Interest rate derivatives house of the year: Nomura

Risk Awards 2023: Contrarian stance on rates volatility helped Nomura hoover up euro swaptions business when inflation sentiment shifted

Photo: MIKI Yoshihito/Flickr

The date is October 28, 2021. Boris Johnson is UK prime minister. Russia hasn’t yet invaded Ukraine. The US Federal Reserve’s target rate is 0%–0.25%. The European Central Bank, at a press conference marking the end of its latest two-day monetary policy meeting, announces that eurozone inflation won’t be as transitory as it had previously insisted.

The statement sent ripples through a rates market that has continued to feel the effects of stubbornly high inflation ever since.

Euro swaptions saw a near 50% rise in implied volatility immediately after the ECB announcement, as traders adjusted to new expectations of rate rises. Most banks were caught on the wrong side of the vol move, leaving them poorly equipped to respond to a wave of requests from clients that were short volatility and needed to restructure or unwind swaptions.

Ali Khan, Nomura

Nomura was in a different position, though. The previous month, the Japanese bank had flipped its swaptions portfolio from short vol to long vol. The move proved prescient, enabling the bank to sweep up business from a number of counterparties – including trades that were first made with other dealers.

A portfolio manager at one US hedge fund says: “We trade very actively, and in October we were the wrong way around. We were able to unwind our risk and go the other way with Nomura. We moved the ship from left to right in decent size trading and they were able to do that for us.”

“Our existing dealers were able to quote but it was an uneconomic price to trade. Other counterparties were able to show prices but at outrageous levels, and Nomura had a fair charge,” the manager adds.

The bank’s competitive pricing wasn’t a one-off. A derivatives trader at one European pension fund says Nomura was one of the few banks able to show good prices for euro swaptions from October through the volatile early months of 2022.

A portfolio manager at a large US macro fund agrees: “Even when things are falling apart Nomura will show you an appropriate, professional price.”

When right is wrong

Nomura’s decision to switch its swaptions volatility exposure wasn’t down to a lucky hunch or vague intuition. The move sprang from cold logic.

In early 2021, rates and volatilities were stuck in the doldrums, and the consensus trade was to short rates volatility. But around that time, the Japanese bank saw some non-traditional players come into the rates volatility space and start buying protection against higher vol in dollars and euros.

Volatility stayed lower than expected throughout the summer, amid a continued dovish stance from the ECB.

“That gave us a clear indication that even if the view is right, the short vol trade was probably not the right trade, given the level of volatility and the positioning that was then prevalent in the market,” says Ali Khan, head of rates options trading for Europe, the Middle East and Africa (Emea), and North America at Nomura.

“That flagged to us that the view people have is a consensus view, and a consensus view is always prone to a move in the adverse direction if it becomes too consensus,” he adds.

The final piece of the puzzle came in September 2021, when inflation at the front end of the UK market was starting to take off, but key macro indicators for euro markets such as two-year options on two-year swaps, or 2y2y for short, were lagging.

The point of view we had at the time was that this is not a business-as-usual type of market and as a consequence one has to be ready for some surprising moves

Ali Khan, Nomura

So, Nomura decided to flip the positioning of its euro swaptions book from short to long vol. The market was sufficiently liquid to reorientate the book and reduce the shorts the bank had built up since July.

From that point, Nomura began warning clients to expect higher euro vol. But as volatility had been rangebound for so long, some were sceptical.

“I remember at that level of 21 cents premium for a 1y1y swaption, we were making various arguments about fundamentals and positioning. But there was a lot of pushback at the time,” says Khan.

However, vols started rising through October as markets started to sense a change was coming, with 1y1y swaptions hitting 42.9 basis points of annualised normal vol (roughly 34c premium) the day before the October 28 ECB meeting.

“I’m pleased to say that we were able to get some people on-side, but the point of view we had at the time was that this is not a business-as-usual type of market and as a consequence one has to be ready for some surprising moves,” says Khan.

When the ECB finally relented at its October meeting, 1y1y soared, hitting 62.7bp vol on October 29, at which point Khan says Nomura started to see unwind requests come through from the buy side.

