Derivative Execution Study

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Derivative Execution Study

Bridging the Client-Dealer Gap

September 2010

CONTENT

Executive Summary Introduction Methodology

Questions & Responses

Executive summary and key findings Detailed Findings

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Executive summary

In June 2010, Reval, along with Treasury and Risk magazine, surveyed corporate and financial institutions across multiple industries worldwide to see how they handle their derivative execution programs. The following study examines the recent trends that these firms have seen regarding their use of derivatives as well as their experiences with bank counterparties.

Introduction

Just past the midway mark of 2010, end-users of derivatives have begun to rise from the global financial crisis and the economy has begun to see signs of life. Lessons learned from major economic events have resulted in a global “eye-opening” to regulatory reform and more prudent approaches to risk management. As the derivative end-user community has now seen and felt the aftershocks of these events, banks have wondered what their role would be when and if their clients were required to switch gears and reassess and readjust their use of derivatives in their risk strategies.

Who would still use these instruments? What would be the impact on their volumes? Would there be shift in complexity? As a strategic business partner to leading global banks and financial institutions, Reval engaged the help of Treasury and Risk Magazine to scour the user market for answers and administered a survey of derivative end-users that resulted in the Reval Derivative Execution Study: Bridging the Client – Dealer

Gap.

This study addresses many of the questions that have been on the minds of most derivative sales desk professionals and aspires to provide pivotal business insight to help these groups. By knowing clients’ risk management needs, derivative sales desks have the unique opportunity to leverage their relationships to help create and execute a clear strategy for them.

About Reval

ABOUT REVAL Reval®

provides an award-winning Web-based platform that auto mates corporate financial risk management for a wide range of interest rate, foreign exchange, commodity and credit derivatives. The world’s leading corporations and financial institutions use this SOX-compliant Software-as-a-Service to support and execute hedging strategies from exposure capture through performance measurement and to comply with international and domestic accounting standards, including ASC 815 (FAS 133), ASC 820 (FAS 157), IAS 39 and IFRS 7. Reval® deploys rapidly and integrates easily with treasury management and ERP systems. The company’s SaaS platform and team of financial experts are also available on an outsourced basis through Reval Center™. Reval was founded in 1999 and is headquartered in New York, with regional centers based in Philadelphia, Chicago, San Francisco, Toronto, London, Frankfurt, Graz, Sydney, Hong Kong, and Gurgaon.

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Methodology

In Spring of 2010, Reval launched its Derivative Execution survey and engaged global corporations and financial institutions to gain a better understanding of derivative use to manage risk and execution preferences of corporate users. Respondents were targeted by their firm type and business role. A total of 347 qualified respondents completed the survey. Respondents received an email invitation to participate in the survey, which included a URL linking to the Web-based form.

In this survey effort, Reval worked with a team of recognized derivative and hedge accounting experts to build the survey questions and with Treasury & Risk on the technical tasks of survey building and fielding. Treasury &

Risk reaches over 40,000 financial professionals through its various publications and events in over 25 industries

worldwide, thus enabling Reval to survey otherwise hard-to-reach audiences.

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Chart 2. Respondents by Company Size

Questions & Responses

The questions included in the survey were developed to gain insight and determine the mix of asset classes, volumes and complexities of hedging programs, execution strategies and best practices currently being exercised by corporations utilizing derivatives to manage and mitigate risk. The questions also addressed areas of service where end-users of derivatives would like to see their derivative counterparties make improvements.

The survey contained the following 12 questions:

1. Do you hedge commodities within your organization?

2. How would you rate the complexity of your hedging programs?

3. Compared to last year, how would you characterize your derivative activity? 4. How do you prefer to execute your derivatives?

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6. How would you characterize the dealer sales coverage of your organization?

7. In your opinion, what percentage of the swap dealers that you interact with will require 2-way CSA’s in the next year?

8. Based on your current derivative portfolio, what percentage of derivatives are in long-haul relationships? 9. How do you perform your long-haul effectiveness testing today?

10. How heavily does the means to assess and measure ineffectiveness in your hedging relationships, factor into your execution decisions?

11. In terms of valuations, does CVA (in addition to market values) factor into your execution decisions?

12. If CTM and Short-Cut is disallowed under your governing body, how do you plan on assessing and measuring ineffectiveness in your hedge accounting?

Executive Summary & Key Findings

The Reval Derivative Execution Study found valuable information in terms of derivative usage, improvements that derivative sales desks could make, and value-added services that derivative counterparties could provide to help corporate end-users of derivatives. The results of this study provide a level of insight that will allow derivative sales desks to manage client relationships and offer more services and support around derivative execution services.

