An exotic failure

Banks have long talked of the importance of building distribution channels for the risks amassed through their structured products businesses. Having accumulated bulky volatility, correlation and dividend exposures, dealers have boasted about honing their distribution capabilities.

Some have unveiled fancy new structured products, aimed at retail, private banks and institutional customers, specifically designed to offset dealer axes (in turn, providing cheap access to so-called hidden assets for investors). Others have built up hedge fund sales teams virtually from scratch, and are now big traders of variance swaps, conditional variance, correlation swaps and dividends.

These tactics, however, were found to be woefully lacking earlier this year. A sharp rise in correlation, spiking volatility and falling dividend expectations combined to create the perfect storm for exotic equity derivatives books. Dealers were left stunned by the extent of the dislocation, leaving most - if not all - with significant mark-to-market losses.

So, what went wrong? First, some of the distribution methods were not as efficient as some dealers had hoped. In particular, correlation swaps proved to be an imprecise hedge for products referenced to baskets of stocks, which typically leave the bank exposed to both correlation and volatility.

In addition, all retained large chunks of correlation, volatility and dividend exposures. It is not viable or even desirable to offset these positions entirely, and dealers were often happy to hold on to these (sometimes profitable) exposures. On top of that, some banks made heroic assumptions on volatility and correlation in their models. In particular, many were caught out by the rise in correlation between the Nikkei 225 index and the yen.

Pretty much all banks have been hit - although some of the newer entrants, unversed in managing shocks in correlation and volatility, have fared worse. Some have even pulled back from the exotics market.

Coming so soon on the back of multi-billion-dollar subprime writedowns, banks needed this like a bullet in the head. With structured products already under the microscope, there's always the possibility that fed-up board directors may decide to pull back from the more complex end of the derivatives market. The vast majority of banks say their exotics desks are still open for business. But, at the very least, dealers are likely to be reviewing the risks they want to hold, reassessing their assumptions and making their risk distribution capabilities more efficient.

- Nick Sawyer, Editor.