Germany 2007 - Warrants and certificates boom
The German warrants and certificates markets are going from strength to strength. The sector forms Europe’s biggest securitised derivatives market, and participants say that it is far from peaking. The number of recent entrants to the market attests to growth expectations. Jean Haggerty reports.
A new securitised derivatives exchange was launched by the Deutsche Boerse and SWX Group in Germany in January, and a number of banks have recently entered or re-entered the local warrants and certificates market.
Royal Bank of Scotland, Morgan Stanley and Barclays Capital count among the relatively new arrivals, and Lehman Brothers is among the institutions expected to return to a market that shared in the global equity downturn of the early years of the century, before an explosive revival.
“It all happens in Germany first. Everyone wants a slice of the action,” said Ralph Stemper, product manager for warrants at Commerzbank in Frankfurt.
Deutsche Boerse and SWX Group’s announcement last spring that they planned to challenge market leader Stuttgart Stock Exchange and launch a joint venture exchange was sparked by the 195% increase in trading volumes in certificates and warrants during the first quarter of 2006. Year-end volumes show that Germany’s on-exchange certificates and warrants market grew by about 109% over the course of last year.
It is unclear how much certificates and warrants business occurs off-exchange in Germany. By some estimates, as much as 50%–70% of business is conducted off-exchange.
“Warrants are one part of it. Certificates are the more important story,” Commerzbank’s Stemper said. Warrant products represent 15%–20% of the total of securitised derivatives trading on exchange in Germany. Germany’s warrants market is geared to institutional investors first, then to retail investors, while its certificates market is retail-oriented. Assets under management in certificates dwarf those in warrants and the growth prospects for certificates are greater.
About 1%–5% of German retail investors own certificates today, but many market participants believe that a penetration rate of two to three times current levels is possible.
Additionally, more funds are starting to invest in certificates, according to Stefan Armbruster, a director at Deutsche Bank.
A big part of the certificates market’s allure is that certificates allow market participants to make money in various market conditions. “Investors like [certificates] because they can offer defined pay-offs,” Armbruster said. “The big topic right now is getting equity exposure with downside protection,” he added.
Against this backdrop, bonus certificates and express certificates are proving popular. Bonus certificates have a lower and an upper barrier, and if the lower barrier is not touched during the life of the contract (usually two to four years) investors receive the upper barrier’s value at maturity. “Their popularity is not too hard to explain. At the end of 2005, most analysts said that the stock markets were only going to rise a little,” Stemper said.
With express certificates, the value of the asset underlying the certificate is important. If, after one year, this asset is above its level when the certificate was issued, the investor receives the principal amount back plus a value such as 10%. If the asset’s value has not risen above its value at issue during the certificate’s first year, each year over the four-year life of the certificate the asset’s value is checked against the asset’s value at issue.
If it is above the value at issue, the certificate is terminated and the customer receives back the principal including the yield (such as 10%) multiplied by the number of years. For example, if the certificate runs for three years the customer receives 30%. If the price of the asset still is not above its price at issue after four years, the customer receives the equivalent of the asset’s performance.
Some of the recent growth in bonus and express certificates in Germany has come at the expense of discount certificates; though this product may see a rebound as it tends to fare better in a climate of elevated equity market volatility, such as the one that has prevailed since the end of February.
According to Deutsche Bank, the certificate market’s dramatic rise in the past few years is illustrated by how quickly it is starting to catch up with the country’s much older fund industry. At the end of 2006, Germany’s equity-linked mutual fund market had about €185bn in assets under management. Equity-linked certificates at the end of last year represented about €70bn of Germany’s roughly €120bn overall certificates market.
That the German securitised derivatives market is attracting a growing number of banks should come as no surprise, nor should the fact that bank marketing efforts have increased and grown more aggressive.
Product information and service, rather than fee reduction, is where competitive advantage can be gained, market participants say. The fees associated with trading certificates in Germany are already very low, which reduces the scope to compete on price. DAX and EuroStoxx 50 index tracker certificates already trade at 1:1 with their underlying index, Commerzbank’s Stemper pointed out.
“When I started at Commerzbank two years ago, Commzerbank had 12,000 warrants and certificate products. Now, we have 24,000,” he said, adding that the focus on product variations will propel this trend.
This ballooning in the number of products on offer sounds like an operational nightmare, especially for an industry that is just starting to move to electronic trading, but exchanges and dealers are coping well so far.
The Stuttgart Stock Exchange’s Euwax platform for certificates and warrants, one of the two exchanges catering to Germany’s securitised derivatives market, introduced electronic trading in January.
For the Deutsche Boerse and SWX Group’s operation for the German market, which is called Börse Frankfurt Smart Trading, the Xetra trading platform will come into operation early next year.
According to Marc Zahn, CEO of Börse Frankfurt Smart Trading and CEO of SWX Quotematch in Zurich, this move is aimed at simplifying access for European participants.
“There we will offer two market models – one with and one without the intervention of a specialist for pricing purposes – and both will be reflected on Xetra. Market making, which supplies additional trading liquidity, can be accomplished by the issuer itself or delegated to a specialist. Over the medium term, trading on both exchanges will be conducted via a common technological platform; full migration to the Xetra platform is planned for the end of 2009,” Zahn said. Issuers will be able to choose the market model that is best suited to the trading of their structured products.
Deutsche Boerse and SWX Group have been trying to establish German and Swiss operations under the brand names “Börse Frankfurt Smart Trading” and “SWX Quotematch” since running into a branding dispute with Rabobank.
Deutsche Boerse and SWX Group were initially interested in using the brand name ALEX, which is the name of Rabobank’s discount brokerage arm.
According to Ralph Danielski, member of the executive board of Euwax, the potential operational challenges that might be expected, with soaring trading volumes and so many new products coming out, have not been a problem and are not expected to cause problems, because many products trade irregularly.
“What the end customer needs is efficient execution. We have half of our products executed within 10 seconds, and for the rest execution occurs within 30 seconds,” he said.
The Deutsche Boerse and SWX Group’s German operation guarantees order execution within 30 seconds and about 75% of all orders are executed in fewer than 10 seconds, Zahn said. Deutsche Boerse’s release of Xetra 9.0 will further enhance trading speed and the system will be capable of dealing with several hundred million quotes per day, he added.
The move to electronic trading in Germany has meant a switch from a broker market model to a quote-driven market model. Under the quote-driven model, if an issuer shows a bid/ask price and a customer accepts it, the deal is completed. This differs from a broker model, where if a level moves after an issuer shows a price, but before the customer accepts, the customer is asked if the price move is acceptable as a trade point. Issuers have not offered market participants much feedback on the market’s new quote-driven model yet.
“We are striving to be the leading börse for structured products in Europe by 2012,” Börse Frankfurt Smart Trading’s Zahn said, adding that France and Italy are the next countries flagged as part of its expansion plan. “Our new exchange will focus exclusively on structured products. As a specialised exchange, it can address more directly the specific needs of customers in this segment. The advantages of the joint venture also lie in the aggregated liquidity that will be attracted to this centralised trading venue from a large network of participants across Europe, he added. In Switzerland, SWX Quotematch is the only exchange to offer trading in structured products. Nevertheless, there is a substantial local OTC business, driven by institutional investors and the global banks UBS and Credit Suisse.