Equity Derivatives

FLYING BLIND

By Anita Hawser

Despite new entrants joining the market, the equity derivatives business saw a marked slowdown over the past year, and some well-established firms are now scaling back their operations.

After the global financial crisis of 2007–2009, credit derivatives clearly suffered as an asset class, but equity derivatives attracted a number of new entrants to the market, as banks ploughed money into their equities business. Volatility in global equities markets and the never-ending quest for yield in a low-interest-rate environment also attracted a different kind of investor—real money funds. Newer entrants invested in building up their cash equities and derivatives businesses, but for well-established players some of the newer entrants have not advanced the market in any significant way.

“Competition is good,” says David Escoffier, global head of equity derivatives flow at Société Générale, “but if they [newer entrants] are just doing the easy stuff (vanilla options), it doesn’t add a lot of value to the market or clients.”

According to Escoffier, the market needs someone with a vision, “a long-term plan to do it properly.” Instead what has happened, says Escoffier, is that many players entered the equity derivatives business and took on considerable risk, thinking everything would be okay. “During the bubble years, and also in more recent years, there were some banks that believed equity derivatives were safe because it is equities and not credit,” he explains.

SLOWING ENGINE

The secret to running a successful equity derivatives business, says Escoffier, is having a global book. “You need to be able to unwind your risk and find out what types of clients have an interest to deal on the other side of a trade. The universe of clients also has to be large, as you are trying to create different interest that will match your book at some point.”

Escoffier, Société Générale: Competition is good, but new entrants must do more than just the easy stuff to add value to the market

The amount of technology, risk management, compliance and legal infrastructure required to run a successful equity derivatives business also makes it relatively expensive, says Glenn Koh, head of equity derivatives trading, Americas, Bank of America Merrill Lynch. “These factors all add up. If you are not in the top five, it is going to be difficult to compete.” Added to that is the fact that cash equities volumes were down by an estimated 20% to 25% in 2012, which wasn’t exactly a bumper year for equity derivatives either. “Two thousand twelve was the first year where we saw a continuous drop in the volume of equity derivatives in aggregate,” says Escoffier. “If your cash market is contracting at a very fast pace, there must be an impact at some point on equity derivatives.”

The swaps-futures business collectively is down across North America and Europe, according Jay Bennett, managing director, equity products, at research firm Greenwich Associates. According to a Greenwich Associates’ midyear-2012 survey, the proportion of large hedge funds and long-only funds in North America that reported futures trading went from 60% to 45%. Most of the volumes were driven by options, according to Greenwich’s survey, with the proportion of funds trading index options standing at 60% and single-stock options at 75%. In Europe and the UK, the proportion of funds trading futures went from 80% to 65%. The proportion of funds trading ETFs (exchange traded funds) went from 45% to 35% with most of the volume (75%), again, going to equity index options.

Despite the threat of the fiscal cliff in the US and sovereign debt woes in Europe, volatility was also relatively muted in 2012. “There was a lack of clear conviction in the markets,” explains Bennett. “Nobody is doing as much as they were, whether it’s cash equities or futures. The whole engine has slowed down.” Against such a backdrop, some firms reportedly scaled back their equities activities. “It is not only volumes that [went] down but also liquidity,” says Escoffier. “Less banks were able to provide clients with sizable trade blocks, which means underlying liquidity was reduced for clients.”

In 2012, Royal Bank of Scotland in the UK announced it was pulling back from cash equities to focus on fixed income, foreign exchange, debt financing, transaction services and risk management. Reuters has cited sources saying that Deutsche Bank reduced staff in its Asian equity derivatives business by a third. Barclays also reportedly cut traders in cash equities and equity derivatives, and CA Chevreux entered into exclusive negotiations with Kepler Capital Markets to sell its business as part of consolidation in the equity brokerage space.

SIMPLE TOOLS

While the equities businesses may be less affected by increased regulatory oversight of OTC markets, Koh, says regulation will continue to drive costs for the sell side. “The more precise that you need to be in your hedges and the business you can have in inventory, the more expensive it will be.” Although listed equity derivative volumes declined in 2012, Koh says there is increased interest in OTC products and volatility funds based on indexes such as VIX (the Chicago Board Options Exchange Market Volatility Index). Historically, investors in volatility products were looking for a hedge, says Stéphane Mattatia, head of global equity flow engineering and strategy, Société Générale. “So they were only looking for long volatility positions, but now this market is so much more mature that they also want to take some short exposure.”

In today’s low-interest-rate environment, Koh says, investors are using volatility funds to generate yield, which is where he believes the business is headed. In an effort to help clients generate additional yield from volatility, Bank of America Merrill Lynch developed algorithmic trading strategies, which automatically buy and sell volatility in different market regimes. “Rather than engineer extremely complex products, we are focusing on relatively simple products that fit the investment criteria of the end user,” says Koh.

What is important, says Mattatia, is not to impose complexity for complexity’s sake. The French bank has created what he calls more basic indexes, including long and short volatility trackers, where the investor invests if there is a positive gain or disinvests if there is an expected negative gain. “We are not trying to prove that we are the smartest but to provide our clients with simple and intuitive tools,” says Mattatia.