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CW What’s your experience in
Belgium?

RV The retail CDO market is huge, but I still think that a lot of these products are not understood by the retail clients. And that’s a big danger. If you see how certain of these products have been sold, it’s as a capital guaranteed product. I think that’s not really a good example of how it should be done. But that is the responsibility not only for regulators but also of the bank itself. How far do you go and how far do you want to go? You have the end investors, be they retail or institutional clients, who are demanding because they are coming from a high-return environment to a low-return environment. Everyone wants to have a pick-up in yields. It’s a pressure. What do you want to offer and what risk do you want to put into the products and how do you want to sell them?

MB In the Dutch market, the distribution of these products is up to the banks, which is also the case in Germany and in Switzerland. So there is a certain expertise that is already in-built in the network and fail-safe systems that prevent mis-selling of structured products as much as possible.
But also there is another thing that sets the Dutch market aside. It is a highly educated market. It’s the most liquid single stock options market in Europe, and probably one of the most liquid options market in the world outside the US. Between 40-50% of the market is made up of private investors. Historically there has been an incredible element of education over the past 20 years. Education at all levels, from academic studies all the way down to town hall meetings with private investors.
As an exchange, we run about
200-250 seminars a year on derivatives, on the ground, with private investors who want to learn about how derivatives work. It rubs off. You build a virtuous circle. The Dutch market in that respect is quite unique and it is definitely a market that provides a lot of good lessons in Europe. As a response to that education you have regulators that are very open and interested in the latest financial innovation They provide considerable help to the actors in the market on how to regulate their own business. On the point of UCITS III, I must say that it is one of the main drivers behind what we have been doing in the last three years. UCITS III will become more important at all levels, not just for the end users as a yardstick, but also for banks themselves as a blueprint on how to structure products.

TB I do not agree on this view. UCITS III is certainly a push in the right direction for the use of derivatives, but if you look how it is implemented in the different countries, legislation has definitely failed in the aim of achieving a common standard. It created a lot of costs on the operational side but it completely failed to harmonise investment guidelines across Europe. You can still do very different things in terms of risk and instruments used in different countries.

AD We haven’t seen too much passporting yet.

MB No.

AD I think once you start to see the passporting, you’ll have the arbitrage of jurisdictions gradually go away.

TB Investment policy always reflects the predisposition towards risk, or the question of how conservative the investment community of a country is. It’s very different throughout Europe. If you look at Austria, institutional and retail clients are still very conservative in their degree of risk aversion.

MB This is something that we are acutely aware of at the exchange because we operate five markets in five different countries. It’s not only an operational challenge, but also a cultural challenge for us. Regarding UCITS III, I’ve seen the Italian text, and I’m an Italian speaker so I can translate it quite accurately. It’s word by word exactly the same text as the UCITS III version which is being adopted in the UK. Which is something that only 18 months ago was absolutely unthinkable. This is a big step forward.

TB I agree that the opportunities are probably bigger than the costs. But the costs are wasted in the wrong areas. There are a lot of lawyers employed to try to interpret the meaning of the regulations. These capacities would be better used for upgrading IT systems like front office applications and tools for risk management, risk control, etc, and the training for mid and back office staff in how to use and handle derivatives.

JH Ultimately it’s the regulator that needs to protect the consumer and there is an issue sometimes that the regulator just hasn’t got the skill base. I certainly think it’s a great initiative to have an education processes for the man on the street, but I don’t think you can realistically expect them to understand derivatives.
You’ve also got to be careful of IFAs in the UK; arguably they can be driven by the margin they got from selling a product and not by its suitability for a particular client.

TB The protection of the consumers should be an issue for the regulator, but the regulator should leave the responsibility for issues like investment selection, portfolio construction and risk management with the investment managers. You have to have certain guidelines about what kind of protection there should be.

AD Everyone needs to take their share of responsibility of whether the product is appropriate or not. I look at it from the perspective inside the bank where we put the product together. There are more committees and more ‘flag systems’ than we ever used to have around as to whether a product is appropriate.

