The settlement last month of a suit by Procter & Gamble Co. against Bankers Trust New York Corp. hasn't ended the derivatives controversy. Fallout from the case, and other high-profile trading disasters, continues. Banks can no longer roll products directly off the assembly line and into the portfolios of yield-hungry investment funds and treasury departments. What has developed instead is a more cautious derivatives market. Corporations that may have sought to turn their treasury departments into profit centers through highly structured products are now sticking to guidelines set by wary boards of directors. The industry has also seen its share of customer defections. "We've clearly seen a decline in volume of structured-derivative transactions related to investors," said Joseph P. Bauman, manager of U.S. derivatives activities and global derivatives product director at BankAmerica Corp. "I think the net volumes in this area are still down from 1993 and 1994." The investor base is looking more critically at the risk-reward balance in structured instruments, he said, and it doesn't appear to like what it sees. As a result, structured note offerings from issuers like the Federal Home Loan Bank System have fallen to around $5 billion a year from nearly $30 billion in the early 1990s, sources said. "That issuance has gone down because the buyers have not been there," Mr. Bauman said. "The benefits of using this source of funds has disappeared along with the declining interest of investors in these instruments." At the same time, the industry has continued to post record volume and activity numbers. In its most recent market survey, the International Swaps and Derivatives Association estimated that the notional amount of outstanding privately negotiated derivatives had grown 29.2% during the second half of 1995, to $18 trillion, from $13.9 trillion at June 30. At the end of 1994, outstanding derivative contracts amounted to $8.5 trillion in notional amount. Part of the reason for the growth is that product innovations are having a positive effect beyond the derivatives units of banks, said Mark C. Brickell, a managing director at J.P. Morgan Securities. Corporations and institutional investors, as well as banks themselves, are showing a greater awareness of the problems posed by risks they managed less actively in the past. Regulators, too, have developed a greater understanding of risk, Mr. Brickell said. Mr. Bauman said banks are now more attuned to the overall risk profile of their corporate customers. As a result, banks are offering derivatives products useful in managing risks across an entire organization, instead of for individual transactions. Consolidation within the banking industry has contributed greatly to the rise in derivatives use. John Peters, a senior vice president and head of the balance-sheet management division at First Union Corp., said the company's merger with First Fidelity Bancorp. led it to stock up on derivatives. First Union paid about $23 million in November to buy put options on Eurofutures, he said. The options were used to hedge against an increase in interest rates that might have pushed rates above the limits set in the bank's floating-rate mortgage loan and securities portfolios. The investment provided insurance against such a rate move. While the bank uses privately negotiated derivatives in managing its balance sheet, it was a 337% increase in outstanding futures contracts that caused First Union's notional amounts to balloon to $85.2 billion last year. The reason, Mr. Peters said, is that the notional amounts may be many times greater for hedges using futures contracts than they would be using over- the-counter products. "If you break down those transactions, you'll see that most of those are due to using futures instead of interest rate swaps," he said. "You can customize a little more if you use futures contracts because you can break it into quarterly transactions instead of doing one flat yield level over a whole period with a swap." The industry has high hopes for new products such as credit derivatives. These could eventually allow institutions with limited regional markets to diversify their loan portfolios by buying products tied to credit exposures in other geographic markets.
