas

The bank also executed several large risk transfer transactions and committed balance sheet for funding solutions. After the initial shock of Russia’s invasion wore off, some clients looked to capitalise on dislocations in the euro rates market. Fixed rates on swaps linked to the euro short-term rate (Estr), which are typically lower than their Euribor equivalents, moved nearly 10 basis points higher at the 50-year point in May. This created an opening for European pension funds to transfer their Euribor risk to Estr at attractive levels.

At the same time, some rival banks were desperate to exit basis positions they had taken on earlier in the year. BNP Paribas’s rates desk executed several large risk transfer trades with pension clients during this period in sizes of up to €10 million of DV01 – the sensitivity to a 1bp change in interest rates.

“We were able to take these basis positions from other banks and recycle them with pension funds,” says Clement Joutard, head of European swaps trading at BNP Paribas.

The bank’s deep relationships with Europe’s largest pension funds proved critical throughout this period. “When the European crisis arose, liquidity disappeared. The only way to hedge was through flows and partnerships. We did a lot of risk transfers, mixing and matching interests with clients, which was key to minimising market impact,” says Joutard.

At other times, BNP Paribas was one of the few sources of liquidity available to large institutional investors.

With rates moving wildly, meeting collateral demands from clearing houses and bilateral dealer counterparties became a major headache for institutional investors. Pensions and insurers typically set aside cash buffers to cover 99% of historical moves. For tail events, they rely on the repo market to convert the government bonds in their portfolios into cash at short notice. But as UK pension funds discovered last year, repo liquidity can be hard to come by in a pinch.

When 30-year gilt yields jumped nearly 100bp between September 23 and 26 in response to the UK government’s disastrous mini-budget, pension funds faced immediate cash margin calls of more than £100 million on interest rate swaps and other derivatives used for asset-liability hedging. Demand quickly outstripped repo supply, forcing investors to sell gilts to meet margin calls. This pushed rates even higher, triggering more margin calls, and leading to more gilt sales. The Bank of England intervened on September 28 to end the chaos.

Bankers at BNP Paribas identified the problem years ago, when the EU clearing mandate was first applied to insurance companies, and had been working on various solutions. “We have been very proactive in discussing collateral issues with clients,” says Enrico Ballarini, head of G10 solutions structuring at BNP Paribas. “All clients, even those who did not execute anything until 2022, were nevertheless very aware of what BNP Paribas could offer in terms of liquidity solutions.”

When the European crisis arose, liquidity disappeared. The only way to hedge was through flows and partnerships

Clement Joutard, BNP Paribas

BNP Paribas expanded the range of eligible collateral for non-cleared derivatives and provided billions in committed repo liquidity to large institutional clients. Many of these services were also extended to European energy companies when they had trouble raising enough cash to meet margin calls when prices surged in the summer.

“BNP Paribas stepped up to provide the financing for the energy that is heating our homes today,” says Oliveira.

Pillars of equity

The transformation of the equities business was in many ways even more remarkable.

The bank has historically been strong in equity derivatives, but it needed to improve its cash execution and prime brokerage capabilities to round out its offering. It did so through the acquisitions of Exane and Deutsche Bank’s prime services business. More than 1,600 new employees joined the bank in 2021 as part of those deals, including around 600 in the front office.

“In equities, we have brought together the three pillars – prime services, cash and derivatives – in the past two years,” says Osty.

It then doubled down, signing a referral agreement with Credit Suisse in November 2021 for its prime brokerage customers following the Swiss bank’s exit from the business after the Archegos collapse.

The bank has added over 35 new hedge fund accounts since the deal with Deutsche Bank was announced in 2019 and claims to have significantly increased its balance with multi-strategy funds, which tend to favour banks that can offer a full range of equity products.

The big priority in 2022 was further developing the stock flow volatility business. Nine volatility traders were hired in Europe – four specialising in single stocks, three in indexes and two in dispersion trading. The stock flow team also changed its approach, focusing less on parameters and more on fundamentals and directional views, making the most of Exane’s research. The effort benefited from prime brokerage client relationships. “We traded for the first time with many long/short equity pods at multi-strategy funds that we were not connected with before,” says Emmanuel Dray. “We were previously connected with many pods at multi-strategy hedge funds, but not with the long/short equity pods – the fact we can be relevant with these pods is new.”

The result was a record year in flow volatility, with revenues up 112% compared to 2021.

Cross-selling to prime brokerage clients has generated significant revenue within the derivatives business. Dray estimates that hedge funds will typically do 50% more flow volatility business with their top prime brokers, citing industry research.

“The halo effect is clearly in motion as we have started to harvest as many cross-introductions as possible between our three businesses – cash, prime and derivatives – and across multiple client types,” he says.

Almost every part of the equity derivatives business has benefited from this.

Revenues in the US equity solutions business are up 120% since 2019, when the deal for Deutsche’s prime services business was announced, driven by quantitative investment strategies (QIS) and risk-recycling. Last year, BNP Paribas executed what it believes to be the largest volatility control risk sharing transaction ever seen in the US market, totalling $20 million of vega.

In Europe, it closed the largest QIS deal of 2022, providing €2 billion notional of exposure to a custom basket of systematic strategies. The bank worked with the client, one of Europe’s largest asset managers, on every aspect of the transaction, assisting with strategy design and portfolio construction before packaging it in a structured note through its Theam Quant fund wrapping platform.

The deal for Deutsche’s prime brokerage business closed just before the bear market in equities, but Osty has little doubt it was the right move. “These opportunities arrive once every 10 or 20 years,” he says. “It was not only an opportunity to grow prime services, it was an even more unique opportunity to become an equity player.”

BNP Paribas stepped up to provide the financing for the energy that is heating our homes today

Olivier Osty, BNP Paribas

The upshot is that the bank is now viewed as a credible player in equities by the largest asset managers and hedge funds, which do the bulk of their business with counterparties that can provide a full suite of products and services. BNP Paribas was previously frozen out of this club because it was strong only in equity derivatives.

“The largest asset managers now realise we can offer them a full range of products and we are improving our rankings with them,” says Osty. “And when you increase your ranking with a big client by one or two notches, your revenue goes up by multiples.”

Taking credit

BNP Paribas still has some way to go to achieve its ambition of becoming the top European corporate and investment bank globally. In Europe, it has overtaken a host of local dealers in recent years, but still trails US competitors like Goldman Sachs and JP Morgan in revenue terms. One reason is that large US asset managers route a significant chunk of their European trades to these firms. Osty expects this to change – in no small part because of BNP Paribas’s performance in 2022, which he argues has shown that “we can provide them with better liquidity and even better service because we know Europe better”.

In the US, the bank is hoping to make inroads in equities. Exane’s research and execution services were rolled out in the US in November and the group plans to increase coverage of US companies to 450 stocks from the current 180 by 2025.

BNP Paribas is also going on a hiring spree to bulk up in other business lines. In the middle of the year, it hired Morgan Stanley’s global head of government bond, inflation and electronic trading, Kunal Maini, as co-head of global macro in the Americas. A big push is also planned in credit, where the bank remains relatively underweight compared to its peers. This meant it did not suffer as much as others in an extremely difficult year for the asset class. The bank is looking to add between 80 and 100 credit specialists in the US by 2025. “Three years down the road, when the credit business will start again, we will be there,” says Osty.

Even so, he has no illusions about going toe-to-toe with the largest US banks on their home turf. The goal instead is to be a credible alternative for European companies that want to issue or trade dollar assets. “When European clients want to go to the US, they should think about working with BNP Paribas,” says Osty. “This is already starting to happen, not only on primary business, but also in secondary markets.”

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