JF, chair I think we’ve probably picked one of the most interesting areas of the financial markets, in terms of development, to talk about today. The hybrid structured products market seems to have finally really taken off. Why has this happened now?
CR, Goldman Sachs From my perspective, one of the most obvious aspects is that the traditional asset classes - fixed income and equities - simply started to offer less interesting returns than investors were habitually used to, and as a result there were fewer opportunities available. At the same time, some of the less familiar asset classes, for example commodities, and some of the emerging markets, started to produce very interesting returns. One example is our commodity index, which has had returns of 20% to 25% in the last couple of years It was natural for investors to start thinking about what these other asset classes might return. In addition, from a structuring point of view, amalgamating asset classes can make sense. An example would be to take three different asset classes and look at the difference in cost between buying individual calls on each of the underliers, or buying an arithmetic basket of the three underliers. Buying the basket starts to improve the type of participation you can achieve in your chosen markets. If you take it a step further and leverage the structure by creating, for example, a worst of pay-off, again based on the original basket of underliers that you are bullish on, you find participations going to four times the original participation for the more traditional approach of buying calls on the individual asset classes. Concepts like that, which are relatively simple, clearly outline the opportunities that accumulating packages of asset classes can provide.
AZ, Commerzbank We’re certainly seeing the combination of the use of various different asset classes for risk purposes. I would add that from our perspective there was a kind of saturation with the development of pay-off provisions. All the structured product houses now have huge groups of people providing different pay-offs, where they are coming out with formula after formula after formula, and suddenly we found that we seemed to reach a saturation point in the market, so that what people became more interested in was underlyings rather than pay-offs. That’s a general trend we’re seeing now.
CR, Goldman Sachs The concept of diversification has also become a hot topic. This was originally sparked by the asset-liability debate surrounding the undiversified nature of some of the very large pools of investments backing hybrid liabilities. At the same time, the concept of diversification and the ability to play across asset classes and potentially make your returns more efficient were, I think, key pointers towards some of the more structured products that started to accumulate asset classes and provide investors with diversified returns.
SW, BNP Paribas There’s been a lot of talk on diversification but it is just one of four factors driving the growing interest in hybrids. A second factor driving demand is yield enhancement achieved through the use of asset class combinations. The third element is the investors’ market view showing increasing levels of sophistication. Rather than just looking to go long equity or to buy bonds, investors are looking at the interaction between different markets and different combinations of factors. For instance, investors may wonder about the impact of the price of oil reaching a barrier over equity-linked payoff. This is a good selling point for hybrids because they offer precisely the opportunity to express strong market views. The last element driving the demand is the use of hybrids as a protection tool. Institutional clients are buying them as a way to combine principal protection with two different exposures in a single package, thereby reducing the overall cost of buying protection.
SS, Citigroup I would add to the diversification point that commodities and inflation have in the past been significantly neglected areas with very little direct exposures. We have witnessed an increased level of interest in taking exposure on these underlying as part of a hybrid exposure. Of course, in the last year or two we’ve subsequently seen interest in gaining exposures on a standalone basis, especially around commodities.
AP, SG Hambros I certainly agree with the people who preceded me, but I would highlight a slight difference from Charlotte in the sense of where we have seen the demand for hybrid portfolios originate. In her view, it seems to be a demand that emanates primarily from disappointment with traditional asset classes. In our experience, it’s not so much the disappointment with the absolute performance of the traditional asset classes but more with the volatility of the traditional asset classes, so that’s where I have a slight difference. After all, the results in equities have not been bad in the last few years, so one cannot be disappointed with what’s happening there, even if one would have made more in speculating on commodities. But I think there is a significant concern among private clients about the volatility of the traditional asset classes. The early 2000s were very traumatic, and that has not been completely forgotten by our clients. They have been traumatized by what happened and they have not recovered from that trauma. So I think that the demand for hybrid portfolios is probably more related to the desire of the clients to have their portfolio managed in a risk-controlled environment, rather than disappointment at the absolute level of returns. I think we are simultaneously seeing demand for three things, which have to converge into one single product that we need to deliver to our clients. First, as pointed out, there is demand for diversification and the need to introduce asset classes that were not customarily introduced in a diversified portfolio, like commodities and so on. The second need is to reduce the volatility, or to ensure some form of capital protection for the portfolio. The third, which is extremely important, is, to the extent that you can create a diversified portfolio and then attach to that portfolio a certain form of capital protection, you have to be able to manage the underlying basket in a dynamic fashion. No one today will accept a diversified portfolio, capital protection, but then an underlying basket that remains fixed for a long period of time. So what we are seeing coming together here is: one, demand for diversified portfolios; second, demand for some form of capital protection or controlled risk; and third, whatever you do in terms of creating the diversified portfolio and whatever you do in terms of capital protection, you have to have the ability to manage the underlying basket in a dynamic fashion.