GI What are the limiting factors in terms of usage of derivatives? What can we improve on the side of the users? And what can be done on the side of the providers?

JH One of the limiting factors is systems. Derivatives are changing all the time and pretty quickly as well. To implement any system on a grand scale, you’re talking a good year’s lead time to ensure back office compatibility. That is one of the big problems of rolling derivatives out on a grand scale. You can tailor systems to your own requirements if you’re fairly small or a hedge fund, but trying to buy off-the-shelf products that incorporate risk and performance measurement is actually quite difficult.
The other limiting factor, from a fund management point of view, is there are a lot of fund managers who are classic stock pickers. They’re just not used to using derivatives, you’ve got funds like the enhanced index funds that try to add a bit of alpha using derivatives. But there are a lot of fund managers who simply don’t understand derivatives enough, and they’ll certainly use lack of systems as an excuse not to use them as well. It’s quite easy to say no, there are too many problems, for example with back office systems. There are plenty of excuses for people not to use derivatives.

GI When you say systems, is it really back office systems, or is it risk control systems, or is it organisational, information flows overall?

JH Fund managers will use a portfolio management system that’s linked into an order management system. That’s typically how it works. They’ll generate trade ideas from their portfolio management system and that will transmit to a centralised dealing desk. And these off-the-shelf systems aren’t that tailored to derivatives. The basic stuff is there, futures and listed options, but beyond that, you’re really having to tailor systems to your requirements. And the challenge is that derivatives can change quicker than IT and technology sometimes.

TL You hit the bull’s eye. I agree completely about the systems issues. Another point I want to raise is that if you bring a new product or instrument you want to use in your portfolio then you have to check a lot of things – legal and tax issues, reporting, risk management etc. At Deka Investment we established an efficient procedure called New Product Process. It’s a roundtable where people sit together from the back office, from the IT side, from the trade control, from the trading desk and the portfolio management. They discuss how these instruments could be implemented. It needs time you lose getting the idea into the market, but it’s a forum where quick fixes could be made.
A point which had been mentioned in the 2003 IPE roundtable was the limiting factor knowledge about derivatives. From my point of view the education of market participants improved enormously over the recent years. Four or five years ago, there were portfolio managers saying no, we don’t want to think about derivatives, our business is stock picking. Now people feel more comfortable using derivatives; they are getting more and more open-minded.

JH We’ve got a similar group at F&C and we call it the Derivative Development Group. It’s not something I had in my previous company but now we’re big enough, and we have the resources to have that kind of team. But taking it through from systems to the back office, performance measurement and risk controls, there’s quite a lot of areas to consider to do it properly. You almost do need specialists to actually just implement, on the back office side, to make it work properly.

TL Another difficult thing is system supported performance attribution analysis in an equity or fixed income portfolio with implemented derivatives strategies. As far as I know there is no portfolio management system out there which includes a module where you can analyse the performance attribution of the derivatives in your portfolio and the influence on your risk parameters like tracking error etc.

MC I think the threat is still from the hedge funds that don’t seem to have those systems issues, because that means they are further up the curve and can attack those managers that don’t have their systems in place. So asset managers have to raise their game, they are certainly under pressure to do so. But it may require some significant spend by asset managers to get there, and of course they like to pay dividends to their shareholders.
They would prefer to do that than invest in all this expensive equipment to develop performance, in, they hope, the future. They would rather have revenue now, so there’s this constant battle going on. I think, as hedge funds provide more of a threat, they’ll make more of these investments. And then you see a step change in the use of derivatives with more plain vanilla asset managers.

GI Is it all that rosy for hedge funds managers?

