A crucial engine in investment banks’ equity trading units has stalled this year, prompting many to turn to financial engineering to sell new products.
Sales of the most popular type of retail structured product − known as autocallables − have slumped this year, with banks’ revenues from such activities dropping by 15% to 20%, according to industry executives.
That comes amid range-bound moves in stock markets, which have created a backlog of risky trades for banks to manage and dented investor demand for new products.
Bankers have responded by crafting new indices that do not rely on mainstream stock benchmarks, instead piggybacking on popular trends such as robotics and environmentally-friendly investing to bring in new business. That has allowed banks to continue selling products while diversifying their exposure, but also raises questions about how they will manage these less liquid risks if markets turn lower.
“There is a big concentration of autocallable products in the market that are not called. That’s made it a challenging environment to risk-manage and you have less new business. It is one element of the drop in equity derivatives results at banks in [the first half of the year],” said Nicolas Marque, global head of equity derivatives at BNP Paribas.
Marque said the concentration of products on the Euro Stoxx 50 in particular, which could be more than €60bn across the market, has been complicating risk management as all banks have the same position on.
“Hence BNP Paribas tries to innovate and advise clients to trade other underlyings like custom indices,” he said.
The largest US and European investment banks reported an average year-on-year decline of 11% in the second quarter of the year after an average 17% drop in the first quarter. The drop-off in sales of structured products, long a significant money-making activity, at least partly explains that fall, analysts say.
CALL ME MAYBE
Structured products appeal to retail investors, particularly in Europe and Asia, looking for higher returns than those offered by bonds. The autocallable has become the most prominent of these products in recent years, but it is a risky structure that in effect gives investors exposure to stock markets while capping both gains and losses.
As long as markets are rising, autocallables work well both for banks and investors.
Take the most popular structure, which checks every year where an index like the Euro Stoxx 50 is trading. If the Euro Stoxx has climbed above a certain level after a year, the investor receives a chunky payout and the product automatically expires, hence its “autocallable” moniker.
That process creates revenue opportunities for the bank as well. Not only can it now sell the client another product, the exotic risks stemming from this activity give the bank ammunition to place trades with hedge funds.
But it becomes more challenging for banks and investors when markets decline sharply or even trade within a range, as the Euro Stoxx 50 has over the past year or so.
Investors will have to wait to get their payout if the index has not climbed above that key level after a year. They could also lose some of their money if stocks decline below a certain barrier.
Managing the risks from autocallable books gets tricky for banks whenever stock markets fall quickly, as they did in late 2018. But even markets moving sideways can be problematic as it means autocallables will not come due, leaving banks with a backlog of trades to manage and limiting the amount of new deals they’re willing to do.
“If the market stays range-bound, autocallable issuance is going to be muted over time,” said Kokou Agbo-Bloua, global head of flow strategy and solutions at Societe Generale.
Banks have turned to financial engineering to plug some of that gap, building products using their own indices rather than relying on mainstream stock benchmarks.
Marque estimated banks sell more than €10bn of structured products every year in France, widely thought of as the biggest market for such investments. Roughly 95% of issuance came in autocallable products in recent years. This year, around 35% of that business is now referencing custom indices, he said.
Some customised indexes are simply a wider version of the Euro Stoxx 50, often with more smaller-cap stocks added in, to engineer a higher coupon for the investor. But they are usually linked to "megatrends" such as environmental, social and governance investing, demographics and the ageing population, technology disruptors or artificial intelligence.
“There has been increased appetite for thematic indices,” said Arnaud Jobert, EMEA head of equity structuring at JP Morgan.
The portfolio of stocks is chosen and weighted to produce the desired payout. When investors want “capital-guaranteed” products, meaning they are far less likely to lose their principal invested, banks often use a risk-parity or volatility-control mechanism to dampen the volatility of the index and cheapen the cost of the structure.
“With rates being so low and volatility being fairly low, banks need to innovate and come up with new ideas to get the yield and coupon that investors are looking for,” said Agbo-Bloua.
“No matter what the theme, it also has to be pricing friendly. There’ll be a filter to make sure that the cost of the option on that index is not too prohibitive,” he added.
Inevitably, using tailored indexes means banks cannot hedge all of the risks coming from the products quite so easily as with a widely-traded benchmark. That raises questions about how they will manage these less liquid exposures during falling markets, given autocallables on standard indices have often proved tricky to handle.
Bankers say exposures to customised indices are still small in comparison. Moreover, they note this activity helps them diversify away from standard autocallable products, where the bulk of the risk currently lies.
“The dynamics won’t be easier for banks to hedge, but such tailor-made indices allow banks to help clients in matching their investment aspiration in some specific themes with the risk-return profile they want to achieve," said Jobert.