gs Rankin 2010 A twist in the tail It has been a topsy-turvy year for Italian assets – shunned by international investors, still popular at home – and other aspects of the derivatives markets are also being shaken up. Pricing practices are changing, with credit and funding costs coming to the fore, and central clearing is on its way. By Ned Molloy, with research by Ana Mendes

liberal helpings of hardship and anxiety, the eurozone debt crisis has also Along with produced moments of dark irony. It was investor aversion to peripheral government bonds that drove up funding costs for the holding them – now, in an attempt to deal with the resulting margin compression, Italian banks are turning to the very assets that caused their problems in the first place, dealers say. That means buying higher- yielding Italian sovereign bonds – which have a low risk weighting and therefore consume less capital – or, in some cases, selling protection on them. “To boost their net interest margin in this low rate environment – while minimising capital absorption and risk weighting – Italian banks have been buying Italian government bonds and credit risk. Banks are familiar with this risk and are confident of its creditworthiness,” says Matteo Ferrario, head of distribution for Italy and Greece with Capital in London. Yields on Italian 10-year bonds have come down from a high of 4.3% on June 7 to 3.8% on November 5 – but that’s still far higher than the 2.4% that could be earned on German bonds on the same date. Of course, chasing yield isn’t usually a smart strategy, but Vincenzo Corsello, head of the institutional client group Italy with Deutsche in London, says domestic investors generally feel Italian assets are viewed too negatively by the wider market. “It’s important to highlight that the Italian sovereign risk is perceived as lower by local investors than by the international community. This is due to a better knowledge of very peculiar drivers of Italian gross domestic product, such as the private sector saving rate, NOT FORthe currentREPRODUCTION account situation and the amount of the total output represented by the black economy,” he says.

Exposure relative to capital As of August 2010, according to an Organisation for Economic Co-operation and Development report, Italian banks had a total of €144.9 billion in exposure to their domestic sovereign debt – equal to 157% of the sector’s tier one capital. Of the peripheral banking sectors, only Greek banks have a higher exposure relative to capital – 226% - while Spanish and Portuguese banks have 113% and 69%, respectively. Italian banks haven’t been alone in this: dealers say they’ve also seen strong demand from insurers and pension funds, which are also convinced the relatively high yields on domestic assets are an opportunity rather than a threat: “All these types of clients that

1 Risk Italia Winter 2010 “More than anything we have observed a compression in actual bid/offer spreads, especially in vanilla products, rather than competition on credit charges” Francesco Lavatelli, JP Morgan

Fiercer competition Dealers say that investors’ somewhat bolstered risk appetite has encouraged fiercer competition for client business – and there’s some disagreement about the tactics being used to win business. As a rule, wider post-crisis credit spreads and a keener awareness of counterparty risk has encouraged dealers to include a bigger credit charge in their derivatives prices up-front – in many cases, it is seen as a way of paying for the position to be risk-managed when it’s on the books and is calculated, in part, by referring to credit default swap spreads. Every bank approaches it slightly were searching for yield considered Italian government bond risk differently, however – by taking into account offsetting trades in a fair bet, considering the return that was offered. They did not other books, or even anticipating future offsets, for example. As a believe in any extreme loss scenario,” says Roberto Pecora, head result, dealers often complain that some competitors are turning a of sales in the cross-asset solutions group with Société Générale blind eye to credit when pricing new trades. in Milan. “There are some international players out there, including The bond-buying trend has had knock-on effects for other Italian banks, that seem to be taking some heat, from what we asset classes, he says: “The main question that institutional can see, in terms of credit charges, but they would rather take it clients asked themselves during 2010 was: ‘why should I invest in and try to buy market share, and just lend to the market. But equity and endure the very high volatility of that market, when I among the most established players, I can tell you that credit can earn 150-200 basis points above the risk-free rate by charges are reasonably priced in the same way, among different investing in Italian government bonds?’ In terms of new players,” says Cristiano Committeri, head of flow at BNP Paribas investment, both institutional and retail clients showed risk in London. aversion to increasing their equity linked portfolio, preferring Others echo the latter point: “Perhaps in 2009, some banks fixed income investments.” may have had a competitive advantage on that front but, as time Institutional investors’ search for high yield hasn’t been goes by, most of the international banks are looking at risk and confined to domestic opportunities, however. According to counterparty credit risk in pretty much the same way,” says Gianluca Cugno, head of capital markets at Banca IMI in Francesco Lavatelli, co-head of financial institutions derivatives Milan, “Since the beginning of this year there has been a huge marketing with JP Morgan in London. “More than anything, we amount of money invested in high-yield instruments. In the first have observed a compression in actual bid/offer spreads, place, high-yield emerging market bonds and loans, and then, especially in vanilla products, rather than competition on with a relatively lower appetite, the European sovereign bonds, credit charges.” including Italian bonds.” In an attempt to mitigate these charges, some clients have Despite the wildNOT ride that Italian assets FOR have been on, there REPRODUCTIONbeen happy to sign the credit support annex (CSA) to standard has been little change in this year’s rankings – the top four derivatives documentation, which enables both sides in a positions remain the same. JP Morgan retains top spot with 13% bilateral trade to post collateral to each other – and these of the vote, after winning three of the overall categories; BNP agreements also have a significant impact on dealers’ funding Paribas is a narrow second with 12.8% and two top spots in the requirements. overall categories. Barclays Capital and Société Générale finished If a trade is conducted using a two-way CSA, and the mark-to- third and fourth, respectively. The only new entrant in this year’s market value shifts against the dealer, it will need to rustle up top five is Italy’s Banca IMI, which jumped from seventh place collateral to post – but if the dealer has hedged by putting on a last year. second, offsetting, trade it should be receiving collateral from its