CL, Credit Suisse One of the concerns we have is looking at who the products are initially engineered for. From a private banking perspective, we have to make sure that if a product was initially engineered for an institutional client, or a proprietary trading desk, it is relevant for the private banking client. We need to ensure our clients do not only understand the product, but also that the product has a valid place in the portfolio when considering the client’s risk/return profile.
JF, chair So what do we think of this idea that the large banks or hedge funds may be laying off their risks to end-buyer private clients?
SW, BNP Paribas Certainly, from my side, I don’t see there being a trickle down to private banking clients. The structures that we normally deliver to private banks have been thoroughly discussed, often taking into account the views of the strategists and the desires of the clients.
CL, Credit Suisse There are certain products that come along that aren’t yet understood by the vast majority of private clients, and those are the ones we look at more closely. We always make sure the product truly fits into the private client’s portfolio and that they have the capability and resources to manage the product if and when markets take certain courses of events. We constantly need to consider whom we engineer the product for and their ability to react.
DE, HSBC Private Banking There is still a very wide spectrum of sophistication among clients and this has an effect on their understanding and demand for newer structured products, such as hybrids. The clients that are more sophisticated are still taking asset allocation decisions themselves, as they are still assessing the pricing of more than one risk in the product. A good example here was where we started to see classic interest rate products with some sort of credit overlay to further enhance yield. We found clients still preferred the return associated with one market – the additional return from taking a dual view not providing a sufficient enough pick-up to justify the risks being taken. Whatever the level of understanding of clients, it’s important that all risks are clearly explained in products, particularly where more than one market is involved.
CR, Goldman Sachs I think this business would grind to a halt pretty quickly if these products were based purely around trading desk axes. I agree with Shaun that product creation is initially driven off two things. First, research, which could be our own in-house research or our client’s. Second, understanding the end customer’s views. Given that, we then work on a structure that reflects the views and maximizes the market opportunity.
AZ, Commerzbank I think another point to add is the role of the hedge funds as liquidity providers. At some point we need to get rid of a certain amount of the risk that we have built up through structured product issuance and we will look to the hedge funds and proprietary desks as a conduit for doing that and as a liquidity provider. That’s what we view their role as. The second point is that with a hybrid, unlike with a lot of the single asset class businesses, both sides of the trade can exist purely within the structured products market. Equal numbers of retail investors may have views on whether they want to be long the correlation between bonds and equity or conversely whether they want to be long the correlation between rates and equities, for example: both sides naturally exist.
SS, Citigroup I think as far as product origination is concerned, this is not just a supply-driven business, but in fact a significant portion of the business is demand-driven these days. So I don’t have a fear that we are basically taking on whatever is the residual risk that results from hedge fund activity.
AP, SG Hambros All of us, I’m sure, exercise a critical analysis of these products, so it’s not that we are passive takers of the products that are being given to us by our investment banks. The role of the private bank is to perform very close scrutiny of the quality of the product to make sure it is suitable from the point of view of the client. We have a commercial but also a regulatory obligation to make sure that the client is not being sold, as may have been suggested, a product where somebody else from the investment bank is trying to get rid of a risk they do not want.
