Risk Management: Oversupply of Interest Swaps Slows Growth in Trade

A glut of "plain vanilla" derivatives in the marketplace apparently is slowing trading revenue growth for banks that deal in the financial contracts.

The Office of the Comptroller of the Currency reported a 6% increase in total notional value of derivatives in the second quarter, but a 3% drop in trading revenues, mainly due to a drop in interest rate contract revenues.

Traders say the oversupply in five- and 10-year fixed rate contracts is depressing trading revenues, and may prompt dealers to return to marketing more exotic, high-yielding instruments.

Derivatives are contracts whose value is tied to the value of another asset, such as interest rates, foreign currencies, or commodities. The higher-yielding products have been controversial because of unexpected losses to users, who complained they weren't adequately apprised of the risks.

Volume in the interest rate swap market has grown in recent months because banks and other corporations have been issuing a lot of debt, said Simon Lack, head of derivatives and propietary trading at Chase Manhattan Bank. These businesses generally want to hedge interest-rate risk, so they arrange swaps of fixed-rate for floating from a derivatives dealers.

"It's been a case of everything trying to go the same way at the same time," Mr. Lack said.

Because more seek fixed-rate deals than usual, the swap spread above U.S Treasury notes has tightened as derivatives dealers are becoming less willing to buy fixed-rate instruments.

Spreads on five and ten-year interest rate swaps fell to 22.5 basis points and 30 basis points, respectively, over underlying securities, according to a recent report by Salomon Brothers.

The decline, which picked up steam in April, means the derivatives are less attractive to users, because the difference between the hedge and the cost of comparable treasury securities has dwindled.

At the same time, a recent report by the newsletter Swaps Monitor suggests that profits for derivatives dealers may be narrowing, because the difference between what derivatives dealers pay to buy interest rate swaps and what they can charge has slipped.

"It's difficult to quantify the effects" of these developments, said Charbel E. Abouchared, managing director and head of U.S. trading at CIBC Wood Gundy. "There are lower spreads, but also higher volume. But overall I'd say the higher volume has not made up for the lower spreads."

Meanwhile, as interest rate swap volume has risen, so too has the savvy of customers seeking the best price on these deals.

"Customers know how to price these deals, and there isn't much people don't understand about them," Mr. Abouchared said. "The business' wrinkles have been wrinkled out."

Then, too, "there are a lot more derivatives shops than there used to be," observed Barry Seaman, vice president at General Re Financial Products, a subsidiary of the insurance company General Re Corp. The unit started selling derivatives in 1990.

Mr. Abourchared said his shop is pursuing more structured deals, arbitrages, and other kinds of trades that mean more complexity as well as more profits.

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