risk.net 2 gs Rankin 2010 hedge counterparty at the same time as it coughs up collateral in the original transaction. The net result is a trade with low Overall top 10 banks counterparty risk, low capital requirements and little, if any, 2010 2009 Bank % additional funding required. But these dynamics break down 1 1 JP Morgan 13.0 where there is no CSA or in cases where the CSA requires only the dealer to post collateral – in which case the counterparty 2 2 BNP Paribas BNL 12.8 could be hit with both credit and funding costs. 3 3 Barclays Capital 12.0 The result is that clients that haven’t used CSAs this year have either traded less or have had to pay more, says Barclays Capital’s 4 4 Société Générale 9.2 Ferrario: “We have been forced to price and charge funding costs in non-collateralised transactions because, in the event that the 5 7 Banca IMI 8.1 corporate or other client owed us money but didn’t post 6 5 7.5 collateral, we would have owed money on our hedges to the hedging counterparty, and would have had to post collateral, 7 6 6.8 creating a liquidity gap.” 8 8 5.7 In this environment, clients have been looking harder at how to weigh up pricing across their dealers, and have been looking 9 10 4.8 for ways to reduce the costs they face. This hasn’t necessarily helped dealers. “In a situation where credit and funding charges 10 9 Citi 4.5 have increased enormously, unsophisticated clients – rather than doing the right thing and signing a CSA to minimise those Services, a subsidiary of Banca Monte dei Paschi di Siena, became charges – have been able to cherry-pick which counterparty to the first firm globally to start full-scale client clearing. Barclays trade with, depending on whether the trade had positive or Capital is the primary clearing broker for MPS’s interest rate negative funding implications, and choosing banks that were swap transactions, which will be cleared through LCH.Clearnet. more or less sophisticated with regards to their approach to “We put a lot of effort and months of work into that,” funding and credit charges,” says Ferrario. comments Barclays Capital’s Ferrario. “The agreement includes the backloading of a significant portion of MPS’s historical New pricing practices interest rate swap transactions, which is a first for client clearing. New pricing practices are not an issue specific to Italy – but the The good relationship and dialogue that we have with MPS wave of municipal derivatives mis-selling complaints that has Capital Services allowed us to get that first clearing agreement.” been sweeping the country is a more local phenomenon. Towns It remains to be seen whether this will inspire other clients to and cities from Milan down are up in arms about the payoff follow suit – in the near term, at least. “It’s not about whether profiles on trades, which – in many cases – have been restructured people are receptive or not - if you meet their CEOs and CFO’s multiple times already. Inevitably, the bad publicity has spilled face to face of course they are – but then to actually get it done is over, creating broader scepticism about complex products. a totally different matter,” says Ferrario. n “There are other client segments that have stepped away from all the non-liquid or complex business, namely public pension funds, which have dramatically reduced their activity in everything that was structured and complex,” says BNP Paribas’ Committeri. Separately, as a member of the Group of 20 nations, Italy is committed to centrally clearing all over-the-counter derivatives by the end of 2012. Big dealers already clear a large portion of their interbank activity in the rates and credit space, but many buy-side firms will also be required to use clearers – and will have to access this service through their dealers. Progress on this front has been sluggish, but in September this year MPS Capital NOT FOR REPRODUCTION

