'Integrated problem solutions' is the ubiquitous marketing slogan of derivatives dealers. For most, however, it's still the Holy Grail.

By John Thackray

A decade ago end-users had little trouble figuring out their derivatives' dealers organization. At most dealers, big and little, derivatives were a separate island-an autonomous function that created product ideas and then took them to the marketplace. Because they were a small cottage industry within the larger institution, the personnel were easy to get to know.

But with the increasing breadth and sweep of derivatives, ineluctable organizational changes now threaten to merge these once autonomous groups into closer relationships with other areas of the firm.

Why do users care about such a dry subject as dealer sales organization? Because it can provide important evidence about the quality of service. "Everyone will tell you that 'We have an integrated solutions type of approach. We're not hocking product, we're selling problem-solving skills' and so forth," notes Andy Feldman, Chase Manhattan Bank's managing director of institutional derivatives origination. "However, if you look deeply into organizations, you'll find that there are some guys who are structurally set up in ways that make it possible for them to truly integrate and some who aren't."

At most dealers, integration remains the Holy Grail. As proof many will point to organizational charts in which the old autonomous derivatives groups are no more. These, however, may imply a degree of integration that simply doesn't exist. Efforts to integrate can be compromised or strengthened by informal ties and relationships. Some institutions may take years to find the Holy Grail, and others will always experience it as insurmountable because of problems of 1) integrating derivatives with a cash culture, or 2) "turf" and compensation conflics.

"There have been various attempts at integrating derivatives with the broader capital markets effort," notes executive recruiter Alan Hilliker of Egon Zhender, formerly of Lehman Bros. These attempts, he notes, are recurrent. "At CSFP they combined for a year, then it didn't work so they got divorced. Merrill Lynch had much the same experience. A similar attempt at JP Morgan did take hold, while at UBS they were talking about combining derivatives and capital markets, but because everyone there was against it they decided to keep them separate. Clearly the Street has not yet found the best way to do this."

But the spirit of experimentation is abroad. What's more, some newcomers to derivatives, or those making significant fresh committments, have the frequent advantage that they don't have old fiefdoms to dismantle and thus can pursue integration vigorously. (See box on the Bank of Montreal.)

Integration will be more attractive to some types of customers than others. For instance, the integration of loans and derivatives would be cool for a hedge fund, but of little interest to a plan sponsor. In general, however, most customers have a clear preference for integration. "Corporate downsizing has reduced the number of points of contact available to dealers, software vendors and institutional money managers in the customer base," notes Tanya Styblo Beder, principal of Capital Market Risk Advisors. "If I'm a customer who needs to invest prudently in as many different classes of assets as possible, I really don't want to talk to 10 different specialists from each organization. There aren't enough hours in the day for that. So I'm naturally going to gravitate to firms that can deliver as much as I need from a single, knowledgeable source."

Even those derivatives organizations that remain fairly autonomous within a bank have streamlined the client interaction process. At CIBC, for instance, the derivatives group is divided into five segments. Two of these are based on end-user profiles (corporate or financial) and the others on product type such as equity, credit and muni derivatives. There is a single point of contact for those clients who require multiple types of derivatives. According to CIBC managing director Michael Rulle, "a single marketing person can provide a gateway to many products and services, rather than having one person for equity derivatives, one for interest rate derivatives, etc."

Deciphering and interpreting derivatives organizations can be about as difficult as reading tea leaves. Actual charts of functions and reporting relationships may reveal or conceal the reality. Chase, for example, has a global capital markets business that consists of bonds and derivatives under one roof, except for U.S. capital markets, a function with its own straightline report relationship to the vice chairman of the bank. "On paper, it might look as if in the United States we're going to do a bad job of integrating derivatives with fixed income," says Feldman, "but if you visited our shop you'd find people here comment on how the head of the mortgage department and myself are joined at the hip. So are most other guys on the capital markets desk with our derivatives people."

Consider the progress toward the Holy Grail that NationsBank has registered in the last two years. According to William Fall, senior vice president and head of fixed-income derivatives sales, the bank has moved significantly toward fusing derivatives with four major customer relationship teams, depending on how different customers use derivatives and what other banking products they use: corporate middle markets, non-investment grade corporates, blue chip corporates and financial institutions. "Before, it tended to be a stand-alone group that talked to the odd relationship manager and covered them on a geographic basis, rather than on the basis of customer needs," notes Fall, who believes that integration has contributed to the bottom line. "One of the reasons we've had such a crackerjack year, in contrast to banks that have had just an OK year, is that we've got this whole thing tightly tied together."

Maybe so. But the logic of integration often comes face-to-face with intractable aspects of human nature. "Almost everyone has tried to break down the wall that traditionally divided the interest rate derivatives group from the fixed-income group and tried to create some synergistic relationship between the two," notes Drew Mandler of executive recruiters Smith Hanley. "The idea, of course, is that the derivatives guy can piggyback on the fixed income relationship and a do a deal. I think for the most part it has not been successful. You are merging very different types of animals. The derivatives guy is likely to be an intellectual, quantitative type of person. The fixed income sales guy is more of a kind of cowboy with a shoot-from-the-hip type of sell."

