It was only three years ago that UBS experienced hedging losses due to a build-up of exotic equity derivatives risk relating to its Japan business. Fast-forward to 2015 and the Swiss bank has revamped its models and risk systems with stunning results; combined with superior structuring in its China business, UBS has set a new standard in Asian equity derivatives.
Equity derivatives dealers in Asia have been in exuberant mood over the past 12 months as regional indexes – especially in China – continued to rise and lower interest rates inexorably pushed investors to equities.
Against that backdrop, UBS stood out for capitalising on its strong China-linked structuring capabilities with consistent feedback from clients lauding the Swiss bank for the clever ideas it has generated over the past 12 months.
Lower onshore China rates this year have meant a compression in bond yields and a greater demand for equity-linked structures. UBS launched a product tied to the portfolios of onshore asset managers, which gave exposure to different equity strategies.
Chen Ding, chief executive at CSOP Asset Management, says she has used UBS for several trades, including a leveraged preference shares deal totalling hundreds of millions of dollars. "UBS is very creative. We had special requirements and asked several derivatives desks for a structure, with UBS coming out on top. Other houses took a long time to do the internal due diligence and the pricing was more expensive. The quality of UBS's service is very good, and the people are passionate about what they do."
The Swiss bank also acted quickly to offer clients leverage on domestic Chinese bonds via a renminbi qualified foreign institutional investor (RQFII) bond fund manager. Thirteen trades totalling more than $1 billion were completed. UBS used alternative wrappers and currency overlays to assemble the structures, which were offered to security houses and private banks. It followed up with a set of trades linked to onshore convertible bonds, which offer clients exposure to an asset class that was not previously readily available in China. Three convertible bond trades were completed with Hong Kong subsidiaries of US hedge funds, raising hundreds of millions of dollars.
But spotting and structuring the trade is only half the equation. Without adequate risk hedging in place, it would take a very brave bank to offer such an opportunity to clients. In China, hedging is even harder as the markets are less developed in certain areas.
UBS was aware of the risks inherent in its China business and recycled it to private investors via the wealth management channel by issuing repack notes with kicker coupons linked to money market funds. The four tranches launched in offshore renminbi and US dollars during the first half of 2015 raised $1 billion.
The trade was particularly innovative as it not only helped reduce UBS's China gap risk (the risk of a rapid downward market move) allowing more business to be written; but it also assisted UBS Wealth Management in complying efficiently with the liquidity coverage ratio (LCR) while providing wealthy clients with a high-yielding cash alternative product.
Under the Basel III LCR, a bank must hold liquid assets equal to 40% of a non-operational deposit.
"Hedging this type of risk through conventional means, such as buying puts, has proven difficult due to the bespoke nature of the underlyers. To tackle this, we came up with a compelling cash alternative product that offset the risk. The product not only solved our problem as it increased our capacity to do more China-based business, but it also helped our wealth management produce an alternative to cash deposits," says Bilal Al-Ali, head of quantitative research and structuring, equity, at UBS.
Some of this China risk was also warehoused and then distributed to a major Japanese bank, which provided balance sheet relief to the Swiss bank. UBS assembled a product that put the RQFII bond funds into a special purpose vehicle, which acted as collateral for the note issued to the Japanese bank, which pays three-month Libor plus a spread. UBS then entered into a total return swap to retain the economic benefit while also increasing its return on equity for the RQFII bond fund as it is no longer on its balance sheet.
This obsession with capital efficiency and risk-weighted assets is reflected in UBS's common equity Tier 1 capital ratio that stands at 14.4% as of June 2015 – the highest level among global investment banks.
UBS's onshore structuring capabilities are also a league ahead of its peers. It is the only foreign bank to hold an over-the-counter swap licence through its onshore securities entity. Over the past year, this has enabled UBS to conclude $600 million worth of China A-share linked derivatives business with retail, institutional and bank clients. Typical structures include shark fins – products that pay a minimum return at maturity plus a participation in the rise of the underlying as long as an upper barrier isn't breached – and autocallables linked to topical themes such as infrastructure.
