New-fangled tool breaks into the market

Few of the banks that have benefited from the credit boom have ignored

the equity markets, however. For while the credit markets have

blossomed, a multi-asset approach has increasingly become the vogue,

and investors have increasingly demanded cross-asset research and

service.

Some banks have chosen to put their equity and debt analysts together

to produce cross-asset research. Banks that have done so claim that

such analysis provides them with a flexible framework that gives them a

better chance of spotting trends and divergences between credit and

equity.

Lucrative strategies

Other banks have set up cross-asset trading desks to engage in

reportedly lucrative capital structure arbitrage strategies. In these,

traders sell an expensive asset while buying a cheap one – going long

or short a company’s equity against a reverse position in the credit

market.

It was inevitable that the trend would lead to the evolution of a

cross-asset class product. And so it was that earlier this year

equity-default swaps (EDSs) first emerged.

Although the new-fangled tools are closely modelled on credit default

swaps (CDSs), there are a couple of key differences between the two.

First, EDSs pay out when the stock price of a company declines by a

predetermined percentage, whereas in a CDS the pay-out is triggered

when a so-called credit event occurs. Second, in an EDS the recovery

rate is fixed (for example, at 50%) whereas in a CDS the investor gets

paid 100% of the insured amount.

The supporters of the products are adamant about their benefits.

According to Peter Allen, vice-president and head of equity derivatives

strategy at JP Morgan, the arrival of EDSs will help to grow the credit

derivative market and encourage greater liquidity. “They will also act

as a helpful adjunct, as some names that don’t trade with sufficient

liquidity in the CDS market – or are not traded there at all – can

still be traded via EDSs,” he says.

Unique advantages

Shaun Wainstein, head of equity derivative structured products at

BNP Paribas in London, believes EDSs also offer unique advantages over

more traditional equity derivative products such as warrants. “The

difference between EDSs and warrants is that warrants are often traded

against short to medium-term views – while [EDSs] offer a longer-term

view. They also offer protection against more dramatic events than is

typical with warrants, which are usually just short-term plays on price

movements,” he says.

Shaun Wainstein: EDSs offer more protection against dramatic events than warrants

Another benefit is that with EDSs investors can express views on the

probability that a company’s stock will underperform dramatically –

something that is not really feasible with either equity options or

warrants.

Mark Stainton, a director in the integrated credit group at Deutsche

Bank, says: “Until these tools arrived there had been a gap between the

credit and equity markets. When people invest in equities they are

betting on a company’s ability to grow and perform, whereas when they

look at credit they are looking at its ability to make scheduled

payments and stay solvent. EDSs fill in the gap between the two,

enabling investors to express views across the full capital structure

of a company.”

According to JP Morgan, the bank that has most actively championed the

new products since their emergence earlier this year, there is already

strong demand for them. Chris French, head of credit and equity exotic

and hybrid derivatives trading for Europe and Asia at JP Morgan, says

that the bank has already traded several hundred million euro worth

since May, and is now quoting most of the European, Asian and US names

on a daily basis.

All the banks marketing the products claim that the interest has been

diverse. Mr French claims his bank has seen interest from credit

investors, hedge funds and equity investors, while Deutsche Bank has

seen some hedge fund interest but has done most business with asset

managers and insurers.

Faith in potential

The banks are adamant that the product’s appeal will remain

widespread. Mr Allen believes that because EDSs are clearly structured

to mirror credit default swaps, the natural investors will include

those from the credit derivative user universe, while Mr Wainstein

believes there is equal potential for these to be sold to pure credit

or equity investors.

The only problem that banks face then is in pricing the products and

getting them out to customers. Which department should be

responsible: equity or credit?

JP Morgan’s approach has been to have its equity derivative department

price EDSs, while both its equity and credit derivative departments are

actively marketing them. Deutsche Bank has followed a different route,

with its integrated credit group working jointly alongside its equity

colleagues, marketing and pricing the products together.

Similarly to JP Morgan, at BNP Paribas EDSs are priced and hedged by

the bank’s equity derivatives structuring team, while CDSs are priced

by its credit team. Mr Wainstein says: “But because the two instruments

are often marketed in conjunction with each other, both our equity and

our credit derivatives sales team market them both. This demands that

communications between the two departments work very well.”

BNP’s rival, SG CIB, a leader in the equity derivatives market, is

still organising itself to market these products. But the bank already

has a joint trading venture between its equity and credit derivatives

departments, which deals with credit and equity arbitrage and synthetic

credit product trading, and where the pricing and trading side of these

new products will naturally fit. “The issue is really who markets what

to who,” says Gregoire Varenne, global head of interest rate products

at SG CIB. “Our view at present is that if EDSs have very low equity

triggers, their appeal will largely lie with credit investors, but if

the trigger is 30% or higher, they might have an appeal to equity

investors – so clearly there is no defined fit within one or other

sales department.”

Gregoire Varenne: “The issue is really who markets what to who”

Early days yet

Despite the excitement surrounding EDSs, and the bullish response

from investors, it is likely to be some time before the products take

off. Banks that have not yet determined their strategy still have some

welcome breathing space.

According to Mr Stainton, the volumes so far have been low compared

with those in the CDS or options markets, but he is undeterred. “There

is still a stage of familiarisation, education and due diligence to go

through before volumes will pick up dramatically,” he says. “Over the

medium term, we are very optimistic about the growth of the product.”

Mr Varenne, too, believes that the instruments have potential. However

he says that the industry still needs to come up with ideas to make

sure that EDSs appeal to different classes of investors.

Once that task has been completed and EDSs gain all the traction that

CDSs have done in recent years, there will be a new generation of yet

more convoluted equity-based products coming to market. Already the

more sophisticated banks are working on further equity-credit hybrids

and waiting for the buy-side to play catch-up.