Need to know
- Some banks are worried that the thriving Euro Stoxx 50-linked autocallable structured products market is concentrated on too few product types.
- Product concentration forces dealers to dynamically hedge the same way during times of market stress.
- This has caused millions of dollars of losses for dealers in Europe, Japan and Korea in recent years.
- To reduce the build-up of autocallables referencing the same strikes, some dealers are marketing autocallables with altered characteristics.
- Some have been looking to shift knock-in and knock-out barrier strikes; others have focused on diversifying the underlying through the use of synthetic indexes.
- But an improved risk profile for the dealer often comes at the expense of investor returns, making the products a difficult sell.
Changes to popular structured products aim to help dealers reduce risks and hedging costs, but will investors make the switch?
The Chinese stock market’s Black Monday of August 24, 2015 wreaked havoc on Korean structured products desks. In the aftermath, a product developer at one investment bank in London had an idea. The bank could structure an investment that worked just like the autocallable notes that were so popular with retail investors, but without the sensitivity to correlation between stock indexes that had caused a large amount of dealers’ pain during the downturn.
The new product contained a flaw, however, in that it offered a lower coupon than the bank’s conventional notes. So the developer went back to the drawing board.
“Because it reduced the coupon slightly, the advisers who distribute products to investors said they would not be able to sell it,” says a senior equity derivatives trader at one US bank. “It was better for our risk management, but investors always go for products that offer the higher coupons”.
The tale highlights a predicament now facing structured products developers at leading investment banks. Investors around the world are continuing to pile into autocallables linked to the Euro Stoxx 50 index, which offer a juicy coupon of 7–8% if the index rises past an upside barrier and knocks out, at which point the principal is also returned. The position is funded by the investors implicitly selling a downside knock-in put to the bank, which places their capital at risk should the index fall below a second barrier.
This product flow can inflict hedging losses on dealers when markets tumble. Yet attempts by banks to diversify the product set – either by transitioning away from the Euro Stoxx 50 or shifting the knock-in and knock-out barriers outside the typical range – keep running into brick walls.
“We try to show distributors there are other ways to do these trades; other ideas they can push out into the network,” says an equity derivatives trader at a second US bank. “There are pockets of good success but also pockets where, because it is such an established product, the client base just wants to keep the same product.”
Autocallables have been a popular money-spinner. Bank of America Merrill Lynch (BAML) estimates that around 50% of all structured products issued in Europe belong to this product category, with the Euro Stoxx 50 being by far the most popular single underlying.
Korean investors are also huge buyers of the products, particularly the so-called worst-of variants that reference a basket of indexes. Approximately €200 billion ($238 billion) of new structured products issued out of the country in March and April this year referenced the Euro Stoxx 50, according to BAML research.
It was better for our risk management, but investors always go for products that offer the higher coupons
Senior equity derivatives trader at a US bank
The products may have been a reliable source of funding and fees for investment banks, but they also expose dealers to volatility, correlation, dividend and quanto risks that can be expensive to manage.
As autocallable sellers are long the downside put and short the upside call sold through the product, they must dynamically hedge their volatility exposure by buying and selling options as the referenced index moves between the upside and downside barriers. Dealers have congregated around similar strikes for both barriers – typically, the upside barrier is 100–110% of spot and the downside 70%.
This leaves dealers with highly concentrated positions. A group of autocallables fixed to the same strikes can create hedging difficulties as banks all race for the same hedges simultaneously, distorting prices and inflicting losses. Such stampedes have occurred in Europe, Japan and Korea in recent years. In range-bound markets, meanwhile, dealers’ volatility exposure, or vega, accumulates as products are sold but do not knock out – increasing the total hedge notional. As of the end of last year, BAML researchers estimated there was €96 million of Euro Stoxx 50 vega outstanding in the market.
To mitigate this concentration risk, banks are looking to tweak their Euro Stoxx-linked issuance to avoid requiring the exact same hedges as other dealers at the same time – for instance, by incorporating moving barriers so they are easier or harder to knock out, or by changing the underlying completely.
The trouble is the standard version of the product has proven so popular that investors are reluctant to innovate. One strategist likens it to Apple’s iPhone – people are familiar with it, so they will want to buy it again and again.
It doesn’t help that the modified products typically come with a lower payoff, dampening investor enthusiasm. “The truth is that you can provide something that is smoother or less risky for you or the client, but at the end of the day it will almost always come at the expense of the coupon for the client,” says a product development head at one European bank. “I think investors’ love for the autocallable is also the love for the coupon.”
Lessons from 2015
On the surface, there appears to be no shortage of diversity in the market for Euro Stoxx 50 autocallables. Distributors offer products with grand names such as the Phoenix, which pays a regular coupon as long as the index does not drop below a barrier, rather than accumulating the coupon – as the more traditional products do – until all the conditions are met.
Then there are defensive autocallables, which pay out even if the index has fallen during the year. Double knock-out products – so-called lizard autocallables – which have additional barriers across the observation periods and offer investors the prospect of a higher coupon if all conditions are satisfied, are also marketed.
But underneath the hood they all share similar characteristics, meaning they knock in and knock out at similar levels. For instance, a generation of products knocked out during the Euro Stoxx rally earlier this year, when the index soared from 3,238 to 3,658 between February and May (figure 1). Investors largely reinvested their returns back into the same products.
Since this bull run, however, the index has stalled, meaning fewer products have knocked out. If products don’t knock out, then dealers’ vega inventories are not emptied, meaning they have a larger amount to hedge if and when markets fall.
Equity derivatives desks at major dealers claim they are less exposed to the threat of a sudden increase in downside volatility than they were two years ago. One reason is that long vega positions are increasingly being offset by some banks through risk transfer tools.
