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DERIVATIVES STRATEGY RANKINGS
THE METHODOLOGY BEHIND THIS SURVEY

The 1998 Derivatives Strategy Rankings were designed to be the most thorough and objective reader poll possible of leading derivatives dealers. In formulating our survey, we analyzed all the existing capital markets surveys and conferred with dozens of market participants. To make sure it remained free of behind-the-scenes manipulation of participating firms, the study was managed and executed by Richard Welch and Associates, a leading New York-based market research firm that counts Grant Thorton, Forbes, U.S. News & World Report, and American Express among its clients.

To gather data for the ranking, Derivatives Strategy randomly distributed more than 3,000 questionnaires to derivatives specialists at major North American corporations, to institutional investors and to U.S.-based members of the international dealer community. Respondents were asked to identify the best providers of financial risk management instruments and services. Each ballot required a signature, firm name and phone number so that duplication was impossible. Any unidentified ballots were discarded.

The results, based on hundreds of votes by market participants, rank the best dealers in five key categories: Best Overall Dealer; Best Interdealer Broker; Best Credit Derivatives Dealer; Best Structured Products and Exotics Dealer; and Best Energy Derivatives Dealer. Voters were then asked to name the best dealers in service, pricing, structuring and innovation in a variety of regions and product areas. Each of these votes was then equally weighted and cumulatively tabulated to determine the best dealer for interest rates, currencies and equities in five major currencies, and for emerging markets.

Voters were asked to skip areas that did not apply. Where certain categories received significantly fewer votes compared with others, they were either eliminated or supplemented with additional research and phone interviews by the staff of Derivatives Strategy.

This survey was conducted in May, June and July, solely in the U.S. markets, and thus reflects the opinion and experience of U.S. institutional and corporate investors, and U.S.-based staff of derivatives dealers.

1998 DERIVATIVES STRATEGY RANKINGS
CHASE

BEST OVERALL DEALER

With two big mergers behind it and a restored credit rating, Chase is retrieving its past glory as a dominant force in the derivatives markets.

In May, Chase Manhattan regained the AA-minus rating from Standard & Poor's that it lost a decade earlier. Although it had retrieved its AA- rating from Moody's in 1996, it was a significant milestone for the bank because it marked the end of 10 years in the credit wilderness.

The upgrades have clearly helped Chase's derivatives efforts. So have its two mega-mergers, with Manufacturers Hanover in 1992 and with Chemical Bank in 1996. “When you combine three big institutions, you get substantial economies of scale in processing, technology and market presence,” says Don Wilson III, managing director and head of the global trading division at Chase. “Our people transact hundreds of billions of dollars in notional amount of currency and interest rate contracts daily. That gives us substantial real market information that can assist our customers and help in our own pricing and risk-taking activities.”

Wilson characterizes the bank's philosophy as “Thou shalt be a market-maker.” That means organizing to supply two-way prices in all the material currency and interest-rate markets in all market conditions. The bank's interest rate business, for example, is organized first by currency and then by instrument—swaps, forwards, futures, sovereigns and options. “Offering five product segments across a given yield curve puts us in a good position to provide tight prices and to extract relative value among instruments and between the yield curves,” he explains. “We're acting as one or two digits on Adam Smith's invisible hand.”

Another element in the philosophy is careful diversification via large geographical divisions and global groups. “We've tried hard to position our big rooms in East Asia to be equivalent in economic substance with London and New York,” he says. A fourth major division includes the bank's business in commodity derivatives, equity derivatives and currency options, which are grouped together because they share more attendant risks as a result of optionality, illiquidity or complexity. Each of the four divisions employs about 200 professionals apiece.

Wilson admits the structure is not static and that there's still plenty to do. He's particularly concerned about the new currencies in East Asia going through what he calls “interesting adolescence and maturity challenges.” Ditto constantly tightening spreads across more mature product segments. “There's no question that spreads are always a challenge,” he says philosophically. “But so are flat yield curves.”

1998 DERIVATIVES STRATEGY RANKINGS
PREBON YAMANE

BEST INTERDEALER BROKER

Life isn't easy these days for interdealer brokers. But Prebon Yamane is upbeat and expanding into new markets.

Prebon Yamane thinks of itself as the most cutting-edge of the interdealer brokers. While the firm is strongest in financial instruments such as medium-term swaps, forward rate agreements, structured options and credit derivatives, it is busy developing new emerging markets and energy businesses.

