FOCUS — EQUITY DERIVATIVES
By Gordon Platt
New regulation should improve transparency in the increasingly popular equity derivatives market.
The financial reforms signed into law by President Obama on July 21 will substantially change the way many equity derivatives are traded and cleared. Title VII, the derivatives portion of the Dodd-Frank Act, will require standardized trades to be executed on regulated exchanges and electronic platforms and to be routed through central clearinghouses. The new law will improve the transparency of the over-the-counter derivatives markets and reduce systemic risk, although the full effect of the changes won’t be known until July 2011, when the rule-making process is completed.
Investment and commercial banks, dealers, insurance companies, corporations and hedge funds using derivatives will face tough time constraints in coping with the changes, says Ian Cuillerier, a partner in White & Case’s structured finance and derivatives practice, based in New York.
Pitts: “The complex risks in some
The Commodity Futures Trading Commission (CFTC), the Securities and Exchange Commission (SEC) and other regulators must complete the rules for implementing the derivatives provisions within 360 days of the act’s signing. “The law will become effective on the 360th day after enactment, giving market participants a very short time to adjust,” Cuillerier says. “What we have now is a general framework and directional guide.”
In a marathon 20-hour negotiating conference that ended in the wee hours of the morning on June 25, senator Blanche Lincoln, an Arkansas Democrat who led a populist fight against derivatives trading, agreed to water down a controversial provision that would have forced big banks to spin off their derivatives operations. Banks will be allowed to continue operating derivatives businesses related to traditional banking operations, such as interest rates and foreign exchange.
“Basically, anything a bank that is an insured depository can do related to loans has been excluded from the swap push-out rule,” Cuillerier says. Banks will have to move their riskiest derivatives to a nonbank affiliate with its own capital reserves.
Under the new law, most OTC derivative transactions will be channeled through third-party clearinghouses. Every swap must be cleared unless exempt or unless no registered clearinghouse or agency will accept the swap for clearing. There are exemptions from mandatory clearing for businesses that use derivatives to hedge risk, such as airlines, utilities and manufacturers. US companies could have faced up to $1 trillion in additional capital and liquidity requirements without the exemptions from margin requirements for corporate end users, according to the International Swaps and Derivatives Association (ISDA).
Both swap dealers and “major swap participants” will be subject to new prudential capital requirements. A major swap participant is any person who is not a swap dealer, who maintains a substantial position and has counterparty exposure that could have serious adverse effects on the financial stability of the US, or who is highly leveraged and not subject to a federal banking regulator’s capital requirements. “The definition needs to be fleshed out with rule-making by the CFTC and SEC, since this category is a new creation,” Cuillerier says.
Dealers and major swap participants will also be subject to a new regulatory regime with business-conduct standards and reporting and record-keeping requirements. There will be heightened fiduciary duties for dealers that enter into swaps with a pension plan, endowment, retirement plan or government entity.
The SEC is authorized, but not required, to adopt position limits for security-based swaps. When applying these limits, the SEC must aggregate positions in swaps with those in underlying equity positions. “This appears to be the first time that a regulator has been given the authority to decide how much of a public company someone can indirectly own,” Cuillerier observes.
The derivatives legislation requires international cooperation and could have unintended consequences, he adds. At the G20 conference in September 2009, it was decided that all standardized OTC derivatives should be cleared through central counterparties by the end of 2012 at the latest.
Central clearing could help eliminate some of the counterparty risk, but it could create different types of risks, such as systemic risk in the clearing entity itself, according to Cuillerier. Historically, central clearing has been limited to very liquid futures products, he says. “If it is extended to less-and-less-liquid products, this puts greater risk into the clearinghouse,” he says. “We may end up with a Lehman Brothers situation all over again as a result of concentrated risk.”
Escoffier: “The move towards central
David Escoffier, head of global equity flow for Société Générale Corporate and Investment Banking’s global markets division, says the OTC equity derivatives markets are more developed in Europe and Asia than in the US, where the bulk of the trading is done on exchanges. Nevertheless, there are big OTC swap and index markets in the US.
“The move toward central clearing will reduce systemic risk and improve transparency,” Escoffier asserts. However, central clearing could also increase risk that was previously spread around by concentrating it in an entity that would need to be financially capable to face those risks.
While there could be more than one central clearer, there shouldn’t be too many, Escoffier points out. Some structured deals require cross-margining between different asset classes, a procedure that would involve two different clearers. It remains an open question as to whether the central clearer would have to be a quasi-sovereign entity with state guarantees. Upgrading of central clearing systems will be necessary, Escoffier notes. “A clearer is a utility with a fixed margin, so it will take time to do this,” he says.
