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Credit derivatives house of the year: Deutsche Bank - 10 Jan 2012 - Risk print view

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Credit derivatives house of the year: Deutsche Bank

/risk-magazine/feature/2134471/credit-derivatives-house-deutsche-bank 10 Jan 2012, Risk magazine staff, Risk magazine

The credit derivatives market has not seen a year like 2011. Volatility was higher in the aftermath of the Lehman Brothers collapse in September 2008, but it focused primarily on financial names. Last years fear was less discriminating, encompassing US and European banks, peripheral eurozone sovereigns, but also for the first time infecting the continents core nations, while countries far from the European crisis experienced their own, idiosyncratic bouts of turbulence. On June 7, Germanys credit default swap (CDS) spread hit 36 basis points a low for the year. As of December 19, it was almost three times higher, at 107bp, according to data provided by Markit. Italian spreads, after trading as low as 123bp in April, were at 586bp by mid-November. China saw its spread go from 66bp at the start of the year to 148bp on December 19. Until August, Brazils CDS spread fluctuated between 100bp and 120bp by September 22, it had blown out to 219bp, in tandem with a collapsing real (Risk December 2011, pages 1620). The temptation for market-makers was to pull up the drawbridge and many dealers did, to a greater or lesser extent. Those that remained active were inundated with demand for protection, particularly from other banks desperate to hedge uncollateralised derivatives counterparty risk with European sovereigns as credit spreads exploded a trend driven partly by Basel IIIs looming capital charge for credit value adjustment (CVA) (Risk November 2011, pages 1620). We saw liquidity drying up in the market, especially for eurozone sovereigns, and sensed an opportunity to define ourselves as the most consistent provider. Because of the way we had positioned ourselves over the
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Credit derivatives house of the year: Deutsche Bank - 10 Jan 2012 - Risk print view

past couple of years, we were able to continue offering the liquidity our clients need, says Colin Fan, head of global credit trading at Deutsche Bank in London. The business ran a counter-cyclical strategy based on a strong macro view that the situation in Europe was worse than it seemed. Starting in the third quarter of 2009, Deutsche halved its inventory of sovereign CDS positions, and attempted to flatten the books exposure. This allowed the bank to expand liquidity provision to clients when the market contracted in the second half of 2011 the bank says there were occasions in this period when it traded as much as 25 billion of CDSs in a single day. As a result, the credit business was on course to beat targets for revenue and market share, with annual volume of more than 1 trillion but has been able to run the business at roughly half of its daily 70 million value-at-risk limit. Deutsches decision to wind down its exposure prior to 2011 is mainly credited to its head of European credit trading, Antoine Cornut who Fan refers to as a perma-bear. Cornut and his team first formed an opinion at a time when the Greek CDS spread was around 200 basis points that the countrys debts were unsustainable and that it would need to be bailed out. They concluded the politics of this would be so difficult any resolution would take several years, and positioned the business for a crisis that would end only after a prolonged period of high volatility. As contagion increased last year, the consensus outside the bank was that the size and importance of the Italian bond market meant European politicians would be forced to take drastic action as soon as Italys CDS spread hit distressed levels. But again Cornut and Fan took the contrarian view that an enduring period of Italian stress was possible, and that even France was not safe. The core view was that it was going to be a long and winding road, says Cornut, with no magic bullet that will solve everything. We tried to remain nimble, being aware of what we wanted to take on, going shorter when we were doing too much and when the relative value blows out of proportion going long. When spreads really started to blow up, we were trading short at the time so it was easier for us to provide liquidity. This allowed the bank to continue making markets in Italian CDSs as other dealers backed off in the third quarter spreads jumped 127bp in the first seven trading days of July and there was tangible evidence of that in Decembers revisions to the European Banking Authoritys stress tests that identified Deutsche as counterparty to 34 billion Italian CDS contracts by notional, with a net sold position of 2.5 billion. Cornut puts this in context. On a mark-to-market basis its closer to flat. We have more short-dated exposure at six or nine months. So even though the notional is large, the risk is small. In my view there is no risk of an Italian default in the next six months, at least as things stand today. The residual exposure reflects positions in reverse repo trades or index arbitrage, he says. One trade that panned out for the team came in June, when a European insurer needed to buy protection on 200 million of exposure to one southern European sovereign. At the time, spreads on the country had rocketed and the insurer was unable to find another counterparty willing to provide liquidity. Because of Deutsches de-risking programme, the bank was sufficiently short the name that Cornut felt comfortable taking on the trade and, rather than hedging with the same name, Deutsche instead bought protection on another southern European sovereign that was at the time trading below the first country. In the time since, the two have swapped around producing gains for the bank. Another big trade saw Deutsche take the lead role in the de-risking of a peripheral European banks 8 billion sovereign CDS portfolio in December. The bank was facing a large collateral call on out-of-the-money positions in dollar-denominated CDSs, partly due to currency movements, rather than credit. Deutsche wrote quanto CDS protection for the bank and hedged with fully collateralised credit-linked notes and currency
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Credit derivatives house of the year: Deutsche Bank - 10 Jan 2012 - Risk print view

