Risk managing a structured products business resembles a topsy-turvy version of the card game Snap at times. The retail flow desk sells products that stack up directional risk on the dealer's balance sheet while the institutional structuring team seeks to find a buyer for the opposing axe. Then, snap, the risk is moved off the dealer's balance sheet, freeing up capacity to write more products.
The trick to keeping the game running smoothly is to minimise the lag between accumulating and offloading this directional risk, particularly in an environment where balance sheets are constrained and funding costs uncertain. Credit Suisse, our risk manager of the year, has honed this process to a fine art.
At the heart of the bank's structuring business is a dedicated risk-
recycling function headed by William Treen, managing director, investor solutions, who sits between the over-the-counter traders and retail structurers to pair off risks and sound out the Street on which exposures are flavour of the month. This set-up has streamlined the activities of both desks and helped them to pitch trade ideas that consistently hit institutional buyers' sweet spots.
"We have conversations all the time with Will, so if he sells a long volatility position on the Russell 1000 for an institutional client, I get an email immediately from the head of trading, saying we need to sell short volatility on the same underlying. We're always looking for ways to naturally balance the books and by matching like this we can price our products much tighter than we otherwise would," says Elaine Sam, managing director, structured notes distribution at Credit Suisse.
The bank has ventured further than others in seeking institutional buyers for exotic clips of risk. "When we look at offsetting our balance sheet, we look to people who don't have the same constraints as us. We're actively cultivating reinsurers as buyers of crash risk and gap risk, because they're sometimes better positioned to absorb it. They're willing to take a broader range of risks on their balance sheet. Some are willing to take on crash risk in particular, as they already reinsure variable annuity books that contain similar risks," says Michael Clark, managing director, investor solutions group at Credit Suisse.
The bank is building fruitful relationships with US primary insurers. Life underwriters are tripping over themselves to offer US retirees new iterations of fixed index annuities (FIAs), where returns are linked to the performance of an underlying public or proprietary index. These returns are harvested by the insurer using call options on the underlying, but for the new breed of index products, many firms have chosen to outsource this activity to bank counterparties.
"Insurance companies tend to be conservative," says Clark. "The big concern of an insurer is that when offering something bespoke, they don't want to be beholden to a single investment bank. So when the product is being structured, they negotiate with the bank underwriting the product for ‘a spring-in dealer', who can step in and provide product continuity in the event of a default or significant downgrade."
This process carries a risk for FIAs referencing proprietary indexes, however. There needs to be an interval between the primary dealer defaulting and the spring-in dealer being ready to book the optionality risk, as the substitute will have to replicate the index in full before being able to transact on it.
"A spring-in dealer is nice in name, but, in reality, when it comes to a custom index it will take some time to be positioned. So the question is: will it work efficiently when things start getting challenging?" asks Clark.
Credit Suisse has pioneered a syndication model, whereby multiple dealers are lined up as backstops for small chunks of assumed risk from the first day the bank enters into an FIA transaction, thereby reducing the risk concentration of using one spring-in dealer. The bank is considering rolling out this process for structured variable annuity products containing both crash and lapse risk.
"A lot of this is built on the framework and knowledge we took from our exchange-traded notes (ETN) business, where we are used to syndicating risk. The insurance space is fascinating; variable annuity products are already being structured differently from how they used to be. There's going to be a huge amount of innovation in the next year or two," says Clark.
Volatility is a core asset class for the bank. It accretes sizeable positions both long and short through its Vix-linked ETN programme, distributed through VelocityShares, the ETN provider acquired by Janus Capital in October. Many dealers encountered balance sheet turbulence when volatility spiked in the fourth quarter of 2014, but Credit Suisse was able to ride out the storm, having already auctioned off a material portion of its total exposure to the Street when trouble hit.
When it comes to bespoke risks that cannot be sold through a standard auction process, Credit Suisse is not short of invention. The bank's burgeoning daily leveraged notes business offers investors geared returns on an underlying index over a predetermined time period. This generates reset risk for the dealer as the leverage exposure is recalibrated on a daily basis. The bank has developed a suite of OTC products incorporating these risks and enjoys a thriving business selling them to hedge funds, endowments and pension plans.