DE, HSBC Private Banking I would add that this is a naturally evolving process as product specialists understand the needs of their clients. We are “investment solution providers” and the clients now very much recognize that when asking for our private bank investment views. We look for the product that supports our views rather than finding the story to support the risk position of an investment banking product. I think we will increasingly see further “open architecture” or at least more guided architecture within the private banking market as clients demand further transparency of their bank’s product offerings
CR, Goldman Sachs I think a point worth making is that banks are starting to structure themselves to be more efficient in this cross-asset space and, speaking for my own house, we actually started to do this around two years ago. It was partly driven by our hedge fund clients, who had started to look across different asset classes and structure themselves in an agnostic fashion, and they simply wanted to be able to have access to wherever the value was in as simplified a form as possible. We basically brought all of our micro businesses together and our macro businesses together, meaning all of our single-name type activities were put in one place and our macro activities in another. The upshot of that has been that the correlation books and the cross-asset risk are managed within a single infrastructure and within one pricing set of models. I think that over time we will now see that as the market grows there’ll be increasing efficiencies around product providers.
AP, SG Hambros I think there is also a very clear risk that we run in our business that we can over-engineer the capital protection.
JF, chair So you mean 100% capital protection can be too much, so investors are paying for insurance they don’t need?
AP, SG Hambros Yes, especially in relationship to an underlying portfolio that has low volatility. The trap we have to avoid is becoming like the salesman that is much more interested in selling you a warranty on the product than he is interested in selling you the product.
SS, Citigroup I absolutely agree with you, Andrew, in terms of the danger of overemphasizing capital protection and we should certainly avoid that. However, I think during a risk-averse period, as we saw after the tech bubble, capital preservation was much more important than the pursuit of higher returns. So in those periods obviously the principal protection was the main emphasis, but what we are seeing now is a greater willingness to take on incremental risk in pursuit of double-digit returns.
SW, BNP Paribas I would strongly agree with the fact that we shouldn’t always make structured products synonymous with full capital protection. Furthermore, there certainly is a growing risk appetite as investors show an increasing interest in investing in commodities and emerging markets.
CL, Credit Suisse Another issue is that it is extremely difficult to identify the precise time to switch between certain asset classes, ie, the mix of structured products versus straight bonds, straight equity, or whatever it may be. Our clients trust us to advise on the right structured product, but they also expect us to advise on the best time to employ such a product. They want us to advise them on when the time is right to switch between asset classes, when to invoke the capital protected structures, and which type of capital protection to invoke at a specific time. Our advice needs to take into consideration multiple dimensions.
JF, chair So what are the hot new products or exposures in the hybrid space at the moment?
SW, BNP Paribas On the retail side, the most popular hybrid product is composed of three baskets, out of which one is higher risk and more volatile, one is medium risk and one is more defensive. At maturity, the investor receives the best of those baskets, a mechanism, which could be qualified as quasi-dynamic allocation.
AZ, Commerzbank A lot of the interest we’re getting, and so a lot of the products we’re creating, involve the idea of trying to automate the allocation process in some way, or somehow to find a way to codify it so that we can perhaps take some of the guesswork out of the timing of asset reallocation. So we’re seeing a lot of interest around products that give the investor the ability to switch asset classes in an automated way in response to certain moves in underlying markets. A lot of our customers have views on the coupling and decoupling of equity and bond markets, which is something that you could not express before, and now we’re coming up with tools that are essentially hybrid derivatives that express that view.
JF, chair I think we should touch briefly on hedge fund exposures in hybrids. Are we seeing real demand for this?
AZ, Commerzbank: I think the hybrids derivative market will always lag the single asset derivative market. So to the extent that the products that are being offered on the hedge fund derivatives side are relatively simple, so the hybrid side is even more simple. But we are seeing demand.
SW, BNP Paribas The introduction of hedge funds as a new asset class is definitely attractive as a diversifying tool.
SS, Citigroup Where the underlying is a single manager hedge fund, then putting a structure to manage the downside risk will be quite appealing. On the other hand, where the underlying is a low volatility fund of hedge funds, there may be more appetite on increasing the return through a degree of leverage.
New Frontiers
JF, chair We’re now going to talk about some of the challenges faced when working with and pricing new parameters, such as correlation, and I think Alexis is going to give us his thoughts.
