Risk Awards 2016
BNP Paribas has beaten an unconventional path to this year's equity derivatives crown. Long established as a top-tier structured products house with a strong exotics franchise, this year the bank made spectacular ground in its flow business – the fruits of a large, lengthy investment. Despite lacking a cash equities franchise and a sizable prime brokerage team, the bank recorded its best year for vanilla-listed and over-the-counter products.
Revenues for the first nine months of 2015 in equity and prime services were up 22.5% on the equivalent period in 2014, making it the number one non-US bank for flow revenues, according to Coalition data, and fourth-ranked overall. In 2013, flow derivatives accounted for one-third of BNP Paribas' total equity derivatives revenues. Today, they stand at more than a half.
"This is the result of a 10-year investment at BNP on the flow side. Our first flow sales were made in 2005, and since then we have been driven by how we can best serve our clients: How can we be credible? How can we be loyal? How can we provide constant capital commitment to our clients? What we have done is always the same: push for education, transparency and liquidity – for example on dividend products, where we were first-movers in Euro Stoxx dividend swaps futures in June 2008 and in dividend futures on the S&P 500 this year," says Emmanuel Dray, global head of flow derivatives at BNP Paribas in London.
An increased flow footprint has also given the bank the heft to print outsize deals this year, chief among them the bank's largest equity swap to date – a $4.6 billion notional trade with a US asset manager on the S&P 500 total return index.
"We had on board an S&P 500 inventory that we were able to lay off against our exposure to this swap. Not only did we have the most aggressive price, but we were also able to propose a solution over several maturities, which better met their needs. Ahead of the December 2015 roll, we traded more than $12 billion notional of swaps and futures with various clients on the S&P 500 alone," says Dray.
We sold a lot of contingent options, dual digitals and worst-of bund futures/Euro Stoxx structures. This is an area where we were nowhere two years ago
Emmanuel Dray, BNP Paribas
The strength of the flow franchise, he adds, rests on three pillars. First, a capital commitment that allows it to price derivatives competitively in all market conditions. Clients value this consistency and praise the bank's liquidity, and have rewarded BNP Paribas with increased market share as a result. One large hedge fund client says the bank today handles around 30% of its flow equity derivatives business. This growth has been matched in the listed space, too – Eurex ranks BNP Paribas as top market-maker in equity index options, with a 5.7% market share, and in dividend derivatives, with a 14.6% share.
Second, a focus on theme-based content, tailored for sophisticated clients hunting short-term opportunities. Take, for example, the bank's suite of hybrid options, which took off in the second quarter of this year as clients sought to diversify their sources of return away from pure equity.
"We sold a lot of contingent options, dual digitals and worst-of bund futures/Euro Stoxx structures," says Dray. "This is an area where we were nowhere two years ago."
The latter product – where the pay-off is linked to the worst performer between the Euro Stoxx 50 and Eurex's Bund Futures index – serves as a customised quantitative easing play, benefiting from the traditional negative implied correlation between the two assets.
Scenting opportunity, the bank has blazed a trail in what had been an underserved market, according to a portfolio manager at a European multi-asset fund, who says in his experience it is a "pain in the neck" to receive quotes on hybrids referencing bunds.
The third pillar is its market-making infrastructure. The bank has also ramped up its investment here to facilitate greater product flow, capabilities it has leveraged to sell custom baskets of options in large sizes. This underpins the bank's proprietary index business, which is orientated towards offering institutional clients access to systematic trading strategies. In one week in December alone, the bank sold €1 billion ($1 billion) in options referencing its proprietary strategies across three institutions – one in the UK, one in Australia and one in Switzerland.
"For the institutions, it is a way to outsource sometimes painful options execution activity to a counterparty that has a secure framework at zero operational risk, and helps them to better manage their asset allocation," says Nicolas Marque (pictured right), BNP Paribas' global head of equity derivatives, based in London.
The three pillars buttress the bank's flow franchise – and have allowed revenues to grow dramatically. But not content with merely hoovering up flow business, the bank has maintained its grip on markets where it has a lengthy pedigree. In 2015, it struck its largest ever series of dividend swap deals to-date with a US asset manager covering around €200 million notional dividends. These took the form of total-return receiver swaps referencing both 2017 and 2018 dividend future expiries.
Receiver dividend swaps are highly sought after by funds running long-dated long call positions, as they can be used to hedge the associated short dividend exposure. The higher the cash dividends of the underlying stock, the lower the value of these call options. Receiving flows linked to realised dividends through a swap format helps mitigate the mark-to-market pain.
