The global credit crunch made its impact felt in interest rate derivative trading last year, as users of these instruments shifted trading business to reward providers of increasingly scarce credit and to protect themselves from risky counterparties.
Lending relationships are playing an increasingly important role in companies’ selection of dealers for interest rate derivatives trades, according to the results of Greenwich Associates’ annual Global Interest Rate Derivatives Research Study. As a result, universal or commercial banks tend to dominate the trading business. The top six dealers of interest rate derivatives worldwide are all commercial banks, and almost all gained market share from 2007 to 2008. The business picked up by these market leaders came in part at the expense of some investment banks, none of which count as corporate credit providers, and several of which failed or struggled last year. Also ceding market share were several prominent global banks that either were acquired or lost clients due to perceptions of growing counterparty risk.
The one outlier in this market is Goldman Sachs, which sharply increased its market share in interest rate derivatives trading from 2007 to 2008, while also receiving the market’s strongest scores for overall service quality and franchise strength. Barclays Capital ranks as the world’s largest interest rate derivatives dealer, with an overall market share of 8.1%, followed by Deutsche Bank at 7.3%. Among the leaders in market share, interest rate derivatives customers give J.P. Morgan the highest ratings for overall service quality and franchise strength, followed closely by Barclays Capital.
“With the market volatility that has persisted into 2009, there is no doubt that the competitive landscape will continue to shift — in some cases dramatically,” says Greenwich Associates consultant Peter D’Amario.
Companies Rewarding Lenders
Approximately 42% of global interest rate derivatives trading volume in 2008 was allocated to individual dealers on the basis of lending relationships — a share that was up from the 35% of trading volumes allocated to lenders in 2007. With that increase, lending relationships became more important than high-quality derivatives service as drivers of corporate trading business.
While the average number of dealers employed by interest rate derivatives users fell slightly over the past 12 months, there are signs that credit needs are motivating companies to seek out relationships with new banks. Forty-four percent of the companies participating in a January 2009 survey said they plan to increase the number of core credit relationships they maintain over the next 12 months, and an equal share said they were looking to build relationships with new secondary credit providers.
“Of course, companies with the opportunity to secure new lending relationships in this environment should do so,” says Greenwich Associates consultant Frank Feenstra. “But at a time when banks are rolling back credit extended to existing clients, many companies will not be able to find new banks willing to lend. In many cases, it might make sense for companies to adopt what in essence amounts to the opposite strategy: Consolidate business such as interest rate derivatives trading, foreign exchange, capital markets and cash/treasury management with a small group of existing lenders in order to make your company as valuable a client as possible.”
Counterparty Risk Alters Trade Flows
Nearly a quarter of users of interest rate derivative users around the world say they have reduced the amount of business they do with a specific dealer over the past 12 months due to concerns about credit counterparty risk. Almost 30% of interest rate derivatives users in the United Kingdom say they cut back on the business they do with at least one dealer because of fears of counterparty risk, as have more than a third of users in the United States. In fact, dealer creditworthiness now ranks ahead of factors like quality of dealer sales coverage, promptness of quoting and relationships with senior management when it comes to the important criteria used by interest rate derivative trading customers in selecting a dealer.
Naturally, when asked to rank the most important criteria they assess in choosing a dealer for a trade, interest rate derivatives users place competitive pricing at the top of the list by a wide margin — far outpacing even the mounting concerns about creditworthiness. Spreads have widened significantly over the past 12 months, thanks in part to the dramatic shift in credit conditions. “Dealers are adding credit charges to their quotes, sometimes explicitly and sometimes by simply baking these new costs into the overall price,” says Greenwich Associates consultant Woody Canaday.
For interest rate derivatives users, there could be a bright side to these wider spreads, at least from a long-term perspective. After some dealers essentially pulled back from the plain-vanilla interest rate derivatives business due to the narrow spreads and thinning margins of the credit boom, the flow business is again becoming attractive at the wider spreads. “Down the line, companies might well find that there are more banks competing for their business than there were before the market crisis,” says Greenwich Associates consultant Tim Sangston. “Perhaps over time this will begin to drive down prices, but for the foreseeable future, things will remain much more expensive than they were just a few months ago.”