AZ, Commerzbank There are a number of constraints in terms of our ability to supply hybrid products. As I mentioned earlier, essentially there are existing markets in each of the individual asset classes, and the constraint on what we can do in hybrid derivatives starts from what we can do within the individual asset classes. The layer that we’re adding on top of that in producing hybrid derivatives is correlation. We’re taking views on the correlations between each of the asset classes and within them. These views can be very wide-ranging and so slightly daunting from a trading perspective, because there is an array of relatively illiquid exposures inherent in hybrid structured products. We have seen correlation markets develop before. We’ve seen them in the equity markets, we’ve seen them in the fixed income markets, we’ve seen them in the credit markets, and having that knowledge is extremely useful in knowing how the correlation market will develop in hybrid derivatives. The important next phase, which is still unfolding, is an injection of liquidity, and that will come through inter-bank brokers starting to innovate in the products they provide, and also through hedge funds and other investors being prepared to take on the risk. My personal view is that hedge funds will actually step in once product providers such as ourselves have built up sufficient positions through issuance of structured products that we are willing to pay a small premium to lay that off, which will in turn create a trading opportunity for hedge funds. Interbank brokers will step in far more quickly, as they have done in the single asset classes, by introducing products such as dispersion trades, correlation swaps and so on. These kinds of products are very quick and efficient ways to move correlation exposure between the different product providers, and having this liquidity will give the product providers greater confidence in issuing their structured products based on hybrid derivatives.
SW, BNP Paribas As the hybrids business becomes fashionable, with many new entrants trying to establish themselves on the market, there is a growing concern about its sustainability, especially on the modelling side. Having the necessary confidence in your models demands a high level of technology as well as solid quantitative research skills. We saw this both in the equity derivatives markets and in the interest rate models used, where some popular products were sold without necessarily having the right models in place for hedging the products. This meant that when it was decided those positions could not be run, the book would have to be closed down, the providers changed and the deals novated. We also see how important the close integration between fixed income, the equity and the commodity sides is, particularly at the modelling level.
Using simplified models and adding an asset class, for instance, is simply not possible. It will result in inefficiencies in pricing, making the product either too expensive or too cheap. Determining sensitivities requires a unified model, which includes the best of both the equities and derivatives, and the fixed income models. According to the weight of one asset class over the other, the product will converge towards either model.
AZ, Commerzbank From a trading perspective, we’re not simply looking to find risks that we as a trading desk are comfortable with. We need to make the risk management departments in our banks comfortable as well, and in order to do that we need a sort of established market; we need inter-bank dealers to be able to provide information through systems such as Totem, which will make our risk departments happy that we are pricing the risk correctly and so on. These are the bottlenecks to being able to proceed and increase the volumes in this market. On the other hand, it is worth stressing again that both sides to this risk naturally exist within the hybrid derivatives market, so it is possible for product providers to find someone who wants to take each side of the correlation risk. That means that the hybrid structured product market will develop much more quickly.
JF, chair Let me just pin down Shaun on his point. So you’re concerned about the sustainability of the business as a whole, or do you think banks are getting into that space that shouldn’t necessarily be?
SW, BNP Paribas Yes, we think that it’s a big investment. It’s a high hurdle in terms of quantitative resources and IT resources and modelling resources, which means only a limited number of banks can do it.
DE, HSBC Private Banking How do you see secondary market liquidity? Obviously from a private bank’s perspective, this is one of the biggest issues for us. Apart from initial pricing, secondary daily market liquidity.
SW, BNP Paribas When we sell a hybrid product, security market liquidity has to be a given.
JF, chair So you would be willing to provide daily liquidity? Monthly liquidity?
SW BNP Paribas It depends on what the product exactly is. For a typical hybrid product, where there’s nothing inherently illiquid about any of the components, daily liquidity could indeed be provided.
CR, Goldman Sachs By definition, you should expect to have a very clear and tight pricing environment for the most vanilla, the most transparent, of the derivative tools. As you move into second- and third-generation products there has to be an expectation of losing some of that. That doesn’t mean that a bank can’t put and shouldn’t put a secondary market price around it. However, I think there has to be an understanding within the industry on both the sell and the buy side as to what the aggregate risks are in these products and an understanding going in as to how a secondary market would work and why.
