Sweetspot is buzzing

‘Small but perfectly formed’ was the verdict on the equity derivatives market this time last year. The equity segment of the derivatives market is still comparatively small but in the past year related earnings have soared, making analysts and observers sit up and take notice like never before. The business has become one of the hottest areas to work in.

The Bank for International Settlement (BIS) estimates that the over-the-counter (OTC) segment of the equity derivatives market was worth $5000bn in notional terms at the end of 2005 – a mere fraction of the overall $285,000bn OTC market. The BIS’s exchange-traded figures do not show the listed equity-linked segment as carrying much weight either. Notional turnover in listed equity derivative instruments accounted for just $39,000bn of the $344,000bn total that was traded on exchanges around the world in the final quarter of 2005.

But the ‘noise’ around the market has been considerable. Morgan Stanley analyst Huw van Steenis estimates that equity derivatives will contribute as much as $16.8bn to investment banking revenues this year, up 11% from last year, having risen three times as fast as cash equity revenues. Unsurprisingly, he also singled out the business as one of the top 10 money-making themes for global brokers and asset managers for 2006.

Meanwhile, the Boston Consulting Group forecasts that equity derivatives will contribute as much as $20bn a year to investment banking revenues by 2007.

JPMorgan banks analyst Kian Abouhossein also describes the business in a recent research report as the “sweetspot” for the next two years. Moreover, he believes that the business can expect 15% yearly growth going forward – one-third more than the 10% growth rate he estimates for the credit sector.

Toil pays off

Comments like these will have been much welcomed by the equity derivatives experts who have been toiling quietly over the past few years, while their higher-profile credit colleagues have been hogging the limelight. And many of them probably believe they are well overdue.

So why are equity derivatives suddenly such big business? For a start, there have been the earnings figures. SG, BNP Paribas, Deutsche Bank – pretty much all of the most active players in the equity derivatives segment – have recently had their equity derivatives franchises singled out by management in earnings presentations. Without official revenue breakdowns, it is difficult to quantify the business’s contribution exactly, but the management statement that accompanied Société Générale’s first-quarter figures is telling. The bank’s equity and advisory business powered ahead to deliver €1.145m worth of revenues in the three months to March 31 – up 51.9% on the same period in 2005. According to the bank’s official statement, equity derivatives made an “exceptional contribution” to those figures.

Dixit Joshi, head of equity derivatives at Barclays Capital, says that although most firms have reported great first-quarter numbers from equity derivatives, the business has in fact been incredibly strong for the past two years. “Corporates have been cash flush, fundamental stories have been good, corporate earnings up, and creditworthiness strong. That has led to a significant amount of mergers and acquisitions (M&A), stock buybacks and large dividend payouts – all of which have led to equity derivatives business in some way or another,” he says.

Strong cash equities, futures and listed options volumes, and demand for structured solutions will have helped to fuel additional liquidity and demand for equity derivatives products, he adds.

The growth story

The BIS’s exchange survey does not include individual equity contracts, so its figures for the exchange-listed equity derivatives business are, to an extent, misleading. With these included, the equity segment’s share of listed business would be significantly higher. But there are other reasons for the growing interest in the business than those that might be thrown up by statistics, not least that there appears to be a growing realisation that the market’s potential is far bigger than might immediately be apparent.

Christophe Mianné, global head of equity derivatives at SG, believes that in many ways derivatives products with equity underlyings have a wider scope for application than some others. “There is a very limited market for exchange-traded funds, warrants, certificates or structured retail products linked to either fixed income or credit. The potential market for equity products is enormous – and much of it has yet to be fully exploited,” he says.

Untapped potential

Yann Gerardin, global head of equities and derivatives at BNP Paribas, points to the untapped potential for higher margin business in the US market. The US probably accounts for about 40% of global equity derivatives revenues already, so it is a huge market, comparable to Europe in size.

