New-fangled tool breaks into the market
The trend for cross-asset trading has spawned a new product, equity default swaps. Supporters are championing their advantages but, says Natasha de Teran, it is likely that EDSs will have to jump through a few more hoops before take-up is widespread.
For some banks the fall in equity prices and the demise of the dot.com-fuelled equity investing culture happily coincided with an increased focus on credit risk management and the fast development of the credit markets. Those that managed to gain a lead in the rapidly growing credit sphere have reaped the rewards.
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.