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When US equity volatility surged in February, it immediately separated the market into winners and losers; a snap verdict that rested not just on how firms did on that day, but also on how they had been running their business in the weeks and months prior.
It was a one-off moment that gave dealers, investors and clearing houses an opportunity to test their powers and show off their planning. The story recurs in various forms throughout this year’s Risk Awards.
At JP Morgan, the head of the bank’s derivatives and quant strategy team – Marko Kolanovic – had predicted a doubling in the Vix index of S&P 500 volatility in year-ahead research published in December 2017. He warned the surge would be amplified by popular exchange-traded products that gave investors inverse exposure to the Vix; if the index rose, they would be forced to buy Vix futures, potentially driving the market higher.
Just over a month later, on February 5, the index recorded a one-day jump of 115%.
JP Morgan’s traders were prepared, having adopted a long-volatility bias in order to meet expected client demand – a step that enhanced the bank’s reputation for steadfast market-making.
“When it comes to consistency, JP Morgan is definitely the best in all market conditions and never retrenched,” says a portfolio manager at a large European asset manager.
CME Group also saw the storm coming – and made its members go out and buy umbrellas. During the third quarter of 2017, the clearing house came to a similar conclusion as JP Morgan’s Kolanovic – the high volume of short-volatility bets had given rise to a self-reinforcing effect.
To insulate itself and its members from a break in that regime, CME began to build additional buffers – it increased margin rates for equity products by more than 20% from September 2017 to February 2018, hiked add-ons for concentration and stress exposures, and also bulked up its default fund by 27%. In all, the total increase in financial resources prior to the February 5 event was around $11.6 billion.
Citadel Securities also gave itself more headroom prior to February’s volatility spike – not because the market-maker saw the episode coming, but because of the growing catalogue of similarly violent, intraday moves.
It did so by making its limits framework more dynamic and flexible. Rather than setting and changing limits manually, on a per-business basis, the firm switched to a real-time, partly automated system at the start of 2018. The idea is to quickly reallocate unused capacity from one product or asset class to another.
“These types of events are occurring more and more, and we really wanted to be prepared for the next one to make sure that we continue to have the risk budget in place and capacity to stay in the market, no matter what happens,” says Frank Krepelka, head of risk and trading operations at Citadel Securities.
Other firms haven’t changed much at all, but still stood out, as the end of the volatility drought validated their business model, and left rivals floundering. One example is La Française Investment Solutions, the €12.4 billion Paris-based hedge fund, which at the end of October could boast a 3% return for its flagship alternative premia fund, at a point when Societe Generale’s index of alt-premia funds was down more than 4%.
The LFIS model is to deliver returns by combining transparent strategies that have low Sharpe ratios but also little correlation between them. Other alt-premia funds have come unstuck by piling up exposure to common risk factors, including equity value.
“If you stack strategies – even with a very low Sharpe, but fully uncorrelated – you can reach a Sharpe of two or higher,” says Guillaume Garchery, head of quantitative research and development with LFIS. “If you have a portfolio of strategies with an average Sharpe of 0.6 but they are 30% correlated, you can add as many as you want, but you won’t get to a Sharpe higher than one.”
Vive la France
The big winner in this year’s awards, though, was BNP Paribas, which scooped three market-making categories. On top of that, it landed the overall award for derivatives house of the year, primarily for what is a unique combination among European banks: long-standing commitment to the markets business; investment in the US; technology and business model innovation; and a willingness to shake up the way its salespeople and traders work.
All of this flows from a conviction that post-crisis prudential rules will force the bank’s pan-European stable of corporate clients to use the capital markets for their financing needs far more than in the past – a strategy that is not going to change, says Yann Gerardin, chief executive of BNP Paribas’s corporate and investment bank.
“We need to know who the institutional investors are – around the world – that are going to buy the first high-yield issuance of an Italian midcap in 2025, or a German Mittelstand company in 2030. Without a strong global markets business, there is no way we will be able to help our European clients the way we did in the past,” he says.
Dimitros Tsakonas, alternate director general of Greece’s Public Debt Management Agency, is also thinking long-term. After experiencing an economic cataclysm, the country ended 2016 with a debt-to-GDP ratio of 181% and more than €250 billion of bailout loans from European institutions and member states, repayable by 2060. Over the past year, the PDMA has reached agreements with its creditors to extend maturities and fix the interest rates on around €200 billion of debt, while coaxing dealers to enter into interest rate swap hedges on a further €35 billion.
As a result, Greece now has cash reserves of close to €34 billion – enough to cover its interest payments for the next four years – and its debt-to-GDP forecast for 2060 has been cut by almost 50 percentage points, from 140% to 90%.
Tsakanos sees this as the first step towards Greece’s economic rehabilitation. “It’s not the end of the story, it’s just the beginning,” he says. “Now, we need to very carefully design our future steps, especially as far as access to the capital markets is concerned – that’s our main target.”
Mayhem and machines
The winner of this year’s lifetime achievement award also knows a thing or two about surviving a crisis, and adapting to its aftermath. As Goldman Sachs’ chief risk officer in 2008, Craig Broderick helped steer the firm through the financial meltdown and position it for what came after. Broderick retired earlier this year, after 32 years at Goldman.
Elsewhere, Alexei Kondratyev, head of the data analytics group at Standard Chartered, wins quant of the year for his use of machine learning techniques to optimise margin costs and build interest rate curves.
As always, picking the winners was extremely difficult. Risk asked candidates to submit detailed information on their businesses, and shortlisted firms were interviewed off the record. Risk then gathered feedback from clients and other market participants.
The final decisions were made by Risk’s editors and journalists, weighing a number of factors, including risk management, creativity and innovation, liquidity provision, quality of service and customer satisfaction, and engagement with regulatory issues.
Where decisions were tight, client feedback often helped settle the issue. The Risk editorial team thanks all this year’s participants for their time and help.
The profiles of our winners can be found below. Keep checking back as we add the final articles over the next few days.