It is becoming increasingly clear that record volumes of Asian structured products over the past two years have come at a price. Exotics desks have gorged on risk to chase market share, but with uncertainty looming, it is time to unwind.
The Hong Kong market is a case in point. The mid-October stock market rout triggered $15 million in losses across derivatives desks. In Korea, the largest structured products market in the region, local securities houses are nursing losses of up to $30 million on their hedges as the equity fall extended the tenure of the products. If markets continue their slide, the pain will only get worse.
The Street has to rewind just three years to understand the extent of any fallout from the risk it has been merrily building. In 2015, as China’s Black Monday saw the Hang Seng China Enterprises Index drop 40% from its crest, derivatives desks had to stomach hundreds of millions of dollars in hedging losses. Investors also lost money and new issue volume subsequently slid to just a third of peak levels.
Return to 2018 and the warning signs are flashing. In stark contrast to the start of the year when monthly record highs were a given, volumes have slipped and new money is no longer flowing in.
In stark contrast to the start of the year when monthly record highs were a given, volumes have slipped and new money is no longer flowing in
In Korea, dealers say local securities houses priced and hedged products on the assumption that the instruments would knock out within six months. A fall in stock markets disrupted that thesis. Duration of the instruments has extended to over a year, leaving the desks dangerously exposed.
One way to address the problem is to print new products that would even out dealers’ positions. Unfortunately for exotics desks, the market fall has sapped investor appetite. Monthly trade volume has halved from the record $8 billion seen at the start of the year, leaving desks with just one alternative: sell put options to flatten exposure to long vega – a dealer’s sensitivity to volatility. That comes at a hefty cost due to one-way demand.
In Hong Kong, the problem stems from a structural evolution in popular callable bull bear contracts. Dealers have gradually narrowed the distance between the call and the strike level in the instruments to lure investors in with the promise of improved returns. The narrower the gap, the more likely the contract is to knock out with a low or zero residual value. It makes the trade cheaper to enter while at the same time maintaining exposure to movements on the underlying index. The compression effectively means higher gearing. The rewards may be more enticing but, crucially, the risks are also amplified.
A narrow call-to-strike gap may work well in gradually rising markets, but it can be hazardous in the event of a sudden drop. That is because dealers have only a tiny window to offload hedges when markets fall. For example, to hedge a bull certificate, trading desks buy shares in the underlying index or security at the inception of the contract. If spot falls below the call price, desks unwind their hedges by selling the shares. If the market opens sharply lower, as happened in mid-October, that hedging window might never even open. The losses can be crippling.
The genesis of excess leverage and risk can be traced to a thirst for returns against a backdrop of extreme lows in volatility and interest rates.
That is changing. A key gauge of US stock market volatility, the CBOE’s Vix index, hit its highest level since the February market fluctuations in October. It continues to hold well above its five-year average. Global interest rates have risen, thanks to monetary tightening around the world. Rising uncertainty over the strength of global economic growth means stocks could come under further pressure.
The latest round of losses should serve as a wake-up call. With market dynamics reversing, it is time for structured products desks to curb their risk appetite. October’s rout may have been manageable, but it could just be a taste of the pain yet to come.