In many textbooks, when you read about derivatives, the authors commence
their discussion of the derivatives markets with a focus upon the listed
exchanges, most often the Chicago exchanges. However, the development of the
over-the-counter (OTC) derivatives markets is more interesting from the
perspective of the derivatives dealer for their comprehensiveness and
innovation. Listed markets deal only in plain vanilla options with rigidly
defined contract specifications and a limited number of maturities. The OTC
markets are characterized literally by an infinite variety of maturities,
contract specifications and exotic modifications. Understanding the OTC markets
implies an ability to fathom quickly the nuances of the listed markets. The
reverse is not necessarily true. This article will provide a general overview
of the different ways to organize a dealing room operation and the ways in
which the dealing room interacts with clients, counterparties and other
interested actors in the global capital markets.
ORGANIZATION
Commercial banks and investment banks make up the foundation of
the OTC derivatives market. Their derivatives desk makes markets to customers,
develops new products, trade with one another in order to lay off risks and
form the apparatus for much of the industry's self-regulation. There are, of
course, external regulators including the US Office of the Comptroller of the
Currency, the US Federal Reserve Board and the Canadian Office of the
Superintendent of Financial Institutions. However, the derivatives markets are
so complex and their evolution is so lightning-quick that regulators often have
a difficult time keeping pace. More often than not, large losses that might
incur the curiosity of the regulator are attributable to new cutting-edge
products, the behavioural characteristics of which are different in actual
practice than they may have been thought to be beforehand.
These institutions engage in operations in up to five main
asset classes:
- Foreign Exchange
- Interest Rates
- Equities
- Commodities
- Credit
Readers may be familiar with the first four asset classes, easily
relating them to transactions commonly seen in the media or in textbooks. The
last asset class is the most interesting one for it holds the future of
banking. Historically, commercial and corporate banking has been the practice
of assessing the creditworthiness of other entities to whom the institution
lends money in one form or another. Credit derivatives enable the institution
to lay off that exposure to the risk of default or downgrade in a client's
credit rating on other parties. In the future, banks will resemble funds
holding carefully managed portfolios of credit exposure, tailored through the
global credit markets. There will be greater international diversification. The
distinction between funds and banks will be one of historical happenstance more
than anything else.
Organization of a bank's dealing room operations can proceed
along two lines:
- By asset class
- By functional product delineation
ORGANIZATION BY ASSET CLASS
In this case, the bank sections its dealing room into five
separate, vertically integrated groups determined by asset class. Let's
consider the case of the foreign exchange group, for ease of argument.
In the vertically integrated foreign exchange group, the cash
trader (i.e. the spot trader) will sit next to the derivatives traders. This
improves the flow of information among dealers specializing in the same
underlying market. It putatively reduces transaction costs for the derivatives
dealers since the forward and options traders are all part of one consolidated
revenue pool. The spot trader has an incentive to treat the options trader
well, in order to get as much information about the indirect implications of
options market flows for the spot market.
Most importantly (and this is the key point), the spot trader
knows that if the options trader does well on the year, the available bonus
pool for everyone is only going to be bigger.
Organizing along asset class lines also means that marketing is
integrated for cash and derivatives products as far as the customer is
concerned. Marketing teams are directed to sell all of the products in the
asset class. They sell options to their clients and then they sell spot and
forwards to these clients in the dynamic management of these exposures.
There are two problems with this approach to
organization.
Difficulties arise when customers expect horizontally
integrated products. For example, the manager of a domestic money market fund
might want to take advantage of his view on the Canadian dollar exchange rate
against the US dollar. Technically, he cannot take explicit foreign exchange
positions. However, he can buy a structured note that guarantees his principal
while simultaneously allowing him to take advantage of his view if it is
correct.
There are also management issues that come into play in dealing
rooms organized by asset class. Because of their highly technical and
specialized nature, derivative products themselves might be considered a
separate type of asset. If the bank chooses its asset class line managers from
the ranks of the cash trader or generalist salesperson, it is unfair to the
manager and it is an impediment to business. It is unfair to expect any
individual to expect someone to be responsible for products outside of their
comprehension.
