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The once-mighty Canadian dollar swaps market has fallen on hard times.


The Canadian financial market is among the most close-knit and incestuous in the world. Clustered together in the heart of downtown Toronto, the big five Canadian banks are all within waving distance of each other. Swaps dealers are known to their colleagues at rival banks, and in the past this has made for a typically Canadian, low-key trading environment. As the Canadian swaps market shrinks and mergers loom, however, those dealers must be wondering if they will be waving to empty desks in the near future.

Volume in the Canadian swaps market took off in the late 1980s, growing at more than 100 percent a year, and volume remained brisk into the first half of the decade. During that time, the Canadian dollar was one of the arbitrage vehicles of choice. Canadian yields were considerably higher than those in the United States, the currency was stable and strong, and international borrowers lined up to offer Canadian dollar bonds to retail investors while swapping the proceeds to the currency of their choice at enhanced costs. By 1990, the Canadian dollar was the seventh-most popular currency of issuance. More often than not, the Canadian dollar leg of these swaps—and often the whole position—was written by Canadian shops, even if they did not underwrite the offerings. At the end of 1992, more than $90 billion was outstanding in notional principal, giving it a 5.28 percent share of the global market.

The decline in the value of the Canadian dollar and the descent of Canadian rates to below U.S. rates changed this game entirely. The declines dried up the river of Canadian dollar-denominated debt and starved the Canadian swaps dealers of vital flow and the opportunity to offset receipt of fixed rate from their corporate clients at a profit. By the end of 1996, volume was disintegrating. The Canadian dollar contributed only 3.4 percent of total outstandings, and yet-to-be-released 1997 figures are likely to show additional declines.


These days, Canadian dealers describe a market of torpid inactivity and thin volumes. “Overall volumes have definitely declined,” comments Andy Dickison, managing director with ScotiaBank. “A fairly significant portion of the market was new-issue-related. This is one thing that has changed.” The death of the Canadian dollar swaps market “has been a major blow,” agrees veteran Toronto dealer Sydney Broer, group vice president and head of trading at ABN Amro, Canada.

Nowhere is this more evident than in the death of the Euro-Canadian bond market. Big issuers such as Ontario Hydro, which used to come into the market frequently, have turned to the domestic and medium-term note markets. When asked if he was seeing any likelihood of Euro-Canadian bond business in the near future, one swaps dealer quipped, “What's a Euro-Canadian bond?”

The place once held by Euro-Canadian dollar bonds in the international capital markets has been taken by bonds issued in Czech krona, Polish zloty and South African rand—markets that can offer the retail investor enhanced yields and relative currency stability. A thriving swaps market has developed around these currencies. Recognizing that the writing is on the wall, Toronto Dominion has developed a substantial franchise both as an underwriter and swapper in these currencies. But it is the only Canadian bank to do so.

At the same time, provincial governments are not the big users of derivatives that they once were. In the early 1990s, most provincial governments were running big deficits. Perhaps the worst offender was the province of Ontario, which for several years was obliged to fund deficits that were greater than C$10 billion. The province was an active borrower in Canadian dollars and other currencies, nearly always taking the proceeds back to fixed or floating Canadian dollars with the aid of a mix of currency swaps, interest rate swaps and spreadlocks. The province put a great deal of business on the desks of Canadian houses and was generally admired for its diligence and professionalism. But this is seen much less frequently these days. “Since the provinces started getting their deficits in order, they haven't been doing any jumbo issues. They do smaller C$30 million–40 million private placements, which are swapped by a whole range of shops,” says ABN Amro's Sydney Broer.

Given this range of factors, one may have expected Canadian dollar swap spreads to have pressed out, following U.S. dollar swap spreads. But medium-term spreads remain calm in a 24 basis points–28 basis points range, paralleling the government bond market.


One of the principal reasons for this has been swaps market business conducted by the Bank of Canada. The bank has been fighting a desperate rearguard action to defend the Canadian dollar. To shore up its foreign currency reserves (which stood at close to $20 billion at the end of June), it turned to the swaps market. It converted Canadian dollar liabilities to U.S. dollars by writing currency swaps, which entailed receiving fixed-rate Canadian dollars at the requisite maturity.

In June, the bank raised $300 million this way, but in December and January it received on $2.6 billion. This is a lot of money in any market, but in a market as notoriously thin and illiquid as Canadian dollar swaps, it caused spreads to tumble. This business, and the threat of more to come, has kept swap spreads artificially low and has stymied paying business. One swaps dealer estimated that spreads are at least 5 basis points tighter than they should be. “Do I think spreads are too low? Yes. Do I want to pay? No,” said another trader earlier this year. No one wants to risk it while there is a permanent offer from the best credit in the country.