The US client highlights BNP Paribas' superior pricing, adding the screen price of the referenced futures hardly budged as each transaction went through – a testament to the bank's ability to absorb the short dividend position internally without recourse to the market.
"The nice thing with this trade is we were asked to be counterparty to the first tranche of this dividend swap, and the price we showed was so aggressive that the client felt we deserved to work on the subsequent tranche on a ‘working order' basis. It is very rare a client gives you a working order, so this demonstrates how we were, first of all, able to commit capital, and, more importantly, to get the confidence and trust of the client," says Dray.
It is very rare a client gives you a working order, so this demonstrates how we were, first of all, able to commit capital, and, more importantly, to get the confidence and trust of the client
Nicolas Marque, BNP Paribas
The bank continues to play a lead role in the growth of dividend derivatives on exchange. Having already served as the primary market-maker when Eurex launched Euro Stoxx 50 index dividend futures in 2008, it repeated the trick in 2015, by being the first liquidity provider and printing the first trade for S&P 500 annual and quarterly dividend futures, which began trading on CME on November 16. As Risk went to press, the bank retained a 90% share of open interest in the product.
The bank has used its prowess in dividends to serve its own risk management needs. As an issuer of retail autocallable products referencing major equity indexes, BNP Paribas is structurally axed long dividends and short correlation between dividend and spot, because of the implicit down-and-in and up-and-out put options sold to it by investors to fund their own coupons. As the referenced index falls, the probability of these put options knocking in increases, as does the expected maturity of the autocallable - axing the bank even more long dividends, as well as pushing its exposure out along the curve. As spot rallies, its axe reverses.
Many dealers hedge this exposure dynamically by buying and selling dividend futures in line with spot. BNP Paribas, though, has set about crafting a smarter solution, parcelling out chunks of its exposure to hedge fund clients via a suite of tailored dividend/spot correlation products. The most popular – the so-called dividend-spot switch – offloads its long 2019 Euro Stoxx dividend exposure, but in a rising market offers investors the chance to switch the reference asset to Euro Stoxx 50 spot, when the bank's sensitivity to dividends is diminished.
The bank sold €47 million in this product in the 12 months from November 2014, plus another $25 million of a similar trade dubbed Athena Div with a UK reinsurance client. In total, the trades – along with similar structures – served to offset 30% of the bank's dividend/spot correlation exposure generated through structured products issuance.
Alternative Risk Transactions team
The structures represent the work of BNP Paribas' new Alternative Risk Transactions (ART) team, established to transform hard-to-shift risks into profitable trades for sophisticated clients.
"The equity derivatives business is subject to a number of pressure points. These are coming from our own inventories, and as a risk-conscious house we need to be nimble to manage these inventories," says Marque. "They are also coming from regulation. We have constraints in terms of capital, RWAs and the liquidity ratio. Our idea was to have a team that could work to release these pressure points and turn them into potential opportunities for clients through a partner-orientated approach. To be a little provocative, whereas 95% of our job is to fulfil client needs, the ART team's job is about fulfilling BNP Paribas' needs."
The ART team functions as an additional coverage channel for the bank's roster of buy-side clients, and has scored notable successes in trading variance replication - where the client sells variance on an equity index and buys the replicating strip of options, scooping up the price difference as premium – dividend/spot correlation and, perhaps most impressively, in trades it dubs Monetisation Risk Transfer (MRT) options.
The MRT trades are designed to top up BNP Paribas' Basel-mandated liquidity coverage ratio (LCR) requirements, which subjects most equities to a 50% haircut under the ratio – with financial stocks disqualified entirely. Yet others argue the lived experience of equity markets is that stocks retain their liquidity even in the midst of a crisis, and can therefore be monetised to replenish cash buffers accordingly.
The ART team developed MRT options to transfer this monetisation risk to selected institutions. Here, the client effectively sells BNP Paribas an American put option physical settlement on a block of equities owned by the latter, with the bank receiving the block value in cash – based on market close prices. In return, the client receives a premium paid in arrears, based on the eligible underlying universe, notional and duration covered by the transaction.
One alternative asset manager that bought an MRT option says the structure was more "elegant" than similar deals they had seen from other banks. "The way this is structured, we are not taking delta risk in terms of the block of shares, as the strike of the put is floating based on the market conditions of the time, plus there are volume restrictions in terms of the basket constituents. This means we know we can execute the equities we take on in the market, so it works from our perspective," he adds.
BNP Paribas says it has traded in excess of €10 billion in notional of the MRT options and related structures since November 2014 – predominantly with hedge funds and pension funds.