The equity sector may be one of the smallest derivatives markets but it has a high profile and a profitable reputation.Natasha de Teran investigates this highly lucrative business.
For the status it is given, you would never believe that the equity derivatives business is one of the smallest of the derivatives markets. The outstanding amounts of equity-linked, over-the-counter derivatives contracted were valued at a mere $4400bn at the end of last year.
In comparison, interest rate derivatives outstandings stood at $187,000bn and foreign exchange products at $30,000bn; even the nascent credit derivatives market was estimated to be worth $8500bn. The same is true for the regulated exchanges, where equity-related derivatives business accounts for just a fraction of the whole.
So why all the fuss about the products? Well, for a start, it can be a very profitable business – it powered the first-quarter profits of SG CIB, the investment banking arm of Société Générale, to €498m. On announcing BNP Paribas’ first-quarter results, Baudoin Prot, its chief executive, also attributed a good part of his own investment banking business’s €716m profits to a strong equity derivatives business.
What you need to succeed
These two banks are by no means alone in profiting from strong equity derivatives revenues – meaning we can discard the theory that being French is a prerequisite for success. Christophe Mianné, the global head of equity derivatives at SG CIB, attributes his bank’s success in the business only partly to its nationality. “The fact we are French does help – the French tend to be more comfortable with, and interested in, complex risks than others, and financial engineering and risk management is in our culture.”
Mr Mianné says other elements that have contributed to SG’s leadership are scale, technology, creativity, risk management, distribution capabilities, market knowledge and management commitment, as well as the fact the bank started in the business earlier than most of its rivals. “We are also fully committed to it and recognise that the activity is absolutely crucial for us – we do not compete on a global level in primary equities, debt issues or mergers and acquisitions, but mainly in Europe. But we do have a leading equity derivatives franchise and we aim to retain that position.”
Mr Mianné also points to the attraction and retention of high-quality staff, leaving no doubt as to how he sees SG positioned. “We are fortunate in being able to recruit from among the very best and in ensuring the work environment here remains attractive [so that people stay]. If you are working at Ferrari or MacLaren, it is not so obvious to move to Fiat,” he says.
Among SG and BNP Paribas’ long-term competitors are Deutsche Bank and JPMorgan. Johan Groothaert, the global head of the investment products group at Deutsche, believes one of the crucial components for the bank’s success lies in its extensive risk redistribution capacity.
“The ability to do this consistently well distinguishes the true leaders from the rest of the players in the equity derivatives industry. Then it is a matter of employing the best people, having advanced modelling skills, access to retail distribution networks, extensive institutional client coverage capabilities and the right information technology and infrastructure,” he explains.
The importance of scale
Andrea Morresi, head of equity derivatives investor marketing for Europe, the Middle East and Africa at JPMorgan, believes scale is what keeps banks such as his at the forefront. He says: “Flow business is also more important for the overall success of an equity derivatives franchise a good sized and well staffed flow capability allows you to recycle risks that you may otherwise have to warehouse.”
He believes that many of the smaller or newer entrants to the business will have to limit their structuring and trading capabilities simply because they do not have a developed flow side that can provide the risk offsets.
Two newer equity derivative market entrants have their own perspectives. Dixit Joshi left equity derivatives heavyweight Credit Suisse First Boston in October 2003 to set up an equity derivatives group at Barclays Capital. He aims to bring BarCap into a top five position across the entire equity derivative spectrum and into a top three position in key areas. He says that as well as having a strong geographic reach and product capability, a good flow team and a best-of-breed structuring and exotic capability, it is important to leverage the capabilities across other areas of the firm to deliver integrated products.
Long-term commitment
Joachim Willnow left Merrill Lynch last year to take up a position as the head of equity derivatives at Nomura. He believes manpower, experience, risk management expertise, a strong balance sheet, risk appetite and creativity are all absolutely key in this business. “In taking the decision to join Nomura, it was vital I saw all the ingredients were either there, or that the bank was willing to support their development and implementation. Of course, it was also vital that I saw there was long-term support and commitment from the firm because that is another necessity in this business,” he says.
All those canvassed also insisted on the necessity of having some form of alternative investment platform. Remy Frank, the global head of equity and derivative sales at BNP Paribas, says the bank’s alternative investment management platform enables it to write options and swaps and other leveraged forms of exposure to alternative investments. “Historically, these products have been sold to HNWs and private banking networks but numbers of asset and pension fund managers are now looking at them as well, so it is becoming a very fundamental part of our equity derivatives offering,” he says.
Bernard Desforges, the global head of equity derivative sales and marketing at SG CIB, admits the bank’s alternative investment fund platform, Lyxor, was an advantage in the development of its existing product range. “Increasingly, you need to be able to provide investors with dynamic asset allocation expertise to provide products in different wrappers and to offer products in fund form. That is far more difficult to achieve without an internal platform,” he says.
Mr Joshi goes one further, saying: “It is also absolutely imperative to have a strong alternative investment management platform, solid support areas, good underlying technology and the best modelling and analytical framework available.”
An alternative investment platform is essential – but even that may not be enough. “You need to develop it in such a way that it keeps combining a flexible design – to quickly build upon any innovative solutions – with excellent managers who deliver performance over the long run. Lyxor has reached the critical mass where this alchemy works perfectly,” says Eric Personne, head of Lyxor at SG CIB.
Eric Personne, head of Lyxor, SG CIB
Where to house the franchise
So far, so much the same viewpoint. The competitors’ opinions begin to differ when it comes to where to situate an equity derivatives franchise within an investment bank.
JPMorgan and Deutsche Bank have recently integrated their derivatives business and, despite some early evidence of staff dissatisfaction with the move, they are adamant it will prove critical to their future success. “The ability to produce cross-asset hybrid products is growing in importance and the best way to do this is by integrating teams,” says Mr Morresi.
JPMorgan combined its trading groups across credit, equity and rate products, while leaving the sales side more focused on assets. The staff fallout has been considerable but the bank remains committed to the venture. Russell Schofield-Bezer, head of the corporate financial engineering group for Europe, the Middle East and Africa at JPMorgan, says: “We are very much driven by cross-product solutions, which is why we have integrated our equity, credit and rates business. If we are acting as trusted advisers to our clients – and, increasingly, the derivatives functions at banks are doing so – we need to have a holistic approach that is not limited by asset silos.”
Russell Schofield-Bezer, head of the corporate financial engineering group for EMEA, JPMorgan
Deutsche’s Mr Groothaert subscribes to the same school of thought. His bank recently repositioned its equity derivatives structured products group within the credit and rates-focused Global Markets group, where he can now leverage all asset classes.
Explaining the rationale behind the move, he says: “The immense private client interest in structured products on non-equity asset classes really took the whole industry by surprise, but we were among the first to reposition ourselves, creating an integrated retail platform across all asset classes.”
Mr Joshi, whose own unit sits within the very credit-focused BarCap, agrees that providing equity derivatives in isolation from all the other underlying asset classes does not offer the best solution for clients. “Clients typically trade or use a range of derivatives and you will service them best by offering derivatives across the commodity, foreign exchange, interest rate, credit and equity areas in the most seamless manner possible,” he says.
The market leader’s perspective
Maybe, maybe not. Neither SG nor BNP Paribas has chosen to follow the lead of their rivals – and there is little sign of that having a negative effect on their franchises. SG’s Mr Mianné is unconcerned. With the phlegmatic indifference that only a charismatic market leader can get away with, he says: “During the past year, many banks have merged their derivatives business and they will argue that this is now crucial for success in all rates, credit and equity derivatives. It is still unclear to me whether this is the case and whether these moves have not caused more damage than they have achieved.”