SS, Citigroup It’s undoubtedly the case that some products will have a wider bid-offer spread than others. What is clear is that this will need to be articulated well and expectations managed appropriately on as to the depth of the secondary market, liquidity frequency and the bid-offer spread.
AP, SG Hambros In terms of the secondary market and liquidity, I definitely agree with Shaun that clients expect it today and it is a must. But I think we have to precisely define our terminology in terms of liquidity. We’re not so much creating a true secondary market, in the sense that there is someone else on the other side willing to buy the product, but deconstructing the product and unwinding it by its various components. So I think we have a long way to go before we can say we have a truly liquid secondary market in such products. The second aspect that was touched upon was the pricing, which is quite interesting, because as these portfolios tend to be hybrids, the counterpart of that is that the pricing is also very hybrid, and not necessarily in a good sense. There are so many complexities and so many components going into these products that you end up with a layering of fees, and that’s where one has to be very careful, because that can take away the opportunity to generate decent returns.
CL, Credit Suisse I would say that our product providers are very competitive with their prices and quotes. We rely on open architecture, not only to provide our clients with a wide choice of products but also to ensure the prices received from all of our providers remain competitive. In addition the increasing commoditization of structured products leads to very competitive pricings.
AP, SG Hambros There is also the opposite risk, which is that the providers price the product so low and so competitively that they do not fully get compensated for the risk that they are taking in managing it, and therefore they will manage the product excessively conservatively. That’s what I think is the high cost of low pricing from the point of view of the investor.
AZ, Commerzbank Essentially that would be a scenario where you’ve given a certain amount of discretion for the management of the underlying. Certainly in the majority of structured products that we issue, the formula for the management of the underlying tends to be relatively codified, so we don’t have the latitude to change the risk profile of the product during its life.
SW, BNP Paribas I would like to ask the end-users if they think the price is the only criteria for choosing their provider.
CL, Credit Suisse When a product is commoditized, it comes down to pricing, but when it’s innovation we’re looking for, then absolutely, we expect to pay relatively higher fees for first mover advantage. But in today’s environment first mover advantage tends to last for a matter of days and weeks, rather than months and years.
JF, chair What about the way the establishment of the hybrids business is changing the way product providers are set up internally. If they are reorganizing to be more efficient in terms of providing cross-asset products, then maybe that will feed through to better pricing. Are the providers restructuring?
SW, BNP Paribas Choosing between specialization and having everyone working together is a never-ending question. It is true, however, that, in the hybrids business it is key that the trading side should be looking at the actual trading, with the research, quants and management following in secondary markets. This is very important for us and we have put a lot of effort into this to make the organization as strong and unified as possible.
CR, Goldman Sachs We took a decision that we would like all of these risks in one place. We have one overriding infrastructure that our combined risks go into, where the traders have access to that information, and there’s a sharing of opinion as to how best to manage certain risks, due to this alignment of technology. Efficient risk management is important as you go about building this business, both from the point of view of what the end customer receives and also how you monitor and manage your risk internally in order to make sure that it’s a business that is profitable and has a long life.
DE, HSBC Private Banking Since we employ an open architecture model, I think the pricing is very transparent, certainly with the providers we deal with. The pricing in hybrid products has, at least in my experience, also been consistent.
AZ, Commerzbank One of the strengths of this area is that you can go to people who’ve bought a specific type of product and cross-sell, and we have certainly set ourselves up to do exactly that. We’ve done that with a unified structuring team, so our structurers that are used to structuring fixed income products can feed straight into the hybrid structuring process, and it’s the same with the equity structurers and so on. This is very important for the selling process.
AP, SG Hambros One of the things we’re seeing is competition between the investment banks and the asset managers in hybrid products. That’s a positive, because they have different angles, they approach it from different perspectives, and they have different technologies. It means we can pick and choose which is the best.
