How does a bank compete in the derivatives market with rivals three to four times its size? By being quick to market with the latest products, says Craig T. Bouchard, senior vice president and global head of derivatives and institutional sales at First Chicago Corp.
Quickness has paid off for the $60 billion-asset bank, which holds its own against such giants as Citicorp, Bankers Trust New York Corp., and J.P. Morgan & Co..
After a first quarter marred by losses in the emerging market sector, First Chicago's trading business rebounded to post revenue of $36.7 million in the second quarter. Salomon Brothers estimates the bank's third-quarter trading revenue will soar to $60 million.
Mr. Bouchard likes to strike while the iron is hot and there is still enough demand in the marketplace for a new product to be profitable.
"Product development is very expensive," he explained. "But if you're good at it you can make money selling new products at a premium. We can't make the investment to be the first one in, but if you're among the top five banks in on a new deal, you can make quick money."
First Chicago is a "very fast follower," Mr. Bouchard said. "For our size, we get to a new product quicker than anybody I know."
Mr. Bouchard said First Chicago's portfolio currently stands at about $180 billion, mostly in interest rate derivatives. While many of those instruments are of the low-margin. plain-vanilla variety, he said the bank prefers to deal in the more exotic instruments.
"The growth and higher margins are in exotics," he noted. "Our goal is to become very good at the structured product." He adds that while dealing in exotic derivatives is potentially lucrative, the potential for disaster is also great.
"Our philosophy is that we will offer low-margin product only to the extent that it gets us in the door to offer our structured products."
Business Is Up
And First Chicago has been getting itself in the door pretty often this year. Mr. Bouchard said the bank's revenue from interest rate derivatives is up 30% for the first half of the year, mainly due to strong demand from financial institutions and funds managers.
He noted that while the banks business to corporate clients is off about 10% from last year, the increased demand from other sectors makes up for the decline.
"Corporate treasurers have had to step back in the last few months and reassure their boards that what they're doing is safe and sound," he pointed out. "People are taking a long look at their policy and procedures."
This wariness, Mr. Bouchard said, comes from the well-publicized losses some banks and corporations posted earlier in the year.
And it is not only confined to corporate America. Mr. Bouchard said First Chicago, too, is proceeding more cautiously now than in the past.
"In the bank we're the same way," he said. "We report [to the board of directors] on a monthly basis now. We didn't do that two years ago."
But the worst may be over, he said.
"I'm optimistic about the second half of the year. We'll have a brighter picture. I think we're at the turning point."
He also said the next year and a half should be profitable for many banks as well.
Mr. Bouchard said that First Chicago is well positioned in the derivatives market because of its broad customer base.
"Anyone can say they are in the swaps business," he said. "But if you don't have customers, you don't have anyone to swap. with. Institutions with a large customer base have a leg up in this business."
He pointed out that historically, derivatives began as a separate business for most banks. So too did corporate finance and fixed-income financing.
The key to profitability is to be able to call on the expertise available in these departments for derivatives clients.
"The success of a derivatives business is to marry these areas," Mr. Bouchard noted. "You try to think of all the products that will bring your customer the best return. The houses that can offer products from across those areas have a leg up."
An integral part of the business, he said, should also be up-to-date technology. Unfortunately, most of the systems in place now, while only dating back to the early 1980s, are hopelessly outdated.
Seeing the Full Spectrum
"We run 23 different currency books in our derivatives portfolio," he said. "We might have 150 deals with one customer. You need a system that can see across the portfolio. The details of this business will in the end determine the winners and the losers."
Mr. Bouchard said most of the systems in place now don't give an accurate view of the complicated portfolios banks hold today. Being off by one or two basis points can make the difference between winning or losing a deal, he said.
First Chicago, he said, like most of the major banks, is working to upgrade its systems in order to keep up with an increasingly complicated market.
"Systems and technology that work on credit risk and capital requirements are the most important part of this business."
Traders' Capabilities
Another important factor is the quality of talent on your trading desk. The ability to run an increasingly complex desk is a key factor, he said.
"Mistakes in our business are always costly. How you price a deal can amount to hundreds of thousands of dollars."
Mr. Bouchard said First Chicago devotes an extraordinary amount of time to analytical checks and stress tests that predict the performance of securities under a variety of potential market conditions.
"That detailed work allows me to sleep at night," he said. "That discipline is key to our business."
He also said First Chicago's traders are not in the business of predicting interest rate movements. Rather, they are in the business of figuring out the complex relationships between markets and financial instruments. The Portfolio Dollars in billions Interest Rate Contracts Swaps $114.9 Forward rate agreements 44.2 Caps and floors 9.6 Options 7.7 Foreign Exchange Contracts Spots, forwards, $173.5 and futures Options 24.1 As of Dec. 31, 1993 Source: First Chicago Corp.