SK Current conditions are still favourable for hedge fund managers.When I moved from trading options at an investment bank to KBC I was very impressed with the quality of the modelling as well as the degree of sophistication for screening for potential trades. Five years ago, the typical make-up of personnel on an investment bank derivatives desk was to have one trader per sector for instance trading all the telecom options in Europe, then beside him would sit the the trader responsible for covering all the technology options in Europe and so on. There was also a typically smaller unit of traders covering structured products for more sophisticated investors. Everybody almost had their own little pigeon hole for responsibility in that particular niche as the flow justified such a structure.
When I went to the hedge fund side, the biggest eye-opener for me was suddenly the breadth of assets and asset classes which were being looked at and modelled. There was a higher proportion of quants in the personnel developing very powerful data-intensive systems. This approach obviously requires a lot of infrastructure and forward planning of strategies and trade types.
Hedge funds exist as theoretically they are a lot more nimble than the big banks. Theoretically they have a bunch of smart people with complementary skill sets who can come up with a new angle or strategy and quickly put the systems in place to capitalise on this before the investment banking community catches up with the thinking and any price inefficiencies get ironed out. Then the hedge fund will go back to the drawing board looking for new perspectives and strategies to stay ahead. That’s why hedge funds can start off producing fantastic alphas with their new strategies. This in turn leads to a bigger following and then the management fees can start to dominate performance fees. This is why many hedge funds close so as to sustain the performance for their existing investors.
The last year has been tough for hedge funds with the lack of volatility meaning there were relatively few spreads between stocks and assets to take advantage of hence the market makers and liquidity providers fared better. However, looking to the future, there will always be a place for the new angle, the new perspective so hedge funds will very much remain at the forefront of new derivative opportunities.

TB A limiting factor is data. A lot of funds and other investment vehicles and products are based on daily liquidity, daily marking to market. You need some kind of pricing data, in the best case from an official source to generate fair valuations, net asset values, etc. It is one key issue that can bring some strategies to a limit, if you cannot provide these data sets. This is true for exchange traded, listed derivatives but also for OTC products.
The second thing from my point of view is more market related. If it comes to derivatives, you normally have lower liquidity compared to traditional liquid equity investing. You deal with instruments that are illiquid, so you have to change the process of how you trade them. This is a wish that it could be better, but as we all know, the pricing of liquidity is just as good as the edge you can somehow create from that. But you have to keep it in mind while developing strategies or implementing derivative strategies, where liquidity is most of the time very scarce.

RV In terms of the end-users, there are also accounting problems, fiscal problems that are very important. Even custodian issues are not that easy when dealing with structured products, the legal side is still a huge constraint for a lot of people. It is also linked to transparency. If you become very transparent, it becomes more complicated in terms of what you put in the system and how you have to account it, so it’s a whole chain.

GI What about risk control officers? Are the risk control officers all over you? Are they the true gurus these days?

TB I think we are returning to the same IT system discussion. Basically you have to consider the whole chain. It may be that the manager is ready and the client wants a product but settlement and IT systems, etc, are not ready.

AD I don’t think the risk controlling component is the real limiting factor. At the end of the day, banks and suppliers of the product also have the risk controlling aspect. We also need to develop our systems so we can book and trade the instruments.
RV I just think that the gap between the asset management industry and the investment bank industry in terms of risk management has really narrowed in the last couple of years. There’s been a huge effort from the asset management industry to develop true risk management. There’s been a lot more focus on this side than there was seven or eight years ago, when nobody talked about risk in the asset management industry. And it’s repeatedly coming from the investment banks that there is really such a focus on risk management. I actually think there has been a huge development in the asset management industry. It doesn’t mean there isn’t a long way to go, but the gap is certainly closing, in my opinion.

CW It comes back to the point about systems because, to a large extent, risk management comes down to risk measurement. The risk parameters are set by the portfolio manager or at the mandate stage and the role of the risk team is then to quantify the exposures in relation to the limits. Consequently risk management comes down to setting clear parameters at the outset and then having effective systems for monitoring exposures going forward.

JH Standard risk management systems for equity portfolios focus on tracking errors. A lot of the off-the-shelf ones actually don’t handle non-linearity, they have to class options as futures which is clearly wrong. If you do use them on a grand scale, you’re going to potentially run into some significant problems.

