Will the wind ever remember
the names it has blown in the past?
And with this crutch, its old age and its wisdom,
It whispers, "No, this will be the last."
- Jimi Hendrix
Enough is enough. The dealers have worn their hair shirts for seven years now. They perform an essential function in the about-to-be very risky interest rate markets for private debt. It is time to restore derivatives markets participants, whoever they will be, to profitability so they can support corporate interest rate risk management when the market for private debt returns to normal.
Experience in the energy markets during the past year shows substantial improvement in financial risk management since the disasters of the last energy crisis during the 1980's. Although this story is not over, it is plain that the energy derivatives market provided substantial assistance to the corporate world during this stressful period.
Are the interest rate markets ready for a similar stressful episode? The answer is a resounding "no." There are two major reasons. We are going to need good performance from the interest rate swaps market in the next few years. And without a change in regulatory attitudes and the attitudes of the dealers themselves, we won't get one. Why not?
First. The dealers have been cut out of the game .
The degree to which the dealers' risks of the Crisis have been eliminated is overstated. Like the second half of a hurricane, on the other side of the eye of the storm, as the dealers unwind their books to reduce the punitive regulatory capital charges that have been leveled at the them, ugly things are going to be revealed.
Credit Suisse (NYSE:CS) was embarrassed by one such episode, reported on March 23rd by Bloomberg, here. CS traders, faced with hidden losses exposed as they were forced to wind down their positions with the mid-2015 restructuring, took another unauthorized bite of the forbidden fruit of illiquid high yield assets in January, revealing both that the reporting of values inside the bank's portfolio left something to be desired; and that management was, incredibly, "out of the loop" more than six months into the restructuring. The write-down was reported as further restructuring - revealing that at Credit Suisse, any loss is a temporary loss. Only gains are ordinary income.
Of course the other dealer banks were "shocked" that Credit Suisse' new management could be so lax. No such problems at other banks. But the simple math of the interest rate swaps market tells us that the reported reductions in outstanding positions in the dealers' books owes more to good fortune than actual reduction in inventory. Be assured there is more to come elsewhere.
To see how little has really been done to reduce the dealers' positions, take a look at the open interest in interest rate swaps cleared at LCH:Clearnet, part of the London Stock Exchange ((LONDON: LSE)) at this writing. Open interest has resumed its upward trajectory, surprisingly, slightly surpassing $300 trillion. But without the temporary benefits of compaction (offset of matching long and short exposures by the exchange) open interest would now be above a whopping $1 quadrillion. (Dealer bank stockholders, please don't be alarmed. Due to various loopholes in the bankruptcy code, the dealers have little exposure to the resulting approximate $15 trillion in credit risk created by these open positions. If a dealer bank other than yours fails, the resulting bill - only in the billions - will go straight to taxpayers and/or the claim-holders of the failed dealer (who will be eaten alive). Your dealer bank will probably actually profit from the spoils, as was the case with the Lehman fail.
But what all this open interest means for the future functionality of the interest rate risk management business is that the dealers have no ability to expand their services with the coming enormous increase in demand. When corporations start to feel the squeeze from rising interest rates, they will not be able to turn to the dealers.
The dealer's future situation is truly dire. Even if the dealers were to completely halt their OTC interest rate swap operations, there will be far smaller reductions in open interest due to compaction going forward. And at an average interest rate swap maturity of five years, simply allowing the existing positions to run off will only reduce the size of open interest by 20% annually.
The world's corporate hedgers, however, will inevitably be served. Rule one of economics applies, to wit: Demand creates its own supply. Someone will fill the need for corporate interest rate hedging. The opportunity will be too great to resist.
I am not sure who will feed off the dealers' forced retirement from the market. But I have some guesses. Wells (NYSE:WFC) is in a perfect position (see my "The Big Put" for details.) And other opportunists from the buy side present themselves [Citadel (Private) and Blackstone Group (NYSE:BX), for example].
Second. The regulators' capital restrictions ignore the issue of profitability.
If regulators do not share responsibility for profitability of the derivatives business, the dealers will have no capacity for new business as interest rates return to more normal levels. This will be fatal for the dealers as we know them. As the investment banking arms of the dealers reinvent themselves as corporate advisors and wealth managers, the organizations as a whole will be split up - perhaps to the benefit of existing shareholders. Already the hounds of bank analysis are nipping at their heels. (see IP Banking Research - "Time for Citigroup to Sell Mexico.")
The newly reopened floodgates of monetary policy will lead to a more typical market with rates in a range of 3-7% and correspondingly greater interest rate volatility. This will put the dealers on the defensive, increasing capital costs even further.
The quiet in the market since the Crisis owes a great deal to the fact that there has been no interest rate risk to manage. A number of negative factors will come into play with the more normal interest rate environment.
- Collateral costs associated with the dealers' slowly unwinding positions will more than double, since the amount of collateral associated with a derivatives position depends on the slope of the yield curve. This will drive the dealers' costs upward for a length of time sufficient to make them irrelevant.
- Regulators will consider their Dodd Frank commitment to further increase the banking system capital charges as the economy enters a "boom." Thus the regulatory costs to the dealers will only grow.
Zzzzzz. Dealer Oligopoly Dreams.
I will not mourn the decline of the dealers. During the period following the Crisis, these banks have failed to use the opportunity to reform their market practices. They have depended on their "systemically important" designation, allowing their market share to grow and their profitability to decline. There was a rapidly closing window of opportunity to innovate in the interest rate derivatives market - to futurize these instruments and to be in a position to reap the profits from the coming expansion in interest rate derivatives demand. But they sat on their laurels instead. Too late now?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.