To support the generation of trade ideas and spot market dislocations, UBS has created a 20-strong team of dedicated quants in Shanghai.
"We are unique in providing China access in four directions: onshore assets to onshore clients, onshore assets to offshore clients, offshore assets to onshore clients, and offshore assets to offshore clients. This has helped us to syndicate a third of our China risk around the region, which lowered our risk-weighted assets and freed up our book to take on new solutions," says Tommie Fang, head of intermediary and Greater China sales, equity, at UBS in Hong Kong.
A big contributor to this success was the collaboration with its wealth management division, which resulted in $8.7 billion notional traded in structured and OTC products, with substantial volumes also being traded with external private banks – highlighting that UBS has no need to rely on a multi-issuer structured products platform to generate sales.
Co-operating with UBS wealth management has also led to 10 bespoke product launches worth $1.6 billion targeted at the ultra-high-net-worth segment.
Notable deals included the A-H access note, which sought to take advantage of the narrowing of the spread between dual-listed stock in Shanghai and Hong Kong following the launch of the Stock Connect scheme between the two bourses. The structure shorts a basket of H-shares while going long a basket of A-shares. The $100 million quota for the product was oversubscribed within days, and some investors profited to the tune of 125%.
Another timely product was the India bond fund note quantoed into dollars, which raised $125 million and capitalised on the bullish sentiment in India earlier this year. The product was similar to the leveraged RQFII bond fund note but replaced the China fund with a leading India foreign portfolio investor fixed-income manager.
Engine of growth
UBS has also bolstered its risk management capabilities this year with a risk recycling engine that seeks to systematically optimise crosses and transfer vega, gamma and delta risk in the most efficient way possible. Wealth management clients sell volatility through structured products, while retail investors buy volatility via warrants and hedge funds buy volatility through variance swaps and volatility swaps.
Testament to the success of the system was the 28% share it held in Hong Kong warrants during the volatile month of April, when competitors were forced to take a more cautious approach.
A Hong Kong-based hedge fund manager that trades index options, convexity and outperformance options with UBS says the bank's ability to quickly offload delta risk when executing OTC options sets it apart from its peers.
"Once we agree on a price, the execution gets done fast and accurately, so we never worry that we have lost the best price. Other houses take longer to offset their delta exposure before coming back with a final price – and, given how volatile Asian markets are, such as A-shares and H-shares, this is invaluable to us," says the hedge fund manager.
Another business that has yielded big wins for UBS this year is in the sphere of corporate derivatives. It transacted billions of dollars in bespoke structures with strategic shareholders and investors in Thailand, Malaysia, Indonesia and China. One example was margin financing for a buyer of shares in a Chinese listed company in Hong Kong. The seller had a stake of less than 10% and UBS found a buyer and structured a sizeable margin loan of 50% of the value. The margin call was 15% in cash with volatility triggers in place if the stock dropped 15% in one day or 25% over five days. To minimise the capital impact of a large trade like this, UBS distributed some of the risks to third parties such as local banks.
"We have the strongest syndication machine on the Street. When we like the risk we can go big – distributing a portion of it to other banks. As UBS always has significant skin in the game and an excellent risk track record, protection providers are very interested in these deals," says Nicolo Magni, managing director, strategic equity solutions group, global capital markets Asia at UBS.
The massive equity volatility in China during August triggered margin calls on some of these structures, but Magni says that investors have had no trouble funding these – and, in any case, UBS has executed hedges in the form of put options and credit default swap protection that have performed very well to cover such an eventuality.
In some cases, when stocks had experienced considerable gains, investors have also taken out collar financing deals to eliminate the burden of margin calls.
This involves an investor purchasing an out-of-the-money put option while simultaneously selling an out-of-the-money call option. This caps further upside, but also means that no cash need be posted if the stock goes down.
The week on Risk.net, December 9–15 2017Receive this by email