Interest rate derivatives: The best of times?

Monday, April 11, 2011 Stamford, CT USA — Companies in the market for interest rate derivatives trades last year probably secured pricing that will seem quite favorable relative to the deals likely to be offered by banks in the future.

Several big banks have scaled up their derivatives capabilities in an effort to win more corporate business and a number of smaller players have been staking out a presence in the market by undercutting bigger, more established banks on price.

"The pricing seen by many companies in this market over the past 12 months is not sustainable," says Greenwich Associates consultant Andrew Awad. "That¿s true at both the level of individual banks — some of which are in effect buying business with trades that are barely profitable, or even unprofitable — and for the market as a whole, which is set to absorb the impact of potentially costly new regulations."

Regulatory Uncertainty
Although regulators around the world seemed to have arrived at some consensus of how derivatives markets should be structured broadly, fierce debates continue to rage within and among individual countries about critical details. In the United States, regulators continue to wrestle with the question of just which "end-users" should be exempt from rules requiring central clearing and margin requirements. In Europe, regulators have just started the process of hammering out a new regulatory regime.

Even if regulators agree to broad and comprehensive exemptions for "end users", companies will still face higher costs as a result of new regulation. The reason: The new rules will impose significant new costs on banks in the form of stricter capital requirements, necessary infrastructure investments and costs associated with rules requiring them to lay off their own risks through trades that are centrally cleared and exchange-traded. These costs will ultimately be passed on to customers.

Some of the other effects of new regulation are harder to predict. On the one hand, the move to central clearing should level the playing field for banks. At present, smaller and lower-rated banks have a difficult time competing in the OTC market. With central clearing taking bank balance sheets out of the equation, the market could see an influx of new competitors. On the other hand, flow derivatives trading is already a low-margin business for banks. As new rules are implemented and costs rise, some banks might choose to pull out of this business, which would lessen competition and could potentially even have a negative effect on market liquidity.

The upshot: Companies will soon be paying more for their interest rate derivatives trades. "The pricing now being offered by banks — especially the very aggressive pricing being offered by some smaller banks — will not be possible to sustain in the new market environment," says Greenwich Associates consultant Woody Canaday.

Interest Rate Derivatives Trading Volume Falls 19%
Global notional trading volume in interest rate derivatives declined 19% from Q4 2009 to Q4 2010. Trading volumes in the United States declined 28% from 2009 to 2010 and volumes in Continental Europe — the world¿s biggest source of trading activity — fell 11%. In the smaller U.K. market, trading volumes declined approximately 46% from year to year. Trading volumes in Asia excluding Japan and Australia/New Zealand declined 39%. The one sizable market to show an increase in interest rate derivatives trading volume last year was Japan, where volumes grew by approximately 19%. Volumes also increased in the much smaller markets of Canada and Australia/New Zealand. "These are the same three markets — Japan, Canada and Australia/New Zealand — that bucked the trend in foreign exchange by notching increases in trading volumes while the rest of the world experienced declines," notes Greenwich Associates consultant Tim Sangston.

The fall in interest rate derivatives trading volumes was entirely the result of a slow-down in corporate use of these instruments: corporate trading volumes fell by nearly 25% during the period. That drop, combined with an increase in trading volumes generated by government agencies, shifted the composition of the market. In 2009, corporates generated about 60% of interest rate derivative trading volume around the world, with governments producing the remainder and in 2010 corporates accounted for just 55%.

"Globally, corporate bond new issuance was off about 18% from 2009 to 2010, which put a big dent in corporate demand for interest rate swaps," says Greenwich Associates consultant Frank Feenstra.

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