When stock markets tumble and market parameters whip around wildly, issuers of complex structured products are often quick to lament the “wrong type of volatility”, as a rush to hedge exotic exposures cuts deep into profitability.
Not so for Credit Suisse. The Swiss lender doesn’t claim to have predicted the kind of turmoil wreaked by the Covid pandemic, yet it had been preparing for stormier climes by amassing tail risk hedges to protect against an anticipated turn in the credit cycle.
“The year has been an extremely good one for us, and the market environment was one we generally perform well in,” says James Howard, co-head of cross-asset investor products at Credit Suisse.
“There’s a sweet spot where you have bouts of volatility that create dislocations and allow people who are ready to step in and trade that opportunity; and as the vol comes back down, you package it up and sell it to your clients.”
As equity markets tumbled 35% in three weeks – the fastest drawdown in history – and correlation realised at all-time highs, Credit Suisse was well cushioned, having reinvested $46 million of structured product revenues since 2018 to protect its activities. Much of this was paid out as premium on risk-sharing trades, including $15 billion notional of credit index skew notes, which saw CS offload capital-intensive mark-to-market volatility.
“That’s a pretty extraordinary demonstration of our dedication to managing the risk even when vol is low, before the crisis has hit,” says Paul Bajer, Credit Suisse’s head of credit structuring. “Because we took care of a lot of our risk management before the volatility, we were able to focus on the arbitrage opportunities that were available in the market during the volatility,” Bajer adds.
In equities, the bank sidestepped common pitfalls. While popular autocallable notes burned an €857 million combined hole in the books of three French banks during the first half, Credit Suisse enjoyed a 6% bounce in equity trading revenue, as diversified exposures and effective risk recycling kept the doors open for a 40% jump in issuance as rivals retrenched.
The year has been an extremely good one for us, and the market environment was one we generally perform well inJames Howard, Credit Suisse
Driving this outperformance is Global Trading Services (GTS) – a cross-asset joint venture between the sales and trading operations and the private bank. The platform offers sophisticated ultra-high-net-worth clients access to complex trades typically reserved for institutions. GTS clients range from wealthy individuals to family offices, creating a unique outlet for risk-sharing trades – and in size.
“When we talk about family offices, we’re not just talking about investors who do $100,000 tickets. These are investors who potentially do tens or hundreds of millions,” says Bajer.
Combined with the industry’s largest notes issuance vehicle, Argentum, clients welcomed the innovation Credit Suisse brought – for example realised foreign exchange volatility notes which served as an effective hedge for clients through March and April.
“In terms of structuring, Credit Suisse has been ahead of the curve,” says one private bank client. “They’ve been more flexible and come out with ideas by really understanding our needs.”
Taming the skew
Credit Suisse’s GTS client base provided a vital outlet for sharing risk stemming from the bank’s vast credit trading operations.
Through market cycles, short-term volatility spikes have triggered predictable – and sizable – dislocations in credit markets, which investors can exploit via a range of leveraged bets.
Index skew sees investors trade the gap between CDS indexes and the fair value of their underlying constituents. This gap jumps in stress scenarios as a flight to liquidity sees indexes reprice more quickly than single names. Similarly, negative basis trades see investors trade the gap between bond spreads and comparable CDS contracts. Bond spreads typically widen more than CDS in volatile conditions as investors sell fully funded cash instruments to raise cash.
By packaging these arbitrage trades into note format with high-quality collateral, private clients such as family offices can jump into these dislocations as they emerge and benefit from an expected normalisation. For the bank, it’s a useful outlet to offload exposures with high mark-to-market volatility, which are expensive to warehouse under their value-at-risk capital models.
“Sharing the volatility we have on our trading book with clients is a win-win,” says Bajer. “It lowers our capital requirement and allows clients to get paid for a risk that’s effectively free for them to take. Only in this setup, where we have a joint venture with our private bank, can you do that effectively.”
In effect, it’s a balance sheet lending agreement in which investors receive a yield pick-up – typically 50 to 100 basis points over bank funding rates for a five-year skew note. The bank makes a profit if skew exceeds the coupon paid.
The catch for clients is they must weather the mark-to-market volatility. Notes can be 10 to 15 times leveraged, meaning a five basis point move in the skew can translate into a 5%–10% markdown on the value of the instrument. After hovering around zero in late February, skew on the US CDX High Yield index initially jumped to 49bp in mid-March, before plummeting to a low of -141bp by March 25.
“If you can stomach that, you can get paid a very decent premium to hold this position, and insured,” says Bajer.
Although not unique to the Swiss lender, few competitors rival the bank for size. Credit Suisse sold more than $4 billion notional of skew notes in 2020, and $1 billion of negative basis notes.
“CS were the only ones able to provide us with the package we wanted for the levels we saw in the market,” says one private bank client.
“The mark-to-market is a bit esoteric and can sometimes be more than you expect. Everything blew out a bit in the crisis, but it all calmed down and we continue to look at opportunities in these trades,” the client adds.
