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The End of the Derivatives Industry

Declining profits, maturing product lines, bank consolidations…Is the derivatives business as we know it doomed?

By Ramy Goldstein

Having been at the heart of the derivatives industry during the last 16 years, I have been invited to make a few remarks on the overall direction of our industry. I believe we are witnessing the end of the derivatives industry as we know it today. This demise will happen over the next two to three years, and will have far-reaching effects on where and how derivative professionals work, what issues they work on and how they are compensated.

For a while now, we have had a strong three-way segmentation of the overall derivatives market: the exchange products; the standardized, commoditized over-the-counter products (such as the interest rate swaps); and the structured derivatives segment. Although this three-way segmentation has been stable for a number of years, I believe all three segments will eventually be integrated into different parts of the overall financial services industry, and this process will eliminate the explicit derivatives industry as we know it today.

In two to three years, I believe, there will be no derivatives departments at financial firms. Recently, Bankers Trust, the recognized derivatives leader in the late 1980s and early 1990s, has changed its accounting procedures so that it no longer recognizes derivatives as a product in its revenue or cost accounting. In fact, most institutions no longer report derivatives results on a standalone basis.

I note also that there are no derivatives departments at our clients’ organizations. Historically, corporate finance departments covered chief financial officers and product people covered asset allocators and chief investment officers. Derivatives groups, often with their own effective marketing arms, tended to upset this model. I believe this older organizational form will reassert itself, and will determine the future shape of derivatives markets in ways that will make market size forecasts virtually impossible.

Although all three market segments are labeled “derivatives” and have some common historical and intellectual roots, I believe these have little in common and are governed by almost completely separate dynamics. At this point, the exchange sector is in stable equilibrium, from the perspectives of both product development and industrial organization. In Europe, monetary integration has raised a number of important issues involving contract specification, such as what equity index will prevail and how country equity indices will shift to sector indices. There are also issues of efficiency, such as how many exchanges there will be, where they will be and how they will be organized. Monetary integration will also lead to the demise of intra-European foreign exchange and interest rate contracts.

Capital market and corporate finance groups will not in general be able to justify employment of high-end derivatives professionals, or the commissioning of high-end quantitative research and development.

Beyond this, however, there are no fundamental questions as to what the product is and how it should be organized and utilized. Exchange products for some time have been a standard item on sales menus offered by financial institutions, and are no longer regarded as a specialist area or an industry. Attempts by exchanges to attract OTC business either on the front-office or back-office sides have met with partial or no success. The flexible Standard & Poor’s contracts in Chicago have seen some acceptance, but efforts by exchanges to offer common clearing for OTC products have never taken off. The business issue in this segment, for the most part, is determining who will achieve low unit production costs, which is essentially a question of transaction volumes.

In the standardized OTC segment, despite the fact that the product is legally and commercially more complicated than exchange products, much of the same comments can be made. The acceptance of ISDA documentation has done much to reduce documentation and legal uncertainty. The development of numerical models for estimating counterparty exposure has done much to demystify that risk to credit committees, corporate managements and regulators. It has also facilitated the development of credit exposure mitigants.

In this market segment we see a stable product set, and equilibrium that is most clearly illustrated by razor-thin profit margins. Interest rate swaps are often traded for a profit margin of less than 1 basis point. It is safe to say, especially on the interest rate side, that OTC standardized products have effectively become an integral part of the general activity of both sell-side and buy-side firms. The demise of derivatives as a distinct industry segment is clearly visible.

I turn now to the last segment of our industry, the structured products area, which is in a sense where the true spirit of the derivatives industry lives. I don’t want to spend time attempting to define this segment, other than to say that it involves nonstandard transactions that are not traded on exchanges. The variety of included items is therefore large. This is where new products are created, where leading-edge work tends to get done, and where many of the challenges and problems of the present and the future reside. I’m including here much of the current efforts in credit derivatives, insurance derivatives and structured equity products as well as emerging hedge fund-based investment products.

This structured products segment faces several important problems, which I’ll illustrate with examples from the equity side of the business. There has been persistent institutional demand, especially in Europe, for structured equity derivatives. This product invariably gives customers long positions in long-dated volatility. It turns out, however, that there are few natural sellers of long-dated equity volatility. This has resulted in a situation in which large investment banks are generally full on risk limits of short positions in long-dated volatility. This has in some locations brought market activity to a virtual halt. It has also resulted in an expansion of the spreads between actual long-dated volatilities and implied long-dated volatilities to unprecedented levels.

All this gives rise to a number of implications that lead me to conjecture the demise of this segment as a distinct standalone activity. First, the lack of natural volatility sellers vs. persistent institutional demand means a true two-way market in long-dated volatility products has not developed and is unlikely to develop. Second, the last three years have witnessed a secular decline in the levels of profitability of equity OTC products. This is not always apparent because the rise in implied volatilities (that is, higher product prices) masks the declining profitability of long-dated trades to dealers. Third, the buildup of short volatility positions on banks’ balance sheets, coupled with the realization by bank managements that such positions will periodically produce shocks to bank income, has resulted in a contraction of such activities in some institutions and in a slower pace of entrants into this segment.

On top of all these other problems, structured products are poorly understood. Professionals who sell them and those on the buy side who use the products usually know enough of what they need to know. But beyond that set of professionals, the knowledge curve drops precipitously. Many institutions have been unable to acquire the right knowledge base (the right personnel, management process and information systems) necessary to operate these activities. To make matters worse, understaffed or under-resourced regulatory organizations are attempting to understand and regulate what is a fast-moving, almost ever-changing, market segment.

