In the months following the near collapse of the financial markets in September and October, the fallout from the unprecedented volatility was felt across numerous departments within global investment banks. One of the operations hit the hardest was equity derivatives, and almost immediately many of the world’s largest banks began to announce huge trading losses both resulting from and predating the financial crisis.
Among the most striking of these was Deutsche Bank, which at the end of October was thought to have lost up to $400 million from equity derivatives—almost half of the bank’s second-quarter revenues from equity sales and trading. Meanwhile, J.P. Morgan, BNP Paribas, French bank Natixis and almost every other major bank revealed they had suffered substantial losses as a result of equity derivatives.
Another French bank, Caisse d’Epargne, took a E600 million loss on unauthorized equity derivatives trading during the same period. The affair revived nasty memories of Société Générale’s E4.9 billion hit earlier in 2008 when rogue trader Jérôme Kerviel placed E50 billion of unauthorized futures trades, almost causing the bank to fail and massively disrupting markets as the trades were unwound.
In short, equity derivatives were a bad-news story for much of 2008, and by the end of the year the seemingly inexorable growth of the market had come to a halt. Indeed, many sectors of the equity derivatives market had simply disappeared. In some cases, banks that previously acted as market makers have disregarded their obligations. In many more instances, banks have quoted extreme bid-offer spreads in order to dissuade potential customers.
Many of the investors that were the mainstay of activity have exited the market or scaled down their activities. Banks themselves were huge users of equity derivatives, both for hedging their positions and for speculation through proprietary trading operations. All major banks have substantially scaled down the latter operations. In addition, hedge funds, which were among the most frequent traders of equity derivatives, are now a shadow of their former selves.
Escoffier: Banks lost on both their own positions and those of their clients.
An Unprecedented Shock
In the months before last September, the financial crisis had proved beneficial for equity derivatives. Trading volumes soared as investors and other users sought ways to profit from volatility and hedge vulnerable positions. According to the International Swaps and Derivatives Association, the notional amount of equity derivatives grew 19% to $11.9 trillion in the first half of 2008. Then, over the weekend of September 14 and 15, the world changed as Lehman Brothers was allowed to go into bankruptcy protection and Bank of America rescued Merrill Lynch. The impact on the equity derivatives market was almost immediate.
“After Lehman’s collapse, turbulence reached unprecedented levels, and liquidity dried up in equity derivatives and even some cash markets,” says Pamela Finelli, derivatives strategist at Deutsche Bank in London. “In markets such as single stock options or more exotic products, market makers couldn’t get a feel for where things were going, and risk aversion resulted. That meant wider bid-offer spreads and the temporary disappearance of some markets such as variance swaps.”
At the same time, the high level of hedge fund redemptions resulted in significant liquidation of assets. The most-liquid assets were sold first, creating further pressure on some equity derivatives. “Historically, there is no comparable circumstance to the events of September and October,” says Finelli. “Liquidity had always existed in the equity derivatives market, although it has, of course, depended on the liquidity of the underlying equity.”
Banks Desert the Field
The drying up of liquidity in equity derivatives resulted primarily from increased risk aversion by banks that had previously acted as market makers. Put simply, many banks had to effectively withdraw from the market because they could no longer afford to be participants. One estimate is that as few as five banks are now active market makers in Europe compared to more than 15 a year ago.
“When volatility spiked, lots of banks were caught unawares and lost on both their proprietary positions and those taken for clients. They weren’t hedged properly for such extreme moves,” says David Escoffier, global head of flow and the hedge fund group at SG CIB in London. Many banks, for example, assumed that the market would never fall more than 30% and therefore, in order to reduce costs, hedged themselves only to that extent.
While there have been no official withdrawals from the equity derivatives market, most global players suffered substantial losses, and many have subsequently culled their departments. “Once the number of people in an equity derivatives department is reduced to a certain level, it becomes physically impossible to cover a sufficiently broad swath of the market, and liquidity provided by those houses gets reduced,” says Escoffier.
The result is a market that is now more concentrated, which is problematic because a handful of banks makes for a smaller interbank market and reduces liquidity throughout the system. “It will remain that way for the foreseeable future because the cost of entry in the industry is high,” says Escoffier. “During a bull market anyone can have a go and easily lay off risk. But that is no longer the case.”