But, although the bulk of European business is in the higher-margin structured area, the vast majority of US activity is in the lower margin, more vanilla flow products. “Flow will continue to grow in the US but it will be in line with the equity markets generally. Where there is real scope for US market expansion is in the more complex flow and structured products areas,” says Mr Gerardin.

Asia, where the likes of SG have been steadily building up their capabilities in the past few years, offers another vast opportunity for the business.

More freedom

Meanwhile, the uptake for equity derivatives in more established markets is still growing fast. Amilcare Police, global head of the derivatives solutions group at ABN AMRO, says that the shift towards a more derivatives-friendly regulatory landscape is fast giving institutional investors and retail product providers more freedom and, in some cases, imperative to use derivatives. Accompanying those regulatory changes is a growing realisation of the importance of equity risk management.

“In the bear market, investors had time to think about how to get back into the equity market,” says Mr Police. “They recognised that to get alpha they needed equity exposures, but having recently passed through the 2000-2001 downturn, they were unwilling to get back in with straight long positions. Instead, they have been looking to re-enter equity investments in a more sophisticated way – for instance, not just by getting outright upside exposure, but also by combining this exposure with some form of protection or guaranteed income.”

Risk awareness

The shift is already well in evidence, says Maurits Schouten, head of equity-linked products at Barclays Capital. “Investors are now much more risk aware and willing to use equity derivatives products than they were previously, as has been demonstrated by the hefty increase in non-bank and non-hedge fund clients that now use them,” he says.

Perhaps even more importantly, there is a growing consensus that the prospective applications for equity derivatives technology mean that the franchises will probably carry increasing weight in bank earnings in the future. The arrival of fund derivatives and hybrid-structured product franchises – both of which were born within equity derivatives groups and are based on equity derivatives technology – are but two examples.

Even at credit powerhouses like JPMorgan, this is being recognised. David Herzberg, global head of equity derivatives at the US bank, says: “The best infrastructure platforms in all houses can be found in the equity derivatives space, so it is natural that the complex and hybrid products are being born out of these groups.”

The insurers, pension funds and other institutional investors that are turning to the increasingly fashionable, liability-driven and portable alpha investment strategies are also fuelling the further growth of the business. “All of these techniques are based on equity derivatives,” says Mr Police. “And, because the instruments allow you to transfer risks, to leverage or modify exposures – all of which can be useful in either good or bad market conditions – we can expect the business to remain resilient, even if there is some kind of sustained equity market downturn.”

The competition

Catering to this growing demand will now be high on the wish-lists of all investment banking franchises, stoking yet further the heated competition between rival firms. But with SG’s Mr Mianné having recently said he would hire a further 250 staff in 2006, and, second in the running, BNP Paribas’s Mr Gerardin having said he would expand his business with at least 200 new front office hires this year, the duo are likely to keep well ahead.

Other banks have high hopes of competing, nonetheless. Mr Herzerg believes that JPMorgan’s “name, distribution franchise, cross-asset capabilities and global reach” all put the bank in a strong position, particularly in the US and Asia. At Barclays Capital, Mr Schouten believes the firm’s “terrific” name, “fantastic” client list and “strong” relationships, coupled with its close-knit interest rate, fixed income, credit, inflation, FX and commodity franchises, will stand it in good stead, particularly where the growth in hybrid products is concerned.

At Deutsche, global head of equities trading Yassine Bouhara is confident that the integration of the bank’s equity derivatives, cash and research businesses, combined with that of the overall equity businesses with the bank’s debt franchise, gives his bank a capability in the market that is “second to none”.

With the stakes being higher and more public than ever before, the game is on. But it will not be easily won. The market is now far larger and the scope for the business far greater than previously recognised. It encompasses everything from flow business to complex structured products and hedge-fund linked investments; from retail investors, through their institutional counterparts and on to hedge fund and corporate clients. It requires state-of-the art technology and risk management capabilities, extensive distribution networks and strong sales relationships, clever engineers and legal and regulatory experts.