A large portion of negative basis trades was sold via flexible facilities. These allow clients to enter trades at cheaper levels, before volatility spikes. Substitution rights allow defaulted bonds to be replaced with alternative negative basis packages, ensuring the note remains sustainable through its five-year term.
“We see a few French banks offering this product, but with their Argentum vehicle Credit Suisse offers some differentiation,” says a second private bank client. “It’s well designed, well priced and the legal side is pretty stable compared to others.”
Argentum – the bank’s decade-old note issuance vehicle – came into its own in 2020, as rate cuts intensified the search for yield enhancement via bond repacks.
A record $8 billion of repacks was assisted by heavy debt issuance by US corporates. The bank was able to package these issues into notes alongside cross-currency swaps to offer the exposures in euro denominations for European clients. The bank also saw high demand from European investors seeking to replace expensive European government debt with cheaper government bonds swapped to euros.
“Big rate cuts certainly made it more difficult for investors to hit their target returns in Europe, which made them look for opportunities further afield, whether it be Japanese government bonds, US Treasuries or new issues, because they had no other way of getting a reasonable return in euros,” says Bajer.
While the majority of issuance emerged from CS’s Luxembourg-incorporated vehicle, activity in multi-dealer repack platform Spire also jumped, cementing Credit Suisse – one of four founding dealers – in the top three of 15 member-banks.
Art of risk transfer
Few segments of the market were hit harder by Covid volatility than equity retail structured products. The growing dominance of autocallable notes almost sank some of the instruments’ most prolific issuers as volatility and correlation soared, while European corporates made unprecedented dividend cuts.
Credit Suisse emerged relatively unscathed, thanks largely to a structured products business that is diversified across products and regions.
“We’re not solely focused on long-term autocalls in Europe, which behaved very badly because as the market goes down you pick up exposure on dividends. We had less of that exposure through diversification,” says Julien Bieren, Credit Suisse’s global co-head of equity derivatives structuring.
He adds that while its longer-term autocalls issued in Europe suffered from Covid-related turbulence, this was partly offset by lower risk in the bank’s huge US cliquet business. These are strips of consecutive, forward-starting options, which underpin the US market for retirement products such as fixed index annuities.
“The short-term cliquet business in the US is huge and it has a very different market dynamic. Typically, while the autocall risk increases as markets crash down, the risk in our cliquet book might disappear,” says Bieren.
In recent years, banks have extolled the virtues of alternative risk transfer (ART) for reducing exotic exposures. This slicing and dicing of structured products risk into hedge fund-friendly derivatives packages such as dispersion and corridor variance swaps fell short for most issuers in 2020.
“You have to be smart about risk recycling; so from the bank’s perspective, the trades you put on should not only help you on your day-one risk but really follow up in a wide range of spot moves. It should have the same dynamic as your book has,” says Bieren.
For example, popular risk recycling trades such as geometric dispersion – in which an investor is long the volatility of a basket of stocks and short the geometric mean of the same names – don’t always reflect the real correlation dynamics in a structured products book. A basket of 10 names, for instance, incorporates correlation between 45 unique pairs, whereas Credit Suisse’s book only has exposure to a handful of names. As such, the bank prefers alternative risk transfer approaches.
“With our private bank retail activity, we have a lot of exposure coming in the shape of concentrated pairs of risk,” says Bieren.
The bank traded $10 million vega of so-called ‘pair-wise’ dispersion with institutional clients. These see investors take a long position in the volatility of a pair of stocks rather than a basket, and helped Credit Suisse hedge short correlation and correlation skew stemming from $10 billion-equivalent of single stock autocalls. The trades were sold to a variety of investors including hedge funds, pension funds and GTS clients, in both over-the-counter and securitised format. Several large clips were traded at the height of the crisis.
This recycling trade more accurately hedges correlation exposure associated with ‘worst-of’ autocalls, popular with Swiss and Asian retail. These notes track the most volatile underlying from a basket of two or three names and can easily turn toxic in volatile conditions when all assets tend to correlate.
As short correlation positions are painful for investors in stress scenarios, Credit Suisse provided additional protection in these risk transfer trades by investing part of the carry in a long vega overlay.
“This helped clients greatly in 2020, and is something that didn’t hurt us, because this extra vega is something we can hedge and doesn’t accrete to our dynamic,” says Bieren.
Hedging with FX
CS also created innovative new realised FX volatility notes for clients seeking cheap tail risk hedges.
In a systemic event, FX vol systematically moves higher across the whole market. In late 2019 and early 2020, implied FX volatilities traded close to all-time lows, providing an ideal entry point. For example, one-year implied vol on US dollar/yen hit a low of 5.95% in February.
Options-based hedges can be expensive to trade and do not provide pure exposure to realised volatility. Using realised volatility warrants, which offer unlimited upside to realised FX vol in a delta-neutral manner, Credit Suisse was able to structure cheap tail hedges for private banking clients.
The bank sold $500 million of the structure in tickets of $5 million to $15 million on pairs including US dollar/yen and euro/US dollar. This provided average returns of more than 50% during the risk-off moves in March and April.
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