An AAA rating is no guarantee of success for a derivatives unit, according to a study by the Federal Reserve Bank of New York.
The report, released on the same day last week that NationsBank Corp. announced it had approval to set up its own AAA-rated derivatives subsidiary, said there is only a limited market for these separate entities. The units have failed to generate the windfalls anticipated by their sponsors, it said.
"The amount of capital they need is so large per dollar of a swap transaction that they are not likely to be dominant players outside of the triple-A market," said Eli M. Remolona, a research officer at the New York Fed and one of the report's authors.
The collapse of Drexel Burnham Lambert in 1990 gave rise to these derivatives units, and there now are 11, including NationsBank's new one and the unit set up by Bankers Trust Co. this year.
Merrill Lynch Derivatives Products was the first, posting $300 million of capital to garner an AAA grade from the rating agencies.
To maintain this sterling rating, the separately structured derivatives product company acts as an intermediary between its parent company and the customer.
The derivatives unit passes on most of the credit and market risks created by each transaction through offsetting transactions with its parent company. The parent then decides whether to hold the risks or hedge them elsewhere in the derivatives markets.
Despite the assurance this structure gives to the counterparty, it has yet to gain favor outside institutions like the World Bank, European Bank for Reconstruction and Development, sovereign governments, and a limited number of corporations. Mr. Remolona attributes the poor showing to the expense involved in such structures.
"Outside of that niche, they're not going to be very competitive because in terms of capital they're very expensive," he said.
He said the typical unit has about $300 million of capital backing a portfolio with notional amounts of around $100 billion. To justify this cost of capital, the derivatives unit must charge higher fees.
Reza Bahar, managing director in the derivative ratings group at Standard & Poor's Corp., said these units must maintain enough capital to cover the risks of dealing with a variety of higher- and lower-rated customers that require an AAA-rated derivatives dealer.
Some banks have found the up-front capital requirement too high to justify.
DKB Financial Products, the New York-based derivative unit of Dai-Ichi Kangyo Bank, looked into establishing its own derivatives product company before agreeing to piggyback on Merrill Lynch's unit.
"We were able to obtain the full benefits of triple-A intermediation through Merrill Lynch," said Richard Robb, head of derivatives at DKB, "and we were able to offer a vehicle for which they already have documents."
"They have other things to do than study triple-A complexities," he said.
Mr. Remolona said such innovations will continue to change the structure of these units, like the one Bankers Trust announced at the same time DKB was making its deal.
Its structure, patterned after a Credit Lyonnais unit, was backed by a surety bond and offered a AAA rating through direct dealing with the bank.
While these units have been able to garner only a sliver of the derivatives market, things could change if the world economy stumbles. Mr. Remolona said a default by a lower-rated competitor could give these units a boost.
"If one major dealer failed and the derivatives customers lost money, then you would see people moving toward these triple-A subs," he said. "Another Drexel might do it."
