Not so long ago, the fixed income and derivatives markets were worlds apart. Banks had separate groups to deal with each. Under separate managers, these groups developed their own practices, cultures and computer systems.
But over the past few years, these worlds have collided. Bond traders now hedge their deals with swaps and swaptions, or even caps and floors. A number of securities now straddle the two worlds, such as callable, puttable and convertible bonds, and are widely traded. As fixed income and derivatives increasingly overlap, banks are merging the separate groups under a single manager. But they are finding it less easy to integrate the different computer systems.
The US investment banks, as usual, led the way in making the change. Major players such as JP Morgan, Merrill Lynch and Chemical (now part of Chase) pioneered the integration of fixed income and derivatives in the early 1990s. Deutsche Bank led the way in Europe, followed more recently by Union Bank of Switzerland, WestLB and others.
What are the reasons for these worlds merging? Paramount is the banks’ desire to manage their risks more effectively. Banks do not want to have a bond and its hedge in two different places. Besides, banks have realised that behind the differences in structures and terminology, bonds and swaps are essentially the same instruments. The separation of the two worlds is more historical than logical.
Another thing that kept the worlds apart was the hunt for arbitrage opportunities. Traders looking for profits from price discrepancies tend to keep their eyes narrowly focused. But more recently the increasing efficiency in the markets has been steadily reducing these opportunities. This has forced traders to lift their eyes and look for profits beyond the narrow horizons of their traditional markets.
At the same time as arbitrage opportunities have been evaporating, margins on fixed income deals have narrowed as interest rates have fallen across much of the developed world. This, combined with a decline in volumes, has meant that traders have had to devise more sophisticated deals to generate profits. Many have switched their attention to trading credit risk where the margins are greater. For instance, traders are buying corporate bonds in the emerging markets, hedging away their interest rate risks with derivatives and trading the credit risk.
Meanwhile, customers have become more sophisticated too. They now know that they can hedge their risks by repackaging their assets in other forms, such as swapping fixed income coupons for floating rates or other strategies. Clients want a single point of access to get solutions, even when they combine cash and derivatives.
These factors – the desire to manage risk more effectively, declining margins and arbitrage opportunities, and the growing sophistication of customers – are driving the merger of fixed income and derivatives. Under this pressure, the traditional world of the bond markets is fast giving way to the more innovative, flexible and risk aware world of derivatives.
But while the logic for merging fixed income and derivatives activities at the organisational and risk management levels may be overwhelming, it is not as easy to accomplish the integration at the systems level.
In the past the different requirements, in terms of instrument structures and trading volumes, meant that the fixed income and derivatives groups used quite distinct computer systems to support their activities.
Fixed income products are generally standard instruments that are traded in volume. A trader can make a huge number of bond trades per day. A fixed income system, therefore, must be able to manage volume trading. At the same time, because these trades are generally in a small set of instruments, the system has relatively few cashflows to manage. Each new bond traded is simply another instance of cashflows already calculated and stored in the system.
A swaps system, on the other hand, does not have to deal with the same volume of trades, but it must manage many more cashflows. Swaps and swaptions, now commonly used as a means of hedging interest rate risks, are unique instruments and are traded in much lower volumes. Because each swap is unique, the system must calculate and store its cashflows separately. The database must have the capacity to manage the explosion of cashflow data.
Most organisations in the past have designed their systems for the one world or the other – the high volume trading of securities or the cashflow complexities of derivatives. Because these differences often dictated the underlying architecture of the systems, banks cannot simply reconfigure them for the new task. The data model for a bond system is usually fundamentally different from the data model of a derivatives system. Few thought to design their data models to handle both.
Building an integrated fixed income and derivatives system is not a simple matter. Many banks have already learnt the hard way the problems of specifying, building and maintaining a system for derivatives. Fixed income adds another layer of complexity to an already complicated task.
But an integrated system, especially if it operates in real time, has many advantages. It more accurately reflects the way a merged organisation works. It also enables managers to consolidate bond and derivative risks and to run various forms of analysis across the combined portfolios, such as present value, value-at-risk or scenario simulations.
An integrated system can allow bond dealers to price with the swaps curve, updated by the swaps desk. It can enable repo dealers to see the bond inventory. It enables sales desks to see quotes from dealers. And it means that the system has the potential to show profit and loss for any user, desk or book, calculated in any of a number of ways, including by portfolio, counterparty or instrument, so traders and managers can always be aware of their profitability.
The 1990s has seen the traditions of fixed income collide head on with the rocket science of derivatives. By merging the two, banks are better able to respond to their customers’ needs and to exploit profitable opportunities while managing the risks of today’s fast and complex markets. But to support this consolidated approach, banks need an integrated fixed income and derivatives system that reflects the new world order.