Over the Counter Derivatives Markets
Over the counter derivative markets are characterized by an infinite variety of maturities, contract specifications and exotic modifications while listed derivative markets deal only in plain vanilla options with rigidly defined contract specifications and a limited number of maturities. Understanding the OTC derivative markets implies an ability to quickly fathom the nuances of the listed markets. The reverse is not necessarily true.
Organization of Over the Counter Derivatives
Commercial banks and investment banks make up the foundation of the OTC derivatives market. Their derivatives desks make markets to customers, develop new products, trade with one another in order to lay off risks, and form the apparatus for much of the industry’s self-regulation. There are, of course, external regulators but the derivatives markets are so complex and their evolution is so lightning-quick that regulators often have a difficult time keeping pace.
These institutions engage in operations in up to five main asset classes:
The last asset class is the most interesting one. Historically, commercial and corporate banking has been the practice of assessing the creditworthiness of other entities to whom the institution lends money in one form or another. Credit derivatives enable the institution to lay off that exposure to the risk of default or downgrade in a client’s credit rating on other parties.
Organization of a bank’s dealing room operations can proceed along two lines: by asset class or by functional product delineation.
Organization by Asset Class
In this case, the bank sections its over the counter derivatives dealing room into five separate, vertically-integrated groups, determined by asset class. For the sake of argument, let’s consider the case of the foreign exchange group.
In the vertically-integrated foreign exchange group, the cash trader (i.e. the spot trader) will sit next to the derivatives traders. This improves the flow of information among dealers specializing in the same underlying market. The spot trader has an incentive to treat the options trader well, in order to get as much information about the indirect implications of options market flows for the spot market.
Organizing along asset class lines also means that marketing is integrated for cash and derivatives products as far as the customer is concerned.
There are two problems with this approach to organization:
First, difficulties arise when customers expect horizontally-integrated products. For example, the manager of a domestic money market fund might want to take advantage of his view on the Canadian dollar exchange rate against the US dollar. Technically, he cannot take explicit foreign exchange positions. However, he can buy a structured note that guarantees his principal while simultaneously allowing him to take advantage of his view if it is correct.
Second, dealing rooms organized by asset class need to consider certain management issues that can potentially come into play. Because of their highly technical and specialized nature, derivative products themselves might be considered a separate type of asset. If the bank chooses its asset class line managers from the ranks of the cash trader or generalist salesperson, it is unfair to the manager and it is an impediment to business.
As difficult as this tenet is to accept for many people, having non-derivatives specialists in charge of derivatives operations of any sort is like asking a bus driver to fly a commercial aircraft. The derivatives desks organized by asset class typically take much less risk, win fewer deals, manage their risk as effectively, or make as much money as derivatives desks led by well-trained, experienced leaders.
Organizing by Function
When organizing over the counter derivatives by function, cash traders and salespeople work together, dealing with clients who want cash products exclusively. They are also separated by asset class. Derivatives traders and salespeople handle the sophisticated accounts, across all five asset classes (while usually specializing in one or two of these asset classes).
What are the advantages of this type of organization?
Clients get seamless service across products. Instead of talking to five different contacts at a bank for their various needs, they talk to one person. Instead of having five different kinds of confirmation contract, they have one. It is easy for the bank to structure products that encompass more than one asset class. At the bank organized by function, the customer talks to one salesperson, gets one integrated price and receives one easy-to-read confirmation after dealing.
Hedging can be problematic. Because the bank has organized its over the counter derivatives dealing room along functional lines, the cash trader has no interest or desire to see the derivatives desk do well. He does not have to provide a competitive or even a market price for the internal transactions with the derivatives desk. This can make customer transactions uneconomic, putting the derivatives desk at risk of going out of business. The derivatives desk, for its part, can hide information about flows from the cash side, impeding their ability to trade and sell competitively.
Trading Versus Sales
One important distinction between over the counter derivatives dealing rooms is the business model that they employ, which is linked inextricably to their method of organization.
If the dealing room is organized by asset class, the source of their profits typically comes from proprietary trading. In most cases, cash markets for most instruments are commoditized depending on market conditions and other related factors. That is to say, the bid/offer spread that the bank can hope to earn from transacting business with a customer is very small. There are many participants in the cash market and it is very competitive. Winning in a commoditized market often means being very aggressive in terms of the bid/offer price an institution shows its counter-parties in an attempt to get the dominant amount of flow. More people asking for prices means more spread and a statistically greater likelihood of retaining that spread. Volume thus becomes the main way to make money.
In the case where the dealing room is organized by function, the engine of profitability is the customer transaction on the derivative products. The bid/offer spread for these instruments is directly proportional to the complexity of the product. Vanilla derivatives, like currency options, are more like commoditized cash markets, while highly structured products command hefty spreads (in part because of the difficulty in hedging them). How do you make your money? By executing a small number of lucrative deals that help the client make more money than they pay in spread.
Institutions organized by asset class are not the ones from whom we would expect the consistency of well planned market strategies. Those recommendations come from organizations that live and breathe by a relatively low number of deals.
Over the Counter Derivatives Overview
The organization of OTC derivatives has implications for the kinds of results that can be expected from a particular dealing room. Considerations must be made for the most efficient organization model in relation to the type of asset being dealt with, the kind of communication necessary to adequately address client concerns, and the ultimate function of the dealing room.
– Article by Chand Sooran, Point Frederick Capital Management, LLC
Twitter: @csooran