Some of the larger trades – the type that would be considered very large on a regular day, let alone during a stressed market – came from clients looking to unwind positions they had originally traded with the top three or four banks but who were unable to help at the time.

“Usually you’d try your best to service clients on the way out, so the fact that we were able to crack in gave me a pretty clear indication that not everybody was necessarily keen to take on the other side of that risk at that time. But we were pleased to be able to offer liquidity at the point when those clients needed it,” says Khan.

The portfolio manager at the US hedge fund says he believes Nomura’s positioning was key to helping them get rid of their short vol position after October.

“If you go into a storm the wrong way around, first you need to correct your own position and then you can help others. I think Nomura were better positioned than others,” the manager says.

Even buy-siders looking to put on new risk found it hard to get good quotes in this period. “Most dealers wouldn’t quote and we only had Nomura and one or two others in that [post-October ECB] period,” says a swaptions trader at one large US asset manager.

Throughout 2022, as vols moved up to a high of 169.5bp vol on September 28, the Japanese bank largely ran a flat or long position as the ECB finally started to raise rates once again.

Up the creek without a straddle

However, not all clients are able to manage swaptions if they want to go long rates volatility, which in 2022 was a far better hedge for equity markets than holding bonds. One real money client wanted to express a long volatility view without having to roll, re-strike and delta-hedge individual swaptions.

Tina Rydberg, Nomura

So Nomura created an index based on straddles – which involve purchasing payer and receiver swaptions on the same strike to allow for bets for or against large moves in vol. Nomura’s index is published via a third-party provider and delivers the returns of long or short straddles at a desired point on the volatility surface. Clients can choose up to 63 vega points that cover options expiries from three to 30 years and swap expiries from two to 20 years. Clients can also access a strategy that selects points by relative value over time.

It's early days, but so far Nomura has traded around $1 billion notional in a 5y5y straddle equivalent.

“So you can buy an index product from us, which replicates the risk and return characteristics of a given swaption, automatically managing vega and delta and avoiding daily maintenance. We can offer this across the swaption surface,” says Tina Rydberg, head of quantitative investment strategy sales for Emea at Nomura.

“We’ve created something that makes it accessible to people who intellectually understand what the product is, but might not have all the operational capabilities of booking and maintaining a big, complicated book of option products,” she adds.

Techno fans

Nomura’s rates achievements this year aren’t limited to the niche area of swaptions. The bank has also used technological innovations to address client problems.

Five years ago, Nomura started to move away from off-the-shelf connections to electronic interest rate swap venues, and build its own in-house system. The project aimed to give the bank more flexibility to respond to client requests rather than relying on a vendor to make the required changes.

“If we’re using standardised tooling we may not be able to compete in the way in which we would like to in the future,” says Tariq Malik, head of fixed income electronic markets for Emea and Asia ex-Japan at Nomura.

Photo: Geraint Roberts

Tariq Malik, Nomura

The bank already offered automated pricing of multi-asset swap packages on Tradeweb, taking quote times down from tens of minutes to less than a second. But in 2022 Nomura improved execution of euro asset swaps, which are a Eurex-listed future versus an interest rate swap. These key macro trading instruments enable users to turn bond coupons from fixed to floating.

Euro asset swap execution is a complex and manually intensive process, typically taking more than 10 minutes with multiple touch points across dealer and client. Now, though, Nomura can trade a fully automated euro asset swap in seconds with no manual intervention.

Another nifty piece of innovation was for a pension fund client that wanted to trade more Asian interest rate swaps electronically, as its back office was limited by how much voice trading it could process. However the fund was unable to get two-way pricing on-venue – where they receive a bid and offer price without revealing their trading intentions – which it needed for best execution analysis purposes.

Nomura had previously implemented two-way pricing for euros, and was able to transfer it to yen and Australian dollar swaps, allowing the client to shift to electronic trading and execute more business.

Growth in emerging market swaps trading helped boost Nomura’s electronic swap volumes by more than 50% in 2022, and saw the bank ranked number one for Asia ex-Japan emerging market interest rate swaps on Tradeweb for the year as measured by DV01 traded, which is the sensitivity of present value to a 1bp move in underlying rates.