“Its not about whether people are receptive or not, if you meet their CEOs and CFO’s face to face of course they are, but then to actually get it done is a totally different matter” Matteo Ferrario, Barclays Capital

3 Risk Italia Winter 2010 RISK MANAGEMENT ADVISORY 30 banks cited 2010 2009 Bank % 1 1 BNP Paribas BNL 13.2 2 2 JP Morgan 12.9 3 3 Banca IMI 11.2 4 5 Barclays Capital 10.4 5 4 Société Générale 10.3 6 7 Deutsche Bank 9.3 7 6 Goldman Sachs 8.7 8 10 Mediobanca 6.2 9 8 UniCredit 6.1 10 – 4.2

OVERALL

INTEREST RATE DERIVATIVES CREDIT DERIVATIVES

2010 2009 Bank % 2010 2009 Bank % 1 1 JP Morgan 12.9 1 1 JP Morgan 16.4 2 3 Barclays Capital 12.3 2 5 Barclays Capital 14.2 3 2 BNP Paribas BNL 11.6 3 4 BNP Paribas BNL 11.9 4 7 Société Générale 9.9 4 3 Deutsche Bank 10.8 5 6 Banca IMI 8.8 5 2 Goldman Sachs 10.3 6 5 Goldman Sachs 8.7 6 7 7.6 7 4 Deutsche Bank 7.8 7 9 Société Générale 6.5 8 8 UniCredit 6.4 8 – Morgan Stanley 6.2 9 – Morgan Stanley 6.3 9 8 UniCredit 5.1 10 9 Citi 6.1 10 6 Citi 4.8

CURRENCY DERIVATIVES STRUCTURED PRODUCTS 2010 2009 Bank % 2010 2009 Bank % 1 1 JP Morgan 13.2 1 1 BNP Paribas BNL 13.5 2 3 Barclays Capital 13.1 2 2 Société Générale 13.1 3 2 BNP Paribas BNL 12.4 3 4 Barclays Capital 10.9 4 7 Deutsche Bank 9.2 4 3 JP Morgan 10.2 5 4 Goldman Sachs 9.1 5 5 Deutsche Bank 10.0 6 9 Société Générale 8.4 6 6 Citi 8.8 7 8 Banca IMI 7.9 7 9 7.3 8 5 UBS 7.5 8 8 UniCredit 7.2 9 6 Citi 7.3 9 7 Banca IMI 6.0 10 – HSBC 5.1 10 10 Credit Suisse 5.5

EQUITY DERIVATIVES

2010 2009 Bank % 1 1 Société Générale 13.1 2 2 BNP Paribas BNL 12.8 3 4 JP Morgan 10.5 4 3 UniCredit 9.3 5 – NOTBanca IMI FOR9.2 REPRODUCTION 6 7 Mediobanca 7.9 7 8 Deutsche Bank 7.8 8 6 Banca Akros 7.1 9 10 Credit Suisse 6.2 10 – Goldman Sachs 5.3

risk.net 4 gs Rankin 2010

INTEREST RATE DERIVATIVES SWAPS EXOTIC INTEREST RATE OPTIONS Euro overnight 26 banks cited Euro 27 banks cited 2010 2009 Bank % 2010 2009 Bank % 1 1 BNP Paribas BNL 14.3 1 1 Barclays Capital 15.9 2 2 JP Morgan 13.7 2 2 JP Morgan 14.6 3 3 Barclays Capital 12.1 3 3 BNP Paribas BNL 14.4 4 5= Société Générale 11.1 4 4 Société Générale 12.5 5 5= Banca IMI 9.3 5 5 Banca IMI 9.9