Exchange-listed and centrally cleared derivatives work well with contracts for simple derivatives, Escoffier says, but adds that listing if very unfavorable for complex contracts that are traded by a small number of participants. “There are contracts that were never successful on exchanges,” he explains. For such contracts, market participants become fearful when they see how wide the spreads are on an exchange.
Many banks that exited the equity derivatives business during the financial crisis are trying to build up their teams again. “In the first six months of this year, we witnessed a cycle that normally takes two-to-three years,” Escoffier says. These banks, along with some new entrants to the business, realized in May that concentrating on the “flow” business is difficult. Flow business refers to trading for a client’s account that involves large volumes and mainstream products. Many investment banks lost money on equity derivatives in the second quarter, as they guessed incorrectly on volatility.
“You have to go out and find liquidity,” Escoffier says. “When everyone is asking for protection, it is difficult to find someone else who will sell you those puts.”
Banks are much more risk-averse than they were before the financial crisis. The interbank market can no longer be depended on to price the risk, and the banks have to balance their books themselves.
A major institution such as Société Générale, a world leader in equity derivatives, is in a stronger position because it offers a wide range of products. In retail indexing, for example, it can match up the risk positions of its clients. “This is one reason I am convinced that concentration in the industry will continue,” Escoffier says.
Christian Erb, global head of equity derivatives at Royal Bank of Scotland, says the shift from OTC to listed trading is continuing. At the time of Lehman Brothers’ collapse in 2008, approximately 60% of derivatives in Europe were traded in the OTC market and 40% were listed on exchanges, Erb says. Now, about 30% are OTC trades and 70% are listed, and the exchange-traded portion is headed toward 80%.
For corporations the cost of dealing in OTC derivatives will go up, since both parties to a transaction will have to post collateral, Erb adds. For centrally cleared derivatives there is a proposal that banks would have to put capital aside to support the central clearer. Eventually, the trend toward listed products should lead to increased liquidity and better prices for exchange-traded derivatives, which will help to offset the cost of collateral, Erb believes.
“There is continued interest and growth in the use of equity derivatives,” Erb points out. “Most investors are familiar with derivatives, which can offer an easy way to express views on the market.” The competition among banks is fierce, he adds. “There is a particularly strong interest in growing the flow area, where we continue to see more banks trying to enter the market.”
Cuillerier: “The definition needs to be
RBS, which has always had a strong presence in fixed income, made a decision 18 months ago to invest in equity derivatives as part of its equity strategy, with the aim of becoming a top-five provider. “It’s a key business for RBS,” Erb says.
Clarke Pitts, London-based global head of equity derivatives at Daiwa Capital Markets, says a great deal of the equities derivatives business is driven by investment products—with volumes driven, in turn, by market sentiment. “Therefore, a strong equity market environment would naturally be very beneficial,” he says.
Daiwa Capital Markets, the investment banking arm of Japan-based Daiwa Securities, agreed in July to acquire the global convertible bonds and Asian equity derivatives business lines of Belgium-based KBC Group for approximately $1 billion, of which about $800 million was for the firm’s trading position. The Asian derivatives business, which operates out of Hong Kong, provides market-making services in listed Hong Kong warrants and generates flow business from the issuance of equity-linked notes and OTC derivatives based on the equity of Asia-based companies.
The KBC acquisition is part of Daiwa’s strategy to build a leading global derivatives business centered in Asia. “The range of products will be sold to investors looking for exposure to Asian stocks,” Pitts says. “We are not holding ourselves up as full-service [providers] for derivatives in Europe. Our business is Asia-centric,” he says.
The industry is a long way from central clearing for all derivative products, according to Pitts. “Probably interest rate swaps and credit default swaps will get there in the next few years,” he says. “Once the regulators and exchanges have devised an efficient structure, the market will migrate there, but it’s not imminent—especially for equity derivatives and complex payoffs, which are popular in Asia and Europe.”
Generally, the trend is reverting to simpler payoffs for a variety of reasons, Pitts says. “For example, product providers found that the complex risks embedded in some exotics were harder to manage than they had previously imagined, and therefore they charge more, which discourages investors,” he says. “At Daiwa we are committed to providing a full range of products to meet investor demand.”
One key question for the industry is how regulatory changes and higher capital requirements are implemented across geographies. If they are imposed unilaterally in the EU, for example, this could conceivably drive business into Switzerland and Asia, Pitts says.