Derivatives Week - Corporate Solutions

VOL. XXII, NO. 16 / April 22, 2013

Exclusive Insight for Derivatives Buyers, Sellers and Structurers

Derivatives Week

The weekly issue from Derivatives Intelligence

www.derivativesintelligence.com Credit | 3

FX | 4

Rates | 6

Equity | 8

CS In Best-Of Bonus Structure Credit Suisse has launched best-of bonus structured certificates on a basket of three underlying stocks, a novel offering according to investors. The best-of bonus certificates offer investors unlimited participation in the positive performance of the best performing underlying stock referenced by the certificates, or at least a minimum payment of the 100% bonus level, should a barrier event not occur before maturity. The underlying stocks are Nestlé, Zurich Insurance Group and ABB.

Regulation | 11

Final Redemption Scenarios Bonus Level

A Bonus Level A Barrier Barrier

B B

Bonus Level Bonus Level Barrier Barrier

• If none of the shares has ever traded at or below its barrier, the investor will receive the denomination plus 100% of the positive performance of the best-performing share on the final fixing date, calculated from its initial level. • The investor will receive a minimum repayment of the bonus level. • If at least one share has ever traded at or below its barrier, the investor will receive the predetermined number of shares of the worst-performing reference share. • Fractions will not be cumulated and will be paid in cash. Source: Credit Suisse

(continued on page 24)

Industry Bigwigs Set Out Electronic Trading Challenges Derivatives Week has brought together a group of senior officials to discuss current developments in the electronic trading of derivatives. Among the topics debated were proposals in the U.S. around a minimum of five RFQs, the outlook for the single-name credit market once clearing goes live, and the challenges to developing and rolling out electronic platforms in the current environment. The roundtable participants were Ryan Sheftel, global head of fixed income, fx and commodities e-commerce at Credit Suisse, Sonali Das Theisen, director in credit trading at Barclays, Athanassios Diplas, senior advisor to the International Swaps and Derivatives Association’s Board of Directors, Sam Priyadarshi, head of fixed income derivatives at the Vanguard Group, and Jim Rucker, credit and risk officer at MarketAxess. (See page 13 for the full roundtable)

Q&A

UBS’ Naylor: Buyside Convexity Demand Spikes Institutional investors are showing increased demand for convexity on the S&P 500 in instruments such as wing options or by buying a variance swap and selling a volatility swap on the index, Roger Naylor, head of global equity derivatives at UBS in London, told DI in an exclusive interview. Volume has yet to increase sharply, but requests are up given cheap convexity. “I think, logically, given the uncertainties in the world and the fact that convexity has recently become a lot cheaper to own, it makes sense to look at it,” Naylor said. “Relatively few people are pulling the trigger on the trade because there’s still a lot of faith in policy makers’ ability to stop us falling back into a full-on crisis. They’re also expensive positions to carry, even at the current levels.” (continued on page 22)

People Databank

RBS Floats Custom Fund Play

Regulatory Alert

Track all the relevant staffing comings and goings in derivatives. Inside, we’ve got a month-to-date running tally of which firms have been hiring and which firms have been losing staff.

The Royal Bank of Scotland in Japan is marketing UCITS-compliant funds embedded with the firm’s custom proprietary indices.

Check out our interactive database of new and pending regulatory proposals and directives that relate to derivatives collected from global regulatory agencies.

See page 19

See story, page 8.

Visit the data section of www.derivativesintelligence.com

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IN THIS ISSUE

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Derivatives Intelligence

CREDIT

EQUITY

3 | Javelin Opens London Office, Eyes Product Expansion

9 | VIX Calendar Calls Find Favor

EDITORIAL

9 | Citi Equities Bigwig Departs

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Marketing Director

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General Editor

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3 | Ex-UBS Credit Bigwig Joins Fund Manager

FX 4 | UBS Markets Digital Basket Note 5 | Citi Upgrades Corp Fx Platform

REGULATION & CLEARING 11 | Brokers See SEF Record-Sharing As Tough To Meet 11 | ISDA: Margin Proposals Could Leave Risks Unhedged

INTEREST RATES

DEPARTMENTS

6 | STOXX Launches Libor, Euribor Alternative

13 | Electronic Trading Roundtable

6 | CS Hires Ex-UBS Rates Trader 6 | RBS Pitches SEK Forward Steepeners 7 | IOSCO Issues Benchmark Consultation

19 | People Databank 20 | Learning Curve

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4 | AUD, RMB Deal To Drive Deriv Development

CORPORATE

Jenny Lo

An agreement that will allow the Australian dollar to be settled directly with the yuan in the spot market will grow volumes of fx deliverable forwards and options once further deregulation occurs in China, according to market participants.

Richard Ensor Chairman

Web Production & Design Director

John Orchard Managing Director, Capital Markets Group

8 | Korean Tensions Open Up Kospi Put Spread Possibilities Hedge funds have been buying short-dated at-the-money put spreads on the Kospi at 2% with a 90% strike, in a bid to profit on a recent change in skew due to escalating political tensions on the Korean peninsula.

8 | RBS Tokyo Floats Custom Fund Play The Royal Bank of Scotland in Japan is marketing UCITS-compliant funds embedded with the firm’s custom proprietary indices.

