SURVEY - DERIVATIVES: All bets on hold as market waits out crisis: The US crisis has created turmoil for the equity and bond markets but that is what derivatives thrive on
Financial Times, Sep 25, 2001
The financial markets have suffered a severe shock from the terrorist attacks on New York and Washington on September 11. Everything that was being planned - from mergers and acquisitions to the launch of cutting-edge derivatives instruments - is now under review, cancelled or postponed.
The watchword now is risk. Already we have witnessed a big switch into the least risk-averse instruments - short-dated government bonds, for the most part. Yet derivatives markets should be beneficiaries of investor behaviour. By their nature they are creatures of risk, volatility and uncertainty.
This year had been shaping up as a landmark year in the derivatives industry. The credit derivatives sector has seen the most spectacular growth, since credit risk has been rising in a weakening economic environment and protection against it was becoming a leading concern for investors and companies.
The growth of the credit derivatives business has also proved a lure for insurance companies, looking to diversify their own risk portfolios outside their traditional business areas.
One result of this, bankers say, was the prevalence of regulatory capital arbitrage deals, with banks, which are looking to utilise their own capital, happy to pass on chunks of their risk exposure to those such as insurance companies, seeking diversification.
"The awareness of credit risk is very high in the corporate market," says a senior investment banker. "That creates opportunities for insurance companies to come in and take on that risk. They are looking for a diversified portfolio of risk - property, casualty, credit, etc. They are pretty active, especially at the low-value, plain-vanilla end of the market."
Other investors are more interested in getting more yield on their portfolios. Given that before the terrorist attacks the outlook for interest rates was relatively favourable - that is to say that they were seen to be falling in both Europe and the US - yield investors were going outside their traditional areas of investment, in long-dated government bonds, in search of higher returns. The credit derivatives market is able to provide that. A bond issued by even a top-notch company is almost always going to yield less than a credit derivatives market product, according to fund managers.
"There are huge capital markets volumes in the credit derivatives area," another banker says. "We've seen an increase this year in over-the-counter market activity, and there has been a lot more issuance, since liquidity is a key factor in building the market."
There are three key factors to derivatives products - structuring and pricing, valuation, and risk management, including market risk, credit risk, liquidity risk, and settlement risk. As derivatives products became much more widely available, not just to sophisticated investors but to chief financial officers at companies, the industry has also been attracting the close attention of regulators.
This is hardly surprising - the debate continues, for example, as to whether the use of credit derivatives by banks concentrates risk rather than dispersing it, which is what these instruments are supposed to do.
Other developments this year have included the record growth in turnover in exchange-traded derivative products. Europe's two big exchanges, in Frankfurt and London, continued to slug it out for supremacy and have unveiled a wide range of new products to attract more volume and investors.
The trading pits at the Chicago derivatives exchanges, meanwhile, have carried on echoing to the sound of thousands of traders, even though most of the rest of the world has moved completely into electronic trading.
So, where are the markets heading? Some observers argue that the industry in Europe is in general more sophisticated and less commoditised than its US counterpart. This may be because it is of more recent development and banks have tended to specialise in over-the- counter solutions for clients rather than developing products that can be traded on an exchange. It has also been encouraged to spread by the advent of the euro, which has created a thriving cross-border business.
Christophe Reech, chairman and chief executive of Reech Capital, a derivatives industry specialist, says the growth of the industry and its increased sophistication have a solid foundation. "Traditional solutions (to risk managment) are not good enough any more," he says. "You need to be a little bit creative. If you provide traditional solutions you solve the immediate problem but not the evolutionary one."
One of the fastest-growing niche areas is the provision of weather derivatives. Demand began among natural gas companies in the US looking to hedge their exposure to extreme weather. Now many companies are in the market, with the most basic products designed to hedge against unusual temperature movements.
Much of this business is also tailor-made for clients, with risks managed through secondary market trading. According to Paul Murray, director of weather risk management at Enron, possibly the largest trader of weather derivatives contracts, the market is growing at 40 to 50 per cent by number of transactions. "I'm pretty optimistic about the market - the weather isn't going to go away," he says.
Whether the optimism that characterised much of this year will now evaporate in the wake of the terrorist attacks remains to be seen. With a new air of uncertainty gripping investors, and a sudden bout of risk aversion witnessed in the equity and bond markets in the aftermath of September 11, all bets are off.
However, given that interest rates are certain to fall further - many analysts predict that the Federal Reserve will steadily lower US interest rates by at least another 50 basis points - yield enhancement and risk management are expected to continue to stay at the forefront of investor concerns.
That could create the conditions for much more activity in both credit and equity derivatives. "It's far too early to predict anything, but derivatives are designed to minimise and control risk," says a leading derivatives industry banker. "I am pretty confident that there is a lot more growth to come in this industry."
Copyright: The Financial Times Limited
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