Deutsches Risk Rankings 2014

View/download the Deutsches Risk rankings 2014 results

The record low interest rates and volatility environment has led to a divergence in the investment approach of derivatives users in Germany, with some focusing on hedging a possible reversal following the rally in fixed-income markets, and others looking to add risk and boost returns.

As banks continued to adapt to increased capital requirements and new rules on reporting, clearing and trading, the successful banks were able to draw on strong distribution networks to offload risk and match client demands.

Heading the Deutsches Risk rankings in 2014 was Commerzbank, which snatched first place from rival Deustche Bank after rising up the rankings in the interest rates space and holding on to its lead in currencies. In third place was UniCredit, followed by DZ Bank and JP Morgan.

The past year has not been an easy one for German banks to manoeuvre in, however. Banks have particularly been concerned about the impact of the Basel III leverage ratio, which requires firms to hold Tier I capital against 3% of their balance-sheet exposures.

Concern over assigning large chunks of costly balance sheet to relatively small-margin swaps business has had a knock-on effect on clients, and, in particular, the hedge fund community, bankers say.

“You need to pass internal return on equity hurdles and that means the economics of having large positions on the books at small margins may not work anymore, which has led to a lot of conversations with fast money about how we can do that business going forward,” says Nicolas David, head of over-the-counter derivatives trading for Germany at Deutsche Bank in Frankfurt.

“If you have positions that show up on the balance sheet, but with zero or very small mark-to-market, the cost to you as a bank is going to be a lot higher in terms of regulatory add-on than the benefit. Obviously we need to have conversations with clients about that and the bottom line is, if we are going to continue to provide liquidity, they probably need to leave some more [wider bid offer spreads] on the table.”

Bankers say this has led to a reduction in flows and a liquidity challenge for some clients, and several banks report having renegotiated relationships over recent months, leading to a slimming of client lists and a decline in volumes in some businesses.

Repurchase agreeements
The repurchase agreement business has also been under twin pressures from the Basel III leverage ratio and the net stable funding ratio (NSFR). The Basel NSFR proposals, which require banks to maintain a stable funding profile and is intended to limit reliance on short-term wholesale funding, has also drawn fire because of its punitive treatment of reverse repos conducted with non-bank counter-parties. In its half-yearly report released at the end of July, Barclays said the NSFR’s treatment of reverse repos cut its ratio by 15 percentage points, leaving it below the minimum level of 100% that will be required when the rule takes effect.

The leverage ratio rules meanwhile restrict the ability of firms to net exposures against each other, which means the business creates large exposures for relatively little margin. Bankers in Germany fear repo business may suffer if these regulatory pressures are not eased.

“The Swiss banks were the first to get hit with the leverage ratio and their repo volume has collapsed,” says Tong Lee, global head of rates at UniCredit in London.

“I am not sure we will see exactly the same in Germany, but I can see the repo markets going the same way as the money markets, which is to say people will not actively trade them anymore. They will access them if they need to borrow or they need to lend, but the role of dealers will be putting people together rather than trading in and out,” he adds.

Some banks have reorganised their internal structures to better deal with the new regulatory environment. Commerzbank, for instance, has shifted a number of activities to the front office to ensure that transactions can be managed with a closer eye on new metrics such as the leverage ratio.

“We have been running activities from the front office rather than market operations so that we manage financing transactions and portfolio business under the constraints of the impact of the leverage ratio, the cost of the trade and the economic value-added of the trade,” says Nikolaus Giesbert, head of fixed income and currencies at Commerzbank in Frankfurt.

The low interest-rate environment has raised a tricky situation for transactions that are governed by collateral agreements with a zero threshold – in other words, contracts that require out-of-the-money counterparties to collateralise their positions, no matter how small. 

The difficulty lies in where banks pay interest on collateral provided, which is linked to a certain number of basis points below the floating rate, usually the Euro overnight index average (Eonia). With Eonia dipping into negative territory in late August, the amount payable is also negative, which, under the International Swaps and Derivatives Association  master agreement wording, requires the counterparty to pay the bank interest on the collateral it receives.

But, while the Isda wording is reasonably clear, the German version of the master agreement, the Rahmenvertrag für Finanztermingeschafte, provides more room for manoeuvre, creating confusion in the market.