Euro, less than 2 years 26 banks cited US dollar 21 banks cited 2010 2009 Bank % 2010 2009 Bank % 1 4 Barclays Capital 14..0 1 1 JP Morgan 16.8 2 1= JP Morgan 13.8 2 3 Barclays Capital 14.6 3 3 BNP Paribas BNL 13.6 3 2 BNP Paribas BNL 12.5 4 1= Banca IMI 12.5 4 – Société Générale 10.9 5 – Société Générale 8.9 5 5 Goldman Sachs 9.4

Euro, 2 years plus 23 banks cited Swaption 25 banks cited 2010 2009 Bank % 2010 2009 Bank % 1 1 Barclays Capital 14.2 1 1 JP Morgan 15.1 2 2 JP Morgan 13.5 2 2 Barclays Capital 14.6 3 3 BNP Paribas BNL 12.9 3 3 BNP Paribas BNL 13.3 4 4 Banca IMI 10.9 4 4 Goldman Sachs 12.0 5 – Société Générale 9.1 5 5 Deutsche Bank 11.5

US dollar overnight 20 banks cited FORWARD RATE AGREEMENTS 2010 2009 Bank % Euro 21 banks cited 1 1 JP Morgan 16.1 2010 2009 Bank % 2 3 Barclays Capital 14.7 1 1 BNP Paribas BNL 15.7 3 4 Société Générale 12.9 2 3 Barclays Capital 15.1 4 2 BNP Paribas BNL 12.5 3 2 JP Morgan 14.8 5 5 Banca IMI 11.7 4 4 Société Générale 13.7 5 5 Goldman Sachs 10.7 US dollar, less than 2 years 22 banks cited 2010 2009 Bank % US dollar 20 banks cited 1 2 JP Morgan 16.4 2010 2009 Bank % 2 1 Barclays Capital 14.0 1 1 JP Morgan 15.0 3 3 BNP Paribas BNL 12.8 2 3 Barclays Capital 13.6 4 5 Société Générale 10.7 3 2 BNP Paribas BNL 13.2 5 – Deutsche Bank 10.6 4 5 Deutsche Bank 11.6 5 4 Goldman Sachs 11.4 US dollar, 2 years plus 20 banks cited 2010 2009 Bank % REPURCHASE AGREEMENTS 1 1 JP Morgan 16.1 Euro 23 banks cited 2 3 Barclays Capital 15.2 2010 2009 Bank % 3 2 BNP Paribas BNL 14.6 1 1 Barclays Capital 16.9 4 4 Goldman Sachs 11.0 2 2 JP Morgan 14.3 NOT5 5 DeutscheFOR Bank REPRODUCTION10.5 3 4 BNP Paribas BNL 13.2 4 5 Société Générale 12.1 5 3 Banca IMI 12.0

US dollar 24 banks cited 2010 2009 Bank % 1 1 JP Morgan 15.3 2 2 Barclays Capital 14.9 3 5 Deutsche Bank 13.6 4 3 BNP Paribas BNL 12.7 5 4 Goldman Sachs 11.5

5 Risk Italia Winter 2010 CURRENCY DERIVATIVES FX OPTIONS EXOTIC CURRENCY PRODUCTS US dollar/Euro 29 banks cited Euro 22 banks cited 2010 2009 Bank % 2010 2009 Bank % 1 1 BNP Paribas BNL 15.6 1 2 Barclays Capital 14.1 2 2 Barclays Capital 14.9 2 1 JP Morgan 14.0 3 3 JP Morgan 13.9 3 3 BNP Paribas BNL 13.1 4 – Deutsche Bank 11.7 4 – Deutsche Bank 10.8 5 4 Goldman Sachs 10.0 5 – Société Générale 10.7

FX SWAPS US dollar/Euro 27 banks cited US dollar 20 banks cited 2010 2009 Bank % 2010 2009 Bank % 1 2 JP Morgan 15.4 1 1 JP Morgan 16.1 2 1 BNP Paribas BNL 15.1 2 3 Barclays Capital 15.4 3 4 Barclays Capital 13.5 3 4 BNP Paribas BNL 13.9 4 3 Goldman Sachs 11.9 4 – Deutsche Bank 12.3 5 5 Banca IMI 10.5 5 2 Goldman Sachs 11.7