MC It’s also expensive, certainly in terms of the data that needs to populate a lot of the risk management/modelling systems. Our budget just for implied volatility data is not cheap, and you’ve got to have it to get an approximate value for your options positions. If you take that one step forward into the exotic world of longer dated OTC, even that data becomes even more scarce. So you can never really know what your positions are worth until you go and sell it. Then it becomes almost as much as a gamble being a bank as it is being an asset manager. You don’t really know what you’ve got until you match a trade.
But I think to get yourself into a position where everything is modelled correctly as close as you can, you’ve got to be at the short end. You’ve got to be looking at listed business, which is largely printed at the end of each day and you can actually look at a reference point. I don’t think the problems will ever go away for the more esoteric stuff on the long end.

AD On the correlation side, that’s one of those classical markets where historically you had a bunch of guys, very quantitative, who developed a model. There was a belief in the number that model generated. You put your data in, you had some nice financial theories, you got a number out. And you’d have a good degree of confidence around that.
And then this year has been very interesting, particularly around correlation. I’m picking it as an example because in April of this year there was a small market dislocation because of a supply demand imbalance. There was a trigger in the market that happened around the auto sector. It resulted in a different perception of correlation. People tried to start doing something around their positions and then the market was a little bit one sided, a little bit skewed between investment banks and hedge funds. Prices moved very quickly on the correlation side, then single name credit default swaps moved a lot wider. All of that could be corrected again within the space of two weeks. We had these two weeks of spike level volatilities.
Now a lot of that is down to the fact that there was a belief in models, you trust them to a certain extent, and there had been a naïve ignorance of the supply demand dynamic. At the end of the day there was this perceived arbitrage, but in reality you have to go back to very classical supply and demand dynamic.
When you talk to traders on correlation now, one of the things we joked about is, how are you going to come up with a price for a particular CDO tranche? The answer is, well actually, maybe the best way to do it is you put a number out there and see what the reaction of that number is!
MC It’s a bit like playing poker. You want to see each other’s hand the whole time. It’s difficult to bid liquidity in an auction process because you never want to show the $2bn you want to trade on this tranche, you only want to show $100m on a particular market and to keep trading is very difficult. So it’s easier to do it on exchange on futures, on a traded market you can phase it over a couple of weeks.
This is really difficult, hence there has to be a capital provider or risk provider, so the investment banks step into that role and say here is our price in this size. It requires investment systems to actually understand the risk you’ve got on the book. It’s no small task, but one that holds back derivatives, and will do for a number of years. That’s not to say the problem is not being tackled.

CW That is the price discovery problem and there is no real way around it. You run into the classic game theory scenario of the ‘Prisoner’s Dilemma’ where it’s in everyone’s mutual interests to co-operate, but there is a short-term benefit to be had in holding back and tricking your counterparty. In the game theory scenario the conclusion is that if you are only involved in one play of the game then you are best to hold back, but over several iterations it is optimal to co-operate. It’s exactly the same with regard to price discovery where it is better for both the buy-side and the sell side to co-operate.
I think that given the cycle that the market has gone through, better information, more efficiency and more people staying in the same seats for longer, you’re seeing more relationships developing where people are trusting each other to look after each other and are working towards an optimal solution.

MC I think you mentioned earlier in the day Max, the matched bargain side of the business, the block trading. You agree between two counterparties the price which you can barter about, and then you cross it through the exchange to get a liquid price and then its market on a daily basis?

MB That’s quite a lot of what we do and quite a lot of what our product development efforts have been going into in the last few years. Ten years ago in equities derivatives, you had a certain mistrust of the other party you were dealing with and you had to make a number of calls to check if prices were in line. There were very long debates on the finer points of how the models were constructed and the interpretation of the parameters that fed into them. But as was said, it’s game theory. At the first iteration, there is mistrust, but 10 years down the line, and after several iterations, that changes. In the equity market, you’ve got into a pattern where there is co-operation among the parties. We provide a platform to facilitate that iteration. A lot of what we’ve done in the last few years is not to try to change the way people interact but to facilitate that. The recently launched ABC initiative is a clear demonstration of that.

