Learning a language 5
FB How much knowledge should investors have about the derivatives market? How can they know that they’re getting value for money, and what are the actual costs that they face in using derivatives?
VM I think for any assets you would first look at the pricing in terms of liquidity. One of the first things we would investigate is the bid/spread offer, which is a good measure of whether there is sufficient liquidity in the market. We would then use our general knowledge of particular instruments; say inflation swaps, to see if they are a good instrument to invest in right now.
We also make sure that we are able to double-check the prices we are being quoted and also make sure we know more or less how much the banks make on each of the trades we make. These perspectives together allow us to say whether the timing is good or not.
MR I’m clearly making a case here for exchange-traded derivatives, where you as an end-user, have maximum transparency. You don’t have to pick up the phone to see what the price is because liquidity and traded volume is absolutely visible to everybody. It’s also fairly simple to get a price on a market where, depending on the product, you may end up having more than 100 participants providing prices into the same system, into one point of price determination, the exchange. As a pension fund or asset manager it’s fairly simple to justify: The price is right, there’s no messing around with OTC and back testing to see if the price is correct.
This also goes for liquidity, which is visible with a track record, as well as bid/offer spreads and down to straight through processing. You do the trade and it automatically pops up in your system. In most cases it’s more or less an intra-day system and you have it all at your finger tips – there’s very little room for manipulation and you limit the risk of things falling out or an OTC product being set up incorrectly in a portfolio management system. You also don’t have things like balance sheet burdens and credit lines, which you have to provide for OTC trading. These are all things that come into account when it comes to what the transaction costs are. These are not only direct but indirect transaction costs, because what happens after the dealer puts down the phone after the deal is done is also very important.
TC Pension funds have a natural affinity for exchange traded funds because they like the transparency in what they are doing and how they are dealing. The problem is that a number of people come with solutions to pension funds. With OTC products there is a large financial incentive for this and to a large extent pension funds may buy what has been given to them. I’d certainly be very interested to know what efforts exchanges are making to try and bring OTC products onto the market place. To what extent can you give pension funds more comfort to see that there are proper quotes and extra insurance in the OTC market?
MR From an exchange point of view, we would like to capture business from the OTC market. Then again, as an exchange we also need to launch products that have a fairly long life span, whereas many of the OTC products we see have a fairly short life cycle. Depending on the economic cycle or market condition and the changing risk profile that goes along with market changes and portfolio changes, the investment banks and liquidity providers for OTC structures or structured products, in general, can react in a much simpler way than an exchange can.
To what extent can an OTC product be standardised? This is a sort of conflict in itself, but what we need to do in order to capture that business and help asset managers offload their risk though a central counterpart is to make sure that we understand those components and find a way to allow participants to trade and/or clear the components of an OTC product through our systems.
MP Just one comment on trading with OTC instruments. We always competitively bid between three counterparties typically. We feel that’s the only way, really, that we can demonstrate best execution for non-standard contracts.
FB Do you find there’s much variation?
MP It depends on the underlying instrument. For options that are fairly short term and back some of our retail products, price can be very tight. For plain vanilla swaps pricing is also pretty tight.
But for non-standard structures like RPI swaps, especially where the term becomes longer and longer, there are fewer participants and the bid office spread increases. So it very much depends on the underlying instrument.
AG We quote both markets, and there’s been a big migration out of OTC and onto exchange. This is purely demand driven. The most important thing though is liquidity, then price, because without liquidity you can’t transact.
If you look at what’s going on in OTC products, when we trade OTC we typically look to back it out – even on long-dated products, on the exchange where the offset is the most cost efficient, normally via a one-month option, which we continue to rotate that.
It’s an imperfect hedge, but we’ll run that right the way through the life cycle of that OTC. A good part of our business has been to go to companies doing that sort of business, and this is where specialist training becomes important. We then explain how the market place works, explaining that an OTC user is paying a premium to the banking community, to structure a product. The more complex the structure, the more opaque it typically is, the less ability you’ve got to have a price discovery.
Even on a very opaque structure, which will probably have a large amount of margin in it, it still migrates its way back to the exchange in one way or another as the risk component is broken down. So we typically go out and say, this is the process that’s going on, you have a right as an investor to say that you wish to opt out of managing the risks and just have a structured product that fits your trading profile perfectly... But also be aware of the costs associated and the benefit you could have by doing it yourself if you had a risk system that could allow you to monitor the whole process and individuals who could understand it. Companies have tended to go down the path and moving on to an exchange as opposed to OTC. For us it’s a question of being open and honest about where revenues come from.
RL I think that’s absolutely right. There’s a very difficult balance to be drawn, particularly in the pension fund area, where one of the benefits of using derivatives is to get the assets closer to the liabilities in terms of risk exposure. There is a risk of an asset manager promising to deliver something that involves locking the client in to an unfavourable set of contracts.
In reality most clients change their minds, so what is fine now may not be in five years’ time if the company spins off something or the underlying risk of the pension fund changes.