EQUITY DERIVATIVES OTC EQUITY OPTIONS (VANILLA) EQUITY INDEX OPTIONS Italian 28 banks cited Italian 24 banks cited 2010 2009 Bank % 2010 2009 Bank % 1 1 Banca Akros 13.4 1 5 Banca IMI 14.9 2 3 BNP Paribas BNL 13.1 2 2 Société Générale 13.9 3 4= Société Générale 12.8 3 4 BNP Paribas BNL 13.2 4 2 UniCredit 11.8 4 3 Mediobanca 12.2 5 – Banca IMI 9.4 5 1 UniCredit 11.9

International 23 banks cited International 27 banks cited 2010 2009 Bank % 2010 2009 Bank % 1 1 Société Générale 15.2 1 1 Société Générale 17.2 2 2 BNP Paribas BNL 14.8 2 4 BNP Paribas BNL 15.0 3 3 JP Morgan 12.5 3 3 JP Morgan 12.4 4 – Banca IMI 11.6 4 – Deutsche Bank 12.0 5 4 UniCredit 10.4 5 5 Mediobanca 10.1

Exotic 26 banks cited WARRANTS 18 banks cited 2010 2009 Bank % 2010 2009 Bank % 1 1 Société Générale 14.9 1 2 Société Générale 15.7 2= 3 BNP Paribas BNL 14.3 2 3 BNP Paribas BNL 14.1 2= 2 JP Morgan 14.3 3 4 JP Morgan 13.2 4 – Deutsche Bank 13.5 4 1 UniCredit 10.3 5 – Mediobanca 9.6 5 – Mediobanca 10.2

CREDIT DERIVATIVES

SINGLE NAME DEFAULT SWAPS Italian NOT FOR21 banks cited REPRODUCTIONInternational 21 banks cited 2010 2009 Bank % 2010 2009 Bank % 1 1 JP Morgan 18.4 1 1 JP Morgan 19.3 2 3 Barclays Capital 17.9 2 – Barclays Capital 17.0 3 5 BNP Paribas BNL 13.9 3 4 BNP Paribas BNL 15.7 4 4 Deutsche Bank 12.9 4 3 Deutsche Bank 14.8 5 2 Goldman Sachs 12.8 5 5 Credit Suisse 11.7

risk.net 6 gs Rankin 2010 ADDITIONAL QUESTIONS

1. What factors influence your choice of derivatives dealer? 4. Has this number increased or decreased Price 4.64 over the past year?

Speed of transaction 4.26

Liquidity 4.05

Advice 3.68

3.40 Innovation 48,0% 52,0%

Collateral damage 2.89

1 2 3 4 5 Irrelevant Relevant Agli intervistati è stato chiesto di indicare questi fattori in ordine di preferenza. I punteggi ottenuti sono la media dei voti ricevuti.

2. What is the average notional size of your foreign exchange or interest 5. Do you use, or plan to use, the internet to rate derivatives trades? buy financial products?

€5m 37.9%

22,9% €15m 35.8%

€5m-10m 15.8% 77,1%

€10m-15m 10.5%

0% 5% 10% 15% 20% 25% 30% 35% 40%

3. How many derivatives dealing firms, on average, would you discuss or 6. Have you used credit derivatives products negotiate a trade with before agreeing a price with a dealer? to hedge your credit risk?

da 1 a 3 61,5%

da 4 a 6 30,5% 29%

da 7 a 9 4,7% 71%

più di 10 3,3%

0% 10% 20% 30% 40% 50% 60% 70% NOT FOR REPRODUCTION

How Risk Italia conducted the survey

Risk Italia derivatives survey was completed by 265 dealers, brokers, corporates and asset managers in Italy. Respondents were asked to vote for their top-three derivatives dealers in order of preference in derivatives categories in which they have traded over the course of the year. The survey covered 31 categories, divided into interest rates, currency, equity, credit, commodity and structured products. The votes were weighted, with three points awarded for first place, two points for second and one for third place. Only categories with a sufficient number of votes are included in the final poll. The survey included a series of overall product leader boards, calculated by aggregating the total number of weighted votes across individual categories.

7 Risk Italia Winter 2010