Turning a corner

March 4, 2010

There was trepidation among equity derivatives houses across the region early in 2009 when investors fled equity en masse. As implied volatility shot through the roof, institutional allocation for equities sank to levels not seen in decades. Numerous high net worth investors shied away from making aggressive bets which they had been so used to making in more bullish times.

Demand for equity-linked products dried up as indices tanked and even some of the largest equities derivatives houses were left wondering if they could survive the toxic environment if it dragged on for most part of the year.

Throughout 2009, the fallout of the global financial crisis worked itself out across the spectrum of market activities. The industry was reeling from the painful episode of 2008 when distributors and structuring banks were hit by allegations of improper selling and a lack of transparency.

The sharp consolidation among hedge funds hit the industry and major equity derivatives houses such as Société Générale, BNP Paribas, J.P. Morgan and RBS shifted their focus to servicing the needs of institutions, private banks and high net worth individuals. Those segments too, however, were in a state of shock as a result of the substantial losses they had experienced from equity-linked instruments.

For most of 2009 it was hard to sell long-dated products and difficult to structure highly attractive payouts in view of the low interest rate environment. The situation translated into considerable turmoil in staffing as banks were forced to cut numbers and cost.

Happily, this was not a Lars Von Tries movie we were watching. A positive tone crept back in the second and third quarter of 2009 and the mood in the industry has lifted, even growing ebullient in the fourth quarter, with some banks starting to fill the empty chairs after they had either closed or substantially downsized their proprietary trading desks in the wake of the sizeable losses in the fourth quarter of 2008.

The most considerable challenges for the industry are how to revive the frayed and battered confidence of investors in the various products and how to deal with a regulatory environment that promises to be no walk in the park, especially for entities without the means and ends to comply with the tougher regime.

A work in progress
Auto-callable structures continue to dominate the line-up of structured equity products sold by distributors and mirror the cautious mood sweeping through the market. While activity has considerably picked up in auto-callable structures in the third and fourth quarter of 2009, the volume was still significantly down from where it stood in 2008.

RBS specialists in structuring for equity and investment products observe that with implied volatility down, the fear factor is nowhere near the level where it had been 18 and 12 months ago, and the situation is not as desperate as it had been at the start of 2009. The prevailing opinion is that they are mostly out of the woods, there is a caution that a considerable number of issues still need resolving. The company’s disquiet has to do with the excessive euphoria that seems to have overtaken the market, especially in the third quarter. They feel not comfortable with the strong and surprising rebounds of markets in the middle part of 2009. The gains make it more difficult to ascertain whether enough momentum re¬mains for the market to move an additional 10% to 15%. The specialists don’t see anything on the horizon that will support another strong move from the market.

An incessant fear that has been gripping the industry is that regulators may decide to follow through with considerable restrictions on the sale of equity derivatives, especially to retail clients. RBS suggest this may cause a divide between various countries in the Asia-Pacific, with those that have an accommodative regulatory environment (like Australia, Japan and Malaysia) on one side and those that might limit the development of financial innovation (like Hong Kong, Singapore and Taiwan) on the other. Nonetheless, the regulatory framework across the region remains a work in progress, with most regulators in the process of drafting new rules to distributors and structuring banks on the sale of equity derivatives products. They are hopeful that the regulations would be enlightened and won’t harm the appetite for structured equity products.

Greater degree of disclosure
The process, according to RBS experts, is well under way in Hong Kong, Singapore and Taiwan, the three jurisdictions that have been affected the most by the meltdown in wealth, as a result of the heavy exposures by their high net worth individuals to structured products. Investors in Hong Kong are believed to have lost hundreds of billions of dollars of wealth as a result of the collapse of Lehman Brothers and their ill-advised heavy exposure on share accumulators.

As a result of poor regulation, the mood for complex structures (and so the rebound) has grown more subdued in the two jurisdictions that used to hum for these types of trades. Singapore has restricted some banks from selling structured products and the Securities and Futures Commission in Hong Kong has only approved a few structured products for sale in Hong Kong.
The changes in Hong Kong and Singapore are towards requiring a greater degree of disclosure from issuers of structured products particularly on their financial condition and any changes in the structure of the business. Regulators are making sure too that no mis-selling of equity-linked structured products occurs.

In Taiwan, regulators now require issuers to first establish a local branch or presence before they can sell any product in Taiwan. The regulators want to make sure that they have someone who can be held accountable if problems arise. The Taiwanese authorities learned the hard way: Bear Sterns, which did not have a presence on the island, was able to sell some of its products through distributors. When it collapsed and was absorbed by J.P. Morgan, the authorities and the investors realized that they would have considerable problems protecting their investments.

RBS expert believes that Hong Kong and Singapore are making good progress in terms of completing a comprehensive platform for regulating the sale of structured products and the regulatory change in Taiwan is near completion.

