Equity Derivatives House
Riding the waves: It’s been a difficult year for equity derivatives houses with many banks struggling to find a new business model for the post-Lehman Brothers era. As volatility spiked in May, many got skewered. But one bank stayed above the fray, successfully riding tense markets and continuing to service its clients even through the dark days. Societe Generale is IFR’s Equity Derivatives House of the Year.
Equity derivative markets largely ground to a halt on May 7 – or “Black Friday” as it subsequently became known among traders. A day after the US Flash Crash wiped trillions off the value of world stocks, a shockwave of panic all but seized-up trading in many instruments.
Many houses were caught out in the turmoil, with some very publicly losing hundreds of millions in wrong-way bets. The VIX Index, the industry’s most looked-to indicator, closed above 40 for the first time in more than a year. Dividend futures traders saw 20% wiped off the value of some contracts as markets creaked under the sheer pressure of sellers.
For an asset class still nervous from the billions it collectively lost in the market sell-offs of late 2008 and early 2009, these were testing times. But Societe Generale stood above the fray in the way it continued to consistently service basic client needs, even while others buckled.
The bank has come a long way in the past couple of years. It showed it had learnt from its past mistakes by overhauling risk management and diversifying its revenues streams. As the market sell-off intensified during May – the VIX eventually touched 48.2 – the French bank reaped the benefits of such changes. Amid seized-up markets, it put through more than 10 client trades in excess of €100m.
“Societe Generale is still the one to beat,” said one head of equity derivatives structuring at a rival institution. The respect that Societe Generale now garners from peers is in marked contrast from just a couple of years ago, when many criticised the bank’s decision to remain in structured products and exotic instruments as others closed down those businesses.
Indeed, the events of May were testament to how risk-adroit the bank’s equity derivatives business had become as a result of the crisis. Early in the second quarter, the bank decided it did not like signals coming out of the interbank market and bought up a huge quantity of puts to hedge against any potential downside. It was a costly but necessary exercise, the bank said.
“Our mandate is to be there for clients,” said David Escoffier, co-head of global equity flow at Societe Generale. “We wanted to ensure we had a book that was clean so that we could continue to quote on both sides. We had a feeling the crisis was going to be big.” That foresightedness and willingness to act enabled the bank to continue quoting even through the worst days of May.
Deliberate development
The bank’s strategic decision to hold on to its expertise in financial engineering and more exotic instruments allowed it to excel in vanilla flow. Societe Generale throughout the year showed its ability to transfer risks to the market by structuring complex trades for long-term exotic clients – offloading risks others couldn’t, and saving itself money in the process.
“This didn’t happen by chance, this has been a deliberate development,” said Dan Fields, global head of trading at the bank. “Some players did big trades but then found themselves having to warehouse the risks. But having a diverse set of clients means we can turn out the complex market risk in our books.”
The bank managed to reduce its exposure to the volatility spike by some €500m at the peak of the crisis – and by a further €200m later in the year – as a result of such trades. Its ability to warehouse and then offload complex risk quickly is something rivals speak of admiringly.
“SG excels at recycling their risk by providing clients with attractive trades,” said Mikael Simonsen, chief investment officer at IceCapital Asset Management. IceCapital traded a correlation swap based on how the S&P 500 performed in comparison with the US dollar-Brazilian Real exchange rate, enabling SG to reduce its exposure, he added.
But while the bank’s traditional hedge fund clients have held the bank in good stead this year, 2010 has also been about widening its pool of revenues. It has been keen to reduce its dependence on specific businesses, thus reducing its exposure to the ebb and flow of exotic equity derivatives.
Advisory has been a pivotal component of that. The bank has hired 40 mergers & acquisitions bankers and 25 coverage specialists in an effort to boost what has traditionally been a weak side of the business. “A lot of these revenue streams are about risk management, about diversifying the business,” said Fields.
One of the biggest deals the bank was involved with was Deutsche Bank’s €10.2bn purchase of the shares it did not already own in Postbank. SG provided a cash-settled equity swap for Deutsche, one of the very few banks that could structure a trade of such magnitude. “Advisory is a major push for the business and equity derivatives are a major part of that equation,” said Escoffier.
In another first for the bank, Societe Generale put together a variable annuities product for Dai Ichi Frontier Life, a Japanese insurer. The bank faced significant challenges in putting together the trade because of the need to link it to a basket of mutual funds. The fee for the underlying product did not cover the cost of hedging in a rising volatility environment, providing another obstacle.
SG created a dedicated cross-asset index in response, and also integrated a volatility cap and reinsurance trade to fully hedge the residual risks and give capital relief to the client. In addition, it lowered the fee to policyholders by 30%, helping drive more than US$1.3bn in sales of the product.
“We were convinced by the soundness of their overall risk management approach,” said Yukihiro Murai, general manager of asset management at the Japanese firm. “To our knowledge, they are the most reliable player, with the market expertise, the modelling technology and the asset management skills required to successfully assist us in the massive campaign we launched.”
Resilience of the franchise
At a time when the equity derivatives market is in a state of flux – with many banks struggling to redefine their businesses post-2008 – Societe Generale’s model seems to be working. Net banking income for global markets equities was €1.78bn during the first nine months of the year – down on a year ago, but holding up well compared with rivals during a difficult year.
The resilience of the bank’s structured products franchise demonstrates how Societe Generale has kept revenues steady even while rivals suffer. The bank is by far the biggest player in the structured equity derivatives field – with 20% of the US$7bn industry, according to JP Morgan – and the bank has maintained that share even despite declining demand.
The bank’s management insist it intends to maintain that dominance. Many smaller players pulled out of the space in 2009 following heavy correlation and dividend losses linked to structured products. As demand comes back, they may well regret that decision.
“Rates will remain low and demand for structured products will return so we need to maintain this capability,” said Christophe Mianne, head of global markets at the bank. “We need to have the right deals, the right views – push those to clients – and keep comfortable levels of risk.”
But Societe Generale remains a well-rounded house, proved not least by its dominance of the dividend futures market during 2010. After a bumper year for the new asset class in 2009, the French bank in April launched the first ever exchange-traded fund linked to dividend futures. That gave retail investors – and many other investor types – access to this burgeoning market for the first time through a transparent instrument.
The bank was also the first market-maker on Eurex’s single stock dividend futures, which launched during 2010. Its willingness to put its feet in first shows the bank’s commitment to new markets. Throughout the year, it has proved its mettle, according to its clients.
“SG is our preferred counterparty as their reactivity, pricing and sales capabilities have been especially important within the past year,” said Wenzel Schleining of German savings bank KSK Cologne. “They have been able to facilitate a trade in huge size on dividend exposure, working our order in a very professional and quiet way, where others were not able to show capacities at all.”
Gareth Gore
