A new report shows that derivatives transaction volume soared last year, suggesting further opportunities for banks that trade such instruments.
But the report also showed that customers are migrating into plain, less costly instruments, raising further questions about the profitability of the derivatives business.
According to a survey conducted by the International Swaps and Derivatives Association, the volume of new, privately negotiated derivatives transactions, such as rate and currency swaps, jumped 46% last year, to a notional value of $8.1 trillion.
At yearend, there were transactions worth $11.3 trillion in notional value outstanding, compared with $8.5 trillion at yearend 1993. Notional value is based on the face values of instruments underlying derivatives contracts.
Gay Evans, chairman of the International Swaps and Derivatives Association and managing director of Bankers Trust International in London, said most of the increase in volume came from the use of instruments such as interest rate and currency swaps - instruments used to hedge financial risk.
Although last year's rising rates and gyrating currency markets thrust some aggressive derivatives users into crises, the turmoil also impressed upon many institutions the need to protect themselves from sudden economic shifts. That explains why transaction volume rose.
"I think people were concerned (about getting) caught exposed in any one direction," said Ms. Evans.
From the perspective of banks that trade derivatives, however, the mix of products can mean as much or more as volume in determining profitability.
According to Ms. Evans, the survey underscores a shift away from high- margin, complex products toward lower-margin, "plain vanilla" products. And this is expected to hurt the profitability for derivatives units at banks.
The upshot is that cost cutting will continue as a priority for derivatives trading units at banks, despite rising transaction volumes.
"The sheer profit potential is reduced in this business, so you're seeing a lot of companies start to slim down in terms of the number of people dedicated to these products," said Frank DeSantis, an analyst with Donaldson, Lufkin & Jenrette Securities Corp.
Earlier in this decade, dealer banks posted attractive efficiency ratios despite having higher overhead costs, simply on the strength of product margins.
With customers shying away from exotic, lucrative instruments, however, some banks, such as Bankers Trust Co., are trimming staff in their derivatives units, Mr. DeSantis said.
Diane Glossman, a money-center analyst with Salomon Brothers Inc., said customer migration towards lower-margin products started last year. While she is pessimistic about a quick return to volumes seen in higher-margin products in 1993, she says profitability in this line of business will not necessarily continue to decline.
"There has been some question as to whether demand for high-margin products will fall even further, but we don't believe that will be the case."
Nor is it all bad news that the use of more complex instruments has declined. Tanya Azarchs, bank rating analyst with Standard & Poor's Ratings Group, contends the shift towards conservative products could prevent some headaches for dealers.
"You could say you potentially have less legal risk on derivatives products associated with hedging," said Ms. Azarchs. "You're not going to have clients saying 'I didn't understand.'"
Ms. Evans of the International Swaps and Derivatives Association agreed, saying a few highly publicized incidents prompted end-users to take more care in the way they use derivative instruments.
"If there was a silver lining in what happened last year, it was that company senior management set down specific policies and procedures for derivatives usage," she said.
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Separately, Chase Manhattan Corp. Tuesday issued a $1.365 billion credit card asset-backed offering in two parts.
The Chase Credit Card Master Trust 1995-2 was issued through Chase Securities Inc.. The first part were Class A senior certificates totalling $1.28 billion. It was issued to float 13 basis points over the London interbank offered rate and priced at 100 with an initial coupon of 6.1925%. The average life is 3.031 years.
The second part, consisting of Class B subordinate certificates totaling $82.5 million, will float 25 basis points over Libor.
This class was also priced at 100 with an initial coupon value of 6.3125%. The average life is 3.572 years.
Chase said Moody's Investors Service Inc. and Standard & Poor's Rating Group had given the senior certificates triple-A ratings. Moody's rated the subordinated certificates A1, and S&P rated them A.
