Banks Vie for $2 Billion in Secretive Equity Derivatives

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Investment banks, including Deutsche Bank AG and Morgan Stanley, are vying for as much as $2 billion in annual fees in Europe arranging customized equity derivatives -- a secretive market that has defied the downturn.

The business, about as large as underwriting initial public offerings before the 2008 financial crisis, is now three times bigger and held steady last year, according to estimates from six bankers who asked not to be identified because the information is private. The contracts accounted for almost 10 percent of total investment-banking fees last year in Europe, the Middle East and Africa as revenue from dealmaking and trading sank, data compiled by research firm Freeman & Co. show.

Because the deals, whose value is tied to stocks, are customized and not traded on exchanges, banks are able to charge higher fees than for contracts in which customers seek competing bids. They’re also attractive to lenders because new rules demanding capital buffers against potential losses aren’t as punitive as for other derivatives.

“Regulatory change may drive banks back to the business, not away from it,” said Rachel Lord, Citigroup Inc.’s London-based global head of corporate equity derivatives. “This is one part of the investment-banking industry where, despite compressed margins, the business remains a high priority because it’s so important to the client base.”


Investors such as Aabar Investments PJSC, the Abu Dhabi-based sovereign-wealth fund, and Italy’s Fondazione Monte dei Paschi di Siena, owner of the world’s oldest bank, sought derivatives to protect the value of their holdings or to borrow against equity stakes.

Banks, including Deutsche Bank Morgan Stanley and Goldman Sachs Group Inc. are competing in a region that’s the biggest in the world by fees, surpassing the U.S. and Asia. The annual notional value of tailor-made equity derivatives is typically more than $50 billion in Europe, the Middle East and Africa, according to estimates from two of the bankers.

The market is so big and lucrative that even lenders shrinking their investment-banking arms want to keep the business going. Royal Bank of Scotland Group Plc, which is selling or closing brokerage, merger-advisory and IPO-underwriting units, will continue arranging “profitable” equity derivatives, the London-based firm said last month. Credit Agricole SA, France’s second-largest bank by assets, will do the same for corporate clients, said Bertrand Hugonet, a Paris-based spokesman.

“There’s a lot of competition because there’s been a history of profitable transactions in this space,” said Samuel Losada, London-based head of European corporate equity derivatives at Bank of America Corp. “You can achieve over the long run, if risks are managed properly, above-market returns.”

Daimler Derivative

Because the deals are private, there aren’t any publicly available rankings. Based on bankers’ own assessments and the sharing of information among them, the business is dominated by the region’s top equity brokers and better-capitalized firms. Industry leaders include Frankfurt based Deutsche Bank, Morgan Stanley, Goldman Sachs and Citigroup, all in New York, and Zurich-based Credit Suisse Group AG, the bankers said.

Deutsche Bank, Morgan Stanley and Bank of America arranged a deal in May that allows Abu Dhabi’s Aabar to keep its share of the potential near-term gains of Daimler AG, even as the fund sold a 1.25 billion-euro ($1.7 billion) bond exchangeable for the German automaker’s shares. The sale could cut Aabar’s Daimler holding to 7.2 percent from 9.1 percent when the bond matures in 2016.

The deal was the region’s largest ever derivative overlay, a strategy to hold multiple contracts against the same assets, linked to an exchangeable bond, according to Losada.

Emerging Markets

“There’s a clear trend that the emerging-market business is becoming more important,” said Losada. “We saw continuous activity in this space over the last 12 months.”

Increasing demand from emerging-market clients, such as Middle Eastern sovereign-wealth funds, has helped buck a slowdown in Western European deal flows.

“The business can be divided into two parts: the growth markets, where it’s harder for some to obtain liquidity and hence is driven by financing, and developed markets, where clients seek to manage their equity positions,” said Simon Watson, a managing director at Goldman Sachs in London who heads corporate equity derivatives for the region.

While financial firms are cutting employees in other investment-banking areas, many are looking to add to their equity-derivatives businesses in the region.

‘Beefing Up’

Bank of America, based in Charlotte, North Carolina, may hire two bankers this year to join the eight it has in London today, said Losada. Citigroup this month named Sophie Lecoq to the new position of head of corporate equity derivatives for Europe, the Middle East and Africa.

Morgan Stanley also may increase its team’s headcount, according to Daniel Palmer, the firm’s London-based global head of corporate equity derivatives.