A great year
RBS claim that markets across the region have recovered in a major way and are considerably more buoyant than they were in the early part of 2009. The 50% rebound in most markets, especially in Asia, means that many people are much richer now than they were a year ago and this is the reason why we have been so busy servicing the appetite.

Australia, for instance, has been particularly strong because of the rebound of the Australian dollar and the relative buoyancy of its economy which has exceeded expectations and which stands in sharp contrast to that what is happening in the US and the UK. The experts say 2009 has turned out to be a really good year for investors, adding that the robust environment in Australia allowed them to make two launches of their Pegasus line of structured products where the underlying is a commodity arbitrage index delivering absolute return. The index, they point out, has delivered from 18% to 20% return per annum in the last ten years with a volatility of only 5%.

The equity derivatives industry has begun to regain its bearings after a difficult year, according to recent statements of Barclays Capital.

The recovery in the equity cash market has allowed Barclays Capital Equity Derivative business to enjoy enough flexibility to leverage the existing equity derivatives business. In view of the buoyant liquidity in the space and the access it provides to investors, the group is also focussing on building its listed solutions business.

Barclays experts are optimistic that investor appetite for more complex structured products will return once the new regulatory landscape becomes clearer. However, they admit that, for the moment, investors are still looking at the yield-enhanced, ‘back to basics’ structures, with most high net worth individuals and institutions opting to place their funds in reverse convertibles or simple zero coupon structures with put options. The mood, while still cautious, is beginning to show signs of renewed optimism. Barclays are beginning to see clients look for higher yielding, more complex products, because the basic structures aren’t providing enough yield for them.

While the first quarter of 2009 proved quiet, demand started to pick up in the second quarter, particularly for reverse convertibles. By the fourth quarter, as confidence continued to build, investors sought to take on additional risk. Indeed, demand for Zero coupons with a put option grew markedly as private banks looked to provide better yield pickups for their clients.

Accumulator appetite
Barclays state that nothing much has changed in terms of the economic environment with investors and institutions still having to contend with the low interest rates while grappling with huge asset liability mismatches. They say those mismatches still need to be paired and to be able to do that means investing in structured products or alternative assets, venturing that the low-interest rate environment is not likely to go away any time soon.

There are areas of business that have proven to be insulated from the worst of the downturn such as the listed warrants business, which has remained buoyant and active. In fact, volumes did not slow down as markedly during the crisis, and the appetite for accumulators might be returning. Barclays are seeing a lot of clients asking about share accumulators, but they are not yet as popular as they used to be.

In Japan, however, the structured product market hardly shrunk at all and – if anything – the flow has grown despite the volatility of the Nikkei for most of the year.
The most popular equity derivatives products have always been Nikkei-linked auto-callable structures, Barclays experts explain. Japanese investors are traditional and go for domestic exposure, although in recent months, there has been noticed a shift to a focus on structures linked to overseas markets, such as China or Brazil.

Investors have become more prudent, according to the experts’ remarks. They say when they are now buying structured products, they are looking really hard as to what exactly they are getting into.

According to BNP Paribas experts in equity and derivatives in Asia, while it is still early days for structured products in the region, they are bullish about growth in markets such as China and India. They claim that up to 2008 China’s major wealth management companies were busy selling structured deposits linked to Libor, FX and some linked to equity. The timing chosen to sell those products was rather unfortunate given how the market has performed and how many of these products did not do well. Since many were capital-guaranteed, the meltdown did not turn out to be a total disaster.

On the other hand, the majority of these products take bullish views. They do well in a bullish or range bound climate, but if the market sinks, the way in which they are structured means that major problems will arise. Worse, nearly 90% of the products sold then were of the bullish theme variety, particularly the share accumulators, which were highly leveraged and so exposed buyers unnecessarily to a huge amount of risk if markets veered in the wrong direction.

Barclays Capital remark, this goes back to concerns about why it is important for structuring houses to carefully consider liquidity, transparency and accurate reporting. If those are done, there will be less of a problem when investors decide to cash out of their structure; they will not be forced to wait and sit it out for a long while before being able to get their original investment back. The specialists point out that people need to come up with a consensus in the industry that will allow investors to smoothly cash out and so enhance confidence in the products. This is particularly important with high net worth individuals.

According to Barclays, more exchanges are considering the flex options which popular OTC contracts, such as volatility contracts, last year listed and traded in a regular exchange, and they can sense the gradual shift; the beauty of going listed is that a central party operates to perform margining, which means there is less of a concern about credit risk and liquidity. But the experts caution that listed contracts do not necessarily mean that the investors will be assured of liquidity. They believe it is important that exchanges encourage the participation of market makers in the market. The strong rebound in the equity market has helped many banks to make up their mind and revive their equity derivative proprietary desks after shutting them late 2008 and early 2009 as volume suffered. Banks such as J.P. Morgan, Morgan Stanley, Bank of America Merrill Lynch and Deutsche Bank announced new hires.