9 | Investors Roll Nikkei Calls Large global institutional investors are increasingly rolling their call positions up-and-out on the Nikkei in a bid to switch short-term exposure to long-term exposure on the index as the Japanese equity market continues to spike.

9 | JPM Loses Tokyo Trading And Execution Chief Shaun Moran, managing director and head of trading and execution services at JPMorgan in Tokyo, left the firm this week.

12 | Foreign Synth. ETF Providers Face South Korea Restrictions Foreign synthetic exchange-traded fund providers will not be allowed to directly list or market their ETFs in South Korea’s soon to-be-launched synthetic market.

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Editorial Offices 225 Park Avenue South, New York, NY 10003 Derivatives week is a general circulation newsweekly. No statement in this issue is to be construed as a recommendation to buy or sell securities or to provide investment advice. Derivatives Week ©2013 Institutional Investor, LLC Issn# 713-16410 COPYRIGHT NOTICE: All materials contained in this publication are protected by United States copyright law and may not be reproduced, distributed, transmitted, displayed, published, broadcast, photocopied or duplicated in any way without the prior written consent of Institutional Investor. Copying or distributing this publication is in violation of the Federal Copyright Act (17 USC 101 et seq). Infringing Institutional Investor’s copyright in this publication may result in criminal penalties as well as civil liability for substantial money damages. ISSN# 713-16410

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12 | Fragmented Asian CCPs Could Hurt Liquidity, Spreads Fragmented central clearing in Asia could hit bid/ask spreads and liquidity of cleared over-the-counter derivatives if dealers and end-users are forced to join a number of separate national clearinghouses.

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Derivatives Week



Credit Ex-UBS Credit Bigwig Joins Fund Manager David Gallers, the former head of credit default swaps index trading at UBS in New York, has joined corporate credit investment manager Lucidus Capital Partners as a portfolio manager. Gallers joins the firm from UBS in a new role. He left UBS in November last year, where he was replaced by algorithms that trade using mathematical models, according to news reports. Gallers could not be reached. Simon Meadows, a partner at Lucidus in London, confirmed the hire.

Javelin Opens London Office, Eyes Product Expansion New York-based Javelin Capital Markets, which runs an interest rate swaps and credit derivatives trading venue, has opened an office in London following a spike in demand from end users in Europe. The office, targeting Europe, Middle East and Africa customers, is headed by Dan Moon, who previously worked at HSBC, Bank of America and Santander. James Cawley, ceo in New York, told DI James Cawley the firm plans to register as a swap execution

facility under Clearing Firm the DoddBuyer Buyer Frank Act once SEF rules are Buy_Accept E-APPROVAL finalized. “And PR then from there BUY TICKET we expect to broaden our SELL TICKET product mix PRE-APPROVAL Sell_Accept from interest rate swaps Clearing Firm and spreads, Seller Buyer to include Source: Javelin butterflies, curves and so on in dollars. A lot of liquidity providers are European banks so the next step then is to quote euros and sterling.” The firm will launch its anonymous all-to-all swaps trading venue in London in the coming weeks. “Based on solid demand from European customers, it made sense to accelerate our European deployment,” said Moon, in a statement. “A number of institutions in Europe have realized that the swaps markets are evolving and will offer customers more choice.” Javelin was formed in 2009 as a derivatives execution platform for IRS and credit default swaps, offering both anonymous electronic and voice-hybrid methodologies for trade execution.

Barriers Broken In Euro Debt Auctions By Gavan Nolan, credit analyst, Markit Another week in the sovereign markets and yet more barriers are being broken down. France, Spain and Slovenia all have their problems but they also managed to sell debt this week. The 0.73% yield on France’s five-year OAT bond auction was the lowest on record, following on from the record 10-year yield achieved earlier in April. Spain’s auction the same day was also notable. The sovereign sold EUR4.7 billion of debt, above its maximum target of EUR4.5 billion, and the yield on the 10-year issue was the lowest since September 2010. Spain has now covered 39% of its planned medium- and long-term funding needs for the year. It was perhaps no surprise that major European sovereigns such as France and Spain should sell debt without a hitch. But Slovenia is a different proposition. The Balkan country has been affected by the fallout from Cyprus’s bailout–some investors see it as the next most vulnerable sovereign in the Eurozone—its credit default swap spreads widened sharply as a result. At the start of the year Slovenia’s five-year CDS was trading at 232 basis points; by late March it was quoted at 400bps. The spreads have since recovered slightly, and a successful VOL. XXII, NO. 16 / April 22, 2013

auction of 18-month treasury bills this week helped the sovereign’s cause. The government sold EUR1.1 billion of debt, more than double its target, and gave the country some much-needed breathing space. However, it is likely that a considerable portion of the bill buying came from state-owned banks, where Slovenia’s main problems lie. The banking sector has considerable amounts of bad loans, and the bulk of these are on the balance sheets of state-owned institutions. On the positive side, Slovenia’s banking industry is relatively small in terms of its GDP, and bears no comparison with Cyprus. If it can implement swift privatisations of its banks then it may be able to avoid a bailout. All European countries, and in particular France and the peripherals, are benefitting from the glut of liquidity emanating from the Bank of Japan. The search for yield makes it relatively easy to sell debt. But that is obscuring the economic fundamentals in Europe, which remain dire. Investors are prepared to ignore this while central banks are intervening, and it will take a major negative catalyst to shift sentiment.