On March 19, there was a rumor that the Bank of Canada had been in receiving on C$200 million at 10 years at 24.5 basis points. To many traders, this level looked too low for the Bank of Canada, but the mere mention of its name sent a frisson of alarm throughout the market and spreads backed off a basis point or so. Overall, the bank's conduct has elicited a great deal of annoyance among swaps dealers. It is thought to have conducted itself in a clumsy and ill-informed manner, and far from being an example of orderly market practice, it was quite disorderly. “The bank burned a lot of people,” says one senior banker. “There's no doubt that the bank hurt the market because it came in with such huge amounts in such a short period of time.”

Another banker spoke of the market risk to which the Bank of Canada's counterparties had been exposed: “I told them, ‘Do it, but don't tell anybody, because you will bury the people who are helping you sort out your problems, and those who aren't helping you will benefit.” The bank announces details of its currency swaps business in its monthly news releases. To one dealer, the reason why the bank decided to proceed the way it did and not hold a Dutch auction remains a mystery. The bank was reportedly inundated with calls from irate bankers in the early part of the year, which is one reason why it has been less active lately.

Some bankers even question the economic rationale of shoring up foreign exchange risk in this way. “You're taking on 10-year risk to protect spot rates in Canada. It doesn't sound so sensible to me,” says one person. Officials at the Bank of Canada in Ottawa declined to comment.


Although interbank volume has unquestionably shrunk, not all is gloom and despondency. Canadian banks offer an increasingly adventurous and sophisticated array of products to their clients, who have not been reluctant to take advantage of them. In years past, derivatives desks were able to rely on substantial flow to make the numbers, but lately they have had to be more creative. “It's not a matter of simple swaps these days,” says a chief dealer at one of five schedule A banks. “For example, you might have to structure a plain vanilla swap alongside a couple of foreign exchange options. It takes more time, but it's more rewarding,”

Sue Storey, managing director at Canadian Imperial Bank of Canada in Toronto, agrees. She says that the “sophistication gap” between the United States and Canada has now virtually disappeared. “We can offer the same products as those found south of the border, whether they are commodity-based, equity-based, total return-based and so on,” she adds.

Storey notes that end-users and provincial governments have aggressive hedging strategies, and, despite low rates and a flat yield curve, they remain active. Endorsing this point, a senior banker says, “There is less rate-related hedging, but with the vagaries of political risk and currency depreciation, clients are far from benign.”

Toronto banks are also called to put on more sophisticated trades for their hedge fund clients, of which there are an increasing number active in the Canadian market. At the same time, banks have become more like hedge funds themselves, says ScotiaBank's Dickison. Yield curve analysis is considerably more developed, and the interbank market now sees a variety of yield curve plays, such as “barbell” trades, that were unknown only a few years ago.

“There has been a decline in overall volume, with more structured trades, fewer but larger deals and greater efficiency,” says Anil Vohra, vice president of fixed-income derivatives at Union Bank of Switzerland. “There are not as many opportunities, but greater sophistication in taking advantage of them.”

The extreme flatness of the yield curve and historically low volatility have also made the cost of option products much more acceptable to a wider range of corporates than has been the case so far. Certainly more are getting their ankles wet in these products, but the fact remains that with rates so low, end-users are less likely to hedge than when rates are oscillating. Even sanguine Canadian bankers find this difficult to deny.

Indeed, given these foregoing factors, it is difficult to escape the conclusion that the Canadian swaps market can only support a smaller number of desks. Several offshore banks appear to have realized this. At the beginning of the decade, there were a number of offshore houses vying for business with Schedule A banks, but many have dropped out. Citibank, once a formidable presence in the market, has scaled back. Deutsche Bank cut its Toronto office from 250 employees to 150 in March, but a spokesman for the bank said that this was part of a three-year restructuring of the bank in general and should not be interpreted as a no-confidence vote in the Canadian business. Both Bank of America and JP Morgan are described by a dealer at a schedule A bank as “not very active these days.” ABN Amro and Merrill Lynch maintain active desks in Toronto, while Chase Manhattan is said to be one of the busiest New York-based players. UBS also has a Toronto desk, but of late—for obvious reasons—it has been seen rarely. UBS's Vohra attributes current inactivity to the merger with SBC. “In 1999, UBS will be even stronger than it was in 1997,” he hopes. Prospects for offshore banks may improve if the Bank Act is changed to allow banks to operate in Canada as branches of their parent bodies, say analysts.

The Royal Bank of Canada/Bank of Montreal and CIBC/Toronto Dominion mergers would give the market some much-needed slimming and rationalization. There is no guarantee that these mergers will go ahead, however. The minister of finance and other authorities have yet to give assent, and one senior banker said recently that he rated chances of a go-ahead only 50/50. A refusal would leave the original five schedule A banks fighting for whatever slim pickings the Canadian derivatives market can offer.

It seems likely that with or without mergers, the market will not continue at current staffing levels. Asked how the market will look in 12 months, Vohra has no hesitation. “It will be in fewer hands,” he predicts confidently.

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