Derivatives explosion
By Angus McCrone
Derivatives have been the hottest part of the City jobs market for the past two years and brought rich rewards to financiers
IN the towering glass fortresses of London’s Canary Wharf, a new elite of City workers has emerged to replace the takeover kings of the 1980s and the dotcom cheerleaders of the 1990s.
This new group is less ostentatious, but its pay packets trump those of almost anyone else in the City. They are specialists in derivatives — arguably the most dynamic part of the financial sector, and one in which London is becoming a world leader.
This is quite a turnround. Ten years ago, in the wake of the collapse of Barings Bank at the hands of one futures trader, “derivative” seemed synonymous with “disaster”. Now it stands for “goldmine”.
In the last quarter of 2003, UK banks had liabilities on derivative products totalling almost £1,000 billion, roughly the same as the value of Britain’s national output for a year.
Derivatives have been the hottest part of the City jobs market for the past two years, with directors in charge of teams of 10 to 40 people, who each earn £1m or more a year, while experienced sales executives and quantitative experts pocket up to half a million.
Craig Millar of the City recruitment firm Millar Associates said: “A senior person at a top-tier American bank may earn a serious six or seven-figure salary. Two particularly good areas at the moment are credit derivatives, and cross-asset derivatives such as equity/interest rates, or interest rates/foreign exchange.”
However, derivatives are no longer an obscure corner of the City — in recent years they have mounted an increasingly serious challenge in terms of turnover to the underlying markets, such as shares, bonds and foreign exchange, on which they are based.
Take futures, for example. Between 2000 and 2003, the value of UK equities traded remained fairly constant at some £7.5 billion a day, while the number of FTSE 100 index futures contracts traded on the Euronext.Liffe exchange in London rose from 49,605 a day to 79,110 (equivalent in money terms to about £3.2 billion).
Add in options on the FTSE 100 index future, and we would reach a total that is more than half the value of underlying UK shares traded each day, and growing by at least 20% a year.
Then there are interest-rate swaps. Figures from the Bank for International Settlements put the gross market value of outstanding swaps worldwide at $4,300 billion (£2,400 billion) by the end of last year, with London’s share of the world market in these and other “over-the-counter” (OTC) derivatives up from 27% in the mid-1990s to 36% by the early 2000s.
Credit is one of the fastest-growing areas of OTC derivatives, with UK banks’ liabilities in this area totalling £4 billion in the fourth quarter of last year, up from £1 billion six years earlier.
Matthew Cottrell of the Fitch rating agency said: “About 55% of the market consists of straightforward, single-name credit-default swaps typically for a notional amount of $10m.”
These involve the bond holder paying a premium for a swap to provide protection against default.
Cottrell said: “If the reference entity (the borrower behind the bond) does default on any of its obligations, then the buyer of the default protection issues a “credit event” notice to the seller of the swap, after which a cash settlement is usually made.”
Credit-default swaps can be used as a hedging tool for holders of corporate bonds, or as a low-cost way for an institution to get exposure to a corporate borrower without actually holding the bond.
London’s share of the world market in exchange-traded derivatives, such as futures and options, is nowhere near as high as the 36% in OTC products. However, it may be about 15%, reckons John Foyle, deputy chief executive of Euronext.Liffe, the City-based exchange.
This includes business on the London Metals Exchange, world leader in copper and aluminium futures; the International Petroleum Exchange, home of the Brent crude-oil futures contract; OM, the London-based exchange in Swedish futures; and Euronext.Liffe, home of futures and options on everything from the FTSE 100 index to coffee and British and European interest rates.
In coffee, Foyle’s exchange has been handling up to 11,764 contracts a day this year — equivalent to £114m, or 60,000 tonnes, of robusta coffee.
Part of the demand for swaps and futures in the past year or two has come from conventional investment funds.
James Harwood, head of dealing at Isis Asset Management, said the biggest trend among institutional investors has been life assurance funds’ use of derivatives to meet new regulations on matching their assets with future liabilities.
Institutions also use stock- index futures to effect asset- allocation changes, such as a reduction in their weighting in shares and an increase in their weighting in bonds.
