Equity Derivatives House
Back from the brink
In a year when many of the top guns in equity derivatives responded to large correlation and dividend-related losses by pulling back from the market, one house learned from its previous mistakes by overhauling its business completely to become one of the top players. During that time, it never lost sight of its clients or the need to keep innovating. Credit Suisse is IFR’s Equity Derivatives House of the Year.
It was three weeks to Christmas, and Zurich had made its decision. On a cold Thursday morning last December, Credit Suisse announced a plan designed to put a stop to the bank’s haemorrhaging of cash. The stock had dropped 35% in a month; the investment bank had lost the best part of SFr3bn (then US$2.49bn) in October alone. The time had come to dramatically change the business – and with it cut more than 5,300 jobs.
“These actions will better position us to weather the continuing challenging market conditions, capture opportunities that arise amid the continuing disruption, and prosper when markets improve,” chief executive Brady Dougan explained to colleagues in the memo. The race was on to save Switzerland’s second-biggest bank.
One year on, the fruits of that repositioning are clear to see – not least in the bank’s equity derivatives division. The business accounted for a large piece of the company’s SFr8.2bn loss in the fourth quarter of last year – in part due to structured products bets gone wrong. But by end of the first quarter, equity trading had posted its best ever three months on record, driven by a surge in derivatives business.
In the space of just a few weeks, bosses shifted the core equity derivatives business away from toxic, exotic products and repositioned it to instead concentrate on providing liquidity to its core clients. At a time of fundamental shift in appetite from those clients, who wanted continued liquidity in simpler, less exotic products, the bank was unique in the way it responded so comprehensively – and rapidly – to the new reality.
Results are proof of that, with equity trading revenues in each of the first three quarters of the year beating their year-ago equivalents. The bank is now on course to reap SFr8bn in equity trading revenue for 2009, a result that would surpass its own record year in 2007. At a time when many other houses were trimming staff and shrinking the balance sheet, Credit Suisse surged ahead by identifying the new reality – and adjusting accordingly.
De-risking the book was the first piece of the restructuring the bank had to get right. It had to free up cash to continue servicing its clients – and to grab new business as others continued to retreat. Keen to eliminate some of the correlation positions that brought down much of the industry, the bank targeted pension and hedge fund clients during one of the most stressed periods of the last year, convincing them to take a third of the bank’s exposure off the books.
“It’s now about finding clients who are willing to take risk onto their balance sheets and then about creating the right products that will allow them to do it,” said Lionel Fournier, co-head of global equity derivatives structuring at the Swiss bank’s London office, who says that the lender has exited its highly structured derivatives business to focus on flow and corporate sales. “Over the past months we have actively been de-risking the books and getting out of some of our less liquid positions.”
That was no easy feat. The team had to develop brand new products to convince clients who had backed out of the exotic end of the market. Though many were convinced about selling correlation, they were unwilling to do it through traditional variance dispersion trades. In response, Credit Suisse developed a payoff which dramatically reduced the difference between variance dispersion trades and underlying indices caused by index reweightings. Clients made some very large profits from the trades, put on during a period of very attractive levels – and the bank dramatically reduced its risk.
The team simultaneously developed vega-neutral covariance swaps to capture the premium embedded in implied correlation by minimising index vega exposure. Options on dividends were also offered to clients at a time when implied dividend levels had fallen way off analyst expectations. The strategy paid off, and paid off quickly: Basel II risk weighted assets in the equity derivatives division dropped by 43% between year-end 2008 and the third quarter of this year.
That freeing-up of capital allowed the bank to charge ahead with phase two of its rebirth: capital was immediately put to use facilitating client trades, just when many larger rivals were turning business away due to fears over risk levels and capital availability. “Even during the middle of the crisis we weren’t turning down any clients,” said Thibaut de Gaudemar, head of global markets solutions for EMEA in London. “We maintained the risk book even during the most extreme environments.”
Indeed, the role Credit Suisse played in the long-running Volkswagen ownership saga was particularly impressive. The German carmaker’s stock continually topped implied volatility tables during much of 2009. Yet, the Swiss bank still managed to commit €4bn of capital for a complex options-based purchase of a stake by Qatar Holding. The Swiss bank bought the entire synthetic position for its client, who was unable to face the counterparties involved, before settling the options one by one.
Out in Asia, it was the Swiss bank that stepped in when a client – China Resources Gas – ran into difficulty with its rights issue. The company risked being delisted from the Hong Kong exchange if its largest shareholder bought back the shares. Credit Suisse stepped up to the plate, engineering a solution that saw the bank take a 10% shareholding in the company and entering into an equity swap with the major shareholder – essentially committing balance sheet over the long term in order to keep a client happy.
On a flow basis too, clients have been complementary about the Credit Suisse’s willingness to quote and trade even through the depths of the crisis. Though the bank did cut down on quoting on a small number of exotic trades, clients said that did not hinder their ability to do business, as few wished to trade at that end of the spectrum. What is more, Credit Suisse more than quadrupled its 2007 score in a market survey US flow equity derivatives – traditionally not its strongest area.
“On a client-by-client, trade-by-trade basis we were open to everything,” said Garrett Curran, co-head of European securities sales at the bank in London. “There was a huge opportunity for us to jump into the market share of some of our competitors and capitalise on their exit post-Lehman. There’s a bit of a herd mentality in this business and we’ve seen a good deal of our competitors retrenching in equity derivatives. Still, we tempered our land grab.”
Structured products were perhaps the most affected part of the equity derivatives landscape during the last year. For many, they were a symbol of the excesses of the derivatives heyday, where much of the blame for the excessive warehousing of complex risk – and subsequent losses – lay. Some of the largest houses in the field closed up their operations leaving clients (now ex-clients) dangling with loss-making products.
Early on, Credit Suisse decided it needed to keep its structured products franchise open. For its Swiss clients, it provided a continuous liquid secondary market – a lifeline for many investors who had seen their investments hard-hit by the crisis. That included more than 2,000 products with 80 different payoffs and an average monthly turnover for the bank of US$500m.
It also continued to innovate, developing new capital guaranteed equity-linked products for the UK market at a time when interest rates were at record lows and investors had few other options. The average volume raised per product in the UK more than doubled in 2009 compared to the previous year, and now totals some £2bn. In the Americas, whilst industry volumes have fallen by about 60% year-on-year, Credit Suisse has managed to increase volumes by 10% over the past 12 months.
“At a time when lots of the competition allowed themselves to get distracted, Credit Suisse was always there,” said one London-based head of equity derivatives at a rival bank. He said the Swiss lender had succeeded in maintaining its overall profitability in equity derivatives at the same time as it reduced risk taking, capital allocation and personnel to adapt to the new realities of the business.
Gareth Gore
