Interest rate derivatives house of the year: Societe Generale

Asia Risk Awards 2023

Tommy Paulhan, Societe Generale

The inversion of the US dollar yield curve over the past 12 months has created testing circumstances for banks and their clients in Asia. However, these circumstances have also created opportunities for dealers that have been able to diversify their business by moving beyond popular investment solutions to launch new products – and Societe Generale’s Asia institutional and distribution businesses has been foremost in seizing such opportunities.

In early 2022, with central banks aggressively hiking rates and equity markets entering a downward trend, investors in Asia began to pile into US dollar-denominated principal-protected notes. Yet when the yield curve began to invert a few months later, this pushed forward currency rates below spot rates and made the after-hedge yields on the notes less attractive.

Societe Generale devised an appealing alternative that would become one of the milestone trades for its institutional business. Noting that interest rate hikes in Australia had been milder than those in the US – and the yield curve inversion less severe – the bank began offering AUD-denominated callable notes. SocGen recognised investors could reduce the risk of increases in foreign exchange hedging costs and optimise their returns by diversifying into currencies such as the Australian dollar.

The products were typically principal-protected, long-term vanilla notes, such as callable fixed-coupon or callable accreter notes. They were marketed to insurance firms and banks in South Korea, which began to shift more of their USD investments into AUD notes.

The focus on Asian currency investment solutions has been a recurring theme in many of SocGen’s successes in the rates space over the past year. The bank already had a strong record in driving local currency diversification in the financing space, with its pioneering Korean treasury bond refinancing business, which was set up in 2020 and grew significantly in terms of clients and notional in 2022.

“Diversification has been something that’s very real for us – in terms of the initiatives that we’ve been launching and the successes we’ve been having,” says Tommy Paulhan, SocGen’s co-head of global markets structuring for products and solutions, Asia-Pacific, in Hong Kong. “One of our big focuses was to develop products and solutions in the local currencies of most major hubs in Asia.”

Building on the success of AUD callables, SocGen began offering the same notes in other currencies, including Hong Kong and Singapore dollars. The CNH (offshore renminbi) notes have been particularly well received by Chinese clients seeking enhanced yields on account of China’s central bank keeping interest rates low. SocGen reported a more than 200% increase in the notional on its Asian currency callables in 2022 – reaching US$4.5 billion, and accounting for more than 40% of the total notional traded on its structured notes.

“We have been providing our clients with this kind of advice on what to look at in terms of navigating the different currencies,” says Paulhan. “And the Asian ones have provided quite a lot of opportunities.”

Paulhan says SocGen’s stellar product-pricing capabilities have been key to its success. In contrast to the derivatives markets for USD callable notes, the derivatives markets for Asian currencies are insufficiently liquid to offer structurers an easy route for hedging the embedded optionality of the notes. That makes the pricing of local currency notes considerably more challenging than is the case for the standard USD notes.

“Sing dollar, CNH or HKD traditionally are currencies for which we do not have a lot of liquidity on the derivatives side,” says Paulhan. “So it’s pretty hard to actually find the right risk premium to harvest for notes in these currencies, whether on the volatility side or on the cross-currency side mainly. That’s the most important part: the ability to price it properly and reward as much as possible the investor for the risks.”

Another example of a product that has provided institutional clients with local currency diversification has been the trading of a non-deliverable Korean won structured note. This note, the first of which was traded in Q1 2023, pays an above-market coupon if the USD/constant maturity swap (CMS) rate stays within a predetermined range. The KRW-denominated note, which is ultimately settled in USD, also benefits from a protection-level mechanism.

The product has benefits similar to those of the local currency callables. It has provided SocGen’s clients – Korean insurers and pension funds – with local currency business diversification while offering an alternative to USD structured notes, which have been looking less attractive due the inverted US yield curve.

“You needed to pay more than 2% per annum to hedge back your USD to KRW for one year at that point,” says Steven Hwang, director, fixed income and currencies (FIC) structuring at SocGen. “This cost was making the USD structured note investment much less attractive. So it became much more attractive for Korean investors to go with the Korean won rates solutions.”

SocGen initially opted to make the product non-deliverable, on account of an approval from Korea’s Ministry of Finance being required for KRW note issuers, in addition to a setup process that requires local underwriters and local legal counsel. However, Hwang says the bank may expand into deliverable KRW notes.

“We started with the non-deliverable note first, and it’s good for clients who can really settle their FX back into won,” he says. “But then there are also some clients who don’t want to do this, and we want to grow this business, even for those clients, by pushing the second part, which is deliverable solutions.”

Investing in automation

Creative alternatives to popular products have undoubtedly provided a boost for SocGen’s fixed-income division at a time when equity derivatives businesses have faced challenges owing to equity market corrections. Revenues from the fixed-income franchise were up by more than 50% in 2022 compared with the previous year, and the bank’s market share increased by 36%.

However, SocGen has only been able to cope with the volumes it is now seeing in the fixed-income space thanks to the rapid development of its exotics platform, Star Street.

“The FIC revenues from the structuring franchise have been increasing massively,” says Paulhan. “The platform has enabled a rebalancing from essentially equity-driven flows to the fixed-income flows coming from distribution clients: private banks, securities houses, you name it.”

In 2022, SocGen enhanced the platform with the migration of the fixed-income product pricing methodology and the addition of several popular fixed-income payoffs. Among the latter were FX digital notes, a variation of fixed callable notes with a bonus digital coupon linked to currency pair performance. The idea was to use automation to deliver the kind of user experience for fixed income to which clients in the equity derivatives space had already become accustomed.

“We had more and more clients interested, and a lot of them are used to equity product standards,” says Paulhan. “They want a lot of daily pricing every day. Most of our clients, they like to come into the office and, before 9am, they want to have hundreds of prices available.”

For the more standardised products common in the distribution business, competition is fierce – and SocGen recognised that automation through Star Street would be crucial to capturing these flows. The firm is one of the few in the market to offer auto-pricing on fixed income products. As a result of having invested in the platform it was, in 2022, able to handle 20 times the volume of pure rate products that it had been handling in 2021.

“We know we’ve been beating competition, thanks to the strong automation,” says Paulhan. “Most of the time, the banks will actually pass on some of these kinds of flows – because they don’t have the manpower, because they don’t have the automation capabilities.”

Migrating the pricing methodology for fixed-income products to the automated environment of Star Street had another benefit: it aided a smooth transition from the outgoing USD Libor benchmark to the secured overnight financing rate (SOFR).

The one-, three- and six-month USD Libor settings ceased publication at the end of June. Various regulators had already made it clear there should be no new Libor trades after the end of 2021, except for the purpose of risk-managing existing positions.

For banks, the transition from USD Libor to SOFR required an overhaul of the pricing templates for exotic products linked to USD rates. Despite the large number of products affected, and the significant volumes involved, SocGen achieved this overhaul for pure rates products before the middle of 2022.

“The big challenge at the beginning of 2022 was the Libor transition, because the scope of [Libor] products we had was very large,” says Paulhan. “It impacts the way we are pricing them and even how we’re presenting them to clients. So being able to migrate all those products, including the tricky ones in the inventory, was actually pretty challenging.”