Risk South Africa Rankings 2013

South African dealers had a chance to test their mettle this year as volatility spiked across asset classes and clients sought to hedge some big exposures in the resulting, illiquid conditions. Absa, a member of Barclays, retained its top spot in Risk South Africa’s annual rankings – beating Standard Bank and Rand Merchant Bank into second and third, respectively. By David Wigan with research by Max Chambers

It has been a dramatic year in South Africa – with inflation rising, interest rates see-sawing, and the rand in virtual freefall. But it started in muted fashion.

For the first quarter, GDP averaged just 0.9%, but growth accelerated to 3% in the next three months — an export-driven expansion on the back of a sliding domestic currency. As of mid-October, the rand was down 15% against the US dollar this year, making it one of the worst-performing currencies. Meanwhile, mining strikes, poor jobs figures and fears of less quantitative easing from the US triggered outflows from both equity and fixed-income funds, helping push up longer-term interest rates by as much as 200 basis points.

"This year has been about a slowdown in economic activity, a more competitive landscape and the need to provide simple, uncomplicated structures designed to manage risk," says Stephen Barnes, Johannesburg-based global head of structured sales and distribution for the global markets business at Standard Bank. "After a benign first quarter, the environment totally changed, and there were an incredible number of challenges."

Not least was the need to take on some of the biggest trades of the year, after the second stage of the country's procurement programme for renewable energy closed on May 9 with R28 billion ($2.8 billion) in financing for new wind farms and solar energy projects – part of a scheme that aims to ensure at least 42% of new energy in South Africa is generated sustainably.

"These were large, rand-denominated projects with tenors going out to 17 and 18 years, and with a large proportion of the procurement contracts required to be paid in euros or dollars," says Wayne Dennehy, head of institutional structuring at Absa in Johannesburg. "As a result, some of our clients had huge currency exposures and, with the rand falling at the same time, it was placing considerable strain on the underlying project returns.

After a benign first quarter the environment totally changed, and there were an incredible number of challenges

"The debt on the renewables funding was held mostly by local institutions and was in the region of 20 billion rand. Lenders wanted to hedge between 70% and 90% of that exposure, so we were required to do large trades at the worst time, often with complete anonymity," he adds.

In addition to the flows driven by those deals, volatility was injected into over-the-counter markets by corporates that had raised money in US dollars and were looking to swap into rand, Dennehy says. Even in benign conditions, the South African cross-currency swap market is relatively illiquid, but in May and June the situation was much worse than usual because of deteriorating market conditions across all rand-denominated markets, dealers say.

Absa was able to source liquidity from its Barclays parent network to help execute the trades, Dennehy says: "There was a lot of activity across market participants both locally and internationally."

Absa was rated the top OTC dealer in South Africa in this year's Risk South Africa rankings, retaining its crown with 18.9% of the vote across all product categories – a total that put it narrowly ahead of Standard Bank in second and Rand Merchant Bank (RMB) in third place. Among international banks, Citi was the highest placed, moving from seventh to sixth place, with JP Morgan and Deutsche Bank taking seventh and eighth places, respectively.

Dramatic moves
Coinciding with dramatic foreign exchange moves, South Africa's interest rate markets were also roiled by suggestions the US Federal Reserve could rein in its bond-buying programme – which prompted a 200bp move in just 30 days in benchmark maturities, from 6.5% to 8.5%. The move upwards in rates had a commensurate impact on the swap curve, which jumped sharply in May and June, causing difficulties for corporates and investors that had become accustomed to a long period of lower floating-rate costs.

"On the back of the rollout of the renewable energy programme, we saw a lot of demand from project companies to swap long-dated funding into fixed rates, which put a massive amount of pressure on the swap market," says Standard Bank's Barnes. "With all of the demand in one direction, it became pretty chunky from a liquidity perspective and very difficult to get out of the other side. One of the things we saw was a big withdrawal of interbank liquidity, but the market remained open and, on the whole, banks were able to manage themselves pretty well around those positions."

In response to that stress, interest rate swap bid-offer spreads gapped out to as much as 15bp, traders say.