Derivative Usage

In terms of derivative usage, the survey found that 60% of the respondents hedge either interest rate or currency risk. Further, 40% of respondents hedged some sort of commodity price risk to which they were exposed. Of those respondents hedging commodity risk, roughly twice as many were likely to be hedging it through the treasury department rather than the procurement department. This indicates a trend towards centralizing the hedging of all asset classes within the treasury organization, and that a single area of managing an organization’s risks—whether it is currency, interest rates, or commodities—is emerging and the treasury organization seems well-suited to do this. Complexity of Instruments

The study also found that most end-users of derivatives tend to use very vanilla (linear) strategies when hedging their risks. Additionally, research revealed that the use of options in corporate hedging programs is sorely under-utilized with only 20% of respondents currently incorporating these instruments in their strategies. As options-based strategies could be more profitable depending on the economic environment, banks may want to consider educating derivative end-user clients on the benefits of utilizing options during the sales process. The study also found that despite all the volatility in the past year, nearly 70% responded that their usage of derivatives continued to be roughly the same as previous years.

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Client Relations

The study found that, a major area of improvement that corporate clients would like to see is in post-trade support and services from their bank counterparties, specifically hedge effectiveness calculations as well as credit value adjustments (CVA) for their derivative portfolios.

With the pending discontinuation of the short-cut and critical terms matching, support for post-trade hedge effectiveness measurement using the long-haul method is a clear opportunity. Under these proposed regulations, 100% of respondents indicated that they will need to find a way to perform effectiveness testing currently being accomplished by their use of CTM and Short-Cut, whether through in-house development or third-party help from a vendor or counterparty. Similarly, 83% of the respondents revealed that a significant portion of their current derivative transactions were designated under the long-haul method, which requires stringent effectiveness assessment and measurement.

Additionally, corporate end-users requiring CVA also indicates opportunity for financial institutions. Roughly 77% of respondents suggested that providing the means to calculate credit value adjustments would factor into end- user’s execution decisions.

The majority of survey participants said that if bank counterparties were to provide them with a means to accomplish these rigorous tests, it would play a role in their decision to execute with a particular financial institution. From these results it can be concluded that there is a very lucrative opportunity here for banks to increase volumes and take advantage of this need to offer crucial post-trade services

The study also revealed that over 63% of respondents stated that they considered the coverage from their derivative counterparties as either reactive or unresponsive.

In conclusion, end-users of derivatives continue to struggle with regulations and accounting guidance post-trade and are looking for their derivative counterparties to be strategically involved in their trade and execution decisions. Financial institutions must be able to bridge the gaps between financial, regulatory, client, and investor needs in order to achieve the status of a trusted, strategic business partner among users of OTC derivatives.

Moreover, it is critical that derivative desks be more proactive. Based on feedback found in this study, it can be said that derivative dealers often perceived as merely liquidity providers exists based on the feedback found in this study.

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Derivative dealers have the opportunity to evolve from providing quotes to occupying the role of strategic partner and adding more value to end users’ hedging decisions. In particular, we see that post-sale solutions and services will indeed allow derivative desks to gain the trust of their clients and unlock more value from the end-user community through larger spreads and/or increased flow.

Detailed Findings

Below are the specific findings per survey question

Question 1. Do you hedge commodities within your organization?

Summary of Responses.

• 60% of respondents do not hedge commodities

• 26% of respondents do hedge commodities and it is done out of Treasury • 14% of respondents do hedge commodities and it is done out of procurement

Trend in Findings. The survey found that of the respondents that do hedge commodities, 26% performed the

function out of treasury while the remaining 14% handled it out of procurement. This indicates a consolidation in terms of hedging and execution within the treasury organization. As treasury departments traditionally have experience in dealing with derivative counterparties, this is a logical trend.

Conclusion. Based on the responses received, we see that the majority of end-users are hedging currency and/

or interest rate risks rather than commodities. In terms of the execution of commodity derivative contracts, which were once a purview of the procurement department, the paradigm seems to be shifting in such a way that more execution is being accomplished through the treasury organization instead of the procurement department. As treasury departments have become more strategic in recent years, there seems to be a trend in consolidation towards streamlining all execution with most end-user organizations.

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Question 2. How complex is your hedging program?

• 26% of respondents described their program as ADVANCED with basic plain vanilla options

• 24% of respondents described their program as BASIC with no options but with basic averaging products like average rate forwards

• 50% of respondents described their program as VERY BASIC with no options or structured products

Trend in Findings. The vast majority of participants revealed that they kept to primarily linear structures (forwards,

swaps). The dominance of linear structures over options indicates a possibility that options may be undersold.

