The advent of Basel III and funding constraints in the eurozone have prompted investment banks to make greater efforts to transfer the exotic risks generated from their derivatives structuring businesses.
The combination of liquidity constraints in the eurozone and a wall of new regulations facing banks accelerated the process of adjustment in the banking sector in 2011, with lenders exiting or scaling back businesses that are difficult to fund or will suffer punitive regulatory treatment. Long-term credit-oriented businesses, such as real estate, infrastructure or aircraft and shipping finance, are under the greatest scrutiny. By contrast, derivatives structuring, especially in equity derivatives, has generally been regarded as an area that stands a good chance of generating fee income without incurring heavy capital costs.
The reality is not so simple, however. Yadin Rozov, a managing director in the risk advisory group of independent investment bank Moelis, says his team has seen a steady flow of business advising large players on the unwinding of exotic risks embedded in their derivative books.
“In the first half of 2011, the deals were driven by banks examining the impact of Basel III, then in the second half liquidity became the focus, now attention has returned to Basel III,” he says.
To source liquidity under pressure, banks were offering complex assets, such as structured products, as collateral for repo lending from less cash-strapped institutions. To comply with Basel III, which will significantly increase capital charges on exotic and illiquid market risks, such as correlation, dividends and volatility, banks will need to find counterparties for permanently transferring the risk. This trend is further stimulated by greater use of market risk stress-testing by individual national regulators. In addition, the US Volcker Rule curbs on proprietary trading have changed appetites for principal risk, even at European investment banks.
“When investment banks first built their retail structured products franchises in the 1990s, they were keen to offer opportunities to hedge funds and absolute return funds – for instance, dispersion trades to offset their correlation risk. In the 2000s, the banks built out their own prop trading, and there were fewer offers to funds, but now that trend is reversing again,” says Christopher Childs, director of alternative investments at fund manager F&C, who has been managing derivative-based strategies for the firm since the mid-1990s.
In the future, our business will be more about intermediation and transformation of risk, rather than keeping the risk on our books. That applies to almost everything.
Marc El-Asmar
Whether for liquidity or capital purposes, what these trades have in common is the combination of complex asset valuations with an equally complex and changeable regulatory environment for the banks. Final rules have not yet been set, but banks need to try to anticipate the eventual impact on their capital management, especially for longer-dated trades.
Regulatory adaptation
In fact, Mr Rozov says diverging guidelines in different jurisdictions have created some opportunities for banks under less pressure to buy or lend against exotic risks held by the more challenged institutions. Some banks, such as the largest US institutions, have long had an excess deposit base to put to work. Others have been opportunistic in using their relative health and resulting competitive wholesale funding costs to lend against illiquid collateral to banks that were finding it more difficult to raise unsecured financing from institutional investors.
“Banks that already have large, diversified books of business may find they can net or unwind many of the new trades they take on from a bank that wants to exit these risks, and their cost of capital and funding tends to be cheaper than for a hedge fund investor,” says Mr Rozov.
The lower risk tolerance of investment banks should also drive greater risk recycling via interdealer-brokers. Claude Amar is the chief executive of inter-dealer broker Sunrise Brokers, which is a leading specialist in derivatives across equities, commodities, credit, rates and hybrid products. He says falling trade volumes and continued overcapacity will put pressure on brokers who operate at the lower end of the product spectrum.
But with some banks disinvesting from niche products which are research-driven or human capital intensive, there are opportunities in what he calls “content-driven, rather than flow-driven” business, which Sunrise is trying to capture.
“We have always insisted on setting the bar high in creating value-added solutions for clients, and we realised that the sophisticated business culture at Sunrise has generated a recession proof business model,” says Mr Amar.
He adds that the model focused on intellectual capital also adapts well to the intensifying regulatory pressures on the industry. The firm is able to incorporate the increased compliance needs into its offering, participating in the change sweeping the derivatives business rather than being threatened by it.
Size matters
The implementation of the Dodd-Frank Act and Volcker Rule in the US will further dim appetite for exotic derivative risks among banks. Ultimately, unregulated investors or those that are able to take on illiquid assets and earn the associated premium look set to be the best link in the chain to enable banks to lay off their risks.
“In the future, our business will be more about intermediation and transformation of risk, rather than keeping the risk on our books. That applies to almost everything – not just adopting the originate-to-distribute model in the credit businesses, but also finding an exit from embedded derivative risks to investors seeking yield enhancement,” says Marc El-Asmar, global head of sales for cross-asset solutions at Société Générale Corporate & Investment Bank (SG CIB).
Clemens Lansing, UBS head of flow equity derivatives sales for Europe, says equity derivatives remains a principal and risk business for UBS, but he can see some evidence of the market moving towards a cash equities-style agency business. He believes smaller players that previously conducted a few lucrative derivatives trades and managed their residual positions on a buy-and-hold basis will need to review their presence in the market.
“In today’s environment, banks need to create a model of offsetting flows, and it is better for that to be with clients than with competitors. Even banks aiming for larger equity derivative flows will find that difficult to sustain without the kind of cash equities and prime brokerage functions that we have here,” says Mr Lansing.
But that assessment is not shared by everyone. Royal Bank of Scotland shut down its cash equities business in 2012, but is keeping and building out its large equity derivatives franchise that includes one of the UK’s largest retail structured products platforms.
“In the past, we internalised the hedging process via cash equities where we could, but there was always the option of going externally. What we find is that with direct market access and algorithmic trading, other players have allowed remarkable margin compression on cash equity execution just to win a share of flows, so the cost of trading out of our risks has been going down even though we externalised the process,” says Christian Erb, global head of investor products and equity derivatives at RBS.
