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The World According to Jeffery Larsen

Jeffery Larsen is a battle-scarred veteran of the derivatives market who has managed to survive and prosper in the midst of a series of bank mergers.
He started his career in the 1970s as a trader and salesman at Bank of America's foreign exchange group. Later, he moved on to Citicorp, where he specialized in back-to-back loans, an early predecessor of the interest rate swap. In 1985, he joined Manufacturer's Hanover as a trader, hedging short-term swaps and forward rate agreements against the Chicago futures exchanges. He rose quickly there, becoming head derivatives trader and eventually global head of derivatives.
Larsen kept his function when the bank merged with Chemical Bank, and began building the bank's specialty derivatives businesses in equities, commodities, credit and the municipal area. When Chemical merged with Chase, he was named head of Chase's international capital markets group, but decided to leave when the bank merged international capital markets with its emerging markets group. He says he is currently exploring a number of opportunities in the financial world, including hedge funds, investment banks and insurance companies. He spoke with editor Joe Kolman in April.

Derivatives Strategy: The big news these days is the merger of Citibank and Travelers. You've been through several mergers in your career. Merging may be a smart idea from a global banking perspective, but is it smart from a derivatives perspective as well?

Jeff Larsen: Absolutely. I think derivatives is going to continue to be a huge growth business as we have more opportunities to link investment banking, commercial banking, insurance and money manager clients all together. That will allow some of the old derivatives products to be applied to new customer bases and will allow new derivative products to be developed.

DS: There's a lot of talk about synergies, but when I look at specific mergers, I'm not absolutely convinced they'll occur.

JL: Well, look at Citibank and Solomon Brothers. Solomon is good at equities and Citibank is good at derivatives, so when you put the two together, you can apply the derivatives expertise to equity derivatives. You've got the research for doing index arbitrage. Or you can offer products like a CD linked to multiple indices—say the DAX, the CAX, the Standard & Poor's 500 and the FTSE. You can even structure the CD so it's principal-protected, where the customer has an upside that gets capped out at a certain level. Then you can sell it not only to Citibank's private banking customers, but to Solomon's customers and to Travelers' insurance customers. All of a sudden you can see three pieces—commercial banking, investment banking and insurance—coming together in the equity derivatives market.

DS: I guess what's missing is the money management piece.

JL: That's the fourth piece I see coming together in the market. I think they'll all be consolidated to get the one-stop shopping because they already do connect with each other in many important ways.

DS: You've certainly been through more than your fair share of mergers. What did you learn from the experiences?

JL: There are incredible synergies when you merge. You start with two marketing forces, two trading operations, and two computer systems. So, first of all, you get an ability to pick the best from both. To do it right, you take the best traders and pull them together. Each institution will have developed different skills, so if you can take the skills that existed in one and the skills that existed in the other, you'll end up with a lot stronger whole. Then there's the marketing side, where one bank's customers are different from another bank's customers. So you can immediately increase your customer base by 50 percent to 100 percent. Customers often won't bank with two money center banks, so other than the Fortune 500, the customer base isn't the same. That's a big plus. Then there are economies of scale in many areas. You don't need two systems, you don't need to convert to the year 2000 twice, you don't need to do regulatory reporting twice. You don't need two boards of directors.

DS: It sounds like there would be plenty of systems integration problems that you would have to deal with.

JL: There are definitely integration problems, but the savings are so enormous that it's well worth it. You always have integration problems. In a big institution there are usually two people who develop the same product and two groups marketing to the same customer or trading things that look alike. Big institutions are always trying to consolidate internally, even without a merger.

DS: You make it sound almost easy. There must have been some aspect of these mergers that drove you nuts. What were they?

JL: The hardest part was undoubtedly the personnel part. That involved figuring out who was really the best for the job. Everyone assumes you just put it together and let all the bad people go. That's true to some extent, but what happens is that you first make the easy cuts, and then ou hit the next layer.

You might have two good people who cover an account or trade a certain instrument. You really can't decide which one is the best, but you have to make that decision. Sometimes you're in the shower in the morning and you say, "I really hope I made the right choice,” because you can't really be sure. It's an art, not a science.

DS: What advice would you give to a person that has to make the decisions about cutting, and to the people worried about being cut?

JL: The people who do the cutting have to make sure that they give employees from the other firm—people they don't know as well—as much consideration. It's not a malicious thing. It's just human nature to say, "I know these people better from my firm and I know what they do well and I know what they do not so well.” You really have to fight to look at the other people and ask, "What can they bring to the table and how can I make them feel like a part of this new family?” One of the firms usually ends up dominant, and that's what the manager has to fight.