MC If, like a clearing house, you can stand in the middle like an independent arbiter of value, that’s actually very valuable. Technically you can cross anything, as long as you have a buyer and a seller, as long as both agree that the model is correct in the middle. So we can say here we are, we have something in the middle, it’s regulated, it’s got an independently audited model and prices are published on a daily basis so everyone can mark their book correctly. When it comes back to sell it again, they have an immediate reference point.

SK Everyone is at the same level of development, because that is one of the things that we struggle with as a hedge fund. Our counterparts are very smart people with great systems. But then you get to the end of the month, and our administrators have to come up with some value. The number of times you’re on the phone, saying, really sorry but that in the money call can’t be worth -70.
I joke about it but it really is like that. That’s why I’ve shied away as much as possible from OTC, because even if it is an exchange look alike, that’s nothing to do with the fact that it comes out -70. Whereas if I trade a listed product, it’s on Bloomberg, there you go, there can be no arguments about it.

AD It’s one thing we’re quite keen to have. So far even the building blocks of the OTC products are OTC themselves. So we’re quite keen to see at least some of those building blocks become either exchange listed or very definitely transparent. At least there is some transparency pricing on Bloomberg. There is something to point to.
The first thing you need to have is transparency in your building blocks. We’re getting there, but it’s not 100% the case. Then you can have more confidence in the next bit. It’s going to take time, you’re talking about getting consensus from all of the dealer community, and also the hedge funds, because they are part of the dealing community.

MC Much of my time is actually spent on the credit committee at Henderson. And we have a list of counterparties that we have exposure to. I’ll tell you it’s the most boring meeting you’ll ever go to! You go through each one, look at the exposures to each of the banks, and this is drawn from multiple swap holdings and FX trades and so on. Without the ability to have some sort of mid-central clearing operation, you’ve got to go through this process. It’s time consuming and expensive. Whereas if you have the list of business all done through your central clearer, then you know where you risk lies.

TL In Germany you have regulation that allows you to have actively only 5% (passively 10%) exposure into one counterparty in your portfolio, that limits you a lot using OTC products.
That’s why these facilities from LIFFE and EUREX, eg flex options, are so great for us, because it eliminates all counterparty risk and we could do much more.

MB UCITS III prescribes limits in terms of OTC derivatives counterparty concentration at 5-10% of the assets in the scheme, depending on the rating of the counterpart. It forces you, if you want to have a synthetic fund and use OTC products, to have up 10 counterparts. It’s completely impractical. Funds can expand to 20% but only after netting on a collateralised basis. It is very expensive and you still need five counterparts if you want to have a completely synthetic fund using OTC products.

AD There is still funds’ cash in the market, it has to go somewhere. There is still a lot of room for packaging derivatives together with cash instruments. That’s what we look for, something to back the business that we’re doing.

CW The electronic exchange model has always been about transparency and liquidity and everyone agrees that the benefit of a central counterparty and standardised valuations is massive. The OTC market has flourished as a result of the flexibility that it provides and the anonymity is a further plus. Any solution where you take the best of both approaches will be very well received.
The exchanges seem to be taking a much more pragmatic approach to capturing business. Previously the set-up has been driving towards liquidity on the screen, but having accepted that the market is still primarily a call around market, features such as block-trading facilities have helped facilitate business. Now initiatives such as Bclear have extended this further by allowing fully flexible contracts and anonymity. I think that the next logical step is to take the volatility products such as variance swaps on to exchange.
The challenge is that it’s a big commitment for an exchange to throw resources behind a new product. In a bank when a new product is first developed, you manage the risk on a spreadsheet, then the product gains traction so you formally programme it up. I think that the blue sky would be if products develop in the OTC market and then if they gain real traction and become standardised, then the exchange allocates the resources to list the product. The OTC market would be the ‘science lab’ and the exchange becomes the place where mature business is transacted. I think that everybody would put their thumbs up for that.