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Derivatives Week



FX

F

low in the fx market was broadly muted last week although the yen continues to remain a hot topic among strategists. Société Générale was suggesting opportunities to take advantage of the continued weakness in the yen by buying six-month seagulls on the U.S. dollar/JPY. Other Asian currencies were also in the limelight, with market participants expecting a spike in deliverable forwards and options on the back of an agreement that will allow the Australian dollar to be directly settled with the yuan.

AUD, RMB Deal To Drive Deriv Development An agreement that will allow the Australian dollar to be settled directly with the yuan in the spot market will grow volumes of fx deliverable forwards and options once further deregulation occurs in China, according to market participants. China and Australia last week sealed an agreement which made AUD the third currency after U.S. dollar and the Japanese yen to be able to settle directly. According to William Johnson, senior fx dealer at Sydney broker World First Foreign Exchange, further development between China and the Australian forward and options market is needed before real increases in volumes is seen. More deregulation from the Chinese Government and a willingness from counterparties to create liquid markets for such products will need to follow, he said.

Johnson said the initial benefits of the agreement will be seen in the spot market. “This is a further movement towards freeing RMB and I feel derivative volumes will increase as this process continues,” he added. “However I envisage this single action on its own will have little effect on derivative volumes from the outset. It is aimed initially at delivering RMB through spot trades for settlement of trade in goods and services.” HSBC said in a statement the deal was a vital move towards building a representative and liquid onshore benchmark for major non-USD crosses. The firm also received approval from the People’s Bank of China last week to be one of the first market-makers for direct trading of RMB and AUD in China’s interbank foreign exchange market.

Yen Weakness Sparks Seagull Opps

be financed quite safely in selling a put, the package forming a seagull.” SocGen added that the 95 put strike acts as an important psychological and technical threshold. Many strategists have been tipping further yen weakness, driven by the BoJ asset purchases. In a report, Credit Suisse noted that the BoJ is displacing investors from domestic securities and forcing an asset allocation shift in favor of foreign assets. USD/JPY touched a four-year high Wednesday, hitting JPY99.86. USD/JPY spot had consolidated to 98.91 by press time.

Société Générale is pitching a six-month seagull to take advantage of the continued depreciation of the yen, as numerous banks revise their forecasts higher on the U.S. dollar against the Japanese unit. A seagull involves the purchase of a call spread and the subsequent sale of a put option or vice versa; in equal amounts. The firm specifically recommends buying seagulls with strikes at JPY100 and 107 on the call spreads versus selling the same expiry and notional in 95 puts. The structure indicatively costs 0.30% when referencing spot at 99.30. “I think it makes sense to sell both topside and downside to finance the call strike 100. After all, you can see a seagull as a call spread financed by a put, or just equivalently as a call financed by a strangle,” Olivier Korber, fx volatility strategist at SocGen in Paris, told DI. “Selling topside makes sense because [risk-reversals] are again bids for calls, so that high strikes are expensive again.” In a client note, the firm wrote that policy action from the Bank of Japan has fuelled appetite for yen options, especially in topside strikes. “This pushed up the USD/JPY implied volatility curve to levels rarely seen in post-Lehman markets. However, USD/JPY options are hardly expensive in vol terms.” One-month realized volatility on the pair was 15.49% during New York afternoon trading, well above one-month implied vol which was trading at 13.20%. “The new bold policy mix in Japan constitutes a break from the past and there will be no step back. So that the market is unlikely to forcefully bid the yen in a risk-off environment. With the new BoJ fairly limiting USD/JPY downside, a long call spread can 4

UBS Markets Digital Basket Note UBS is launching a digital plus capital protected note that enables investors to benefit from the appreciation of a currency basket against the U.S. dollar. The notes offer 100% participation, subject to a basket return of equal or higher than 15%, and is 95% capital protected. The equally weighted basket consists of the Brazilian real, Norwegian krone, Canadian dollar and Russian ruble. At expiry, if the basket return is equal or higher than 15%, then the investor receives their denomination multiplied by the sum of 100% plus the basket return. If the basket return is higher than 0% and lower than 15%, then the investor receives their denomination multiplied by 100% and a coupon. If the basket return is zero or negative the investor will only get their denomination multiplied by the capital protection. The basket return is a total of all four currency returns divided by four. The maximum profit potential for the note is unlimited. The certificates have a minimum investment of USD1,000.



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www.derivativesintelligence.com www.derivativesintelligence.com

FX Citi Upgrades Corp Fx Platform Citigroup has re-launched its corporate fx electronic execution platform, CitiFX Pulse 2.0 “We’ve enhanced our offerings of options. We had just plain vanilla options on the initial release and we now have a slightly larger suite of structured products on this release,” Umesh Jagtiani, head of fx electronic commerce in London, told DI. “In addition, we have revamped our exposure management module with an enhanced framework to view, control and manage balance sheet and cash flow exposures.” The platform now offers structured products, such as target and participating forwards, and the firm plans to add more exotic structures such as knock-in forwards and multi-leg options in the third quarter of this year. “Pulse 2.0 caters primarily to corporates. So the basic platform difference between Pulse and Velocity is that Pulse is a web-based portal, whereas Velocity is an installed application which we give

primarily to our banks, hedge funds and institutional clients,” said Jagtiani. In February, DI reported that Citi was planning to add multi-leg options and other option payoffs to its institutional fx electronic trading platform Velocity (DI, 02/25). Pulse 2.0 provides access to 700 currency pairs both onshore and through regional hubs in nearly 80 countries.

