The last decade has not been kind to commercial banks' product lines, which have came under fierce attack by nonbank competitors. As a response, during the late 1980s, a few of the most venturesome banks perfected a shiny new product with a wondrous profit margin: the derivative. Soon, many investors and corporations were using them for hedging risks and betting on interest rates and currencies. Dozens of other banks rushed in, and the number of derivatives dealers mushroomed between 1988 and the end of 1993.
Now, though, the once wondrous margins are shrinking fast. A slew of multimillion dollar hits taken by corporations and institutional investors has caused many users to run for cover. Demand for the most exotic derivatives contracts--those that are most lucrative for dealers but often carry the most risks--has plummeted. Many users now limit themselves to the safest derivatives, those least profitable for dealers. "The only thing people are buying these days is Chevys," says Bruce L. Campbell, associate director of corporate derivatives marketing at Fuji Bank & Trust Co. "They don't even want to see a Maserati in the showroom window."
STILL HANDY. Derivatives will not go away. Too many corporations and investors view them as useful, indeed critical, risk-management tools, and experts expect derivatives activity to continue to expand at a healthy pace. But they agree that the days of outrageous profitability for dealers are over. With corporations and investors still licking their wounds, traffic in the most complex derivatives will likely stay slow for some time. "The structured-note market will continue to exist," says John K. Darr, finance director of the Federal Home Loan Bank system, referring to the intricately structured instruments that are a big part of the complex derivatives market. "But it may be somewhat smaller than it was."
Moreover, with the proliferation of derivatives dealers, it will be difficult if not impossible for the preeminent ones to retain a lock on the market, especially for complex, exotic derivatives. Inevitably, as profit margins shrink, making money in derivatives will depend more on volume than spreads--just as in dozens of other bank businesses.
In the halcyon days of the market, derivatives were a dealer's best friend. Citibank and, later, Bankers Trust and J.P. Morgan were the dominant U.S. banks in the business and produced huge returns. As more complex derivatives were developed, banks with the product know-how could book a return on equity in excess of 100% on some of the more exotic derivatives.
But the bond-market rout of 1994 changed all that. Big hits were taken by Procter & Gamble Co., Gibson Greetings Inc., and other corporate derivatives users, many of them clients of Bankers Trust New York Corp. Several of the losses quickly led to lawsuits.
The market tumult has hurt all dealers in derivatives. J.P. Morgan's derivatives-trading revenue was down 17%, to $663 million, for the year. Citibank's was down 50% for the first nine months of 1994. And Chase Manhattan Corp. took a fourth-quarter loss of nearly $20 million on several derivatives contracts. But Bankers Trust, arguably the preeminent bank in derivatives, has been the most vulnerable. Indeed, its fortunes have been something of a mirror for the derivatives turmoil. "They're a one-trick pony," says one dealer.
Nearly a third of Bankers' 1993 net income of $995 million came from derivatives, and with derivatives dealers' margins high, Bankers produced a handsome 26% return on equity. But beginning in the second quarter of 1994, income from derivatives fell sharply. One key reason: Bankers Trust specializes in the most complex derivatives, the segment of the market that dealers and consultants agree has slowed the most.
The slump is literally scaring some dealers away. Charlotte (N.C.)-based First Union Corp. was gearing up to start dealing in structured notes, a type of complex derivative, in early 1994, but activity was off so much, the bank decided to wait, according to Terry L. Turner, managing director of its derivatives group. "The whole idea of leverage [and exotic derivatives] for many investors is out," says Heinz Binggeli, managing director of Emcor Risk Management Consulting. "We're getting back to prudent hedging rather than yield enhancement." Market sources say as much as half of the limited activity in complex derivatives in 1994 was transactions aimed at reversing old trades.
Worse, thanks in part to the spate of customer lawsuits and complaints, Bankers Trust is losing some market share in exotics even as that market slows. A survey of dealers by the magazine Risk shows that in mid-1994, Bankers Trust dropped in rankings in several markets for complex derivatives. And it's not as if Bankers Trust--or any other dealer--can easily generate big profits in the more prosaic end of the market. Today, margins on everyday interest-rate swaps are down to a few basis points.
Bankers Trust, whose derivatives business has been very transaction oriented, is now trying to build longer- term relationships with clients that will eventually produce more high-margin business. "We can do more in the risk-management field when we come up with strategic solutions to problems" rather than simply try for a lot of transactions, says Charles S. Sanford Jr., chairman and chief executive of Bankers Trust. In December, Bankers merged its equities sales force and its equity derivatives sales force, a move that sources say could lead to a more integrated approach to clients. Market sources say an internal restructuring of its derivatives business is also in the offing, though a Bankers spokesman declined comment as a matter of policy.
Certainly, Bankers Trust has proven it can change its stripes. In the late 1970s, then-chairman Alfred Brittain III decided to exit retail banking. The bank sold its branches and its credit-card portfolio and grew into a capital-markets powerhouse--a transformation like no other bank's. "We like to think of ourselves as a change-agent, innovative type of firm," Sanford says. "I would hope we'll be in a transformation for the next 10 years."
Change of the kind Bankers Trust is contemplating can take time, though. Says Thomas C. Theobald, former chairman of Continental Bank Corp.: "This is multiyear if not decade-long stuff to move a cultural positioning. You can't flip-flop in a year or two."
In the meantime, Bankers has to deal with a competitive handicap. After Gibson Greetings sued it over derivatives losses, the Federal Reserve Board looked into Bankers' derivatives sales practices and eventually reached an agreement uith the bank that publicly called for it to modify them. Among other things, Bankers Trust must now give many clients daily prices on their derivatives. Customers receiving that information can use it to bargain for lower prices or share it with other dealers, giving them insight into Bankers' transaction structures. Already, savvy customers of all dealers make a habit of shopping around for transaction prices. A Bankers spokesman says he does not expect the requirement to hurt the bank.
DON'T RUSH. While Bankers Trust tries to revamp, its biggest competitors are pushing hard to win market share. U.S. rivals including J.P. Morgan and Chase Manhattan as well as foreign threats such as Swiss Bank Corp. are making inroads. At Bank of America, "over 25% of our client base were new users of our services last year," says Joseph P. Bauman, senior vice-president and director of the bank's global derivatives business.
Few see Bankers hobbled indefinitely. But derivatives profits are not likely to reach old peak levels anytime soon, says Arthur Soter, a bank stock analyst at Morgan Stanley & Co. He expects Bankers to generate only $240 million in derivatives income in 1995, well below 1993's $330 million.
For Bankers and other banks, the lesson of the derivatives debacle is clear: Rushing into seemingly miraculous markets is not a recipe for long-term success. In today's financial markets, high-profit products tend to have distressingly short life cycles.
End Of The Windfall
Wary customers and heightened competition mean profits for derivatives dealers will be more elusive in coming years
MORE PLAYERS have entered the market, and they are aggressively competing on price to win market share and clients. There is even more competition for the most complex deals, long the province of a few dealers. That is reducing once lofty margins on all deals.
DATA: BUSINESS WEEK
EXOTIC DERIVATIVES BUSINESS has slowed thanks to unsettled capital markets and well-publicized losses by sophisticated users. Market sources say activity in the most complex derivatives is off by a third or more. Many users are confining their dealings to conservative, risk-limiting moves using plain-vanilla, low-margin derivatives.
NEW DISCLOSURE REQUIREMENTS could force users to report on all their derivatives, even if used as hedges. Dealer profits might be hurt if aversion to this leads investors and corporations to limit use of derivatives. Dealers may also be pressured to disclose more information on how they price derivatives, which could cut further into profits.