CR, Goldman Sachs It’s a very interesting point about, as you phrase it, the competition between the asset managers and the investment banks. One of the things that is clearly happening within the non-asset management part of the business is the development of the concept of lightly managed structures, or maybe it began as path dependent payouts and moved onto having some form of tactical overlay. This is becoming increasingly common among structures from investment banks and at the same time the asset management community is starting to provide more exotic payoffs. At the moment I think that means there is a more fertile market than there otherwise might be.
AP, SG Hambros I think there has almost been a revolution in the last two years or three years in terms of hybrid products. The technology has almost revolutionized the ability to actively manage the underlying basket.
SS, Citigroup I think the technology and product universe has developed a great deal, but I think the biggest shift has been in mindset. The focus is now away from looking at the aesthetic value of a complex payoff used and is rather a focus on intelligent packaging. The starting point is to identify the investment theme and then focus on packaging the theme in a cost efficient and optimal risk/reward manner.
CR, Goldman Sachs Just to extend from there and maybe throw out a question. There has been an explosion in personal wealth that has happened across Europe, the Middle East and Asia, and I’m assuming all of you at the private banks have had a significant and steadily growing flow of assets coming in from clients that have reasonably high requirements in terms of what they want back. How have you changed? Have you seen a big change in how you put together your structuring teams and how you service that client dialogue?
SS, Citigroup Increasingly, there are a number of people who used to be on the sell side switching to the buy side,. A number of private banks are increasingly putting together product specialist with capital markets expertise. Once you have a dedicated team in the private bank with capital markets expertise the reverse enquiry becomes a more significant part of the business.
DE, HSBC Private Banking The problem we face now is that our product range is so wide that you have to take this into account of when you present an offering to a client. It comes back to looking for investment solutions rather than products, where we look at what the best vehicle is for the client’s investment view. For example, it may be a structured product or it may be a long-only fund. We look tend to employ a themed approach to whatever we’re proposing: the private bank’s investment view, our idea for the trade and the most appropriate vehicle for making that investment.
JF, chair Are you being asked by clients to restructure their trades?
CR, Goldman Sachs When you’re talking about hybrid products with an amalgamation of underliers, then you’re quite likely to be asked at some stage to look at how you can restructure, adding to or changing asset classes to reflect new views.
AZ, Commerzbank One of the things we’re trying to address is whether we can build into the original structure a feature so that the investor has the ability to switch or somehow reflect their changing view. We can go in and say, ‘You’re bored of commodities right now. You’ve done very well with commodities, what can we do to switch you out?’ and see if we can somehow build the right to switch into the original product, so they’re not paying the bid-offers on the way in and out of two different products.
Expanding markets
JF, chair Let’s finish by talking about markets and geography. Which are the most exciting markets for hybrids at the moment?
CR, Goldman Sachs Europe is experiencing a huge amount of growth and change, and we’re all living that at the moment. It is also true in Asia, particularly in the private banking business.
AZ, Commerzbank I agree that Europe and Asia are both huge and exploding markets, but I think there is a slightly different flavour to each. In Asia, investors tend to be using hybrid derivatives to maximize upside or to make more extreme returns. In Europe, perhaps because there is overall an ageing population - and as governments and large corporations pull out of pension provision - people are focusing increasingly on retirement planning, and the structured products area is moving into that. Hybrid derivatives can actually bring that idea into the modern age and essentially provide a set of tools that can increase the efficiency of retirement planning.
AP, SG Hambros From our point of view, the demand for this type of product is to a large extent European demand. In Europe I think there is greater interest in capital preservation and a better understanding of risk diversification, of creating portfolios that are diversified across asset classes. Investors in Asia tend to be more oriented towards higher risk/higher reward-type investments. And in the Middle East, the big attraction for investors in that particular region tends to be private equity. They like to have a more hands-on approach. So I completely agree that the growth area for the moment is in Europe for this type of investment.
AZ, Commerzbank Hybrids lend themselves to compound views, and compound views lend themselves to yield enhancement because of the lower probability of two things happening rather than one. The investor might form the opinion that if he can get paid more for a given investment if he gets both of these predictions right, then he’ll take that view.
JF, chair I think we’ve covered all of the points in detail, so we’ll wrap things up. Thank you all very much.
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