Derivatives house of the year: Morgan Stanley

Risk Awards 2018: From inflation repacks to Formosa flows – US bank’s slimmed-down fixed-income business is gaining share

Jakob Horder

At the end of 2016, UK utility Anglian Water was sitting on inflation swap liabilities worth £561.2 million – a problem for its dealers, as the inflation payment due from the utility would not be made for more than 40 years in some cases, meaning decades of uncollateralised counterparty exposure. The utility wanted to restructure the trades; the dealers wanted to step out.

Morgan Stanley stepped in. The US bank restructured the trades in July 2017 so the inflation component was paid through their life, then routed those payments to a special-purpose vehicle, which issued inflation-linked bonds to a group of institutional investors.

At a stroke, the inflation repack – originated by Morgan Stanley in 2012 – had enabled Anglian Water to change the format of its swaps, lifted the counterparty and funding burden from the company’s dealers, and provided inflation-hungry investors with a new source of supply.

The deal is one of seven repacks the bank has completed, leading the market. It also neatly sums up Morgan Stanley’s approach to the derivatives business.

“When comparing the size of our balance sheet to one of the larger American or European banks, we’re clearly at a disadvantage if we try to compete on flow business alone,” says Sam Kellie-Smith, the bank’s New York-based global head of fixed income. “The ability to manage more exotic risk, decompose it and make it more plain-vanilla is what differentiates our firm from the competition.”

Clients vouch for that: “Where Morgan Stanley is strong is taking challenges and being able to use really interesting solutions to come up with answers,” says Jane Pilcher, group treasurer of Anglian Water.

Those abilities were on show this year throughout the fixed-income business, but particularly in rates, where the bank played a big role in recycling volatility from Taiwan’s US dollar bond market to European pension funds and US mortgage agencies, and snapped up a series of unwanted exotics and options positions from other dealers.

Morgan Stanley has been ahead of the competition in right sizing and restructuring our business and has therefore been able to capture additional market share

Sam Kellie-Smith, Morgan Stanley

To be fair, Morgan Stanley isn’t alone in doing these kinds of trades, but it is alone in being two years removed from a major restructuring of its fixed-income business, when headcount was slashed by 25%, amid continued cuts in risk-weighted assets (RWAs). The choices it made during that process – to focus on its strengths in structuring and exotics, to combine its sales and trading efforts, to value pension funds over hedge funds – are now paying off.

Comparing the first half of 2017 with the same period in 2016, one third-party analyst reckoned Morgan Stanley had taken an additional 1.9 percentage points of market share in fixed-income – achieved while global revenues were falling. With flow businesses struggling, it has been a good time to be strong in rates structuring. No other bank gained more than 0.9 points, and some saw a steep decline.

“Throughout 2016 and 2017, a number of competitors – especially in Europe – have been focused on RWAs, balance sheet reduction and disposal of legacy portfolios, which has resulted in a lower appetite for exotic and longer-dated trades. Morgan Stanley has been ahead of the competition in right sizing and restructuring our business and has therefore been able to capture additional market share,” says Kellie-Smith.

Other analysts variously rank Morgan Stanley second globally for structured rates this year, fourth globally for fixed-income exotics and options, second in Europe for inflation. These are the things the bank chose to focus on in its restructuring.

New leadership

Jobs were cut in late 2015, following a period in which RWAs had already been falling – and the new fixed-income leadership was announced in early 2016. Kellie-Smith moved from his former role as head of trading for the bank’s successful equities business; Jakob Horder moved from global co-head of rates to take charge of fixed-income for Europe, the Middle East and Africa.

On January 19, Morgan Stanley discussed its plans during its first-quarter earnings call. A presentation from chief executive James Gorman bluntly confirmed what was being rumoured and reported two months earlier. Summarising the bank’s progress in improving return on equity in its fixed-income business, a slide said simply “Failed to meet objective: initiated major restructuring.”

However difficult that process at the time, Horder saw it as the right move.

“I thought that given what was happening to the wallet in fixed income, it was a necessary step. It was, of course, a difficult process because it involves a lot of resources and a lot of people, but given the outlook for the wallet in fixed income at the end of 2015 – and borne out by what’s happened since then – it was a necessary step,” he says.

If you have limited resources, and you don’t engage with the clients on where you need to deploy them, then you risk deploying them in the wrong place

Jakob Horder, Morgan Stanley

According to research from Coalition, global revenues for fixed income, currencies and commodities were $69.9 billion for 2015 – effectively flat on the previous year’s $69.4 billion, and a 31% drop on the $91.7 billion earned across the Street in 2012.