The corridor variance swap is one way to transfer this risk. The instrument gives an investor, typically a hedge fund, exposure to the realised variance of an index, but only when the underlying moves within a set range, which is often linked to autocallable barriers. This allows banks to sell vega exposure to investors directly instead of via the crowded options market.
Yet even with such products at their disposal, some banks continue to express concerns about the degree of concentration.
“As long as the market is growing in terms of assets under management, I think the necessity to diversify is there,” says Eric Le Brusq, global head of equity at Natixis. “There is a big concentration related to certain types of payoff, and that has been raising some questions”.
Adjusting the autocallable
Shifting the upside and downside barriers is one way to mitigate dealers’ exposure. Put simply, these products would respond to movements in the underlying index differently than traditional products, so that dealers would not be required to hedge the same risks at the same time as everybody else when spot moves sharply.
“Some of it can be transforming the way the knock-in puts or coupons work. We try not to get involved in things that become quite large – instead we like to use product innovation and try out new trade ideas,” says the second US bank’s equity derivatives trader.
The London-based product development head says there are various ways in which they have looked to adjust their autocallable products to make them easier to hedge. For example, structured products developers could lower the knock-out barrier, so instead of creating a product that is out-of-the-money from inception, the investor would be in-the-money from day one.
Since most of the risk of an autocallable comes from uncertainty over whether it will or won’t knock out, making this event more probable would make it easier for the bank’s trading desks to hedge, he says.
As far as we are concerned, diversification is less a matter of twisting the payoff than about diversifying the underlying
Eric Le Brusq, Natixis
“It is easier to hedge if you make it closer to a long-term product or, alternatively, more like a short-term investment,” he says. “Uncertainty is highest when the probability of a call is at 50%.”
Increasing the probability of a knock-out would be attractive to investors. However, the lower risk profile – for both investor and bank – inevitably reduces the coupon the former can expect to receive. “That is the drawback for the client,” he adds. “Even if we optimise our pricing, it is still more expensive for them. They will need to accept a lower coupon.”
Dealers cannot expect a helping hand from product distributors, either. “Private banks do not share these [hedging] concerns,” says Karl Faivre, global head of structured products at HSBC Private Banking in London. “We do not have hedging issues on our side and we trust that investment banks are going to manage the risks on their side.
“Our concern is the quality of the solution that we are putting together and its alignment with the clients’ willingness to invest in a specific instrument,” he says. “And that rests on the ability of a product to generate a good return in a given environment”.
Synthetic champions
Another approach, which avoids impacting investors’ potential gains, is to diversify an autocallables’ underlyings. This has been one of the drivers behind the proliferation of products linked to smart beta indexes.
The liquidity redirected into smart beta index-linked autocallables helps reduce concentration in Euro Stoxx products while also making it easier for banks to manage the dividend exposure they are exposed to. Forward index dividends are a pricing input for autocallables, and as dealers have increasingly looked to hedge their long dividend positions they have pushed forward yields lower, resulting in a lower coupon for investors. This has led some dealers to offer indexes with synthetic dividends.
“As far as we are concerned, diversification is less a matter of twisting the payoff than about diversifying the underlying,” says Natixis’s Le Brusq. “We have been looking to engineer new types of indexes that are equally weighted and, for some, we’ve added synthetic dividends on top of that. The synthetic dividends combined with equally weighted components not only removes our dividend risk but optimises the coupon for the end-investor as well.”
The growing popularity of smart beta index-referencing autocallables has been noted by product developers. But Steve Lamarque, founder of structured products distributor Hilbert Investment Solutions, says it is nevertheless clear which index remains dominant in Europe.
“We have noticed a rise in smart beta and dividend-reinvested types of indexes that banks are aiming to promote in a structured product format,” says Lamarque. “From an end-investor’s perspective, the Euro Stoxx 50 remains the most popular index in Europe, so it is easier for clients to access structured products linked to it. We believe that this is the main cause of the concentration issue”
Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.
To access these options, along with all other subscription benefits, please contact info@risk.net or view our subscription options here: http://subscriptions.risk.net/subscribe
You are currently unable to print this content. Please contact info@risk.net to find out more.
You are currently unable to copy this content. Please contact info@risk.net to find out more.
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. Printing this content is for the sole use of the Authorised User (named subscriber), as outlined in our terms and conditions - https://www.infopro-insight.com/terms-conditions/insight-subscriptions/
If you would like to purchase additional rights please email info@risk.net
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. Copying this content is for the sole use of the Authorised User (named subscriber), as outlined in our terms and conditions - https://www.infopro-insight.com/terms-conditions/insight-subscriptions/
If you would like to purchase additional rights please email info@risk.net
More on Markets
Robinhood buys Marex FCM as futures entry takes shape
Retail broking giant follows WeBull into futures market
Deutsche Börse building equities dark pool
Move comes hot on heels of Euronext launching its own dark pool
European funds face upsurge in settlement risk after T+1
Trade body Efama finds up to 40% of daily FX flows may have to settle outside protection of CLS
Energy credit optimisers vie to become headline act
Competing initiatives may dilute ‘network effect’ as race to fill void left by TP Icap intensifies
Traders eye negative CDS-bond basis
Changed market dynamic can be profitable for those firms able to capture it
Reluctantly, CME moves to clear US Treasuries
CME Group will seek regulatory approval to clear US Treasuries, chief executive Terry Duffy said today
JP Morgan leads US banks’ FX trading revenues
Only two dealers saw revenue growth through 2023 as Goldman Sachs reports 75% drop
Singapore Exchange to return to short-term rates market
SGX president Syn hails new Sora and Tona futures as the “missing chunk of the rates complex”
Most read
- Quants are using language models to map what causes what
- Reluctantly, CME moves to clear US Treasuries
- The bank quant who wants to stop gen AI hallucinating