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MC Well the real winners here should be the asset managers. Because if they are becoming more efficient and the banks are having to sweat to actually earn capital on this risk, then we have to technically be the winners. It’s just that we’re not using derivatives enough, hence the question of where it’s going to develop. I think there’s stacks of opportunity for asset managers to use keenly priced derivatives now. We need to utilise them more.

CW One of the things that improves our ability to make tighter prices in large size is when we know that we are the only people in the market to have seen the order. With the larger trades we are able to agree the trade with our counterpart and then cross the trade at the close of the day with the block trade facility. The fact that the market hasn’t seen the trade ahead of us means that the price doesn’t get skewed against us and the client ahead of trading and the fact that we don’t need to disclose the trade immediately allows us to do something intelligent in the market to manage our risk and this allows us to make a tighter price.
But from the buy-side, if you’re setting up a mandate, how much flexibility do you have when dealing? Do you require three price quotes before trading, in which case you’ll probably be getting some slippage?

TL I think you have to differentiate between best execution and best price. Best execution includes all the services that brokers and investment banks provide to us. That comprises their research or the capital commitment during order execution. To find the optimal brokers and counterparts for best execution, we have a broker review process in our company. I think it‘s the same for my colleagues here. For the service we receive, we pay some commissions.
The second thing is best price. That means only the executing price matters. The large asset managers in Germany have a dealing desk. They receive an order from the portfolio manager and have to execute that order with a discretion that depends on the trader. How do they do that? Are you going out to one broker and trade exclusively or are you asking a lot of different names? In my experience it’s not a good idea to shop around in the market asking everybody and checking every price. Some of my colleagues tried that strategy and the result was that the prices got worse for them because everybody knew the deal and what was going on.

TB Derivatives are most of the time illiquid instruments. You cannot apply the same trading rules or best practice rules as you do in liquid markets, where you can ask three different sources and take the best price. In this case, market participants will quickly recognise what is going on and will multiply the market impact, which will result in higher trading costs. Additional skills and market intelligence systems have to be developed and implemented. Communication with the market becomes a key issue.

JH I think experience is important as well. You ascertain fairly quickly if you’re trading regularly, what the normal market size is, where you’re going to be within the spread, what kind of price you’re going to have to pay for that size. Occasionally there is benefit to calling around for prices, but you’ve got to make that judgement call, is there benefit or is it just going to spook the market? Is it something that is sufficiently perceived as normal market size that you’re not really going to spoil the market by talking to a couple of counterparties? It’s a judgement call, you need a skilled trader to make that call.

GI What about during difficult times? The end-users will say that all this is fine in normal times. But then there are the big problems they read about in the papers every two or three years, when a special situation arrives. Such difficult market conditions are mostly unpredictable, by definition. So what does “best practice” mean in those circumstances?

AD I think you need a trusted adviser in those situations. This business is still to a certain extent about relationships, and you need to have the right relationships with the right houses that can provide you certain services. We’ve talked about one stop shops before. There are some banks that believe the one stop shop is beneficial. In difficult markets, you want to go to someone you know has been in that market some time. Someone who is committed to that market and is a real market maker, such that they are a liquidity provider of last resort. You want to have the right relationships with those types of institutions, so that in difficult markets, you can actually then have a very open discussion and say look, this is what I need, this is what we are trying to do, how can I best go about it.

CW In difficult times there are two things to consider. Firstly, anybody there who is not in the risk business will hide in a difficult market. It’s a positive for us as it highlights who is properly in the risk business.
And the other point comes back to what Adam was saying on relationships. When the market kicks off, it’s a relationship game, and you’ll always make sure that you look after somebody that you’ve got a long-term partnership with, because the value in the relationship goes beyond that particular trade or that particular week.
Looking back to 2002 when things really kicked off, several of the trades that we took down actually cost us money, but that’s part of the business that we’re in and you can’t just be in it for the good times. But if you are on the buy-side and you have pushed your market-maker hard on every trade and everything you’ve traded with him has traded value, when you go in to buy 10,000 puts in a busy market he’s going to sell them to the guy he’s got the relationship with, not somebody who has just beaten him up for the last two years. It’s not a cosy relationship by any stretch of the imagination because you have two parties looking for different things. But you have got shared interest and you need to work together to get through that.

TB In terms of market crisis or extreme events, we shouldn’t have illusions. In these kind of markets you don’t get any reasonable price. I’m coming from a country where there is no housing bubble. But if I would fall into panic today and try to fire-sale my apartment, I’ll most likely not get any bid price today. I’ll probably have to wait another week or month. That’s the same case with illiquid markets. In my team we are also managing emerging markets equities. And it’s the same thing there. Once you come to illiquid markets and you have extreme events, you just do not get any price. I don’t think there’s a solution to that because that’s the way it is. If there’s panic there’s panic, and from time to time Investors tend to panic.
GI From a pension fund perspective,these are the sort of crises that last a few minutes, a few hours, a few days. But pension funds can probably sift out most of them quite easily, that’s not their time horizon in the first place. I think it’s more where such crises lead to default, for example of an instrument, so that you have a fiduciary problem there. That loss is going to be on your books forever. That is something to consider in your discussion, different time horizons and different perspectives of what is perceived as “risk” for a pension fund/sponsor, versus what is risk for a market maker or a fund manager. It’s not the same thing.

