Profile: Deutsche Bank - A new lease of life

Deutsche Bank has been aggressively ramping up its institutional equity derivatives business, after a departmental restructuring. Equity derivatives specialists Denis MacCarthy and Charles-John Donley tell Jill Wong about the Asian business

Going by the results of our end-user poll in June - when Deutsche Bank topped the equity derivatives rankings for the first time - the business in Asia certainly seems to have exceeded the rapid growth in Europe. Tell us how you're leveraging off the single platform created by the merger of your debt and equity divisions and integration of cash equities and equity derivatives in late 2004.

Denis MacCarthy, managing director, institutional client group, global equity derivatives: Three years ago, we started to build up the equity derivatives business in Asia by focusing on areas such as aXess products, futures and options, and over-the-counter (OTC) products. Then we moved into more complex trades, such as variance, dispersion and correlation, before looking to develop the business in other ways. In late 2004, we integrated global market equities (the cash and derivatives divisions) as well as the debt and equity businesses, and with this came opportunities to develop our franchise even further.

Within the hedge funds and derivatives space, we have typically focused on offshore clients dealing in onshore products in Asia. Over the past year-and-a-half, we've started to look at other applications, such as private deals - pre-IPOs, convertible bonds and so on - and in conjunction with that, we've been leveraging off the prime brokerage platform. When we talk to a client about a private transaction, we can finance and package it into a prime brokerage structure, where the client will see the benefits of our cross-margining structure.

Our focus, as it has been for the past year, is to build on the hedge fund business - flow products and high-end derivatives such as dispersion and correlation trades - and to continue building the institutional client base on a local level. We've had recent success with commodity products, such as a gold variance swap, which I believe was the first in the world when we first traded it four months ago in Asia.

The upside is potentially greatest in the private transaction business. No longer does this just involve origination and syndication skills; there is now core support from the derivatives team in Asia to provide the financing and packaging for these transactions. We're one of the few banks that allow hedge funds to finance private transactions within prime brokerage, and that's an incredible advantage for us.

In developing the business in Asia, we have facilitated client trades that have not been done before and this has created opportunities for other areas. For instance, the delta hedging from the dispersion activity makes us a major player in cash markets. Surprisingly, most of the cash business from institutions is actually coming from derivatives and delta hedging of the deals. The integration of different product areas within the core functions - such as research, sales and trading - has resulted in greater product penetration across the board.

Tell me more about the gold variance swap.

Charles-John Donley, director, institutional client group, global equity derivatives: One of the most interesting things in the hedge fund business over the past five years has been the growth in volatility as a stand-alone asset class. Volatility isn't only confined to the equity markets. Although variance swaps have traditionally been an equity product, we have used the variance technology for a broader base of underlyings. We've traded variance swaps on gold and silver, and we have the capability to price variance swaps on WTI crude (West Texas Intermediate, the global benchmark oil price). As Denis said, we recently did what we think was the first gold variance swap, and our competitors have been very quick to pick up on this.

But the commodity variance swap business is in its infancy, and a wider appreciation of the structuring capability is going to take place through the rest of the year. I expect 2007 to be the year of commodity variance, as the appreciation of the product grows. There is a fair amount of education required, because variance swaps are quite complicated products. To date, we have only traded gold variance swaps for hedge funds. The rollover to the institutions side is going to take a little bit longer. It tends to be a slower product cycle for the institutions.

DM: The gold variance swap is an example of a solution-driven trade: wherein a client tells us about the exposure they have, the problem in terms of a hedge or directional trade, and asks us for advice and a solution. Clients are also starting to see a lot of correlation between equity and credit. The volatility business has grown from traditional options to include variance swaps, dispersion and correlation, and options on variance and conditional variance. Cross-asset class is now back in vogue.

How are you taking advantage of the spike in volatility and what strategies are you advocating?

DM: Before the volatility spike, we had been advocating an approach to go long volatility in the region. When the volatility spike happened, we advocated a very strong policy of using typical hedge fund products to take advantage of this for nearly every client, be they macro strategy funds, directional or long/short. For example, we've been very active in the market for corporates buying and selling volatility, both on an index level and also on an individual stock level.

CJD: Gap risk - meaning the risk that markets will jump from the absolute highest to the absolute lowest very quickly - is not properly priced in Asian market as it is in the developed markets of Europe and the US. We spent the first half of this year implementing trades that capture this mispricing in gap risk - trades that would benefit in markets that tend to jump and act irrationally. The reason we took this approach is that, if properly constructed, it would offer funds a more cost-effective way of implementing hedges.

Volatility in Asia is an expensive asset, and our job as financial engineers is to mitigate the cost of hedging. Looking at inefficiencies within gap risk is something that's paid dividends for our clients. How do we trade gap risk? It can be as simple as buying downside puts, using variance swaps or even forward-starting risk reversals that don't have a lot of path dependency. That is very technical, but if you're looking at these types of trades and dislocates within the Asian volatility space, sometimes a very simple way of transacting is not the most cost-effective.

What we've done is develop core expertise to provide more efficient ways of designing payouts, either from a volatility standpoint or a directional standpoint. There are also clients who are using correlation trades as a transitionary tool between active and passive mandates. No longer do fund managers have to draw down their actively managed portfolios and put them into index funds when correlation is high; they can trade correlation as an overlay and synthetically re-adjust their asset allocation.

The bank has seen several departures in recent months of your colleagues from the retail equity derivatives group. How are you doing in terms of headcount?

DM: From three people when we started three years ago, we now have 14 people in this side of the business, with the team broken down into different responsibilities. We now have people doing private transactions, synthetic equity and institutional business, and hedge fund specialists covering the high-end derivatives, such as dispersion, correlation and variance. We also have a sales team that deals with listed flow products.

On the retail side, there have been some changes, but headcount has actually increased. Resources have been added to structuring and origination and, under Vinod Aachi, that team has capitalised on the growing requirement for cross-asset-class products and enhanced the structuring platform to cater for both corporate and institutional needs.