As difficult as this tenet is to accept for many people, having
non-derivatives specialists in charge of derivatives operations of any sort is
like asking a bus driver to fly commercial aircraft. It is terrifying for the
manager who will have to explain any loss or other problem to his superiors (or
to answer their general questions) without any remotely sophisticated
comprehension of what is going on. It also does not make sense from a business
point of view. The derivatives desks organized by asset class typically take
much less risk, win fewer deals, manage their risk as effectively or make as
much money as derivatives desks led by well-trained, experienced leaders.
Having said that, many managers who should not be responsible for derivatives
operations hang on to them tenaciously because of the cachet of being perceived
as sophisticated and cutting-edge.
ORGANIZING BY FUNCTION
The other type of organization is by function. Cash traders and
salespeople work together, dealing with clients who want cash products
exclusively. They are also separated by asset class. Cash foreign exchange
people will not enter into transactions in cash bonds. Derivatives traders and
salespeople handle the sophisticated accounts, across all five asset classes
(while usually specializing in one or two of these asset classes).
What are the advantages of doing things this way?
Clients get seamless service across products. Instead of
talking to five different contacts at a bank for their various needs, they talk
to one person. Instead of having five different kinds of confirmation contract,
they have one. It is easy for the bank to structure products that encompass
more than one asset class. Think of a cross-currency swap (an exchange of cash
flows denominated in different currencies) with an embedded currency option to
hedge against fluctuations in the cross-currency swap exchange rate. At the
bank organized by function, the customer talks to one salesperson, gets one
integrated price and receives one easy-to-read confirmation after dealing.
Hedging can be problematic. Because the bank has organized its
dealing room along functional lines, the cash trader has no interest or desire
to see the derivatives desk do well. He does not have to provide a competitive
or even a market price for the internal transactions with the derivatives desk.
This can make customer transactions uneconomic, putting the derivatives desk
out of business. The derivatives desk, for its part, can hide information about
flows from the cash side, impeding their ability to trade and sell
competitively. The dealing room can become an adversarial environment.
TRADING VERSUS SALES AS THE ENGINE OF DEALING ROOM
PROFITABILITY
One important distinction between dealing rooms is the business
model that they employ. This business model is linked inextricably to their
method of organization.
If the dealing room is organized by asset class, then typically
the source of their profits comes from proprietary trading. Cash markets for
most instruments are commoditized in most cases, depending on market
conditions, etc. That is to say, the bid/offer spread that the bank can hope to
earn from transacting business with a customer is very small. There are many
participants in the cash market. It is very competitive. Winning in a
commoditized market often means being very aggressive in terms of the bid/offer
price an institution shows its counterparties in an attempt to get the dominant
amount of flow. More people asking for prices means more spread and a
statistically greater likelihood of retaining that spread. How do you make your
money? Volume.
In the case where the dealing room is organized by function,
the engine of profitability is the customer transaction on the derivative
products. The bid/offer spread for these instruments is directly proportional
to the complexity of the product. Plain vanilla derivatives like currency
options are more like commoditized cash markets while highly structured
products command hefty spreads (in part because of the difficulty in hedging
them). How do you make your money? By executing a small number of lucrative
deals that help the client make more money than they pay in spread.
Institutions that have a spotty track record in terms of
recommending products that make money for their clients will find that they
cannot afford to charge hefty spreads. They rely on the strength of
institutional and personal relationships. Sophisticated investors, who do not
mind paying for information if it is consistently good, will prefer to deal
with functionally-oriented banks.
This means that institutions organized by asset class are not
the ones from whom we would expect the consistency of well planned market
strategies. Those recommendations come from organizations that live and breathe
by a relatively low number of deals.
WHAT DOES THIS MEAN FOR SOMEONE LOOKING FOR A JOB?
You cannot be too careful in picking the institution for which
you work. Your first choice may decide your prospects of career growth. If you
choose a bank organized by asset class, it may exclude you from ever working
for a functionally oriented bank. The other thing is that people will pay
higher salaries and bonuses for individuals who can give high-quality advice on
sophisticated cutting edge products on a consistent basis. Relationship
managers are much easier to come by.
Article by Chand Sooran, Principal Victory
Risk Management Consulting, Inc. |