forwards. The de-risking is likely to be completed in January. The net result of all this was a jump in Deutsches market share. Nowhere was that more evident than in the electronically traded CDS market, a business that had previously been a virtual monopoly for JP Morgan. Deutsche and other banks had held back from entering the market, clinging to the traditional trading model. However, it became apparent that incoming regulation the Dodd-Frank Act in the US and the European Market Infrastructure Regulation will force much of the worlds over-the-counter derivatives business onto electronic platforms, and that JP Morgans success was no flash in the pan. In November 2010, Deutsche launched its own platform on Bloomberg. Over the course of last year, the share of CDSs traded electronically at Deutsche moved from virtually nil in January to 25% in November. The growth of the electronic market generally 70% of Markits iTraxx index contracts were traded electronically in 2011, up from 30% in 2010 meant this was big business. This was a real focus for us this year. We knew this was the future and that we had maybe been a little slow in moving into this area. So we had to be aggressive, says Fan. The big question is whether Deutsche has been able to do this safely it says the contrarian approach makes the business sustainable and insists there are no nasty surprises lurking in the books. In part, thats because of a new risk dashboard put in place during 2011, that looks at every trade through the lenses of revenue, risk, and capital. We look at a three-dimensional matrix with recalibrated metrics, says Fan. Everyone at the trade level is aware of things that in the past were not as relevant. Profitability adjusted for resources and risk is the new VAR. In particular, theres a new focus on assessing the capital cost for each trade. Risk-weighted assets (RWA) the building-block for regulatory capital calculations are evaluated at both the trade and portfolio level, and feed into the matrix. The RWA numbers are calculated using the new metrics introduced by Basel 2.5 from this month, which supplement the old VAR-based calculation with a stressed VAR measure, plus the incremental risk charge to capture default and spread migration, the comprehensive risk measure for the correlation book and new rules for securitisations and resecuritisations. Again, each of the contributions made by these components can be seen on a trade-by-trade basis, as well as at the desk and overall book level, Fan says. The Basel 2.5 requirements dictate that stressed VAR should be calibrated using a one-year period of market turbulence relevant to the banks portfolio. Like most banks, Deutsche currently uses a period that includes the Lehman Brothers default for now, anyway. This may change over the next 12 months, particularly as regards the sovereign portfolio the stress on sovereigns was not very significant in 2008. We may find ourselves calibrating to a 2011 period this year, says Fan. For flow business, incremental RWA is calculated according to benchmarks for instance, a liquid UK corporate is used as the jumping-off point to gauge its peers. The spread level of the benchmark and the portfolios sensitivity to it can be used to calculate an incremental VAR that Deutsche uses to work out the RWA contribution from trades with similar underlyings, Fan says. For structured credit deals, a full Monte Carlo simulation is performed for each trade. Deutsche plans to extend this to full Basel III capital including the CVA charge. Although this is normally calculated at a portfolio level, Fan believes a trade-level number will push traders towards more costeffective business. We are focused on being ready for Basel III and looking at the business through that lens. By making traders aware at a transactional level what the cost of capital is, we can get them to concentrate on making the calls that deliver better return on equity, he says.
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Credit derivatives house of the year: Deutsche Bank - 10 Jan 2012 - Risk print view

In 2012, the team sees the eurozone crisis moving from the sovereign sector to corporates bringing widespread credit deterioration, downgrades, and defaults. Cornut has been adjusting the focus of his traders accordingly. Europe is entering recession, so we are analysing every name to see if they can survive a severe downturn cyclical industries are at risk. But the biggest problem will be refinancing some corporates will need to borrow again in 2012, but banks are no longer lending, says Cornut. He sees firms in the crossover ratings band between BB and CCC as having an increasing probability of default. The team has been gutsy in making these calls and some of them could be found out. That corporate crisis may not emerge. Italy may default in the next six months. The eurozone could even break up, with catastrophic consequences. The latter event is still considered too remote a probability at least by Deutsche to affect book positioning, says Fan. But, so far at least, Deutsches decision to step up in a year that other houses were stepping back has not just been brave, providing the market with some much-needed liquidity it has also been smart. Print | Close Incisive Media Investments Limited 2013, Published by Incisive Financial Publishing Limited, Haymarket House, 28-29 Haymarket, London SW1Y 4RX, are companies registered in England and Wales with company registration numbers 04252091 & 04252093

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