Large investment banks are generally full on risk limits of short positions in long-dated volatility. This has in some locations brought market activity to a virtual halt.

All these features—coupled with a financial press that has virtually no understanding of structured transactions and which often equates derivatives with evil, black magic or both—virtually ensures that no bank management will want to be seen as championing structured derivatives in a highly visible manner.

Despite all of this, however, the usefulness and efficiency of these products have made them a permanent and irreversible feature of capital markets. As long as users of capital markets, issuers and asset managers find structured derivatives effective in facilitating their objectives, the financial industry will find ways of organizing the delivery of such products.

What is a likely scenario for the industrial organization of supply? It is generally easier to see things that are not to be than to see things that will be. First, derivatives expertise will move from standalone derivative departments that attempt to sell products to other departments that use derivatives as building blocks in the provision of other financial services and products, usually not characterized as “derivatives” but which will have derivative content. Capital markets desks, which are responsible for new paper issuance, will need to house significantly higher concentrations of derivative resources. Corporate finance departments, traditionally homes of relationship banking, will also need to make derivatives experts integral parts of corporate finance transaction teams.

In the better quality groups, we have already seen the shift from product selling to problem solving. While beneficial to clients, this has tended to cause internal conflicts between derivatives and other groups around compensation time. These problems will eventually wither away as derivative departments disappear.

I believe all this will lead to a positive change, which I believe will have many repercussions. Change is not always comfortable for the people impacted by it. Let me focus on one or two aspects of the process.

The derivatives-enhanced capital market and corporate finance groups will not in general be able to justify employment of the high-end derivatives professionals, or the commissioning of high-end quantitative research and development. This is likely to result in downward pressure on compensation levels for higher-quality derivatives professionals. It is also likely to produce a tendency for this talent to set up specialized firms, which will, in turn, allow large institutions to outsource highly specialized derivative services and allow buy-side institutions to do the same. This will tend to close the information and knowledge gap between buy-side and sell-side firms and will put more pressure on the profit margins of derivatives dealing operations.

This economic process will be fueled by the ongoing consolidation in the banking and investment-banking sectors. As banks get larger and larger, managements of these institutions are going to be interested in the massive cost reductions that are available from such consolidations. On the revenue side, mass-market products whose production can be industrialized will dominate management attention. Complex one-off derivatives transactions—brought by talented derivative professionals who come with highly developed egos and bonus expectations—are not going to be the centerpieces of the new large banks.

There are a number of important topics that I have not yet dealt with. Let me mention the two most important omissions: What this scenario means for the internal organization of risk books (Where, for example, should equity interest rate correlation risks be booked?), and what all this means for the control and the middle-office infrastructure that is necessary for a safe operation of these activities.

My comments thus far have treated the OTC derivative business as a single business activity, which of course it is not. In some respects, it is a microcosm of an investment bank: it has an origination element, a risk management element and several distinct support elements. In reality, these functions overlap and intertwine. My remarks about the end of derivatives apply mainly to the origination function.

Derivatives expertise will move from standalone derivative departments that attempt to sell products to other departments that use derivatives as building blocks in the provision of other financial services and products.

But what happens to the risk and support functions in this scenario?

The rational structure for the support elements is easy to see. The support organization will become a centralized structure, provided by the institution itself. Corporate managers will realize that these services—much like securities settlement, for example—are the responsibility of the organization as a whole and not of the derivatives group. These elements include the so-called middle office (product control, financial control and operational accounting), information technology (for risk, middle office and origination), quantitative analysis and development, as well as legal support. All these support functions will be highly centralized for reasons of commercial, operational and corporate control. Centralization will capture economies of scale and scope. It is the easiest way to enforce consistency of treatment in valuation, accounting, credit and legal issues across large institutions. It will also force senior managers to focus on the provision of appropriate infrastructure for the operation of these activities, which all too often do not sit well on the standard corporate platform.

The organization of the risk function is less obvious. This is because risk management performs a function that can be thought of as both support and origination, at least as far structuring and pricing are concerned. Thought of as support, risk is best organized centrally for the same reasons as the other support functions. This tends to simplify controls and improve transparency. It is not, however, conducive to maximizing origination. The best results in the OTC business have often been achieved when there is close integration between risk management and origination, a result often created by the important interaction between the two.

A more detailed and more insightful description of what organizational form will emerge deserves a separate forum, and will depend heavily for any particular institution on the type of transactions the institution is targeting as well as that institution’s own overall structure. In terms of crystal ball gazing, there may not be a general best configuration to emerge, but rather a set of issues to consider in the case of each investment bank, and perhaps this is the true reason why this topic does not belong in the crystal ball session.

The view I have expounded is a natural evolution of the trends we have lived through since the early 1980s. It means a fairly radical change in where opportunities lie for derivatives professionals and derivatives businesses and how these opportunities can be captured.

Ramy Goldstein has held senior roles in the derivatives industry at major institutions including UBS and CS First Boston in New York Tokyo and London. He has worked in a number of different areas, including origination, risk management, quantitative analysis and technology. Goldstein holds a Ph.D. degree in economics from Yale and a BA from Cambridge University.

A version of these remarks was presented at the Global Derivatives ’98 conference in Paris on April 28–29, 1998, organized by ICBI.

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