Equity Derivatives House
Rising stock index levels during 2003 did not spell an immediate return to health for bank equity-related businesses. For developing its ability to source equity volatility risk in one area and sell it in another, and increasing its structured product capacity at the same time as it was broadening its access to retail investors, Deutsche Bank is IFR’s Equity Derivatives House of the Year.
Broadening of distribution channels for risk has become the key to success in equity derivatives. Whether this involved repackaging of risk from structured note sales for distribution to hedge funds, or funnelling of single stock risk from corporate transactions to the warrant market, Deutsche Bank has been at the forefront of industrialising the movement of risk in 2003.
It developed the supermarket concept of providing derivatives online to self-directed clients in Europe and significantly boosted its synthetic asset management business. Equity derivatives revenue in the broadest definition of the market space is likely to hit €2bn at Deutsche Bank in 2003, but just as significant has been a move to give investors greater control of their use of derivatives in a bid to enlarge the sector.
“The derivatives business is central to our value proposition. It is not just that it is high margin; it is also high strategic value,” said Kevin Parker, head of equities at Deutsche Bank.
Margins in the flow equity derivatives business lines where Deutsche Bank has long been a leading player have come under serious pressure. Moves by traditionally niche structured products dealers to build flow trading operations attest to the need to have a significant flow business, however. Deutsche Bank has maintained its leading flow product position while expanding its footprint in the fiercely competitive, but rewarding market for structured products in Europe.
Faced with the realisation that SG had built a commanding lead in the development of exotic payout structured products, Deutsche Bank took the direct approach to building market share by hiring staff from SG to join a specialist structuring team that had been set up in 2002.
This increased the speed at which range notes on various asset classes, knock-out structures, conditional coupon deals and different types of principal protection could be combined.
As with most areas of the equity derivatives markets, margins in the more easily replicable structured product arena have been under downward pressure. But Deutsche Bank was able to weight its output, so that more than half of the earnings from structured notes came from the high-margin, tailored end of the value scale, according to Yassine Bouhara, global head of equity derivatives.
This market remains primarily one for continental European and Asian retail investors, but Deutsche Bank has also made sales in the nascent US structured product market and was an active seller of mandatory callable notes in the UK.
Less heavily structured notes that are targeted at retail investors have also sold well, including concepts like the “Waves” knock-out call or put options that were developed for the retail warrant market.
The Waves concept had been developed in 2002 as part of a move to replace Citigroup as the leader in the German warrants market, the biggest in the world. Another part of this move had been the hiring of most of the old Citibank Frankfurt warrants team and the approach bore fruit in 2003, as Deutsche Bank established a dominant market share of a German warrants market that finally revived as the DAX rallied.
This local market dominance alone was enough to ensure that Deutsche Bank was a leading warrant player globally in 2003, by dint of the relative size of the German market.
“I would point to that as one of the best examples of the firm saying: ‘That is where we want to be, that is the business we want to take, this is who we want to take it from – let’s do it’. . . it is an enormous call option for us on what is the most active derivatives market in Europe,” said Parker.
Investment to build market share when the warrant business was in the doldrums was rewarded, as Deutsche Bank generated over €100m of income from the sector.
It was also an area where a concept developed to increase retail market share – Waves – led to increased flow in another business line: servicing institutional users of equity derivatives. Waves options effectively create a cheap option that has the benefit of a stop-loss feature, and have been adopted by institutional clients as a low-cost leveraged vehicle that avoids the need for margin management.
Other products targeted at institutional clients have included “Wings” and “Protected Capped Certificates”. The Wings product met the need of institutional investors looking to boost income by selling volatility. It is a short-strangle option strategy, securitised by an upfront payment of a put strike, while upside short call exposure is capped by the sum of two strikes. This creates a collateralised product where the maximum loss is the premium invested. It normally carries a coupon paid at maturity but can be priced at a discount, depending on whether the client is looking for capital or income return.
Protected capped certificates were developed for clients that wished to protect key stock holdings, but did not have access to listed or over-the-counter options. They involve a long stock with collar strategy, where the option combination is securitised by the sum of a long zero strike call, a long out-of-the-money put and a short out-of-the-money call.
Deutsche Bank also had a leading share in the market for provision of variance and correlation swaps to hedge funds. Although hedge fund demand for illiquid risk products continues to grow on an absolute basis, the customers are the quickest in the market to squeeze bank margins. Deutsche Bank provides tailored versions of variance swaps, such as deals with capped pay-outs and stock price barriers, but its most significant pricing lever is its ability to source risk in other markets.
Market share of over 10% in listed single stock options and a leading structured note business are crucial for the bank in winning hedge fund business in variance and correlation swaps, and a role as a leading prime broker also helps to ensure flow from funds.
Emphasis on technology
Prospects for taking equity derivatives revenue to a new level are probably best in the field of synthetic asset management and the provision of lightly structured products directly to retail investors. Technology is central to winning business from self-directed retail investors that are changing the way they use certificates. After largely withdrawing from the market during the equity slump, many of these investors are returning with a jaundiced view of the value of buying products from a single adviser or dealer.
Technology platforms that offer a supermarket approach, with links to multiple banks and stock exchanges, are key to wooing these investors back to the market, as is swift origination. Deutsche Bank’s Xavex On-Line platform meets these criteria. By the second half of 2003, it was dealing with 150,000 quote requests a day and handling around 20,000 trades each day, and claimed a typical time-to-market for new products of 20 hours.
Deutsche Bank managed to increase its straight through processing rate during the year to almost 80% of all trades done with institutional clients, and 100% of retail deals.
The field of synthetic asset management saw great strides by Deutsche Bank during 2003, notably through a tie-up with DWS, the bank’s asset management arm and the largest asset manager in Europe.
As assets under management topped €15bn, Deutsche Bank introduced a number of investing innovations. These included “profile” funds that used derivatives to give access to proprietary bank indices on different asset classes and enhanced fund-of-fund products designed to maximise premium inflow while protecting capital. This was a global effort, with products such as Singapore dollar yield enhancement funds proving among the more popular.
The bank has high hopes for the future of synthetic asset management as investors question the role – and fees – of traditional asset managers.
“We are acting as a catalyst for market change by creating activity that is fully disintermediated,” said Bouhara.