“We expanded our business significantly over the past three years,” said Palmer. “Our team is now almost complete, but we might add one or two heads later in the year.”

Nomura Holdings Inc., which took over Lehman Brothers Holdings Inc.’s European business in 2008, may add one senior banker to its 12-person team in London, said Kenneth Brown, global head of equity capital markets. Lenders are “beefing up their European teams” of corporate equity derivatives because Europe is a now a bigger market than the U.S., he said.

‘Resilient Market’

It’s also a more resilient market, and the teams, which typically employ about a dozen people, are small compared with those that manage IPOs, said Christopher Wheeler, a banking analyst at Mediobanca SpA in London.

“It’s a business driven by the sweat of the brow,” Wheeler said.

While banks can earn more arranging tailor-made equity derivatives than underwriting stock sales, increasing competition has driven down fees for financing some deals, including margin loans, or loans from securities firms backed by clients’ equity holdings used as collateral, the bankers said.

Margin loans are a way for investors who have limited access to bank funding or capital markets to raise money. At least 10 firms competed to win a margin loan from an Italian client this year, compared with three or four that would have bid for the business a couple of years ago, said one banker, who declined to be identified citing client confidentiality.

Monte dei Paschi

Fondazione Monte dei Paschi, the biggest investor in Banca Monte dei Paschi di Siena SpA, last year raised about 600 million euros through loans backed by collateral on its stake in the lender.

Eleven banks participated in the deal, which helped raise funds to pay for shares sold by the bank in June, said Gianni Tiberi, a spokesman for the foundation. The firms, which included Credit Suisse and JPMorgan Chase & Co., participated equally, Tiberi said, declining to elaborate. The loan was reduced to about 525 million euros as Monte dei Paschi shares fell, he said.

In one type of equity derivative, known as an equity swap, one party agrees to receive gains in a stock or basket of stocks and in return makes interest payments to the other party on the value of the securities it bet on. Investment banks typically act as intermediaries between the two parties in the swap.

Basel III

Under the so-called Basel III rules, approved by the Basel Committee on Banking Supervision and scheduled to be phased in through 2019, banks will face a capital charge for potential mark-to-market losses on over-the-counter derivatives.

While banks largely have managed to keep their structured equity derivatives out of the regulatory spotlight, they are under increasing pressure to be more transparent about their credit-derivatives business.

JPMorgan yesterday disclosed for the first time its revenue breakdown from trading interest-rate swaps and credit, which were among the biggest sources of the firm’s trading income. Goldman Sachs also made an unprecedented disclosure of the gross value of credit-default swaps the lender bought and sold related to five European countries.

“Because credit markets tend to be less liquid and transparent than equities, banks often need proxies to measure the counterparty risk in credit derivatives, creating data gaps and higher capital charges,” said Anastasios Zavitsanakis, a financial-risk consultant at PricewaterhouseCoopers LLP in London. “The actual exposure in equities is more measurable in the short term, and there might be more collateral, reducing further the capital charges.”

Risk Appetite

Still, banks’ waning risk appetite is spreading the business around more evenly, said Citigroup’s Lord.

“In the past 10 years, two to three banks would typically lead the industry, while over the last year it has been much more broad-based,” Lord said. “Before 2008, banks would have been happy to be sole books on very large deals. It’s not feasible to do that now, so there’s a lot more deal-sharing.”

Morgan Stanley has expanded its business by building up a book of margin loans, said Palmer.

“Some competitors are looking to sell their loans,” he said. “As banks de-lever, we’ve come across clients coming to us seeking to raise money on a shareholding, for example.”

Even with the increased competition, Deutsche Bank sees demand from clients “as high as ever,” said Ian Holt, the bank’s London-based global head of equity structuring.

‘Good Business’

“It’s a good business because you are providing bespoke solutions and providing clients with what they need in and around complex situations, which makes higher margins naturally achievable,” said Holt.

Success for most firms this year depends on whether there’s a pick-up in mergers, bankers said. When companies combine, a seller left with a minority stake may seek to raise funds against the holding by buying put options on the shares and using the options to raise cash. Banks can also use derivatives to help investors who receive stock protect the value of their holdings.

“In M&A, you’re the exclusive adviser, and that’s where you can have prime access to interesting situations before they become public knowledge,” said Bank of America’s Losada. “That’s where the real alpha is.”

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