The equity derivatives industry that emerged after the post-financial crisis regulatory shake-up is a kinder, gentler animal than the prop-trading, opaque structure-peddling beast that went before.
Hichem Souli, global head of equity derivatives sales and structuring at Bank of America Merrill Lynch in New York, says that regulators defined a new landscape for the financial industry since the crisis. “The new landscape for equity derivatives is about being simple, efficient and understanding our clients.”
The most obvious way this is true is in the complexity of products that regulators allow to be sold to retail investors. Structured products in jurisdiction after jurisdiction are restricted in terms of underlyings and capital protection. Gone are the 50-stock worst-of baskets, in are simpler auto-callables on up to three indices.
Bankers also point to their conversion to the originate-to-distribute religion: large notional derivatives positions which would otherwise bloat bank balance sheets have been cut, while volatile exotics positions are frowned on. Instead, the risks for banks generated by their retail structured products sales are recycled to hedge funds with the appetite and understanding to take on exposures.
“Whenever we decide to develop a new business, we make sure that our model is allowing us to distribute some of the risk embedded into it,” says Souli. “Being a global firm helps us facilitate this on a vast cross-border scale, so for instance we might source some risk through our Apac distribution networks and place some of it with key US hedge funds.”
The reduction of risk held at banks and the overall fall in leverage across the system, has contributed to lower volatility across markets, says Richard Quessette, global head of equities and equity derivatives at Société Générale in Paris. “The stability of volatility is spectacular,” he points out. “We see that even with, for instance, the stress of Brexit or the stress on France and other situations, volatility can spike but it rapidly comes back to a normal level. Why? Because there is less reaction in the market coming from derivatives actors to increase volatility.”
And banks are finding efficiencies elsewhere, says Andres Schmitz, head of EMEA structured derivatives sales at UBS in London. “There are synergies in the risk management space and they are absolutely key to running a business efficiently but there are less obvious synergies that I think are also important.
“For instance, in the risk premia space, we’ve taken a tailor-made OTC product for pension funds and wrapped it through our securitization platform into a product that suits intermediaries.”
‘Risk premia’ products are the new big thing in equity derivatives, emerging over the last few years as investors look for low-cost versions of the stable, uncorrelated returns offered by absolute return fund managers.
Schmitz says clients are replacing their fixed income allocations or sometimes their diversified fund of hedge fund allocations with risk premia products. For institutions, such as insurers that face capital constraints, the products aren’t only beneficial from a risk-reward perspective, he says. “Clients also understand how effective it is to hedge and they understand the capital benefits, which is definitely now a driver of the business.”
These types of products are popular with retail and institutional clients, says Souli. “We’ve seen a move from active to passive styles over the last two years and investable indices are the right instruments to be in between the two — providing full transparency, liquidity and efficiency as well as alpha and yield without the higher fees of active management.
“The investable indices business for institutions is a huge growth opportunity, we see a lot of pension funds and asset managers very interested and looking to get some allocation towards it. On the distribution side, investable indices are helping clients access upside while keeping principal protection.
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The document provided the standardization of derivative contracts that until then had to be laboriously negotiated deal-by-deal. “In the mid-1980s there was a desire to standardise some of the more boilerplate elements of the contracts that were being heavily negotiated to enable the parties to focus on the key commercial elements,” explains Katherine Tew Darras, general counsel at ISDA. “Putting in place the overall structure was of huge value. People recognised that that had to happen or they’d be mired in these long negotiations for each individual agreement and the market would never grow without that standardisation.” “It was a much smaller market then. ISDA at that point was the International Swap Dealers Association, and also did consultations beyond its membership to other users of the products. As now, to get a wide a segment of the market to use a publication, there needs to be a broad consultation held.” |
From big data to AI
Banks are learning to move away from a silo-based approach.
“At a time when we face a number of pressures — from a cost point of view, from a regulatory point of view and from a technology point of view — the only way to excel is to create synergies and to have touch points into every client segment,” says Schmitz.
In similar vein, Peter McGahan, head of equities and equity derivative sales at Société Générale in London, points to the way that clients increasingly look across asset classes and don’t want a firm that can only deliver in one. “The regional view and the global view is important but the cross-asset angle is one that has evolved noticeably over the last 10 years,” he says. “Clients won’t just look at one siloed asset class any more — they’ll look to have ideas across the spectrum.”
The biggest driver of change in the industry isn’t market conditions, though, but technology. Efforts to automate trade execution and other parts of the derivatives life-cycle are moving on to an even deeper level. Some tip artificial intelligence to soon move from the realms of science fiction to real portfolios.
“More and more clients are focusing not only on price but also on service,” says Quessette. “For instance they want to trade directly and to get direct reporting. We can also offer direct access to the client to rebalance a basket allocation, for example.
“As this progresses, artificial intelligence will create product advice and strategy advice. You will take the ‘big data’ of the market and the criteria of the client, and combine everything to give intelligent advice in the dynamic management of the portfolio.”
It won’t happen overnight, says McGahan, but SG and other bigger firms are already focused it. “All firms will be competing hard on efficiency and automation through the life of the transaction and the post-trade environment as well. That’s going to be a key focus, certainly for us over the next few years.”
Schmitz says that the solutions and advice-heavy part of the business will become more important and it’s where banks will dedicate more time. “At the same time we need to invest in the public distribution side as technology will be the key driver of efficiency gains and differentiation versus competitors,” he notes.
The importance of all themes — recycling risk globally and between client groups, finding synergies between the intellectual property created for the public and private sides, and the heavy investments being made in technology — all point in the same direction. Lower costs and better service for customers — but perhaps a winnowing of the banks that aren’t big enough players to sustain the efforts needed. “Banks that aren’t big enough to invest will have difficulties to stay competitive,” says Quessette.
