Merrill Lynch research found that nearly E34 billion of equity-linked structured retail products were sold in Europe in the first half of last year, with more than half of that being sold in Italy and France.
The fickle nature of the market makes it demanding. Reverse convertible structures, popular in 2000, rapidly went out of fashion with the market downturn early in 2001. It’s a business that thrives on new ideas and rapid responses. But the underlying trend in the market is growth.
The latest generation of deals is based on a correlation play that enables the buyer to have both a capital guarantee and a coupon pegged to the euro-zone inflation rate. How many dealers can dynamically hedge that kind of correlation over the typical five-year life of the product? Only a handful: SG and its French rival BNP Paribas, along with Credit Suisse First Boston, Goldman Sachs and JP Morgan Chase.
But even some of these firms concede that SG has maintained its lead in equity derivatives technology. This lead is confirmed by Risk’s most recent Global Derivatives Rankings, published in the September 2001 issue of the magazine and derived from the votes of dealers in the interbank market. In the rankings, SG had a clear lead in exotic equity derivatives products. It came top in binary and digital options, barrier options and volatility/variance swaps.
In a low interest rate, low volatility environment, SG’s key products have been its ‘mountain’ range: Himalayas, Altiplanos and Kilimanjaros. These products have enabled it to prosper by selling correlation between stocks, rather than volatility. In the case of the Himalayas for example, the structure locks in the best performing stock in a basket of stocks over, say, a quarterly period. That stock is then removed from the basket and the investor receives the average of the locked-in returns over the life of the Himalaya. The final payout to the investors is the average of locked-in returns over the life of the product. It is SG’s ability to dynamically hedge that correlation risk over the life of complex products such as these that makes it a winner.
SG’s lead in the equity options business dates back to the mid-1980s, when Antoine Paille, at the time one of Société Générale’s foreign exchange analysts, suggested the bank could profitably expand its forex and interest rates derivatives business to include equities. From the outset, there was a retail flavour to the business. Société Générale cashed in on the early growth of the European warrants market, and it is still a leader, along with Citibank, although lately it’s been losing market share to bold new players in local markets, such as Unicredito in Italy.
But SG, as the investment banking arm is now known, has more than the technology of options pricing at its disposal. The barriers to entry in the equity derivatives business are being raised ever higher by the need for a more complex infrastructure. This is particularly true because of the growing popularity of fund-linked products – including products based on hedge funds – as retail and institutional investors seek enhanced returns through active investment. A key element in the SG package is its AA-rated Lyxor Asset Management subsidiary, established in 1998 as a ‘wrapper’ or ‘fund factory’ for the credit-enhanced management of its products.
One SG and Lyxor client last year was Banca Nazionale del Lavoro (BNL), the BBB+-rated Italian bank. BNL’s life insurance subsidiary wanted to replicate a E500 million portfolio of actively managed funds with equity capital guarantees using a constant proportion portfolio insurance structure. This would help hedge the insurance company’s liabilities, a declining proportion of which is index-linked. According to Andrea Magnani, head of equity derivatives at BNL, this was a structure complicated by Italian and European Union accounting regulations. But because SG had the machinery for the transaction in place – including the Lyxor wrapper – it was able to structure the deal within a month of proposing it last July. SG was also more competitive on price than four other dealers that tendered for the annual management fee for the deal. “They are far ahead,” is Magnani’s verdict on SG.
Derivatives dealers that want to construct the best fund-of-funds products are having to work harder to persuade the biggest and best hedge fund managers to deal with them. Permal Asset Management, the New York-based manager of $7 billion of hedge funds and funds-of-funds, recently partnered with SG to create equity-guaranteed products. Demand for these rose sharply after September 11 last year, says Larry Salameno, who is responsible for Permal’s product and marketing strategy.
“SG’s dynamic hedging is the most effective we have seen,” he says. “They are simply able to put more assets under management, and structure products for longer terms, without internally leveraging the core product.”
One interesting recent development at SG is its ClickOptions website. The site allows investors to bet in small amounts, for short periods of two, four and six weeks, on scores of different exotic options scenarios. They can buy short-term barrier or touch options on French and other European stocks, or follow races between four different stocks, gambling on which will perform the best.
Selling ClickOption presents SG’s quants with a tricky problem of pricing and hedging an options book, which – because of the shortness of the durations – cannot be merged with its wholesale markets books. And SG knows the site is widely followed in other dealing rooms – professionals will be the first to pounce on any mis-pricing of the retail options, which are expressed simply as a percentage of a E100 payout if the better gets it right. So why bother? Partly because ClickOptions, which is attracting around 4,000 trades a week according to SG, could be the sort of internet technology that most European retail investors eventually turn to.
One obvious danger to SG’s lead in equity derivatives is that its competitors throw so much money at the business that they win more and more deals. Some of the largest distributors of capital guaranteed products in the European retail market, such as the Italian post office, have become adept at forcing dealers to tender competitively for transactions. Even a relatively complex product can be described in a four-page terms sheet. It is easy for a distributor to hand the details of a new product around any number of dealers eager to bid for new business.
It can be frustrating, concedes Christophe Mianné, SG’s head of equity derivatives, especially because when a competitor wins business by mis-pricing an equity structure, it can take months for that mis-pricing to become evident, even to the dealer involved.
But Mianné is confident that the market for equity-linked retail products will grow faster than the ability of new players to create products. He also says the majority of distributors of retail products will want to be careful that they do not kill off a thriving business with greedy pricing. “There will always be distribution networks that will pay for innovation,” he says. What Mianné wants for the coming 12 months is a bullish market to revive demand for listed products, such as warrants, with higher volatility to revive demand for volatility-based option products.
That scenario doesn’t look likely right now. On a positive note, says Mianné, there’s growing demand from life companies and private banks for SG’s structuring skills – the firm is becoming less dependent on retail demand. So what is the greatest threat to SG’s equity derivatives business? It is apparent to any visitor to the SG towers at La Défense – the modernist financial centre on the wind-blown western outskirts of Paris – that a largely unexciting bank has nurtured an exciting business with a driven, enthusiastic and uncommonly loyal staff.
Société Générale’s senior management has fostered that culture says Mianné. He reports that an internal risk management review has recently concluded that the reserve maintained by the equity derivatives business against model risks and liquidity risks has been, if anything, too conservative. So more capital will be allocated to new products this year, he says.
There’s no doubt that equity derivatives are massively important to Société Générale. This one business (including stock lending and convertible bonds) will probably account for 25% of the group’s 2001 net profits of E2.2 billion, forecasts Roman Burnand, an analyst at JP Morgan Chase. The return on equity from the business will remain hugely attractive at around 100%, Burnand reckons. But it is not a capital-intensive business. The real challenge, he says, is that the revenues from equity derivatives have fallen in 2001 because of increased competition and because equity markets have been weak. It’s the first time in 10 years that SG has been faced with that problem, and how it responds will be critical.
Equity derivatives dealers’ ability to innovate will be the decisive factor in 2002, just as it was in 2001. Mianné is confident that his team has the right ideas up its sleeve: a new range SG has dubbed its ‘Gemstone Collection’ that will be launched with ‘Sapphires’ and ‘Emeralds’. Mianné will not say exactly what these are until distribution agreements are in place, but, he insists: “From what we know, and from what our clients tell us, we have the right products for 2002.”
The week on Risk.net, December 9–15 2017Receive this by email