Revenues actually picked up in 2016, but based on three quarters of data for 2017, Coalition estimates this year will see the industry fall back to sub-$70 billion levels again – its post-crisis lows.

Cutting costs and capital in line with the shrinking market may have been a necessary move, but it wasn’t sufficient – on its own – to make the business a success. What happened next was just as important. The bank sought to collapse some of its product silos, and bring together the sales and trading teams under Kellie-Smith’s leadership. In parallel, Horder and other senior figures spent a lot of time speaking to clients.

“It’s a constrained optimisation challenge. If you have limited resources, and you don’t engage with the clients on where you need to deploy them, then you risk deploying them in the wrong place – so we spent a lot of time on client engagement in the first half of 2016,” he says.

Mindful competition

The takeaway was that, in many asset classes, Morgan Stanley needed to continue offering the full product suite – Horder gives the example of credit, where clients want cash and derivatives products to be available side by side, or in combination – but would not try to compete only on price, or in flow. 

“We are better positioned to compete in the structured space, where the ability to recycle risk and identify resource-efficient solutions is a differentiating factor,” says Kellie-Smith.

Take the inflation repacks as an example, or the trades done by the bank on the back of Taiwanese debt issuance. In the latter, huge demand from local insurers for callable US dollar debt – Formosa bonds – also produces a steady stream of hedging by issuers. The complexity arises because these hedges effectively leave dealers long Bermudan-style swaptions – exercisable only on certain dates – which are hedged in turn by selling European-style swaptions to the market.

Those flows have opened up opportunities for investors, but it requires a nimble bank to join the dots: the constant supply of US dollar swaptions has helped produce a downward-sloping term structure for US volatility, allowing investors to buy forward volatility relatively cheaply. Other investors have been keen to take the spread risk between the Bermudan and European swaptions.

Our fixed-income business has strong relationships with real-money accounts and a greater proportion of Emea revenue comes from this client base, when compared to our competitors

Sam Kellie-Smith, Morgan Stanley

Morgan Stanley has done both kinds of trade, Horder says – connecting Taiwan’s bond market with participants as diverse as US mortgage agencies and European pension funds.

One of those clients – a very large derivatives user – cites these flows when praising the bank’s rates franchise: “We like them a lot – they’re a top-three shop for us. Their coverage is strong, risk appetite is strong, and they feed us plenty of Formosa stuff.”

This approach to the business requires good traders and smart salespeople, strong risk management and the ability to track resource consumption effectively. Horder says the bank invests heavily in its technology and modelling infrastructure as a result. Crucially, it also implies a diverse client base – Morgan Stanley doesn’t have the balance sheet or capital base to load up on illiquid risk, so it needs an exit.

If the risk can’t be recycled, then the bank can’t afford to take it in the first place, says Horder: “It takes a lot of rigour. Lots of internal discussion, and an ability to move across silos and look at things as one business.”

Pension funds are a particularly important segment of the client base in this respect; they have the appetite and sophistication to digest some of the awkward exposures other market participants want to offload. More importantly, that demand is structural. By contrast, hedge fund demand can be cyclical.

We are hopeful we’ll now see some regulatory forbearance, particularly as it relates to reducing complexity and the administrative burdens of compliance

Sam Kellie-Smith, Morgan Stanley

“Our fixed-income business has strong relationships with real-money accounts and a greater proportion of Emea revenue comes from this client base, when compared to our competitors,” says Kellie-Smith. “Focusing on real money instead of hedge funds has been a deliberate strategy for 2017.”

Kellie-Smith says the “single most important objective” for Morgan Stanley is delivering its promised firm-wide return on equity of 9–11%. In 2015 and 2016, it fell just short – at 8% – but this year the firm has met its target in each of the first three quarters.

The question is whether it’s sustainable over the longer-term. For fixed income, Kellie-Smith says the reforms the bank has pushed through will help – and there are external reasons for optimism, too.

As one example, prudential regulation may be more stable and simpler in the years ahead, in line with the policy agenda of the US administration and some of its regulatory appointees.

“We are hopeful we’ll now see some regulatory forbearance, particularly as it relates to reducing complexity and the administrative burdens of compliance. So far, though, there has been relatively limited tangible progress because the agenda of the new leadership has not been implemented,” he says.

Other factors could lend a hand, too – but he’s not counting his chickens: “Over the longer term, there are several catalysts that could increase activity and revenues – tax reform, further interest rate normalisation, the unwinding of quantitative easing, a return of normal volatility. However, we are not there yet.”