"The hardest part [of the mergers] was the personnel part. Everyone assumes you just put it together and let all the bad people go. That's true to some extent, but what happens is that you first make the easy cuts, and then you hit the next layer.”

The people who are in danger of getting cut have to be as honest as they can about what they can bring to the table and not fret over every change if one of the companies is becoming dominant over the other. In a good merger, one company will inevitably be dominant in one area and the other company will be dominant in another.

DS: Everyone is now playing guessing games as to what the next big mergers will be. Who are the most eligible bachelors on your list?

JL: Look at a well-run company like JP Morgan. They have a great trading institution but they don't have the customer base that a Merrill Lynch or a Chase Manhattan has. Another example would be Bankers Trust, a good trading bank that's moved toward investment banking. They bought Alex Brown, which catapulted them up on the equity side, but they don't have the customer base that a Bank of America or Nationsbank or Citibank has. So they would be another eligible bachelor.

The quickest ways to move forward are by acquisition, strategic alliances or a merger of equals. Growing simply takes too long. We saw firms like JP Morgan do a good job growing the equity business over a long period of time, and in one fell swoop Bankers Trust became bigger than Morgan in the equity business. Building is a long process, and I don't think the world is going to wait.

DS: Volume in the derivatives business seems to be increasing at the same time as profitability seems to be declining. Are those trend lines going to continue?

JL: People talk about declining profitability because the raw dollar amount per deal has dropped. A $10 million one-year generic interest rate swap made more money 10 years ago then it makes today, but the real use of derivatives and the applications and the acceptance of them have increased dramatically. So the industry makes a lot more money then it did 10 years ago.

DS: But more and more people are judging their business not in terms of how fast it's growing but on the return on equity.

JL: Risk management to me means risk-adjusted return. Say you make a million dollars. It's not necessarily a good thing if to do so you put $10 million at risk. But if you put $100,000 at risk it would be a good return. More people are looking at the risk-adjusted return and return on equity. That's why you're starting to see a lot of institutions say, "Maybe we've been growing our investment banking too quickly,” or "Maybe we should get out of equity derivatives and equities overall.”

People love to talk about revenue, revenue, revenue. But they need to focus on the net bottom line on a capital-adjusted basis and on a risk-adjusted basis to compare apples with apples and decide what businesses to get into and out of. A company that makes $100 million will be worse off than a company that makes $20 million if the company that makes $100 million spends $110 million dollars to do it.

DS: Let's talk a little about technology. All aspects of financial services have been changed dramatically by the impact of new technologies. How do you think this will affect the derivatives business in particular?

JL: Let's remember that we got into the derivatives business because of technology. When I put my PC out on the trading floor in 1985, a senior manager asked "What are you doing? This is a trading floor. You're not allowed to have a PC.”

Now the ability to buy and sell things over the Internet has exploded. The only financial area that has taken advantage of it is the equity market. The rest of Wall Street hasn't pushed it as much. I think they're going to have to. If you can deliver generic derivative products like forward rate agreements and generic swaps through the Internet, you can cover the world and cut out a lot of your staff. You can cut a lot of the costs associated with processing the paper and back-office monitoring and sending out confirms. The technology side is going to drive down the cost of delivering products.

DS: We are already beginning to see some asset classes, such as currencies, opening to Internet-based trading. Does that mean corporates will go to financial institutions on-line and buy vanilla interest rate swaps without ever talking to derivatives salespeople?

JL: I think so. When corporations start to embrace Internet execution, they'll find that it's a lot more useful. They don't have to talk to someone over the phone, they don't have to give their instructions. Everything is standard and set.

DS: I guess that's not terrific news for salespeople.

JL: Salespeople don't make their money offering generic products. They offer generic products to get other structured deals where they can make more money. That's one of the things that financial institutions are going to have to figure out. How do we take well-trained, well-paid salespeople and make them more productive?

"Let's remember that we got into the derivatives business because of technology. When I put my PC out on the trading floor in 1985, a senior manager asked ‘What are you doing? This is a trading floor. You're not allowed to have a PC.'”

DS: A lot of people are worried that European monetary union will dramatically decrease the business and profitability on the derivatives side.

JL: I think there will be a two-pronged effect. There will definitely be less opportunity to trade in the interest rate and foreign exchange areas, because the currencies will be pegged and later will become one. But on the flip side we'll see a much bigger market in Europe—one that looks more like that of the United States. You'll also see a lot of credit spread trading between the securities of the different countries in Europe, and trading in the equity markets of the respective countries. So there will be a decrease on the one side and an increase on the other. If you're flexible, there will be plenty of opportunities in derivatives for both end-users and dealers, even with all the changes taking place.

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