Equity derivatives have shown strong growth recently and major banks have been quick to adapt and strengthen their departments to capitalise on the boom. Natasha de Teran reports.
The equity derivatives sector is one of the hottest segments of both the global over-the-counter (OTC) and the exchange-traded industries. According to the latest statistics from the Bank for International Settlements, the equity-linked area was the fastest growing of all the OTC markets, growing by a record 35% during the second half of last year. In comparison, the overall growth recorded by the OTC markets was just 16% during the same period. The exchange-traded markets have seen even stronger growth: in the year to December 2003 the market grew by about 54%, compared with the 32% overall growth rate of listed derivatives products.
Banks with established equity derivatives businesses have been among the largest beneficiaries of the explosion of interest in the sector. Capitalising on their reputation, they have built up their franchises in line with the market’s development. Among the market leaders are names such as BNP Paribas, JP Morgan, Deutsche Bank and Goldman Sachs; the most prominent position in the industry is, however, held by SG CIB, the Paris-based investment bank that is part of Société Générale.
Bernard Desforges: SG has invested heavily in equity derivatives to keep its number one spot
Maurits Schouten, Barclays Capital: ‘We feel there is a huge overcapacity in the market’
Selective focus
Bernard Desforges, global head of equity derivatives sales and structuring for SG in Paris, believes that much of SG’s success lies in the relatively narrow focus of the bank.
He says it aims to be a market leader in a few select niches, rather than to spread itself across the full gamut of investment banking services. Equity derivatives is one of the key areas.
“SG is fully committed to the equity derivatives area and as a result has invested heavily in it, allocating it a significant part of the bank’s equity, head count, IT and operational resources. We do this in order to ensure we retain our prominent number one position in the market,” he says.
Mr Desforges believes there are three crucial ingredients to being successful in the business. First, it is important to continually innovate in order to bring relevant new ideas and investment strategies to customers. Second, banks must be able to provide the full range of the necessary support services to clients – including secondary market liquidity as well as tax and legal support. And third, they must be able to provide top quality advice to clients as regards market timing. “We try to keep at the forefront of innovation, developing products that really make a difference to investors. Clients repeatedly return to work with us because they realise that they increase their distribution because of our products’ widespread appeal,” he says.
SG’s strong franchise also owes much to the bank’s in-house asset management arm. Lyxor Asset Management, which has attracted more than E38bn since it was established in 1998, is a crucial component of the division’s strategy and has been a particularly valuable adjunct to the bank with the growth in structured retail products.
Mr Desforges says: “We realised there was a growing convergence between asset management and structured products some time ago, because the risk profiles and investment targets are very similar in many cases. Lyxor is very valuable to us – there are many products that can be distributed either through the asset management arm, or through the investment banking side, and having both together under the same group means we can leverage off that.”
He says it is also important to have this capacity in order to create products with asset management wrappers, and in order to be able to offer exchange traded funds (ETFs), and alternative investment products to investors. “Overall it has proved to be very successful strategy,” he adds.
Drawback of leadership
Being a market leader is a double-edged sword – more often than not, you are targeted by others looking to build up their own businesses. Until recently, Barclays Capital was focused on the fixed income side of the risk management and financing business, however, over the past 18 months it has been building up other asset classes including equity derivatives.
Barclays Capital has raided SG, and many of the latter’s leading competitors, for staff, and has built up its European trading team to 55 strong, up from just 35 a year ago. In addition, it hired 20 equity-linked specialists, as well as eight structuring specialists. Such is the bank’s commitment to the market, it is still hiring.
Expansion on horizon
Hassan Houari, head of equity derivatives structuring at Barclays Capital, says: “We have a very global focus. The next step will see us expanding further the coverage outside Europe. We plan to build up the team in Asia by the end of the year, and by early next year we will also have a four to five-person sales team in place in New York.”
Maurits Schouten, head of equity-linked products at Barclays Capital, who joined the bank from Credit Suisse First Boston in April last year, explains the bank’s strategy.
“In the equity derivatives markets we have to position ourselves differently to our competitors. We don’t do block or programme trading on the cash equity side, although we do direct market access (DMA) execution for clients. We are happy with the relatively low scale of our cash business, as we feel there is huge overcapacity in the market, and margins are very low,” he says.
Because the bank’s market share in equity derivatives is relatively small compared with its competitors, and also for the size of the bank and its credit rating, Mr Schouten believes there is tremendous room to grow and to make money out of the business. He says: “We have a blank sheet of paper and at the same time we have a very experienced team. What is very rewarding is that people are really interested in our story, so we are able to hire top people.”
Much of the record volumes in the OTC and listed markets have been driven by the surge in assets under management at hedge funds, which have provided bankers with a welcome surge in flow business. Elsewhere, however, the market has been driven by the growth in structured products taken up by retail investors.
According to research from BNP Paribas, the notional issuance of equity derivatives retail structured products totalled a whopping E100bn in Europe, and a further E25bn in Asia: growth in some countries soared by as much as 40% during the year.
So far this year the trend has shown little sign of abating. Axel Kilian, co-head of equity derivatives marketing at JP Morgan in London, says: “Demand for retail products picked up strongly during the first part of this year. There was strong interest in income products – especially high coupon products linked to equity baskets, and these products are still in strong demand across Europe and Asia.”
Shaun Weinstein, BNP Paribas: market has been characterised by a fast-changing environment
Change in retail market
Along with the soaring volumes, the retail product market has undergone substantial change, making the market particularly challenging for banks. Shaun Weinstein, head of structured products trading, at BNP Paribas in London says the market has been characterised by very fast-changing conditions largely because of the changing rate and global economic outlook.
Christian Kwek, global head of structured products marketing at BNP Paribas, adds: “The volume of growth has been enormous, but as a consequence of the uncertain outlook we have seen customer behaviour change – capital at risk has become very important to them. We have also seen a move towards more transparent structures – people want to have structures that have straightforward pay-offs, and yet offer a guaranteed minimum return. Finally there has also been tremendous interest in hybrid underlyings.”
Mr Kwek says retail investors have also switched their preference from capital-at-risk structures to products offering full or partial protection coupon-paying products, and “cancellable” structures became increasingly popular. Fund-linked structures and hybrid underlyings also developed significantly. In the coming months, he expects to see issuance and distribution becoming more segmented and a more dynamic approach to product management emerge, along with greater diversification across asset classes.
Meanwhile Andrea Morresi, co-head of equity derivatives marketing at JP Morgan in London, expects to see the trend toward more hybrid products continue to develop, and also an increase in the use of hedge funds and other funds as the underlying product to which equity derivatives’ performance is pegged.
Banks that are now entering the market will face significant challenges. They will need to be nimble enough to adapt products for different user groups and also have a widespread distribution capability to reach all the different investors now active in the market.
According to Mr Kwek there is widespread migration of products between different investor classes – although most of the products that are now being taken up were initially developed for the retail market, many of these are being sold to different client types.
“Last year we developed our so-called Stellar product for the institutional client base, for instance, but soon found ourselves selling it on to private banking networks and more recently to retail across continental Europe,” he says.
The broader the better
Only by having a wide customer franchise and a range of activities can banks offset the different risks they assume in the business. Mr Desforges says it is partly because SG offers a wide range of products that it achieves statistical risk compensation and can take on more risks. “We have found a useful way to offload risk which enables us to continue to build up our franchise. In a sense we are almost working like reinsurers – taking risk on in one area, and offsetting it by a different set of risks.”
