Currency derivatives house of the year: Barclays Capital

The foreign exchange market was characterised last year by a series of big events and correspondingly big moves – one by one, the yen, Swiss franc and Brazilian real all experienced severe volatility that put dealers’ risk management capabilities to the test. And, of course, there was the escalation of the eurozone’s debt crisis.

But it was also a year of big trades for Mike Bagguley, London-based global head of forex trading at Barclays Capital, and the rest of his team. Chief among these was a massive dollar-sterling option, underpinning an $11 billion bid by IT giant Hewlett-Packard (HP) for UK software company Autonomy. The acquisition was completed in October, but under UK takeover rules, talks could not be held unless HP was able to prove it had sufficient funds in sterling to close the deal, and the US company decided buying a dollar put option would be a smarter move than arranging a credit line. While the option was simple in terms of structure – with a single strike agreed for a single day – it was a mammoth trade in terms of size. “In my 17-year career in currency options, there’s only been one transaction I’ve worked on that has been larger than this, and very few others have been anywhere close to its size,” says Rob Bogucki, New York-based head of forex trading for North America at Barclays Capital. This presented the bank with some significant challenges.

For HP to successfully complete its acquisition, secrecy was paramount – and that meant the accompanying option trade as well. “Our ultimate goal was to have no noise in the market on the trade. I would compare it to walking an elephant through a small room with no-one noticing,” says Bogucki. “Once the notional amount of a trade goes above $1 billion, everyone starts to ask questions.”

HP’s interest in Autonomy had already made its way into the press. It faced the danger of the market immediately identifying this massive trade as part of a cross-border strategic transaction, putting two and two together and coming up with HP as the answer. So Barclays Capital split the trade into smaller pieces, and hedged using a range of different currency pairs over a certain period.

“The client’s goal was to end up with a dollar/sterling option at a specific expiry. Given the size of the transaction relative to the market and the level of confidentiality around the underlying transaction, we executed this by breaking the transaction up into a number of tranches over the course of several days. In addition, we mitigated the risk across a variety of currency pairs, in varied amounts, and at different times across our three main market centres,” says Bogucki.

Our ultimate goal was to have no noise on the trade whatsoever. I would compare it to sneaking an elephant onto the trading floor without anyone noticing

This strategy only worked because of the depth of the bank’s forex franchise, Bogucki claims. “We had some risk mismatches on this trade initially, because of the range of currency pairs used to give the client this concentrated position, but we were confident the strength and liquidity of our voice and electronic platforms would eventually take us out of those mismatches. The business came through with flying colours,” he says.

The timing of the trade, scheduled for early August, didn’t make things any easier. On August 1, members of the US Congress finally agreed a deal to raise the nation’s debt ceiling, avoiding a sovereign default by just a few hours. However, the preceding weeks of grandstanding and brinkmanship had not gone unnoticed – on Friday August 5, Standard & Poor’s removed the US’s AAA credit rating, knocking it down a notch to AA+.

“Our biggest risk on this trade in the aftermath of the US downgrade was illiquidity in the currency market. In that scenario, volatility increases and correlations break down, so there was a possibility we would have to reconsider our execution strategy,” says Bogucki. “Once we saw the early movements in Asian markets the following Monday, we were confident liquidity would hold up and we’d be able to do what we planned to do, so we advised the client to go ahead with the trade.”

Alongside the HP elephant, Barclays Capital has completed a number of other chunky trades this year. These included a swap of European Union farming subsidies from euros into sterling on behalf of the UK’s Department for Environment, Food and Rural Affairs (Defra). The contract hedges Defra against its exposure to the euro between the point when it pays UK farmers the subsidies in sterling and receives the receipts. The gap between payments and receipts can be several months, so Defra often faces substantial risk on movements of the euro verus sterling on trades that can hit notional values of above £2 billion.

Chris Pleass, head of finance for the food and farming group at Defra, is highly complimentary about the bank’s performance on this trade. “We selected Barclays Capital through a competitive tender process. We feel like we get a lot of customised, personalised service from them, and they keep us well informed about what’s going on so we can understand the macro issues around the transactions,” he says. 

The bank has also flexed its muscles in product innovation. Over the first half of 2011, the Brazilian real appreciated strongly against both the dollar and euro as carry-trade investors flocked to take advantage of the country’s high interest rates. By July, the real was overvalued by around 30–35%, analysts at Barclays Capital estimated. As a result, it became expensive for corporates with operations in Brazil to hedge against a sudden drop in the currency’s value, which eventually happened in a violent few weeks during August and September, after intervention by the Brazilian government – one of the most severe swings the Latin American forex markets have seen, even during the crisis years (Risk December 2011, pages 16–20).

“Few corporates were selling Brazilian real and buying dollars or euros to hedge themselves because the cost of carry was expensive, anything from 7–12% a year,” says Rudi Alexis, head of corporate forex for Europe, the Middle East and Africa at Barclays Capital in London. Corporates were left in a quandary – accept the exposure, or hedge but pay through the nose to remove the risk of a slide in the value of the real. In response, the bank worked out a system that allows clients to hedge their exposures dynamically by using two market parameters to estimate how much they need to cover on a day-to-day basis – the trend of the Brazilian real spot price and the volatility of the real.

“It’s simple, accounting friendly and allows the client to save carry in periods when the currency appreciates and be hedged when the currency depreciates,” says Alexis. This strategy was used by one of Europe’s biggest corporates.

Volatility was not just a challenge for clients – over the past 12 months, many dealers fell into one of the event-driven traps that appeared along the way. Arguably the biggest was the decision by the Swiss National Bank to halt the rapid appreciation of the Swiss franc by pegging it to the euro on September 6. The currency swiftly moved from Sfr1.11 to the euro to Sfr1.20 – a slump that left many dealers nursing losses, in part because of legacy structured trades transacted with French local authorities. In the mid-2000s, many banks extended long-dated euro-denominated loans with coupons linked to the Swiss franc, creating a long vega position in the euro/Swiss franc cross. When volatility collapsed following the imposition of the peg, individual losses for some dealers are said to have topped $100 million.

Barclays Capital claims to have avoided the pain, and Bagguley puts this down to discipline. “For every product type you have, and for every portfolio you hold, you need to be very disciplined in how much exposure you take on and in mapping out how you will respond to a tail event, especially those that might affect your inventory of structured positions. I think we’ve managed to do that very well this year,” he says.

Bagguley says September – which included most of the Brazilian real slide as well as the Swiss franc move – was actually a big month for the bank’s forex business. “In terms of volume, our top five highest-volume days ever occurred in the second half of this year. The reaction to the Swiss franc peg was a great example of how strong our business is – we have a huge amount of capacity, we are connected to clients across the globe and we can very quickly move resources to where they need to be,” he says.

But things could get tougher still in 2012 and beyond. The introduction of Basel 2.5 and Basel III is set to make over-the-counter derivatives a far more capital-intensive business – particularly for uncollateralised trades, which are common among the forex market’s big base of corporate end-users. And new regulation on both sides of the Atlantic will see some portion of the forex business moving to central clearing, as well as ramp up the pressure to trade electronically.

Bagguley remains optimistic. “We approach the various strands of regulatory reform with a lot of confidence, focused on ensuring fair and equal access to all execution and trading related venues. The foreign exchange industry benefits from a safe settlement mechanism in CLS Bank. Safe settlement combined with increasing transparency leave us very optimistic that volumes and client numbers within the asset class will continue to grow, and that we’ll be able to build on our strong performance this year into 2012.”