CitiFX Pulse Platform Ready to Trade:

Coming in Q3:

s S ingle vanillas

s Vanilla structures in strip view (flexible multi-leg pricer)

s P ar-forwards

s A merican knock-in forward

s P articipating forward

s American knock-out forward

s Target forward

s E uropean Knock-in forward

s R isk Reversal

s European Knock-out forward

s S eagull

s A merican Knock-out forward with European knock-in

s P ut spread

s European Knock-out forward with rebate

s Call spread

s A merican Knock-out forward with rebate

News Roundup Equity

Fx

• One-third of U.K. pension funds are using derivatives as an alternative to equities, according to Aon Hewitt’s latest Global Pension Risk Survey. (Financial Times, 4/15)

• Velocity Trade has named Sal Provenzano has head of

• Rabobank is planning to eliminate roughly half of its 50-member

fx futures, including Indian rupee/U.S. dollar contracts, in the third quarter, subject to regulatory approval. (Hindu Business Line, 4/15)

equity derivatives staff in Asia and Europe, including Howard Tong, head of equity derivatives for Asia. (Bloomberg, 4/15)

• Emmanuel Slezack has left Nomura Holdings as head of index flow derivatives trading for Asia ex Japan, along with Jean El Khoury, who was head of equities trading for the region. (Bloomberg, 4/15)

Credit • Credit default swap spreads for Western European sovereign debt remained relatively stable in the first quarter despite the crisis in Cyprus, according to S&P Capital IQ. (FTSE Global Markets, 4/16)

• Tradeweb’s new electronic platform has drawn more than USD600 billion in index credit default swap volumes from interdealer-brokers, about 80% of that part of their business, since the platform launched last October. (Risk.net, 4/15)

• Dealers appear to be warming to new credit default swap futures. The products debut in May with four contracts from IntercontinentalExchange, (International Financing Review, 4/12) • JPMorgan Chase has begun using a new value-at-risk formula for credit derivatives, the fourth such model introduced since the beginning of last year. (Bloomberg, 4/12) VOL. XXII, NO. 16 / April 22, 2013

institutional fx. (Securities Lending Times, 4/16)

• The Singapore Exchange has announced that it will add Asia

Regulation & Clearing • Bloomberg has filed a lawsuit against the U.S. Commodity Futures Trading Commission to overturn regulations that set different margin rules for swap futures and over-the-counter futures. (Financial Times, 4/16) • The impact of reform of the over-the-counter markets on fixed‑income revenue may have been overestimated, according to a report by Morgan Stanley and Oliver Wyman. (Financial News, 4/17) • U.S. banks initially expressed reservations about a request made by the U.S. Securities and Exchange Commission that they improve disclosure of the fair value of their structured products, according to correspondence between the institutions and the SEC. (Risk.net, 4/17) • The Committee on Payment and Settlement Systems and the International Organization of Securities Commissions has begun the process of monitoring implementation of the Principles for Financial Market Infrastructures, which include clearing and settlement systems, central counterparties and trade repositories. (IOSCO, 4/17)


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Derivatives Week



Interest Rates

T

he International Organization of Securities Commissions issued its long-awaited consultation paper on its proposed ‘Principles for Financial Benchmarks,’ while index provider STOXX launched two benchmarks to rival Libor and Euribor. The Royal Bank of Scotland’s interest rate strategy team had its eyes on Scandinavia last week, suggesting investors consider forward steepeners in the Swedish krona.

STOXX Launches Libor, Euribor Alternative Index provider STOXX has launched two benchmarks to rival Libor and Euribor. The STOXX GC Pooling index family provides a representation of the secured euro funding transactions taking place on the Eurex Repo GC Pooling Market, effectively creating a third-party alternative to unsecured interbank Konrad Sippel benchmarks. Konrad Sippel, head of business development at STOXX in Frankfurt, told DI, “We have seen a rising demand for transparent, rules-based, independent alternatives to unsecured interbank benchmarks such as Libor and Euribor/Eonia. By teaming up with Eurex Repo, STOXX was able to develop the STOXX GC Pooling Indices, which are based on the daily transactions on the regulated GC Pooling market.” Sippel said the indices can be used for benchmarking purposes in the money markets, as well as underlyings for financial instruments, including swaps, futures, overnight interest swaps or structured products. The electronic GC Pooling market run by Eurex Repo has an average outstanding volume of more than EUR150 billion. “The

indices fulfill major requirements expressed by the working group of 13 central banks established in March 2013 by the Economic Consultative Committee, such as real transactions as well as clear and binding rules,” Marcel Naas, managing director of Eurex Repo, said in a statement. The indices will be based on the ECB basket and the ECB EXTended basket, two standardized fixed-income securities baskets available on the GC Pooling Market. Each will have a volume-weighted average rate, and total volume. STOXX has plans to release indices that reflect the entire yield curve shortly.

CS Hires Ex-UBS Rates Trader Credit Suisse has hired Victor Lin as a U.S. dollar interest rates options trader in New York. Lin joined the firm at the end of last month, according to a U.S. Financial Industry Regulatory Authority BrokerCheck report. DI reported that Lin left UBS in Hong Kong after the firm announced plans to wind down its fixed-income division. At UBS he was an executive director in yen rates options trading (DI, 11/19). Prior to UBS, Lin was at Nomura and Deutsche Bank. Lin’s reporting line could not be determined by press time and spokespeople for Credit Suisse did not respond to requests for comment by press time. Lin could not be reached.