You don't have to look far to see why. Growth can be something of a challenge in the medium-term interest rate swaps market, where interdealer bid-offer spreads are sometimes as narrow as one-half basis point. Harry Fry, managing director of Prebon Yamane USA, notes that tightening spreads are somewhat offset by growing volume: The average trade has gone from $25 million–$50 million a few years ago to $100 million–$200 million today.

Tight spreads have made efficient execution even more important than before and have inspired Prebon to invest heavily in technology. “You can't quote and assist in a fast-moving market with eurodollars, U.S. Treasuries and the swaps market moving up and down unless you have robust systems,” says Fry.

The company has also been out in front of its competitors in a number of product initiatives. It is building a business brokering forward rate agreements, swaps and equity options in Latin America. It also now has more than 100 energy traders in its New Jersey headquarters and its new Houston office covering the physical markets as well as related derivatives. “One of our strengths is that we broker both physicals and derivatives in any active market,” explains Fry. “The physicals always lead the way.” That knowledge of the physical markets and their trading patterns are particularly valuable in new markets such as electricity, which have not yet developed mature price indices and reference points.

When Prebon seizes on a good idea, it's loath to give it up. In 1994, it attempted to develop a product that offered a prepackaged Treasury-eurodollar spread. Although the idea ran into several regulatory obstacles, other innovative proposals emerged this year when Prebon announced plans with the Chicago Board of Trade to launch Chicago Board Brokerage, an electronic trading system for cash Treasuries.

1998 DERIVATIVES STRATEGY RANKINGS
CHASE

BEST CREDIT DERIVATIVES DEALER

Volume in the credit derivatives market has tripled, and Chase's secured loan trust note has propelled it to the top.

When asked the reasons for Chase's success in the credit derivatives category, managing director Gregg Whittaker ticks off two reasons without an instant of hesitation. The first is the unwavering support of senior management during the group's startup phase. “In the first two years, we did not move the bottom line of this organization,” he admits wryly. “Even when no one had a big business in credit derivatives, Chase made the commitment to build one with the confidence that the business would be around when we got our platform up and running.”

The second, perhaps more important, factor is the support the group gets from the bank's business units in the underlying asset classes. “Most of the work in credit derivatives revolves around exposure to one of three asset classes—bank loans, high-yield bonds and emerging markets,” Whittaker explains. “We could have all the management commitment in the world and the cleverest structures, but if you can't execute in the underlying, you can't execute in the derivatives. That gave us a real foot up when it came to building the group.”

The past year has been a watershed for credit derivatives—a period, Whittaker estimates, in which volume tripled or even quadrupled. He has been particularly impressed by the depth and diversity of the market that extends beyond vanilla default and total-return swaps into options and a variety of structured products.

The structure that likely propelled Chase over its rivals was its secured loan trust note (CSLT), an instrument Whittaker characterizes as “a second-generation CLO/CBO-type product.” The first generation of collateralized loan (or bond) obligations typically chopped up a portfolio of non-investment-grade securities into three tranches with different credit ratings. The CSLT took the idea one step further, giving investors an equity-like return but with an investment-grade rating. The bank has sold about $10 billion worth of the structures and expects to do even more now that it has bigger supply pipelines in place.

Whittaker is similarly optimistic about end-user demand for credit derivatives. He argues that credit derivatives are moving beyond an eccentric little oddity to become a core product used to manage the balance sheets of financial institutions. “Two years ago, when you talked about credit derivatives, you'd get a blank stare,” he recalls. “Now most people have a grasp of the basics, and finding people who haven't heard of them is the exception. I don't think we've even begun to see the tip of the iceberg for this market.”

1998 DERIVATIVES STRATEGY RANKINGS
JP MORGAN

BEST STRUCTURED PRODUCTS AND EXOTICS DEALER

Sometimes the simplest ideas require the most complex risk management. Morgan makes it look easy.

JP Morgan says the goal of its business in structured products and complex options is to meet its clients needs while seamlessly managing the risks necessary to support the products. That's particularly important because the simplest-sounding structures, such as callable or puttable bonds, often involve the most back-room sweat and tears.

“The key to structured products is to know your client,” says Robert Rossman, head of Morgan's swaps marketing efforts in the Americas. He credits the bank's success to deep client relationships, tight integration of its marketing efforts and its trading desk, and a marketing style focused on transparency.

Philippe Khuong-huu, global head of options trading, cites two other important trends. “We've seen a consolidation in the industry, whereby we have fewer global players with increased market share,” he says. He believes that big investments in risk management are a significant barrier to entry and will continue to be so in the future. At the same time, however, he sees growing liquidity in the general derivatives market, making many things possible that were difficult or impossible a few years ago. “Five years ago, long-dated structures were many times more expensive than they are today, and multi-asset-class structures were hardly available,” he explains.