MB At our end, it’s pretty much the direction of a lot of our thinking. As you know, we discuss with our membership quite a lot. We discuss new product lines that could be brought on exchange. Most of the time they are products that have already gone through the process that Chris described and are ready to be taken on an exchange framework, as the rest of the infrastructure has already moved along with them. As a consequence of that you have better risk systems.
One of the skills we developed in the last few years is looking at the way the risk management process is connected to specific products. Before, we didn’t pay much attention to that. Now we are a lot more aware that risk management can be a limiting factor to the development of a product, or at least to the development of some sort of centralised function for the exchange to become a useful tool. There is a lot of effort now going into providing a smoother path for the transition of products from OTC to an exchange environment. However, as organisations we have changed. We are no longer mutual companies. We are commercial, for-profit organisations and we look at the commercial angles as much as anyone else. And there must be a commercial rationale as well for us to move into new product lines. Having said that, we sometimes pioneer new products. A case in point is single stock futures. We were willing to take a long-term view. In 2001 volumes were small but we managed to develop quite a healthy market working closely with our members.

JH I think one of the limiting factors is actually that we’ve forgotten how important the retail investor is to liquidity. Just the other day, I did a strangle trade on a stock option. I then looked into it and about 1% of the premium that I generated was exchange fees. The problem there is that these contracts are £5,000 in notional, so they are almost designed for the retail investor. If you start doing institutional size trades, you end up paying quite a lot in exchange fees. That can be one limiting factor, and if you do trade quite high volume then you can be forced down the OTC route, because as well as those fees, we’ve got to pay fees to the central clearer and fees to the executing broker.

GI It’s always difficult to understand for the end-users. You’ve got all these big players around who say they can do everything all the time, all the products and any time limit. But then when the discussion moves on, you end up talking about liquidity problems and pricing problems and transparency problems. We should not forget, that pension fund directors have a fiduciary duty. If they don’t understand what’s going on in terms of the underlying products or strategies used, or pricing is not particularly transparent nor competitive, or disclosure is not so clear, we shouldn’t be too surprised that there is a natural reluctance there.
Part of the reason why we are sitting here is to thrash these issues out. It’s not just conservatism or inertia of the pensions world (which is certainly there), but there are also some very rational reasons for a certain reluctance. At the end of the day, trustees are in many cases personally liable for any problems or mistakes that can happen. Any ideas on how to get the market more liquid, more deep, more transparent, more efficient in pricing?

RV If you look at the development, starting from seven or eight years ago, on the OTC market, the efficiency and pricing is huge. If you compare the pricing now with the past, there are more competitors, there are more people pricing. The margins that investment banks are taking are less now than seven or eight years ago. I think the development is there already.

AD As an investment bank our aim is usually to come up with a new product and if that product has a major theme or trend to it, we’ll look to industrialise that product, standardise it as much as possible, and move it down the spectrum. So in a sense an end-user entering the market will usually look to only improve the quality of the product going forward.
I’m idealising to some extent but that is what we are trying to do. We realise as a bank that the way we survive is to bring new products and to industrialise them and bring in volume. And when you bring in volume you’re no longer talking about margin, you’re talking about standardisation and your traders being able to take a view from the fact that they participate in the market flows. But they are not going to be able to make their money from the margin they generate from each transaction.

CW We have seen our business change a lot over the last three years and it’s definitely become more efficient. The spread on pricing has tightened and the amount of liquidity has dramatically increased; both of these are good news for end-users of volatility products.
Our role has changed and the emphasis has shifted. Previously an end-user client would come to the market with a view looking to do something and we would own all the information on the volatility surface. With information being much more freely available and end-users better informed we don’t get paid for collecting orders and turning them in the market, we get paid for understanding our clients’ objectives, taking down their business and then warehousing the risk on our balance sheet.

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