RBS Pitches SEK Forward Steepeners To position for no hikes in Swedish rates, the Royal Bank of Scotland is recommending a 2y forward 2s10s steepener in the Swedish krona. The firm noted that the strategy provides a positive roll-down and the forward curve is 12 basis points flatter than the spot curve. “I think that when the Swedish economy has recovered enough to motivate a tightening of monetary policy, it will not be in the form of rate hikes, but rather by introducing macro prudential measures that would have the same contractionary effect,” wrote Par Magnusson, chief analyst for Scandinavian rates, in a client note. “Should I be correct in this view, we should not expect any rate hikes from the Riksbank in a very long time.” Magnusson expects the Riksbank to lower the repo rate next time it changes its policy as inflation is far below the target of 2%, the gross-domestic product output gap is substantial, industrial production is trending lower, unemployment remains on the rise and the Swedish krona is at a strong historical level. “However, contrary to Riksbank expectations the latest 6

reading actually saw a retrenchment in household leverage, which is exactly what the objective the Riksbank wishes to achieve. Add to this the moral and fx effect from a June cut by the [European Central Bank] and the potential havoc of the event risks we are currently facing (Cyprus bail-in repercussions, Italian politics, Slovenia, North Korea, etc.), and the risk-reward is decidedly for lower rather than higher policy rate in Sweden.” The firm added that the strategy would benefit from a downside surprise to rates, while at the same time being carry positive.






Interest Rates IOSCO Issues Benchmark Consultation The International Organization of Securities Commissions has issued a consultation paper on its proposed Principles for Financial Benchmarks noting that compilation, distribution and governance for financial benchmarks should be undertaken by an administrator. In its paper, IOSCO’s Task Force on Financial Market Benchmarks wrote that regardless of the particular structure for benchmark compilation and administration, there must be an overall entity which is responsible for the integrity of the benchmark. The responsibilities would include the development, determination, dissemination, operation and governance of a benchmark. The 18 principles issued by the commission include managing conflicts of interest for administrators, benchmark design and interest, benchmark methodology and termination of a benchmark. In a statement, Gary Gensler, chairman of the U.S. Commodity Futures Trading Commission noted that, “To promote Gary Gensler market integrity, it is critical that benchmark interest rates be anchored in observable transactions and supported by appropriate governance structures.” IOSCO added that “the data used to construct a benchmark

should be based on prices, rates, indices or values that have been formed by the competitive forces of supply and demand and be anchored by observable transactions entered into at arm’s length between buyers and sellers in the market for the interest the benchmark measures.” The task force added that administrators need to have clearly written procedures in the event a benchmark ceases to exist. “Benchmarks play a vital role in the confidence and integrity of financial markets. The Principles proposed today are a key step in enhancing the oversight and quality of benchmarks,” said Martin Wheatley, chief executive of the Financial Conduct Authority and co-chairman of the IOSCO Martin Wheatley Task Force. “Through IOSCO, the FCA will continue to work closely with the European and international community to establish clear standards for effective global benchmarks. Once agreed, the Principles will be reflected in future reviews of additional supervisory activity of benchmarks undertaken by the FCA.” Comments must now be submitted by May 16.

The Forex Forum 8 May 2013, The Brewery, London

For more information, or to apply for your place, please visit the website: www.euromoneyconferences.com/forex Keynote Speakers Announced: John Taylor, Chairman, CEO and Founder, FX Concepts • Neil Record, Chairman, Record Currency Management The Euromoney Forex Forum is widely recognised as the most prestigious event in the FX calendar. Back for its 13th year with a brand new format and plenty of new topics for discussion, it’s an event not to be missed by all those investing in or managing their exposure to the FX markets.

Lead sponsors: Exhibitors: Media Partners:


The The weekly weekly issue issue from from Derivatives Derivatives Intelligence Intelligence


Equity

A

sia Pacific dominated index flow trading again this week, with investors globally rolling their call positions on the Nikkei. Hedge funds are taking interest in calendar call spreads on the VIX and Korean tensions are providing put spread opportunities on the Kospi. Elsewhere, senior departures were also seen at Citigroup and JPMorgan.

Korean Tensions Open Up Kospi Put Spread Possibilities Hedge funds have been buying short-dated at-the-money put spreads on the Kospi at 2% with a 90% strike, in a bid to profit on a recent change in skew due to escalating political tensions on the Korean peninsula. The chance of the Kospi shrinking 5% within the next month has increased to 15% from 10% since the start of April, according to a senior equity derivative trader in Hong Kong. “[Skew] increased after North Korea’s statement of a state of war existing between the two countries,” the trader

said. “The market wasn’t really that concerned, but right from the end of March when they made that statement we saw the implied probabilities jumping up, and now it’s up to around 15%, which is higher than it’s been for over a year.” North and South Korean tensions have continued to elevate since March, as North Korea prepared to celebrate the birth of its founder, Kim Il Sung, on April 15. Since March, the North has voided the 1953 armistice that ended the Korean War and detailed plans to aim missiles at the South and its U.S. and Japanese allies. North Korea’s rhetoric is causing retail domestic investors to retreat from the market, with only government pension funds left as major buyers in the nation’s equity and structured product markets, the trader added. “If you believe the correction would be around 10%, then taking advantage of more elevated skew by buying ATM 90% put spreads for about 2% seems attractive with a risk reward of around 5-to-1,” he said.