“Under the German master agreement there may be an implied 0% floor on interest received on collateral, which would mean that clients would not be expected to pay interest on the collateral they are posting themselves, even if there is a negative number,” says Deutsche Bank’s David.  “It’s an important issue to resolve because, obviously, if there is a floor it has an impact on pricing.”

Banks are starting to have difficult conversations with some clients about collateralising their positions. Some of German banks’ largest clients are supranationals, and bankers say they have been attempting to get them to post collateral on their derivatives trades. So far, however, they say they have been unsuccessful.

Another part of their client base that has remained opposed to collateralisation is corporates. Despite the pricing benefits associated with collateralising their swaps, German corporates by and large have so far not shown a willingness to post collateral.

“Corporates don’t want the hassle of having to forecast cash flows for collateral purposes and, for those that are hedging, they have no interest in the mark-to-market,” says UniCredit’s Lee. “For us, as a commercial bank we are more willing to provide credit and liquidity to the clients and they are typically willing to absorb the additional costs.”

The introduction of mandatory electronic trading for certain interest rate and credit derivatives products in the US earlier this year caused waves on both sides of the Atlantic, with market participants claiming that European derivatives users have avoided using the electronic platforms, known as swap execution facilities (Sefs), to avoid trading with a US person and therefore being subject to US derivatives rules. Industry groups claim that this has led to a bifurcation between US and non-US derivatives users, splitting liquidity pools at the same time.

UniCredit’s Lee says, however, that this has not been a problem for banks and derivatives users in Germany. 

“There is a bifurcation, but I would not say it has a huge impact on liquidity,” says UniCredit’s Lee. “There is sufficient liquidity for clients to trade on Sefs and clear if they are transacting with US counterparts, or not to do so with European counterparts, and I would not say that one side has an advantage.”

Nevertheless, banks have been watching the US for clues on how the local market will react when the rules eventually go live in Germany.

“Looking at the experience on Sefs in the US it’s quite interesting to note the difference between interest rates and credit,” says Lee.

“On the interest rates side, most of the volumes are through broker Sefs, so it seems like that market has remained the same in that it is dominated by interdealer brokers. On the credit indexes side, we see the likes of Bloomberg and others starting to offer limit order-book protocols, which is a new way of trading and may have the potential for creating alternative platforms and sources of liquidity,” he adds.

Lee says that the gradual migration to a limit order-book framework makes more sense in credit than in rates, because the contracts and tenors are more standardised. “Credit default swaps on indexes are more like futures in the sense that they’re fungible. The fact that it’s standardised opens it up to more potential,” he says.

In the product space, a reduction in rates-focused hedging has been offset by an increase in demand from some clients for yield, and banks have responded with a longer-dated and sometimes more complex solutions, often in note format, than have been seen in the market in recent years.

“A lot of clients were surprised and came into the year thinking rates would stabilise,” says Deutsche Bank’s David. “Some clients did some structured trades at the beginning of the year and, in hindsight, that was good market timing, but then there was the rally and a lot of clients did get caught by surprise, and some real-money guys were left sitting on too much cash.”

As rates and credit rallied in the first half of the year, investors who were short the market played catch up, seeking out yield enhancement opportunities through long maturities out to 50 years. Popular structures included multi-callable fixed- or zero-coupon notes, where investors sell banks the right to call for an uplift in return. Range accruals also have seen a return to favour, bankers say.

“Yield pressure is pushing people into areas that are a bit more fancy, for example, long-term forex exposure in higher yielding currencies,” says David. “Euro/dollar forwards have attracted a lot of interest because they are trading at very high levels in longer maturities, so if you have a view and can hold risk there are some interesting trades out there.”

In the credit area, the options market has continued its spiralling growth over the past year, with market volumes in the first half reaching four times the levels of three years ago.

“The options market is growing fast, particularly because of how well the market has performed and also due to clients looking for a low-cost hedge,” says Ruediger Rohner, head of credit sales for Germany, Austria and Switzerland at JP Morgan in London.

The market for total return swaps on indexes such Markit’s Iboxx, which replicates investment grade and high-yield fixed-income markets, is growing even faster, he says, because they eliminate the basis risk that occurs when clients hedge through credit indexes.

“That basis risk can run as high as a couple of hundred basis points during periods of market stress, which could mean a severe underperformance for your hedge,” he says.

How the poll was conducted
341 votes were received from dealers, brokers, corporates and asset managers in Germany. 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 was 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.

View/download the Deutsches Risk rankings 2014 results