Conclusion. In the aftermath of the global financial crisis, it is a fairly safe assumption to say that executing more

complex structures has lost much of its appeal and users have become much more conservative, which has affected the volumes and spreads that the dealers see. A potential correction to this deficiency could be to provide additional education about valuation and accounting, options and more creative structuring choices as this lack of knowledge may be a reason for the preference of linear products. As will be evident in responses to subsequent questions, derivative providers may need to provide value-added services that will boost confidence in the use of these instruments amongst

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Question 3. Compared to 2009, how would you characterize your derivative activity?

• 13% of respondents indicated they are executing 50% or more transactions • 12% of respondents indicated they are executing 50% or less transactions

• 75% of respondents indicated they didn’t experience much change and only saw a 10% variance

Trend in Findings. It is clear there has been very little change in the volume of derivative transactions by the

enduser community. The below chart from the Bank for International Settlements further supports our findings.

Conclusion. Though many financial institutions have reported a decline in the volume in recent months, we see

that the constant nature of the underlying volatility of exposures in the end-user community may have lead to the “churn” of derivative products being the same as the prior year.

Question 4. How do you prefer to execute your derivatives?

• 28% of respondents said that they prefer to execute trades over the phone • 72% of respondents said that they would like to execute via web portal

Trend in Findings. Of the respondents, 72% said that they would prefer to execute trades in an automated way.

These findings indicate that relying on more manual execution processes such as telephone/verbal methods actually increase operational risk and decrease efficiency.

Conclusion. With end-users looking to increase operational efficiency while reducing associated risk, an automated

platform for execution would be a welcomed addition to services and support options offered by the dealer community. Those that would prefer this type of execution such as a web portal, would require access to multiple sources of liquidity and/or the ability to execute derivatives across multiple asset classes.

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Question 5. In your opinion, what could financial institutions do to improve their derivative execution services?

• 18% of respondents said they would like to see improved Market and Economic analysis

• 25% of respondents said they would like to have access to more post-trade services such as valuations and hedge accounting

• 36% of respondents said they would like to see improved pricing

• 20% of respondents said they would like to be offered more creative structuring ideas

Trend in Findings. In addition to clients wanting to see improved pricing for their transactions, a key insight from this

survey is that respondents would also like to be offered more creative structuring ideas. As seen in the findings from question 2 above, there has been a shift from complex to more simplistic structures. There are two possible reasons for this; one is again that clients need creative structuring even on the most basic trades as the complexity stems from the need to satisfy the delicate balance of investor, regulatory and financial needs. The second conclusion may also be that the reason for staying away from complex trades could be that clients don’t feel comfortable with the structuring recommendations provided by the counterparties from a risk perspective. Also apparent from the data, is the need for more post-trade services. This topic will be addressed in the subsequent questions.

Conclusion. Financial institutions have the opportunity to build client trust and partnerships by providing more

creative valuation and accounting options. We have also seen many of our financial institution clients achieve success with their corporate counterparties by really making the effort to provide local expertise to help keep a pulse on regional issues that could impact their clients’ needs. When financial institutions are in tune with local markets and trends and the affects these have on their clients’ overall strategy, they can provide more creative and personalized options to help clients realize their goals through the use of derivatives.

Question 6. How would you would you characterize the dealer sales coverage of your organization?

• 37% of respondents found their sales representatives to be proactively responsive and knowledgeable of the market

• 63% of respondents thought their sales representatives unresponsive and reactive, only responding quickly with quotes and added limited value to their needs and strategies

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Trend in Findings. The responses to this question provide insightful areas of improvement for derivative dealers. In

addition to the need for better pricing, the responses show that over half of end-users feel that sales coverage effectively amounted to providing quotes and not other value-added services that would make them feel confident that they had a strategic partner in their bank counterparties.

Conclusion. Providing post-trade services such as hedge effectiveness testing and credit value adjustments, in

addition to market commentary and creative structuring ideas, would enhance dealer reputations and could lead to more deal flow. There is a great deal of room for financial institutions to offer improved hedging strategies and advice.

Question 7. In your opinion, what percentage of the swap dealers that you interact with will require 2-way CSA’s in the next year?

• 84% of respondents think that 50% or less of swap dealers will require 2-way CSA’s • 16% of respondents think that 50% or more of swap dealers will require 2-way CSA’s

Trend in Findings. Based on the salience of credit risk after the global financial crisis, it is interesting that only 16%

of respondents stated that more than half of their derivative counterparties would require 2-way CSA’s in negotiating ISDA agreements.

