Derivatives decline hits dealers’ earnings

A decline in corporates’ use of equity derivatives and institutional investors’ moves out of the plummeting equity markets have hit some dealers’ second-quarter earnings. For example, Merrill Lynch last month reported an 18% decline in second-quarter trading revenue, which it blamed principally on a drop in equity derivatives business. Merrill says the decline in equity derivatives was due to reduced customer flow and lower volatility during much of the first quarter.

While dealers agree the slump in business is widespread, not everyone says the product is now unprofitable. “Equity derivatives revenues have been lower, but it is still a profitable business,” says Juan Carlos Pinilla, managing director and equity derivatives trading head at JP Morgan in the US.

The decline in corporate demand for equity derivatives comes on the back of declining merger and acquisition and corporate issuance activity this year. Corporates generally look to hedge possible price volatility when carrying out capital market transactions. This type of client demand has been one of the main drivers of the equity derivatives business in the past, particularly in the US.

The demand for equity derivatives in Europe has followed a similar trend to the US. Despite a huge increase in implied volatility in June and July, which reached levels last seen during the Long-Term Capital Management crisis, client driven volumes have tailed off in the past few months.

Worst levels
Officials at French bank Société Générale, one of the major players in the European equity derivatives markets, say that client driven equity derivative business is near its worst levels. “End-users are almost gone. The only flows to have really survived are from interbank activity,” says Fabien Hajjar, head of European volatility trading in equity options at Société Générale in Paris.

In warrants, for instance, most of the business currently being seen has come from in-and-out trades, conducted on an intra-day basis, says Hajjar. Rather than hedge their exposures to the volatile equity markets, however, most institutions have decided to move out of the equity markets altogether, dealers say.

“The large institutions are reducing their exposure to equities. One way of doing this is to sell futures,” says Alexander Ineichen, head of equity derivatives research at UBS Warburg. “This allows them to buy back the futures at a later date while selling the equities – a more efficient way of moving out of equities.”

Ineichen’s claim is borne out by futures volumes in recent months. EuroStoxx 50 futures volumes have doubled over the past couple of months from levels earlier in the year. Total monthly volumes of the Eurostoxx 50 futures contract stood at E305 billion in June, compared with E144.6 billion in January.
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