RBS Tokyo Floats Custom Fund Play The Royal Bank of Scotland in Japan is marketing UCITS-compliant funds embedded with the firm’s custom proprietary indices. Filippo Olivetti, managing director in Tokyo, said the idea was to embed either an offshore or domestic fund with an RBS’ dynamic custom strategy tailored to a client’s specific view. RBS would then distribute the fund via asset managers in Japan, who will market it to their regional banking clients. Some corporate investors had also signaled interest in the structures, Olivetti added. DI reported RBS in Hong Kong was looking to structure derivatives that reference popular UCITS-compliant funds, such as those offered by PIMCO and Franklin Templeton, as underlyings instead of custom indices (DI, 4/11). RBS said investors are keen for investments with greater transparency. Olivetti said funds have a number of beneficial aspects over simply offering clients exposure to custom indices, including a potentially a better accounting treatment and greater transparency. Custom indices also benefit from high daily liquidity and low access costs, he added. A typical structure could use Japanese government bonds as collateral for a swap, which switches the coupon of the JGBs for the performance of the index. The indices can also include a volatility control mechanism to target specific volatilities and potentially cheapen options written on the indices while providing an efficient risk-management overlay. “There are several different types of strategies, for example momentum based, where if a certain asset is above the moving average it goes long, or vice versa if it’s below 8

the moving average,” Olivetti said. He noted the underlying indices could range from referencing a basket of equity stocks, fixed income, commodities futures or a basket of currencies. “There are indices for example that essentially try to play the carry trade via a dynamic strategy, where basically you look at the rates differential that is imbedded in the forward-implied rates and you tend to go long on the currencies where the interest rate is higher,” he said. Olivetti added the greatest challenge placing the structures with investors was education. Investors need to be comfortable with the structure, while also understanding the concept behind the index, he noted.

BNP Flow Chief Flips To Prop Desk Jonathan Moldovan, head of index volatility flow trading for Asia at BNP Paribas in Hong Kong, has switched to the firm’s proprietary trading desk. Moldovan confirmed the move, but declined to comment. He had been in the position since June 2009, joining the prop desk about two weeks ago. It is understood Moldovan held a similar prop trading position prior to taking up the head index flow trading position in Hong Kong. Further details, such as the reason behind Moldovan’s relocation, could not be determined by press time. A spokeswoman at BNP did not immediately return calls.






Equity VIX Calendar Calls Find Favor Institutional investors and hedge funds are increasingly considering buying calendar call spreads on the VIX as it provides the most cost-effective way to hedge a potential spike in volatility. The instruments are gaining interest as a cheap way to hedge against an increase in U.S. volatility at a point when investors have, in recent weeks, had a more positive view of the U.S. economy. However, with the VIX nearing its six-year low and poor retail sales data recently published in the U.S., investors are looking at positioning for the index to gap out. According to market participants, the majority of interest has been in buying June13 VIX calls and selling higher strike July VIX calls. “When we push time forward by one month in our assumptions, there appears to be little decay, so you aren’t being penalised too much if nothing happens. It has been so punitive from a cost perspective to carry any kind of hedge,” said Phil Rapoport, a strategist at Macro Risk Advisors in New York. “People are pretty constructive on the U.S. right now so their willingness to pay away any money to hedge has been pretty low. Therefore, the hedging we are seeing is based on being cost effective.” BNP Paribas is also recommending investors buy calendar call spreads to position for higher U.S. volatility. It cites risks including the European debt crisis and the potential escalation of the situation in North Korea that could lead to an increase in volatility.

Investors Roll Nikkei Calls Large global institutional investors are increasingly rolling their call positions up-and-out on the Nikkei in a bid to switch short-term exposure to long-term exposure on the index as the Japanese equity market continues to spike. Rolling call options up-and-out involves increasing the strike and moving the maturity out on call options due to expire. It allows investors to balance the decrease in premium for selling a higher strike price against the greater premiums received for selling an option that is further from expiration. A senior equity derivative trader in Hong Kong noted the rolled call options had strikes typically of 16,000, 18,000 or 20,000 and maturities out to 18 months. “Newcomers are trying to catch the train and some of the guys that have had the position for a few months are running them on the upside,” the trader said. “Most of the people rolling are usually unwinding a call, which is in-themoney and shorter-term into a little more out-the-money and longer term.” The Nikkei was trading at 13,382.89, up 161.45, during Wednesday afternoon trading. The Bank of Japan’s continued commitment to quantitative easing has weakened the Japanese yen to about JPY100 against the U.S. dollar, fuelling the rally in Japanese equity. VOL. XXII, NO. 16 / April 22, 2013

Specifically, BNP is recommending investors to buy the Jun13 26-strike VIX call and sell Jul13 30-strike call spread. The position benefits from the VIX futures curve flattening or inverting. “Due to the shape of the VIX futures curve, the June 26-strike option can be bought costless (indicative) against the July 30-strike,” wrote strategists at BNP. “The near-term contract is closer to the money, creating more delta.” During Tuesday morning trading in New York, the VIX stood at 14.35.