Khuong-huu is proudest of the newer fixed-income instruments Morgan has constructed to allow investors to get returns linked to equity, foreign exchange and credit risks. The goal: to diversify risk portfolios across different markets and yield profiles. He stresses, however, that the most interesting applications originate not from the trading desk, but rather directly from the needs of the clients themselves.

1998 DERIVATIVES STRATEGY RANKINGS
ENRON

BEST ENERGY DERIVATIVES DEALER

Enron's recipe for success: build strength in the cash markets and the derivatives expertise will follow naturally.

By anybody's reckoning, Enron Capital and Trade Resources occupies a dominant position in the energy markets. “People describe us as a hybrid,” explains president Kevin Hannon. “That's accurate, and we benefit greatly by that distinction.”

The firm is so big that many people fail to realize it is actually an amalgam of four different businesses. The first involves the physical delivery of commodities and associated services. The second, risk management, focuses on managing the risks inherent in trading energy commodities. A third area, finance, provides capital to customers in some combination of equity and debt. And a fourth area focuses on developing new energy assets.

“We wouldn't be as strong in the energy swaps and options markets if we weren't able to construct critical mass in the other three areas,” explains Hannon. “It gives us insights into the embedded financial risks that have to be managed in this business. And it allows us to create a broad-based book of risks so we can effectively manage and price a wide array of derivative products.” Earlier this year, for example, Enron purchased a long-term sales contract to deliver physical power to a Northwest utility, guaranteeing the firm physical delivery of power. To do that deal, Enron had to have the capability to construct a power plant that would service that contact, as well as finance the purchase of the contract and manage 17 years of price risk.

Hannon has been gearing his company to take advantage of a number of trends in the fast-changing energy business. He notes a major decline in liquidity in the long-term natural gas market since a number of investment and commercial banks pulled out of the market. “There's much more focus on front-month liquidity in options and swaps, and that's led to quite a bit of volatility,” he says. That has played to Enron's advantage because of the company's ability to do longer-term transactions. In the power markets as well, Hannon is seeing significant retrenchment in the number of players that entered last year, as well as a temporary decline in liquidity, which, he predicts, will begin to turn up toward the beginning of 1999.

Although he says the power sector has received a lot of press in recent weeks, he's busy positioning the company to attack the energy markets from multiple angles by moving into new areas such as coal, emissions credits, weather derivatives, and pulp and paper derivatives.

1998 DERIVATIVES STRATEGY RANKINGS
INTEREST RATE

BEST OVERALL RUNNER-UP
Chase Manhattan JP Morgan
Barclays Capital NatWest Markets
CIBC Wood Gundy Royal Bank of Canada
Societe Generale Banque Paribas
Deutsche Bank Dresdner Kleinwort Benson
Citibank JP Morgan

A flat yield curve in the United States and nervous anticipation of the euro dominated interest rate derivatives markets this year.

The past year has been bumpy for big dealers in interest rate derivatives. In the United States, Chase Manhattan reigned supreme according to our readers, after losing out to JP Morgan in 1997. But Chase's success was far from a walk in the park. The extraordinary flatness of the U.S. yield curve, a result of strong economic fundamentals and an accompanying dearth of cash Treasuries, has made the interest rate market unprecedentedly tight, even as emerging market troubles attract investment into the short end of the yield curve.

In Canada, the story is a familiar one—too many players chasing too few deals. CIBC Wood Gundy, far and away the top dealer in 1997, continued to dominate in 1998. But the Canadian derivatives market, like the rest of its banking system, continues to be too small to attract big-time liquidity. Mergers currently on the drawing board could reduce the list of Canadian schedule A banks from five to three by year's end, a symbol of the Canadian banking crunch. And the Euro-Canadian bond market, wracked by a weak Canadian dollar and minuscule Canadian yields, has virtually dried up.

In Europe, nervous anticipation of the impending euro has ruled the market in 1998. In the United Kingdom, Barclays Capital continued to lead the pack, as euro anxiety, the strongest economic fundamentals in Europe, and the alarmingly swift demise of the London International Financial Futures and Options Exchange proved a boon for U.K. swaps. In France and Germany, Societe Generale and Deutsche Bank, respectively, continued to dominate their home markets, as the inevitability of the euro translated into a convergence in yields between the two countries.

