Once the domain of the largest New York banks and Wall Street, the booming swaps and derivatives business is attracting new players.
"This is a rapidly growing market with a low level of risk, either operationally or economically," said Thomas F. Robards, executive vice president of Republic New York Corp.
Republic is a newcomer to the derivatives business this year, as are three North Carolina companies -- NationsBank Corp., First Union Corp., and Wachovia Corp.
A Competitive Necessity
Setting up shop in the derivatives business is viewed as a competitive necessity in corporate banking.
"The returns in lending and payment services aren't getting more attractive," said Samuel V. Tallman, senior vice president at Wachovia. "Derivatives rank near the top of those business lines that a commercial bank can go into working with its corporate customer base."
Republic has been the fastest out of the blocks.
The bank hired the 30-person staff of the Mercadian Group, a derivatives boutique affiliated with New England Mutual Life Insurance Co. In addition, Republic got the company's sophisticated computerized tradings systems, a big benefit in this high-tech business.
First Union started selling derivatives three months ago. The Charlotte-based bank recruited eight derivatives traders from New York banks, promising to pay at least what they were making up north. A mid-level swaps trader can earn nearly a million dollars annually.
NationsBank has agreed to buy Chicago Research & Trading Group Ltd., a 750-person options boutique, for $225 million. The deal is expected to completed next quarter.
NationsBank wants the firm to expand its products to include customized, or over-the-counter, derivatives.
Wachovia, the nation's 21st largest banking company and smallest derivatives player, has recruited two swaps traders from New York banks.
Traditionally, swaps and other derivatives has been a highly profitable business for Bankers Trust New York Corp., J.P. Morgan & Co., Citicorp, and Chemical Banking Corp., along with a handful of the biggest investment banking firms.
Explosive Growth
And it has been a rapidly expanding business.
The International Swap Dealers Association said that in the first six months of 1992 new interest rate and currency swap contracts, a major component of the derivatives business, increased by 44% over the previous six months.
While those are the most recent figures available, traders said the growth hasn't slacked since then. In 1991, the value of notional principal of swaps and other derivative contracts totalled $3.9 trillion.
Corporations, particularly financial service companies, use derivatives to reduce risk from changes in interest and foreign exchange rates.
Before it hired the Mercadian group, Republic had been looking for years to get into the derivatives business. The bank wanted a business that would take advantage of its double-A credit rating. A high credit rating is important for success in the derivatives business. The other newcomers, for example, have at least an A rating.
The Mercadian team became available last year after credit-rating agencies downgraded the parent insurer.
After failing to find a higher rated partner for Mercadian, New England Mutual let Kenneth Sullivan, Mercadian's president, negotiate his own deal.
Old school ties from Harvard University helped bring Mr. Sullivan together with Thomas Robards, executive vice president of Republic New York. Mr. Sullivan and his crew joined the bank in January.
Analysts applauded Republic's jump-start approach.
"Republic has always been good at identifying ways of entering business at a reasonable cost but with a meaningful position," said Felice Gellman, an analyst with Dillon, Read & Co.
Mr. Robards said Republic's derivatives business focuses on smaller, more complex deals bigger players may avoid.
He declined to say how much the derivatives business earned last quarter. But in a recent report, Thomas Hanley, an analyst with First Boston Co., said the derivatives business accounted for a "significant portion" of the bank's 30% increase in noninterest revenues over the year-earlier quarter.
To be sure, dealing derivatives is no cakewalk. The newcomers must complete against the established powerhouses.
The big players are not going to yield turf easily and their capabilities aren't easily matched. Each has hundreds of derivatives traders, sophisticated computerized models, and a presence in markets worldwide.
No Guarantee of Profits
These big players sneer at the newcomers' chances of earning sizable profits in the business. Analysts said the newcomers will struggle to compete.
"A dozen traders doesn't give a bank a think tank like Bankers Trust has," said Tanya Azarchs, an analyst with Standard & Poor's Corp.
Nor are profits guaranteed.
"It is expensive to carry the personnel and systems until you build up a customer base," said Ms. Gellman.
Competition has already caused profit margins to thin in the interest-rate swap business, Mr. Robards said.
The fattest margins come from what insiders call "exotics." These are unusual swaps or hedges. For example, a corporation can swap a revenue stream from its minority investment in another corporation for a less volatile stream. Or it can buy a hedge against fluctuations in real-estate prices.
To offer so-called exotics, a dealer needs years of experience and sophisticated economic modeling techniques. Bankers Trust is widely considered the leader in this field.
But profits are not the only reason to peddle derivatives. Newcomer banks say they must offer swaps and other instruments if they want to keep their middle-market corporate customers.
"We will use this as a way to go after new customers and to tie our customers close to us," said William L. Maxwell, executive vice president at NationsBank. "We may not make a lot of money in derivatives but [we will] in the other products we offer."
Mr. Maxwell believes his bank's entry will spur others.
"Other banks see their customers sought by us and others, and they have to protect themselves," said Mr. Maxwell.
The newcomers believe they have a niche: middle-market commercial and industry borrowers that have been slow to use derivatives to manage balance sheets.
"We don't sense the New York banks offer these products to our customers," said Jerry Schmitt, executive vice president at First Union. "We don't sense that our middle-market customer base has been well served."