Liquidity has not disappeared entirely, however. It remains strong for index products, where the bid-offer spreads are not much wider than a year ago for near-dated contracts, despite the retreat of some banks. However, single stock options have suffered: Bid-offer spreads have widened, and only a few banks are able to show good markets even on Euro Stoxx 50 or S&P; 100 names.
For more exotic products, liquidity has always been linked to the quality and commitment of the provider. Clearly, it has become harder for banks to price the myriad elements involved in exotic products, given the highly stressed markets of recent months. There is no legal obligation for the provider of an exotic derivative to provide liquidity during times of crisis. But banks that do not do so are aware that they risk losing that client and killing their franchise.
Unsurprisingly, some banks have chosen to take that route in recent months. “A number of clients have come to us because their original provider has decided not to stand by their exotic deals,” says Escoffier. “We’re not in a position to buy back all the products from our competitors—no bank is—so whether or not we provide liquidity on competitors’ exotic products comes down to the strength of our existing relationship with the client.”
Finelli: Turbulence hit unprecedented levels after Lehman’s collapse.
Implications of the Shock
The collapse of Lehman Brothers and the drying up of liquidity in some equity derivatives markets that followed has already had major repercussions for the shape of the market. The most significant change is an exodus of equity derivatives trading from over-the-counter (OTC) to exchange based. “[The scale of the move] is hard to quantify as all volumes have been thin following the spike in the fall,” says Deutsche Bank’s Finelli. However, she estimates that whereas a year ago just 20%-30% of European option volumes were listed, as much as 80% of standard or so-called flow equity derivatives were listed at the end of 2008. Turnover of equity index derivatives on derivatives exchange Eurex reached 64 million contracts in December last year compared to 55 million in December 2007.
Historically, users of equity derivatives favored OTC trading over exchange trading because it has lower margin requirements and trading costs and also offers greater flexibility on features such as strike or expiry dates. “Prices have not been reduced on exchanges, but the other attractions of exchanges, such as the reduction in counterparty risk, have proved increasingly important,” notes Finelli.
The increased awareness of counterparty risk in the wake of the collapse of Lehman Brothers is hardly surprisingly and is part of a broader trend, according to Finelli. “Clients and banks now want to fully understand the risks in any product,” she says. “Market participants have gone back to the basics. A lot of institutional investors are now taking longer in their asset allocation process and seeing the direction the market takes before getting back involved.”
Finelli believes that the trend toward exchanges will continue because many of the issues highlighted in recent months, such as counterparty risk and pricing transparency, will not diminish in importance. Moreover, as SG CIB’s Escoffier notes, the move to exchange trading has been reinforced by pressure from regulators for confirmation of trades in a timely manner—something that sounds simple but can be challenging in an OTC environment.
Value of Smaller Market Questioned
Some former major users of equity derivatives—such as hedge funds, including convertible arbitrage funds and dedicated volatility arbitrage hedge funds, as well as banks’ proprietary trading desks—are unlikely to return in large numbers anytime soon, if at all. However, Deutsche Bank’s Finelli says that more traditional users of equity derivatives, such as asset managers, insurance companies and pension funds, are currently holding a lot of cash. “We believe they will come back,” she says.
But will the equity derivatives market in its current shrunken state be of much use to them? “The liquidity situation hasn’t impeded clients’ ability to act,” says SG CIB’s Escoffier. “There are fewer banks able to quote, but at the same time there has been a reduced demand overall. Where clients do want to act—for example, large insurance companies selling the upside on their portfolio or institutional investors entering into sizable hedges to match assets and liabilities—they know where to go to get the liquidity needed.”
More generally, it would be wrong to bet against a recovery in equity derivatives volumes in the medium term. To be sure, some current activity is curtailed: Hedge funds are less active than they were because their assets under management are lower and also because lower liquidity in single stocks or emerging markets has made it harder for them to be active traders. However, at some point in the next year it is almost certain that stocks will hit a bottom. It is far from impossible that a strong bull market could follow—and drag a resurgent equity derivatives market with it.