Conclusion. As a general market observation, the issue of credit risk might not be as significant as it was during the

global financial crisis. In addition to these findings, experience tells us that clients largely lack the analytical tools to assess and measure financial risk in their hedge relationships and the role of financial institutions in these trades is to provide the means to identify and mitigate the risk that may threaten the clients’ financial performance.

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Question 8. Based on your current derivative portfolio, what percentage of derivatives are in long-haul relationships?

• 61% of respondents noted that they have 25% or more of their derivative portfolio already in long-haul relationships

• 39% of respondents noted that they have 25% or less of their derivative portfolio already in long-haul relationships

Trend in Findings. Although most respondents stated that their programs were very basic (see data from question

2), over 83% of respondents stated that at least half of their derivatives were in long-haul hedge accounting relationships. In light of proposed regulatory changes, auditors have begun to advocate the death of abbreviated methods of hedge effectiveness assessments, thus promoting early adoption among end-users. This factor supports the trend identified in this study.

Conclusion. With the emphasis on the “long-haul” (more complex) method of hedge effectiveness assessments

and measurements, there is increasing pressure being placed on the accounting departments within the end-user’s firm. We expect this trend will continue.

Question 9. How do you perform your long-haul effectiveness testing today?

• 47% said that they have an in-house tool that does Dollar-Offset and/or regression analysis for hedge relationships

• 34% said that they counterparty provides them with on-going assessments and measurements • 19% said that they outsource to a third-party vendor

Trend in Findings. With a combined 66% of derivative end-users indicating that they are already looking at support

alternatives, the need to perform effectiveness testing is quite clear. Looking back to the results of Question #5, many users would like to receive this support from their banks. With only 28% currently receiving these post-trade assessments and measurements, there is clearly an opportunity for the dealer community to add value in this area.

Conclusion. The increase in auditors scrutinizing accounting for derivatives and advocating the more complex

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Question 10. How heavily does the means to assess and measure ineffectiveness in your hedging relationships, factor into your execution decisions?

• 62% of respondents said that effectiveness testing help from their counterparties would play a role in their execution decision

• 38% of respondents said it would have no bearing

Trend in Findings. End-users are being challenged by the accounting requirements placed upon the use of

derivatives. In line with the findings above, increasingly stringent regulatory requirements make it necessary to perform this testing.

Conclusion: Many end-users lack the resources, tools and expertise to assess and measure the effectiveness of

their hedges. Counterparties would make themselves an invaluable strategic partner if they provide clients the ability to perform these functions. Once addressed, these capabilities would no doubt factor into the end-user’s execution decisions.

Question 11. In addition to market values, how does the ability to perform CVA factor in your execution decision?

• 77% of respondents said that CVA is a big hurdle and support in this area would factor favorably into their execution decision

• 23% of respondents said it has no bearing

Trend in Findings. Similar to the need for hedge effectiveness analysis, calculating credit valuation adjustments

also places a fairly large burden on end-users and discourages them from using complex structures and executing larger volumes.

Conclusion. With the issue of CVA addressed either in addition to or in isolation of hedge effectiveness

assessments, volumes would rise and dealers could gain more market share and capture higher spreads on on-going transactions.

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Question 12. If CTM and Short-Cut is disallowed under your governing body, how do you plan on measuring ineffectiveness in your hedge accounting?

Summary of Responses.

• 34% of respondents said they would build this functionality in-house

• 34% of respondents said they would expect their counterparty to provide this service

• 32% of respondents said they would look to third-party vendors that specialize in this area to provide this service

Trend in Findings. 100% of all respondents would need to find a way to handle effectiveness testing currently being

handled by their use of CTM and Short-Cut in the likely event that the proposed changes to derivative accounting regulations take place. Whether it is in-house development or third-party help from a vendor or counterparty, the need to perform complex effectiveness testing will exist.

Conclusion. By addressing post-trade challenges in their suite of risk management services, derivative dealers

could go a long way to becoming strategic partners. Leveraging this position, dealers are likely to either extract more value through larger spreads from existing flow of transactions or could see an increase in the number of transactions that they are able to execute with end-users.

Recommendations to Financial Institutions

With over 300 respondents from the end-user community participating, this study provides a baseline from which to gain insight into the thought processes and execution habits of end-users. While pricing remains the major hot button for derivative users, it is clear based on the findings in this study that end-users are struggling with the rapid pace of change in accounting regulations, namely those around ASC 815 (FAS 133) and ASC 820 (FAS 157). By providing a means to alleviate these posttrade challenges, derivative desks may start to realize better relationships with their clients either through justifying larger spreads or through more deal flow from end-users.