Interest rate products in emerging markets, predictably, have struggled this year. Citibank has done better than the rest, according to our readers, but the road has been rough for all. Consider the example of Toyota Motor Credit Corp., an extremely solid U.S.-based subsidiary that hasn't suffered the least bit from the troubles in Asia. Even though it derives its receipts from U.S. auto sales and leases, its borrowing costs have jumped 10 basis points Libor because of its Japanese parentage. Asia has been, and will likely continue to be, a four-letter word in the capital markets.

1998 DERIVATIVES STRATEGY RANKINGS
CURRENCY

BEST OVERALL RUNNER-UP
NatWest Markets Barclays Capital
Royal Bank of Canada CIBC Wood Gundy
Societe Generale Banque Paribas
Deutsche Bank Citibank
Citibank BancAmerica Robertson

Canadian bank interventions, euro jitters and wide fluctuations in Asian currencies made this a tough year for currency dealers.

The Royal Bank of Canada, the winner in the Canadian currency category, received this year's top award for helping its clients deal a currency hitting the bottom of its historical range. In the past year, the currency has dropped below 66 cents on the U.S. dollar. The biggest factor contributing to the collapse has been the collapse in commodity prices resulting from the Asian crisis since Canada is a significant producer of commodity-based goods.

Societe Generale, the winner for the French franc, and Deutsche Bank, for the Deutsche mark, have earned high marks for guiding their clients through the uncertainty in the run-up to European economic and monetary union. Earlier in the year, many doubted the union would be launched on time and questioned the veracity of the budget numbers being produced by the individual countries in the accord. Although both sets of doubts hurt the component currencies earlier in the year, most of the damage has since been undone. The Deutsche mark has traded below the 1.80 level against the dollar in recent weeks, and signs of more economic growth in Germany and France are helping those currencies recover. NatWest Markets, the winner in the British pound category, won by helping clients understand the complicated relationship between the pound and the EMU currencies across the channel.

Citibank, the winner in emerging market currencies, came out on top for advising clients about how to weather the currency storms of the Asian crisis. A good part of the crisis can be blamed on mistaken confidence within Asia that various currency pegs to the dollar were immutable. When that was disproved, everybody rushed for the exits at the same time. Some of the currencies, however, have recovered somewhat from their lows. The Korea won, which stood at 800 at the start of 1997, reached almost 1,800, but has since come back to below 1,300. Thailand's baht, meanwhile, which stood at 26 before crisis, hit 53 and is now around 41.

1998 DERIVATIVES STRATEGY RANKINGS
EQUITY

BEST OVERALL RUNNER-UP
Goldman Sachs Morgan Stanley Dean Witter
Deutsche Bank NatWest Markets
Royal Bank of Canada CIBC Wood Gundy
Societe Generale Banque Paribas
Deutsche Bank Dresdner Kleinwort Benson
Citibank Goldman Sachs

The hedge fund boom boosted business in the United States, but the mood is more conservative in the wake of the Asian flu.

It is hardly surprising that Goldman Sachs won in the U.S. equity category. Readers praised the firm for developing its web-based analytics and for a number of influential research reports. This year, Goldman and other equity derivatives firms all enjoyed increased business resulting from the growing number of new hedge funds. That interest was across the board, including long or short trades in Asia, and in options on individual stocks in the technology sector. Many funds, moreover, were active in hedging their overall positions with puts on the Standard & Poor's 500.

The other winners, Royal Bank of Canada in the Canadian category, Societe Generale in France, and Deutsche Bank in Germany and the United Kingdom, all received praise for helping clients track the effects of European monetary union. In the past year, investors were busy adjusting their European benchmarks and rebalancing their portfolios to prepare for the seismic shifts that are bound to occur next year.

The other area of concern for equity investors worldwide was the continuing fallout from the Asian crisis. Citibank, the winner in the emerging markets category, scored high by helping its clients through this turbulent period. Asian jitters, of course, inspired the 554-point drop in the Dow Jones Industrial Average last October, and were soon felt in double-digit drops in European equity indices as well as in Hong Kong's Hang Seng Index. The shocks also inspired a number of equity derivatives losses at Union Bank of Switzerland, Salomon Brothers, Chase Manhattan and other major dealers. The volatility in the emerging markets, however, also inspired a number of players to buy and sell. This, in turn, led to significant growth in the swaps market as a vehicle for getting exposure to Asia, particularly in Malaysia.

In the coming year, dealers say they expect more conservatism among equity investors because of fears about slowing global economies and higher volatility. Although derivatives dealers say they continue to see a greater acceptance of international derivatives in managing country exposures, they admit to being concerned about the challenge of maintaining deep and liquid markets in sectors that are experiencing strong capital flows in both directions.

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