How axed dividends left SocGen in a €200 million hole

Collapse in equity trading revenues prompts rethink of autocall hedging


Societe Generale is reviewing its hedging strategies for autocallables after losses linked to the structured products decimated its equity trading division.  

The French bank reported a €326 million ($358 million) loss in the first quarter, with equity trading revenue dropping 99% year-on-year to just €9 million.

SG’s structured products book took a €200 million hit as companies held back pre-announced dividends last month – an unprecedented move that structured products issuers, including SG, did not hedge.   

“The story of equity and derivative businesses is making history in the fact that dividends – and especially European dividends – have been cancelled after their announcement,” says a trader at the bank with knowledge of the losses.

SG had hedged its dividend exposures in 2021 and beyond – but not this year.

“On the announced dividends, this risk never materialised and no one could think of something that brutal,” says the trader.

The problem relates to the hedging of popular autocallable notes, which accounted for 60% – or $150 billion – of the $250 billion-equivalent of structured products issued globally in 2019.

Autocallables typically track equity indexes or baskets of stocks and deliver above-market coupons while spot remains between upside and downside barriers. The structure knocks out when spot hits the upside barrier, returning principal and an improved coupon. If the downside barrier – typically set at 40% below the initial index level – is breached, a knock-in put option is triggered and investors could lose a portion of their principal.

Autocall investors remained protected as the Eurostoxx 50 tumbled from 3,865 on February 19 to a bottom of 2,386 on March 18, a 38% fall. For issuers, hedging was dicey as exotic risk parameters, including volatility, dividends and correlation, whipped around wildly.

Payout problems

Issuers see their long dividend exposure in autocallables increase as markets fall. This risk is typically transferred to hedge funds and other sophisticated investors via listed dividend futures or over-the-counter swaps.

Like most issuers, SG did not hedge current year dividends, betting that companies would not cancel announced payouts. On March 23, Airbus and Spanish IT company Amadeus became the first constituents of the Eurostoxx 50 – a popular autocall index – to do so. Others followed, sending front-year Eurex-listed ES50 dividend futures into meltdown.

The December 2020 expiry contracts fell from 122 points in mid-February to 55 at the end of March. A €100 million long position in front-year dividends would have seen a loss of €55 million. The contracts have since rebounded to 75.

Hedging costs at the long end of the curve may also have contributed to the losses. As spot markets fall and the chance of the products being called declines, their estimated maturities lengthen, leaving issuers exposed to longer-dated risk.

For instance, a bank that hedged its dividend risk from 2021 to 2025 may suddenly need to go long dividends for 2026 at a time when implied prices are falling. A €10 billion book of autocalls with a 50% delta would need to go long €5 billion of 2026 forward Eurostoxx 50 contracts. This would equate to €150 million of long 2026 dividend exposure, assuming a 3% yield. If those dividends fell faster than models predicted – say 40% rather than 30% – the bank could see an additional €15 million of losses.

This maturity extension also raises other risks. “The nature of these products is that when markets go down and the probability they will be autocalled is less, then all risk metrics – whether dividend, volatility, correlation, skew – shifts to a new maturity,” says the trader with knowledge of the losses. “All kinds of derivatives metrics start to pop up and have to be managed very actively.”

Adding to SG’s losses was an additional €175 million provision to cover potential losses on future hedges and a further €55 million loss resulting from defaulting counterparties.

The latter is believed to be attributable to a single, large hedge fund client.

The market rout in March wrong-footed some big volatility firms. New York-based Parplus Partners is said to be the cause of a $200 million loss for ABN Amro’s clearing business. Malachite Capital Management, another volatility specialist, also shut its doors in March.

Change of strategy

SG is understood to be incorporating pre-announced dividend risk into its hedging strategy in response to the structured product losses. This may involve transferring these exposures to hedge fund clients via the sale of front dividend futures contracts.

That could cut into profits. If the strategy is widely adopted, the expectation of heavy selling by autocall issuers, coupled with the recent cancellations, would be reflected in the pricing of dividend futures.  

Front-year contracts have historically traded with a market beta of just 0.2 as payouts were thought to be guaranteed. Longer contracts trade with a market beta around 0.6 despite structured products hedging dampening prices.

“It will have an impact on equity derivatives because the very pricing of the front future will be more complex as there is an additional risk – it’s a tail risk, but you’ll never be able to say it’s zero,” says the trader at the bank. “It could have an impact on liquidity of futures, so we’ll see how the market adapts.”

It is not yet clear if other dealers with concentrated structured products exposure have weathered the storm any better. BNP Paribas is due to announce its results on May 5 and Natixis on May 6.

“Just about every bank has a problem right now,” says David Hendler, principal of Viola Risk Advisors. “But others are more diversified. SG is over-concentrated in structured products and the problem is that they’re always exposed to these 100-year flood conditions that seem to be happening every six quarters.”

Some dealers with more diversified business models have posted solid results. Goldman Sachs, for example, noted the negative effects of dividend cuts on its equity derivatives performance, but equity trading revenues still rose 22%, buoyed by increased flow activity. JP Morgan grew its equity trading revenue by 28%, while Citi posted a 39% jump.

Increased diversification of the business mix is a core aim of SG’s management. As part of that strategy, the bank has spent the last 18 months integrating the structured products business of Commerzbank, which largely comprises linear products such as exchange-traded funds and listed warrants.

“We will continue to look for a balanced model developing products that are less complex and less volatile,” says a spokesperson for Societe Generale. “We also have almost finalised the integration of [Commerzbank’s equity markets and commodities] activities, which will notably allow us to develop our franchise on the listed products side.”

Still, some say that may not be enough to balance SG’s footprint in more exotic products. “They don’t have the overall diversified operating income profile to take a hit and make it more reasonable. Even if they adapt their dividend strategy, is it going to be as profitable if you hedge it to reflect everything that happened in the past? Probably not,” says Hendler.

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