Scarce tactics
There is a consensus, however, that all banks will want to minimise the effects of derivative transactions on their risk-weighted assets, and that it takes time to adapt a platform to this new model. Yann Gerardin, the head of equities and commodity derivatives at BNP Paribas who set up the bank’s equity derivatives franchise in the 1980s, says he was cautious about the outlook for equity products in the aftermath of the Lehman crisis, and ran the business conservatively as a result. That decision paid off when it became clear that European equity volumes will remain subdued for some time, and that new regulations will have implications beyond the fixed-income space where the crisis originated.
“We did not disinvest from equity derivatives, but we did reduce risk-weighted assets and funding usage. We adopted a lean business model and educated our sales team to think of capital and liquidity as scarce resources, even before the eurozone funding squeeze in 2011,” says Mr Gerardin.
He estimates that the BNP Paribas equity derivatives business proportionately consumes about five or six times less capital and 10 times less funding than pre-crisis. Conversely, it has increased levels of investment in staff and technology, while keeping the overall headcount steady. He says the bank may have sacrificed some market share, for instance, by showing greater caution on offering worst-of equity basket products to private banking clients, but the early adaptation was essential.
“Clients have taken longer than we did to adjust, so it can be difficult from a sales viewpoint. But correlation from products that typically have three- to six-year maturities is much stickier to sell or unwind than, for example, dividend exposure where there are now listed swaps available. It can take years, so we needed to start early,” says Mr Gerardin.
For those banks that did not start early or need to make a quick exit because of a highly constrained financial position, it is no easy task to unwind a correlation book rapidly. Moelis advised French bank Natixis in 2010 on its sale of a credit correlation book with a nominal value of underlying positions exceeding €30bn. Benoit Renon, a managing director at Moelis, says there are hedge funds with cash to put to work buying exotic assets from banks, but fund manager return expectations are often well in excess of what banks are willing to offer. As regulatory deadlines approach, he expects the gap between bid and ask prices to converge.
“What makes these transactions unusual is the combination of the ability to value complex assets with the classic merger and acquisition skills of creating a competitive auction process and pricing tension. It is difficult for a full-service banking group to arrange such deals, because they may be counterparties to some of the trades contained in the book, so there has to be an independent advisor,” says Mr Renon.
Changing investor base
Once the dust has settled on Basel III compliance and strategic rethinks by individual banks, the players that remain will need to find a home for their alternative risk transfer on an ongoing basis. Alastair Beattie, head of European flow-exotic sales and UK flow sales for SG CIB, says there are now five or six banks trading regularly in equity derivatives, with a further 15 or so that are active to a lesser extent. To some degree, the need for risk transfer itself has eased because retail investor appetite for complex pay-offs or very bullish products that left banks with extensive one-way risk has diminished.
Banks need to create a model of offsetting flows, and it is better for that to be with clients than with competitors.
Clemens Lancing
“Derivative books are better balanced today, partly because there are fewer exotic products offered to clients. Recently, our work is less about developing new pay-offs, and more about redeploying those same people and resources towards a more advisory approach, helping investors to better understand how to hedge the risks within their portfolios, as well as to achieve their investment objectives, using relatively plain-vanilla products,” says Mr Beattie.
On the other side of the trade, however, hedge funds have also deleveraged significantly. Rich Herman, global head of the institutional client group for Deutsche Bank, estimates that total hedge fund assets in the first quarter of 2012 were at $2100bn, slightly higher than the pre-crisis peak in 2007, but average leverage on those assets has fallen from about five times in 2007 to between two and three times today.
“That is partly because of tighter credit line provision from prime brokers, but partly also because fund managers are seeing fewer opportunities. It is hard to have strong directional views at the moment, and market-neutral strategies are often difficult to implement with any scale,” says Mr Herman.
However, Mr Erb at RBS still finds a core of hedge funds focused on relevant strategies such as correlation and volatility arbitrage. He says the bank’s approach is to maintain a strategic dialogue with these funds, who often prefer the unique risk that RBS can offer from its own book to more crowded generic trades.
In addition, the decline in hedge fund activity has been partially offset by the growth of absolute return funds offered by conventional fund managers such as F&C, or Standard Life, whose Global Absolute Return Strategies (GARS) grew from an internal fund for its own pension scheme before 2005, to a range of publicly offered funds totalling £17bn ($26.49bn).
But such fund managers may take a different approach to investing. European mutual fund regulation does not place significant limits on the use of derivatives, but fund managers increasingly want to be able to demonstrate pricing transparency and daily liquidity to clients.
“These days, we are less likely to look at hold-to-maturity volatility or dispersion trades where we are earning a premium for complexity or illiquidity, and more likely to express a specific investment view via more liquid short term, often listed futures and options,” says Stephen Crewe, a co-manager of F&C’s Active Return Fund and other offerings that use equity derivatives.
Guy Stern, portfolio manager for Standard Life GARS, takes a similar approach. He says he is agnostic on the use of cash products, listed futures and options or over-the-counter total return swaps – it all depends what is the most cost-efficient way to express an investment view.
“Investment banks still come to us with some fantastically complex structures, but for us it is about unwrapping the onion to see if it suits our needs,” he says.
The combination of liquidity constraints in the eurozone and a wall of new regulations facing banks accelerated the process of adjustment in the banking sector in 2011, with lenders exiting or scaling back businesses that are difficult to fund or will suffer punitive regulatory treatment. Long-term credit-oriented businesses, such as real estate, infrastructure or aircraft and shipping finance, are under the greatest scrutiny. By contrast, derivatives structuring, especially in equity derivatives, has generally been regarded as an area that stands a good chance of generating fee income without incurring heavy capital costs.