"Premiums were very wide and that added a lot more pop to the underlying transactions," says Saloshni Pillay, head of risk solutions at Absa. "Our idea was to have an execution strategy catering to all the rises in the currency, interest rates, as well as the basis market, and we attempted to manage that quite tightly, minimise liquidity premiums and to separate the risks so they weren't all going through the market at the same time."

Where it was difficult to find interbank liquidity, dealers either chose to warehouse risk for short periods of time or sought proxy hedges in the bond market, taking on the resulting basis risk, says Standard Bank's Barnes. International dealers or hedge funds were also willing to step in.

"Quite often we have offshore hedge funds or one of the big international banks help out. Fortunately we do have a huge contingent of offshore liquidity providers in the rand market," he says.

In the interest rate space, RMB was number one in the Risk South Africa rankings, followed by Absa and Standard Bank — a repeat of last year's results. In the underlying product categories, RMB took first place in options, exotics and inflation, while Standard Bank held on to the top spot in interest rate swaps and cross-currency swaps. Absa took first place in repos and forward-rate agreements. In the foreign exchange categories, by contrast, Absa swept the board, taking number one in US dollar/rand options, forwards and swaps.

Credit markets
Perhaps surprisingly, credit markets in South Africa remained relatively well-bid until the broad-based emerging market sell-off in June. Traders say demand was underpinned by strong international interest as fund managers looked to play the carry trade against low US and European interest rates.

With companies carrying high levels of cash on their balance sheets, supply in the corporate bond space largely failed to keep pace with demand, helping depress yields further. That fuelled appetite among the asset management community for higher-yielding products, with banks responding through loan sales and printing of credit-linked notes (CLNs).

For Standard Bank, the CLN format became a key funding source, with most recent demand being for vanilla structures referencing single names – but with added complexity stemming from the associated hedging programme.

"The complexity comes through when we go and hedge our risk, which is in dollars," says Barnes. "That means we need to manage the quanto risk between the dollar hedge and the rand issuance, because as the currency moves around it impacts your hedge ratio."

Barnes declined to provide details of the exact hedging strategy, but added: "We are running credit risk on the dollar hedge and have credit protection in rand on the other side of the transaction, so when the hedge ratio moves, we need to go and buy more protection, which can be a challenge in the current liquidity environment. Instead we try to manage that hedge risk within the CLN itself."

Inflation-linked activity
Another area to see intense activity was the inflation-linked space, where breakeven inflation surged out of the range it had occupied for the last year. Amid high levels of portfolio flows in the second quarter, there was a flurry of trading in the inflation asset class, alongside a rise in liability driven investment mandates being handed out to fund managers, which has been supportive of the market for bonds linked to South Africa's consumer price index (CPI).

"CPI bonds remain far more liquid than CPI swaps, with a lot of demand for cash," says Absa's Dennehy. "We have seen the local equity market run extremely hard and a big trade has been to jump out of equities and into CPI linkers, or to dump the swap for the cash. That's because CPI swaps were trading 120bp below cash, so it made sense to sell the rich asset and buy the much cheaper asset, where implied inflation was much lower."

In many other derivatives markets, investor demand in recent years has focused on simple structures and payoffs, and uncomplicated accounting. South African banks report the same trend, with the slowdown in economic activity leading to lighter flows and a cut-throat competitive landscape, particularly in the equities space, which one banker describes as "massively over-traded". Bankers also say derivatives are now being increasingly used to offset existing positions – as an old-fashioned hedge, in other words – rather than to express views.

"In the equities space, teams are far smaller than they were four years ago and the market has shrunk quite significantly, with increasingly sophisticated clients helping to push margins lower," says Standard Bank's Barnes.

One reason for the aversion to complexity is the combined impact of regulation and post-crisis changes in market practice, dealers say, and in particular the trend for banks to incorporate in prices the full through-the-lifecycle cost of funding, counterparty risk and capital.

"Until recently, issues such as the cost of funding were only a concern for banks, but now clients need to worry about the same things," says Stephen Charles, head of franchise trading at RMB. "We have been through an education process and some clients have been quick to realise the implications while others are taking it more slowly, but customers can't afford to ignore the increased cost of derivatives and they need to get the best bang for their buck."

View/download the Risk South Africa 2013 rankings results in PDF format