Citi Equities Bigwig Departs Ronan Connolly, head of equities trading for Europe, the Middle East and Africa at Citigroup in London, has left the firm. Connolly could not be reached. A spokeswoman declined to comment. His departure comes after four years at the firm, where he reported to Andy Thompson, head of equities for Europe, the Middle East and Africa, and Simon Yates, global head of equity derivatives in New York. He lead the expansion of the firm’s trading operations in Europe, with hires including former HSBC single stock trader Mark Green (DI, 3/9), former Goldman Sachs index trader Kudakwashe Chinhara, and ex-Citadel trader Rory Hill (DI, 7/9/10). Prior to Citi, Connolly was head of single stock derivative flow trading in London and before that, worked as an equity derivative trader at JPMorgan.

An equity derivative strategist based in Hong Kong said investors in the Japanese Uridashi structured product market are also rolling their deals, which is driving the trend in the Nikkei call options market. “Expiring [Uridashi structured products] we thought were just going to die and that was it, but it seems like fresh structures have gone on again,” the strategist noted. “And that’s keeping the December 2014 bucket of volatility very cheap, compared to where the other money is.” DI reported in February dealers were gearing for an issuance spike in Uridashi autocallable structured products as dealers sought to replace transactions that had been knocked-out due to the Japanese equity rally (DI, 2/22).

JPM Loses Tokyo Trading And Execution Chief Shaun Moran, managing director and head of trading and execution services at JPMorgan in Tokyo, left the firm this week. Moran had been with the firm since 1995, covering cash and equity derivatives. The reasons behind his departure could not be determined by press time. A spokeswoman at the firm in Hong Kong declined to comment. Moran could not be contacted.


9

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Regulation

L

obbying against proposed swap execution rules continues in U.S., with the Wholesale Markets Brokers’ Association Americas protesting against the need to keep and share records with SEFs and the U.S. Commodity Futures Trading Commission. Elsewhere, traders fear that proposed rules surrounding margin requirements for non-centrally cleared derivatives could force them to leave risks unhedged.

Brokers See SEF Record-Sharing As Tough To Meet Requiring swap execution facility to post position data for traders would be a difficult requirement for SEFs to meet, according to brokers. In a letter to the Commodity Future Trading Commission, Stephen Merkel, chairman of the WMBAA in New York, wrote, “While SEFs will monitor for manipulative and abusive behaviour, given the competitive relationship among trading systems and platforms, SEFs will be unable to obtain position data from other SEFs.” The rules were expected to be finalized by the beginning of last year, but have been repeatedly opposed by brokers since. They would force traders to keep records of all transactions and make them available, upon request, to the SEF and the commission. Merkel believes that the CFTC should not adopt any provision

in the final SEF rules that requires a facility to use a large-trader reporting system or obtain data from other sources than its own trading system or platform. The WMBA believes it would be impossible for firms to post the correct data, because market participants often establish more than one position on SEFs, making it hard to attribute a particular position to an individual execution platform. The association also states that many traders do not have the technology needed to report their positions electronically, and that manual reporting would be time-consuming and error-prone. Messages left for the officials in the division of market oversight at the CFTC were not returned by press time.

ISDA: Margin Proposals Could Leave Risks Unhedged Margin requirements for non-centrally cleared derivatives proposed by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions could force traders to choose less effective means of hedging or to leave the underlying risks unhedged entirely, rather than raising or diverting funds to comply. In a letter to BCBS-IOSCO, Robert Pickel, ceo of the International Swaps and Derivatives Association, said that in addition to leaving risks unhedged, traders could avoid undertaking risks in the underlying economic activity. “On this reconstructed playing field, it’s likely that many market participants would Robert Pickel simply abandon their use of non-cleared derivatives and that, as a result, volumes and liquidity in the market would shrink dramatically,” said Pickel. Under current proposals, traders would be forced to turn to a handful of third-party custodians in order to comply with requirements to segregate initial margins, leading to increased concentration risk. ISDA fears this would reduce market liquidity, tax the banking system and introduce dangerous pro-cyclical risks. BCBS-IOSCO released the first draft of its proposed margin requirements last summer in response to a mandate from G20 leaders and the Financial Stability Board. ISDA has opposed the requirements several times. This latest letter comes since the association was approved as an affiliate member of IOSCO earlier this month. Ed Murray, a partner at Allen and Overy in London, VOL. XXII, NO. 16 / April 22, 2013

told DI that the new affiliation is unlikely to stop the new margin requirements from going through. “I think there’s a real risk that these margin requirements will be imposed. If you look at the second consultative document, Basel and IOSCO were pretty adamant that they had a near final view on these things,” Murray said. “One hopes that closely reasoned arguments of this type will have an impact. My gut feeling is that they will plough ahead with margin requirements.”

ISDA Concerns In Brief sT he outright quantum of margin required even in normal market conditions is very significant. Increased initial margin requirements in stressed conditions will result in greatly increased demand for new funds at the worst possible time for market participants. s The initial margin requirements could force market participants to forego the use of non-cleared over-the-counter derivatives and either: (1) choose less effective means of hedging, or (2) leave the underlying risks unhedged, or (3) decide not to undertake the underlying economic activity in the first instance due to increased risk that cannot be effectively hedged. sT he initial margin requirements should not be used as a tool to meet objectives of policymakers to reduce risk by encouraging more clearing. No incentive is sufficient to safely clear non-clearable derivatives, and an incentive that seeks to encourage such practices is inconsistent with efforts to create robust and resilient clearinghouses.