Harwood said: “You can switch a lot of money out of equities and into bonds — or vice versa — more easily, in a shorter period of time, more discreetly and with a lower execution cost if you use futures than if you try to do it through a programme trade, buying or selling shares.
“The scary thing is that pension funds are generally overweight in equities and under-weight in bonds, and that this position may not fit their liabilities with the baby boomers approaching retirement.”
Harwood said that if pension-fund trustees decide to shift funds out of shares into bonds, then many of the larger ones are likely to use futures to effect the change, or employ specialist ‘transition managers’, who will probably use derivatives.
However, much of the demand for derivatives comes from less traditional investors. Hedge funds, the proprietary trading desks of large banks and individual speculators relish the leverage these products offer — the ability to take a large position in a market on the basis of an initial margin (cash upfront) of only a few percentage points of the underlying exposure.
The speculative element also includes those funds and traders who use contracts for difference (CFDs) to go long and short on British shares.
Dominic Connolly, an independent expert on CFDs, reckons 35% of all share trading in London now consists of deals by brokers to hedge CFD positions built up by their clients.
“CFDs were invented for the British market, but have become an export earner for the City as foreign investors use them to go long or short on European and American shares,” he said.
The London Stock Exchange has been arguing that the Treasury should even up the balance between shares and CFDs, and between dealing in UK and foreign stocks, by removing stamp duty on share deals.
So far, the Treasury has sat on its hands, reluctant either to lose the £2.5 billion a year in stamp-duty revenue from share deals or damage the golden economic goose of the City’s expertise in derivatives by slapping taxes on these products.
Even highly successful products such as interest-rate swaps, credit derivatives, futures and CFDs do not create a huge number of jobs. The only detailed estimates on City employment suggest its derivatives and foreign-exchange category employs 15,428 people, out of a City jobs total of 317,000.
The Securities Institute, which awards qualifications for regulated jobs in the City, said that about 1,000 people each year take its Certificate in Derivatives exam, and a further 2000 take its Certificate in Securities and Derivatives.
However, Richard Roberts, an author of several books on the City of London and Wall Street, said: “Derivatives is a profitable area. That is the great thing about it. The rate of innovation is such that firms can come up with new products and sell them at a premium.”
Michael Spencer, chief executive of Icap, the London-based broking giant, said last week that his firm’s turnover in derivatives had increased 17% to £309m in the year to March, with interest-rate swaps, credit derivatives and the even newer area of “inflation swaps” doing particularly well.
The economic impact of derivatives is valuable as long as the industry steers clear of trouble, but can it continue to avoid a repeat of the problems of the 1990s, when the casualties of derivative mistakes included not just Barings but also Germany’s Metallgesellschaft and California’s Orange County? There are plenty of sceptics.
Warren Buffett, the American who has been one of the world’s most successful investors for the past 40 years, warned shareholders in his Berkshire Hathaway company last year that derivatives were “time-bombs both for the parties that deal in them and for the economic system”.
“Large amounts of risk, particularly credit risk, have been concentrated in the hands of relatively few derivative dealers who, in addition, trade extensively with one another. The troubles of one could quickly affect the others,” he wrote.
Stephen Lewis, chief economist at Monument Securities in London and a veteran analyst of international financial markets, said: “Over-the-counter derivatives add to the service that the financial community can offer to its customers. The only problem is that it is not always clear that all the parties know what they are getting themselves into.” Lewis is particularly concerned about credit-default swaps.
Foyle at Euronext.liffe said: “Of course there are risks if people do not know what they are doing, or if they are allowed to take positions they cannot afford to finance, but the risks are not as high as they were in the early days before the regulatory system was in place.
“The biggest damage to people’s savings has occurred in the underlying cash market — for example, from the dotcom bubble — rather than in derivatives.”
Derivatives began some 200 years ago as a way for food producers and buyers to hedge their exposure to unpredictable harvests. They continue to be used to reduce risk, and many people believe they have cushioned investors from recent shocks such as September 11 and the Iraq war.
However, each time there is a seismic event in the world, there will be plenty of people in London’s Square Mile and Canary Wharf nervously wondering if the complex, financial structures they designed will be able to take the strain. |