The most radical path to integration is where the derivatives group is abolished, as happened at JP Morgan, and the entire function melded into the rest of capital markets activities. A second choice is to integrate but retain a derivatives brain trust in some specialized areas, say structured products, and allow them some direct customer contacts for high-end concepts, plus responsibility for advising the bank's relationship managers on run-of-the mill derivatives transactions. Such joint selling efforts, however, are often pitted with departmental rivalry and disputes over compensation.

Some observers of the derivatives scene believe that JP Morgan defused these potential conflicts because it never allowed a "star" system, along with the usual high compensation packages, to take root in the first place. And it has done this by frequent rotation of derivatives people, and by the imposition of a strong corporate team culture. Consequently it didn't have to cope with the problem of lower pay and lower future pay expectations among its top derivatives people. As one source observed: "At Morgan everyone makes less and they move them through so fast that they don't build a star system. The culture of JP Morgan was an advantage."

At business school, organizational design is presented as a rational art. In the real world, organizations are often reflections of the personalities they are built around and the way they want to shape their empire. One major U.K. player is reportedly in the throes of a second push to integrate interest rate derivatives and capital markets, this time with a different leader and a new organizational structure. At major Swiss-owned players, there seem to be strong efforts at integration today, "but for some years the whole fixed income and underwriting were on one side of the firm and derivatives were on the other. That is not likely to yield an integrated approach," observes one derivatives head at a bulge bracket firm.

Clearly the quest for, and failures resulting from, integration efforts drive some of the restless rounds of entrances and exits of derivatives professionals between dealers. The tensions and stresses of the integration process have also led to many firings and voluntary departures. But in the end, some form of integration must prevail if history is any guide. There are a number of standard capital markets products today that were once solitary islands with their own sales machines-CMOs, for instance, medium-term notes and currency swaps in the days they were separated from interest rate swaps. Eventually they were all sucked into the fold.

Another facet of the organization that may be hard to interpret are the various derivatives support and consulting groups that stand behind the sales contact people. NationsBank has two such groups, as many rivals do also: a purely quantitative research group and a strategies group that acts as liason with trading and provides the direct-line sales force with high-powered support and ideas. The effectiveness of these groups depends as much on their communication and education skills as on their intellectual fire power.

What's the likely course of evolution? Those who feel they are mastering the process think it will continue unabated. "We will be continuing to grow derivatives into the infrastructure of the bank. I don't know how far you can do that," admits NationsBank's Fall. "I don't know if you end up with a single person covering high grade companies for multiple products including derivatives, bonds, loans and so on. I don't know if we'll ever get there, but I know we must move in that direction."

The Reemergence of Bank of Montreal

In the past bank wannabes in derivatives have followed this pretty standard pattern. They check with recruiters on which professionals can be lured away with fat hiring bonuses and guarantees, put together a hot team of them, give them some capital and wait for the pot of gold.

One institution that didn't take this route is Bank of Montreal. "We wanted to make derivatives a core competence, not a stand-alone product line," says David Hyma, senior vice president of global financial products. "Our goal was to make derivatives pervasive across all aspects of the bank. We felt that was more comprehensive than hiring a bunch of traders."

This "core competence" strategy reflects both the importance of derivatives to all of the firm's banking functions and the need to integrate them into lending, capital markets, investment banking and other key areas. A few years ago the Bank of Montreal had a small and autonomous derivatives department chugging away in the background. But after studying the G-30 recommendations, and other sensitivities to derivatives risk, bank management decided to analyze their involvement and then make a decision on whether to commit or pull out of derivatives. "We were at the crossroads," observes Mark Caplan, managing director of trading. "It became apparent that we were a niche player and we had to either invest or divest ourselves of this business."

In the end, divestiture was out of the question, given the perceived centrality of derivatives. Hyma and his colleagues made the case to their superiors that derivatives skills would be crucial to a profitable future across the entire product line. "We realized that the bank could not to make the same kind of money in mature businesses like FX and money markets without some core derivatives expertise," says Kevin Holme, managing director in charge of derivatives marketing. "In fact, most of the money we'll make in the future will be directly or indirectly related in our derivatives activity." They made a second argument: if bank employees didn't understand derivatives fully as dealers, they wouldn't be able to evaluate them correctly for their own internal functions as treasury and portfolio managers.

This strategy, however, is more painstaking than assembling a hot product team. A year ago the bank had five people in the United States marketing and trading derivatives. Today there are 21 in the United States devoted to interest rates, equities and commodities. To build a derivatives bedrock, the bank hired quants and purchased an information system. "This initial foundation that we built was instrumental in helping us attract people from First Chicago, Bank of America, Lehman Brothers and Salomon Brothers. We have first-tier talent because they saw the strength of the commitment that management was making in this area," Holme says, adding, "This was a difference between us and many of our competitors who don't have the same management commitment. They see it as one product among many-we see it as a core competence. With us, derivatives are not just another product, but a fundamental building block to other products."

It is also a little less stressful on the derivatives professionals. Had they joined a stand-alone derivatives group there would have been immediate first-year bogeys for return on asset performance. But because the BofM's perception was that it was investing in new infrastructure knowledge, it took the long-term view and set realistic performance targets.