The number of funds helping banks offload complex and illiquid risks from their structured products books has risen sharply this year, marking an extraordinary turnaround in fortunes for a business that suffered huge losses and investor exits when markets nose-dived in 2020.
These investors now face a stern test as they navigate the biggest surge in stock market volatility since the early days of the coronavirus pandemic.
The number of hedge funds and other investors engaging in alternative risk transfer trades has roughly doubled this year, bankers say, after a sustained period of low equity volatility sapped profitability from other investment strategies and attracted more interest in these niche transactions.
This increased appetite has helped fuel a rapid expansion in banks’ structured products issuance over the past year or so. It has also left these specialist investors exposed to risks that can be fiendishly tricky to handle in choppy markets, with a sudden plunge in global equities in early August having shattered the market calm.
“The proliferation of hedge funds and real money clients willing to take exotic equity derivative risk has really grown since 2020, but this year it’s really exploded with at least seven newly active entrants,” said Steve Nawrocki, head of equity derivatives for the Americas at BNP Paribas.
“They’re all calling, saying ‘we want more’. In previous years, we have run out of ART supply, whereas this year, because the primary [structured products] business is booming so much, we constantly have stuff to sell them. That recycling of risk is currently a very active business for us.”
Nawrocki, like the other interviewees quoted in this story, spoke to IFR prior to the intensification of a global stock selloff on Monday that pushed Cboe's Volatility Index – also known as Wall Street's fear gauge – to its highest level since 2020.
ART hedging has a checkered history for investors brave enough to dabble in the space. Canadian pension fund AIMCo was one of the most active investors in ART when it lost C$2.1bn (US$1.5bn) in early 2020 when stocks slumped at the start of the pandemic. Other funds active in ART were also forced to leave the business, licking their wounds. That episode illustrated all too vividly the dangers of what essentially amounts to selling banks crash protection for parts of their structured products books.
It’s not hard to see why banks are keen to see more funds taking on these risks. Selling structured products, where banks pay investors a coupon depending on the performance of a bunch of stocks, can be an extremely profitable business for banks – but it can be an extremely costly one too.
Structured products desks are notoriously prone to blow-ups as the exposures they harbour can become extremely difficult to manage when equity markets take a sudden, sharp tumble. AIMCo wasn’t the only one haemorrhaging money in early 2020; some of the biggest banks in structured products, including BNP Paribas, Natixis and Societe Generale, also suffered huge losses following the violent market moves.
The ART of hedging
Banks have long looked at ways to recycle their structured product risks with investors, resulting in the development of ART businesses years ago. These transactions allow banks to unload certain exposures – such as volatility and correlation risk – that they would otherwise have to hold on their books from their structured products activity.
“ART is not something new as we’ve been doing it for more than 15 years, but we have seen a significant growth in the number of clients wanting to transact,” said Guillaume Arnaud, head of investment strategies at Societe Generale. “I would say that’s because of the growth in AUMs and the implementation of the multi-pods model at some hedge funds.”
Hedge funds receive a chunky coupon payment on a regular basis for absorbing these risks. Proponents say this provides a more diversified stream of income than more mainstream investment strategies. That, they argue, has become increasingly important in recent months due to low equity market volatility drying up other sources of revenue.
In the first half of the year, the VIX had been hovering near its lowest levels since before the pandemic. It rocketed to an intraday high of 66 points on Monday, from as low as 12 points in July, after a selloff on Monday in Japanese stocks cascaded across the globe. The VIX had retraced to about 28 points on Thursday after equity markets showed tentative signs of steadying after Monday's steep declines.
“[This year’s] market environment is the primary reason we’re seeing more buyside interest in ART,” said Joseph Khouri, EMEA head of equities derivatives structuring at Bank of America, referring to the low volatility backdrop that had prevailed until recently. “We’re seeing increased appetite from the buyside to harvest alternative sources of alpha, with ART emerging as a natural choice.”
Booming volumes
The willingness of more investors to enter these strategies has helped facilitate a boom in structured products issuance, as banks have been able to free up capacity to keep originating new products without hitting internal risk and balance sheet limits.
In the US, banks sold US$42bn of structured notes in the first quarter, according to data provider SRP – a 53% rise from a year earlier. Citigroup said it has seen a 40% increase in demand for structured products across its global client base this year.
“The structured product business has been strong this year across the globe,” said the head of equity structuring at a European bank. “By partnering together with non-bank investors that have different risk limits and constraints, we can support the growth of our structured products business without necessarily adding more risk to our balance sheet.”
Banks say investors have also broadened the range of risks they’ll assume through ART transactions. Many, for instance, will take on the entire other side of a bank’s structured product trade, whereas before it was more common to absorb only a portion of a specific risk, such as those related to dividends.
This expansion comes as funds have hired more traders from banks and invested in risk management systems to gain a competitive edge over rivals in winning ART business.
“Funds have become increasingly sophisticated at handling ART and there is now greater competition among the buyside to take the entire other side of our risk rather than just a portion of it, as was the case in the past," said Raphael Cyna, global head of payoff structuring at BofA.
Whether past experience will be enough for investors to avoid the kind of devastating losses that sunk so many in 2020 remains to be seen. On the face of it, at least, banks say funds are in a better position to weather the storm, having upgraded their systems and personnel. Either way, August’s volatility surge – even if it proves short-lived – should provide a wake-up call for the new breed of ART specialists following such a prolonged period of calm.
“It’s very much a case of the buyside having come through the experience of 2020, learning from that experience and wanting to do better the second time around,” said Luca Valitutti, managing director, exotics and hybrids trading at Citigroup. “As time has gone by, more risk management has been put in place and different vehicles have been deployed to better profitably navigate the risks stemming from ART products.”
Corrected story: Corrects attribution in the 17th paragraph