Equity Derivatives House
In 2004 equity volatility plumbed the lowest levels in decades, posing challenges for derivatives dealers. For adapting its structured product business to cope with the new volatility environment, extending its market reach across regions outside Europe – especially in Asia – and creatively deploying its fund management arm to tap alternative investment demand, SG CIB is IFR’s Equity Derivatives House of the Year.
The continuing slump in equity volatility in 2004 confounded many dealers. SG CIB contributed to the fall in volatility with an unloading of positions around the turn of the year that in retrospect was well timed. It also reworked its approach to the retail targeted structured product business that it has dominated for over a decade and which has been a key driver of growth for the entire SG group.
“We had to develop products that were Vega neutral, which has changed the retail structured product market,” said Christophe Mianne, global head of equity derivatives at SG.
Partly by structuring products that do not depend on high or rising volatility, SG was able to increase its total equity derivatives revenues by over 25% in 2004, outstripping all its major rivals. Net banking income from equity derivatives of roughly US$2.2bn for 2004 could be as much as US$500m more than that of SG’s closest competitors, once earnings from related but distinct areas such as prime brokerage are stripped out.
Tailoring of structured products to the new volatility environment has meant that sales to the core SG retail client base in Europe have held up, but the 25% overall growth was driven by a faster pick-up in other areas.
“On the two fastest growing markets in equity derivatives we have been leading the way – Asia on the one side and alternative investments on the other,” said David Escoffier, head of equity derivatives at SG in London.
SG sold roughly US$10bn of structured products into Asia in 2004 and built 50% market share in an area that has for the first time made a meaningful contribution to earnings for international dealers.
Different products were developed for the varying customer appetites across Asia. A “Trigger” capital-guaranteed fund designed to cope with low rates while offering exposure to an upturn in equity markets raised US$1.2bn in Hong Kong and was also popular in Taiwan. The structure offers a 10% fixed coupon in its first year, followed by a potential lock-in coupon equal to 10% plus 50% of the performance of the six worst stocks in a basket of 24 equities, with a payment floor of zero. As soon as the sum of the coupons hits the target 20% of the offer price the fund matures, meaning that investors could get 20% or more as soon as two years, or have a note of up to 10-year maturity with a capital guarantee.
The Trigger structure appealed to Hong Kong and Taiwan investors and their appetite for a bet, while the more cautious Japanese investor base was sold products that combined low returns with low risk. Over US$3bn of structured notes were placed in Japan, nevertheless.
SG also made progress in opening new Asian markets, including the first sale into China of a capital-guaranteed CPPI fund structured and guaranteed by a foreign bank. Sales of the Harvest Pu An Fund were expected to hit US$1bn by year-end, underlining the potential for future growth in China.
The deal took almost nine months to put together, as it involved due diligence on the local fund manager, Harvest, and the suitability of the structure for retail investors, as well as technical work on provision of the capital guarantee by use of local Chinese bonds.
Progress was also made on sales in the US structured product retail market, which almost qualifies as undeveloped due to the longstanding reluctance of American investors to buy complex notes. SG structured products in 2004 that were sold via more than 70 US broker-dealers, including the biggest – Merrill Lynch.
The ability to structure and support complex products sold to a wide retail investor base is appreciated by the banks with the biggest distribution networks globally.
“SG has consistently delivered solutions that meet our needs . . . in creativity, development of innovative products and secondary market support,” said Sandra Lee, head of retail products at HSBC Asset Management in Hong Kong.
“SG definitely has a better distribution platform [than its rivals],” said Anupam Gupta, head of structured products at Citibank global consumer banking in London.
SG’s ability to channel exposure from its traditional structured product business into trades designed for hedge funds is also given plaudits by the biggest end-users of new offsetting tools.
“SG has been the first to present and trade products like equity correlation swaps and options on hedge fund volatility . . . it has proved itself to be at the cutting edge of innovation on equity derivatives,” said Pavandeep Sethi, head of volatility trading at giant Chicago hedge fund Citadel.
Unimpressive performance by the broad hedge fund market did not stop the flood of money into alternative investments in 2004, and SG used its dedicated asset management firm Lyxor to tap this demand. Lyxor’s alternative investment assets under management more than doubled over the year to US$23bn, or almost half of its US$50bn of overall assets under management.
Lyxor invests in over 800 separate hedge funds, and manages the largest investible index globally, in the form of the MSCI Hedge Invest Index, which has over US$3bn in assets under management.
Short-term structured products based on the MSCI Hedge Invest Index were sold by SG to corporates as money market style investments, with a low leverage capital guarantee on the index offered in tandem with returns of around 200bp over Libor.
This helped to ensure continuing contact with corporate users of equity derivatives in a year when business linked to core restructuring was thin on the ground across all the major regions.
Lyxor’s approach to monitoring of the funds in which it invests has been criticised in the past for being overly restrictive. In an environment where returns have been low, many funds have been making poorly disclosed switches in investing strategy and regulators are threatening closer supervision, the tight Lyxor monitoring increasingly looks like a competitive advantage, however.
Strict rules on fund supervision by Lyxor also help in the scaling of its business.
SG works with the biggest funds of funds, including Man, Permal and Unigestion, and has developed structured products that offer investors hedge fund exposure combined with guaranteed returns.
One of these product lines, the Diamond income series, was structured specifically to offset some of the gap risk that SG runs due to its hedge fund investments. The notes are linked to a basket of 50 diversified hedge funds, with a guaranteed annual income of 12.5% and a capital guarantee that holds as long as the funds do not see very large drawdowns.
To tempt high net worth investors via private banks in Europe and the Middle East, SG offered additional safety features, such as removing the three worst performing funds out of the 50 in the underlying basket from the provisional clause to the guarantee. This makes the notes look like a good bet, but the conditional nature of the guarantee helps to hedge SG’s own exposure to the risk of a sudden slump across the entire hedge fund industry.
This is an approach that underlies SG’s approach to entering new business lines, as well as developing new products.
While SG maintained its global warrant leadership in 2004, with roughly 15% market share, it also made its first serious foray into flow trading of equity options, with a series of hires from rival banks.
“It was not a year of flow, which was a good thing for us because it was an opportunity to develop strength – it is better to do that in a year when flow is not too good,” said Mianne.
The timing of the flow sales staff hiring move was also due to a desire to more closely control the shifting of risk globally for the equity derivatives business at SG.
“Instead of giving our flow to the Street we want to give it to clients,” said Escoffier.
This philosophy also underpinned the commitment to developing the most complex products, as SG attempted to ensure continuing leadership for its equity derivatives franchise by ensuring it could manage its own exotic risk.
“The best players in the future will be the ones best able to unwind their risk. The clients on our alternative risk transfer business are not only hedge funds, but also classical clients buying funds with correlation swaps, so the possibility to unwind risk is bigger and that is key to continuing to develop the overall business,” said Mianne.