AD The way institutions could help, is not necessarily just by providing a price, but also by being there with information and support. So you’re not so busy dealing with the in-house problems, or what’s happening in the market that you can’t actually service your clients. Once you come out of that short-term crisis, if you haven’t serviced your clients, you won’t have any clients and you won’t have any business.

CW Yes, you are getting paid for filtering, for delivering information that is relevant.
GI Let’s talk about future trends? What can the end-users, particularly pension funds or DC pension plan members, expect?

TL I think portfolio managers are always searching for asset classes which are not negatively correlated with the others. So I think trading volatility will become a trend. We analysed the usage of volatility in an equity portfolio, back-tested some strategies and received really good results. So now we are thinking about launching a product which uses a EuroStoxx portfolio and volatility long mixture.

GI Can you just explain how you can make money for the consumer out of volatility.

TL The advantage you have results from the slight negative correlation between equity markets and volatility. That means, for example, in periods when equity markets fall, volatility tends to rise. So you make money. Volatility itself generates no returns like dividends or coupons but it is a diversifier and improves your risk return profile in the portfolio.

MC I think alternative assets generally will be the end game. The pension fund manager’s job is to find a diversified range of assets to get a smooth a profile as possible. And the more assets that are available, via derivatives, pooled funds, the better.
So really the hope would be that the market continues its improvement in liquidity or unusual contracts like property derivatives that are starting out now, and that they mature and become a commoditised business. That should give much more of an armoury of products for those pension fund managers to adhere to their fiduciary duties much better than they have done perhaps in the past.

CW I think that diversification is tough as well. The other big trend is increasing correlation across products and also across asset classes. It used to be if you were a European equities trader all you needed to know about was European equities. Then you needed to know about US and Asian equities. Then you needed to know about fixed income. Then you needed to know about currency. Then you needed to know about the weather in America!
So it’s gone on and on, and in terms of what drives it, it’s quite difficult to define. Certainly you need to be conversant in other asset classes as well as your own. I think that as information has improved, people are able to do that. The market has up-skilled, a lot of people have worked in different asset classes, and those who haven’t know the basics of other asset classes. So it’s a more informed community.

GI But volatility is not just about diversification.

TB Yes the discussion about volatility goes far beyond the issue of diversification. It is about the question if one could view it as an asset class of its own, that can generate alpha independent from returns of other asset classes. But while watching the time series of volatilities and observing the characteristics of an own asset class, the question remains, can one really trade it as directly as possible? If the time series itself is volatile, it is possible to make money out of it in a directional sense as well as in a relative sense, if there is a way to trade it.
The more difficult question then is how to do that. Because volatility, the standard deviation in statistical terms, is just a calculated figure, or it’s an estimate when applied to the price of an option. The result of the calculation still depends on a convention. You cannot observe it like a price for product or stock. It’s much more difficult to really trade it. One product is the volatility futures, another is the variance swap. With these products you have to keep in mind that you always have just exposure to specific volatilities in specific time periods. But all these complexities should not make us shy away from it, it should encourage us to further explore it.

RV I’m not convinced that this volatility will be an asset class, certainly not for the traditional asset management industry. Firstly, they are not really concerned about volatility, secondly it’s very difficult. I think it’s something more for the hedge fund industry although there is some convergence going on. But what I do believe is that you can use these instruments more as a hedging tool than doing some directional trades on volatility.

TL I have some problems with seeing it as a hedging tool. Because in situations when you need that hedging tool, for example in special events or when the market is falling, it is not sure that volatility is rising so much that you will gain the money you lose in your residual portfolio. And from my perspective during special incidents, such as terror attacks, volatility is not tradable.
RV I see it more as proactive. If you have a certain replicating strategy where you are short volatility, you can always for a certain part cover this risk by doing variance swaps or similar. Because you know there is somewhere a risk, and if you can neutralise a bit of this risk, it’s fine to me, it’s a sort of premium that you’re paying.

CW I think volatility has emerged as an asset class for the pension fund industry. There are two benefits. One it becomes a source of alpha and if you have got the ability to invest in alternatives you can access it in that way. An equally if not more important spin off is that it just makes for a more efficient market. If you have people trading volatility as an asset class you’ve effectively created links between a whole lot of previously unrelated products, which means the market is more efficient which means you can get tighter prices in larger sizes. At the end of the day, that’s what pension fund and pension fund clients are looking for.

GI Regarding long-term investing, maybe it’s an old fashioned idea, but I feel that you need some sort of underlying asset somewhere in order to generate long-term instruments and the liquid markets around them. Do you feel that that has improved?

AD There was an attempt at issuing a longevity linked bond by one of the French investment banks, and that was pulled back for reasons unknown. I think part of it is that it’s hard to find the other side. The natural people to sell your assets to are already long that risk, so you have to find someone else who is willing to take that risk. That is the challenge, to find the supply and the demand. One of the arguments is, shouldn’t governments therefore issue this risk. Shouldn’t the next round of gilts be linked to longevity or shouldn’t they issue gilts linked to very long dated inflation linked product. But the argument then is; isn’t the state effectively taking on the pension fund problem, nationalising pensions to a certain extent?

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