I think it is a difficult balance, because if you go to a pension fund and say that there’s a much better way of managing these risks than buying a 15-year-plus gilt index fund, then you have to be pretty sure that the risks you’re going to take if you go down the manufactured route rather than OTC, are acceptable to the client. I think we are very aware, certainly at the long end of the sterling curve, that not many people are operating, the spreads are reasonably wide and who knows whether the people that are operating there will be around in two or three years’ time.
KM I’d like to reiterate something I mentioned in the beginning and that is that liquidity is a critical component of using derivatives. People think of credit risk and market risk, but liquidity risk is key. There is a spectrum of derivatives from high volume flow derivatives, such as exchange rate derivatives or plain vanilla swaps, down to the more customised structures. The traders whose job it is to price these derivatives make a quote that is intended to represent the cost to themselves in managing the portion of that risk that cannot be offloaded in the market. The hope is that throughout the life of the product, the hedging costs will not exceed whatever margin was originally quoted. The harder the product is to hedge, the wider the spread will be. Nonetheless, the bid/offer spread is not the only measure of liquidity, and can also be misleading. You can see on various exchanges derivatives that may be quoted on relatively tight bid/offer spreads, but with small volume quoted at each level and that’s what we refer to as depth. It’s important to see what the depth of the market is, and not just what the nominal price would be for a small amount traded.
GS I agree, the more standardised the products the more liquid they will generally be. If we buy structured products, we always ask the question about liquidity because it might be that we need to unwind the position.
CL In terms of the efficiency of pricing, what we tend to find is, that the more liquid exchange traded options have fairly competitive pricing. With some of the less liquid instruments; long-dated exchange traded options or OTC options, pricing can vary quite significantly so certainly we recommend that when transacting derivatives, investors shop around for the best deal. One type of option that has been around for a while, is called a flex option, which is an option on the FTSE 100 and enables the counterparty to choose what strike they want for the option and also what term, up to a term of five years. So that’s an example of an exchange providing a quasi OTC service in terms of allowing people flexibility to choose terms and strikes.
FB And you think that’s good for the market?
CL Yes, because there’s certainly a preference for exchange-traded options, so to introduce that flexibility and have the option to trade on the exchange is seen as a plus for a lot of our clients.
JA The products we’re using in essence are highly liquid and that liquidity provides the competition to make sure that they remain at a level price. I think we’re comfortable that this liquidity gives us the security of getting the right price.
FB How should institutions judge the success of their use of derivatives? And guard against mistakes?
VM Comfort that they’ve done the right thing. Not just when they enter into derivatives but also 10 years later by feeling that this was right to do and having no regrets at having done it.
TC I do think we need more work on performance measurement. It’s a problem that’s been there for a long time, and I just don’t know what the answer is. I’d be very interested to see just what funds that have got experience in that area have actually done and how they’ve been able to measure it. How do you measure the results of an action you’ve taken against an action you didn’t take but could have done? I am not aware of people that have actually done this.
MP In terms of mistakes, the key one would be adequate risk control. In terms of judging success, certainly a closer matching of assets to liabilities could be achieved through the use of derivatives. You can also implement decisions that you perhaps otherwise would not have been able to, but you can now with derivatives.
AG Success. Exchange traded volumes last year were up 17%, to a $690trn nominal value. That kind of volume underlies the success of the market.
I can say again that there have been fund managers in insurance companies who utilised the derivatives market to cover a lot of their downside risk. Did they make money in 2003, possibly not. . But in comparison to their peers, which is the ultimate test, there are insurance companies who did not cover their risk and nearly went out of business. So that, for me, is an outright success.
RL When you ask about success you have to look at whether the outcome was what the buyer expected when they went into the derivative strategy. And on the mistakes, I don’t think it’s a risk control question. I have a suspicion that Orange County may have had exactly the right risk controls in the sense that the out- turn was exactly what they might have predicted given the instruments they had bought, but they had bought completely the wrong instruments. There was a lack of congruence between what the client really needed and what they actually bought, and I think that’s the biggest risk.
CL Success depends on the purpose. Derivatives can be used for a whole lot of different things: reducing risk, efficient portfolio management etc. It’s important that any derivative transactions are benchmarked somehow. If you’re using derivatives for efficient portfolio management then you benchmark the fund manager’s performance against some sort of index. Hedging strategies can be benchmarked as well. You can obtain independent pricing from brokers etc.
In terms of mistakes that commonly get made, one that I see far too often is institutions trying to call the market, which is dangerous! Another mistake is judging hedging strategies based on where the market has gone. Institutions usually buy protection because they can’t afford markets to fall and impact adversely on their solvency position. They then pay the premium for the protection, markets go up and then someone in the organisation says, well you got that wrong, didn’t you?
GS There’s ambivalence in peoples’ judgement of the success of derivative strategies – especially with hedging strategies. Some people will say it’s only successful if the market moved in the direction where you needed the hedge. For others the problem is lost opportunity.
Anyway, don’t let yourself be talked into anything that you don’t need and don’t do your first hedging transaction in a fast market. Take your time, there will be opportunities again and again and again, but don’t be hurried in anything!