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The weekly weekly issue issue from from Derivatives Derivatives Intelligence Intelligence The


Regulation Foreign Synth. ETF Providers Face South Korea Restrictions Foreign synthetic exchange-traded fund providers will not be allowed to directly list or market their ETFs in South Korea’s soonto-be-launched synthetic market. Instead, the country’s Financial Services Commission is investigating ways foreign firms can give domestic third party providers exposure to their ETFs via swap agreements, which will then be packaged into synthetic funds and listed on the Korea Exchange, according to a senior official at an ETF provider in Hong Kong. The FSC could also allow ETFs listed in South Korea to physically invest in foreign synthetic ETFs listed abroad. “What is being discussed by the regulator is to implement a master-feeder structure whereby a Korean ETF invests in a foreign ETF, and this is something that we may consider,” the official said. “At the moment there are no immediate plans for

Korea as the tax disadvantage does not give the possibility to cross list ETFs as we do in Hong Kong or Singapore.” In South Korea, foreign firms operating in the country are subject to a punitive tax regime. The official said either option that the regulator is investigating could allow foreign firms to indirectly take part in the Korean ETF market and give investors there greater diversity to track more difficult international markets. “The Korean providers also may not have the know-how to replicate these markets just yet,” he added. The KRX and the FSC recently announced plans to open the ETF market to synthetic structures (DI, 3/1). The bourse expects to see the first deals listed by the second half of the year. An official at the KRX and spokespeople at the FSC did not return calls.

Fragmented Asian CCPs Could Hurt Liquidity, Spreads Fragmented central clearing in Asia could hit bid/ask spreads and liquidity of cleared over-the-counter derivatives if dealers and end-users are forced to join a number of separate national clearinghouses. Gavan Nolan, credit analyst at Markit in London, said in research note Thursday cost is a major issue for Asia’s future clearing marketplace. “Clearing is a volume business and CCPs in the smaller markets could be forced to implement higher charges,” Nolan said. “Margins will have to be maintained at the individual CCPs rather than netted across. Becoming a member of a CCP is costly in terms of capital.” He said institutions could elect to use clearing brokers in some instances to save costs. Nolan said clearing in Asia also faced other challenges due to

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fragmentation, including the form collateral will take for the various CCPs. “Fragmentation across seven different countries will be costly and increase demand for collateral that meets the requirement of central clearing,” he said. A further problem is that these requirements vary from CCP-to-CCP. Some will only accept local currency cash or government bonds, while others are more relaxed and accept bonds issued by governments in the U.S. and Europe.” In Asia Pacific, the Japan Securities Clearing Corp. said recently it would start client clearing next march, while the Hong Kong Exchange said it will allow client clearing six months-to-nine months after interdealer clearing starts in April (DI, 10/18/12). The Singapore Exchange has tipped it will allow client clearing in the future, but has declined to specify a date (DI, 10/4/12).

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Derivatives DerivativesWeek Week



Electronic Trading Roundtable

Participants

Athanassios Diplas, senior advisor to the International Swaps and Derivatives Association’s Board of Directors

Sam Priyadarshi, head of fixed income derivatives, Vanguard Group

Jim Rucker, credit and risk officer, MarketAxess

Ryan Sheftel, global head of fixed income, fx and commodities e-commerce, Credit Suisse

Sonali Das Theisen, director in credit trading, Barclays

Rob McGlinchey, DW Managing Editor (moderator)

DW: Let’s start by discussing proposals for a minimum of five RFQs and look in more detail at the potential scenarios in terms of final rules surrounding SEFs—how would they work? How would the market structure evolve under those different scenarios? And what would be the potential impact on liquidity? Athanassios Diplas: We are still waiting for the final rules—we are talking about rules from the Commodity Futures Trading Commission and the Securities and Exchange Commission not necessarily coming out at the same time. The big question mark over the CFTC rules is the controversial five-dealer RFQ minimum that was imposed on clients in the initial proposals. This has generated the most dissent among dealers and clients. Our belief is that five is not

required—it is more than is required by Dodd-Frank. In a recent survey we conducted with market participants from [Securities Industry and Financial Markets Association], ISDA and the [Managed Futures Association], the vast majority expressed strong concern against the requirement for a five-dealer RFQ model. They feel that two dealers would be more appropriate. The majority of participants also stated that they would be more likely to trade products that are not subject to the same rule, if the CFTC moved ahead with this rule. This, however, is still being debated within the CFTC and we don’t know how it is going to come out, but we remain optimistic that we will come to something that will be more friendly to the whole marketplace. In terms of looking at how this may evolve, I think that if the rule is amended, the impact of liquidity would be minimal. If the rule went through in its current form,

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13




Electronic Trading Roundtable then there would be a substantial impact on liquidity as it will create an adverse condition for buyside participants that are initiating a query, in addition to the dealer respondent. Sonali Das Theisen: The landscape for the ideal SEF framework is at minimum three dimensional. The trading protocols, “made available to trade” test, and block thresholds all have to work well together. Ideally there will be flexibility of trading protocols instead of a rigid prescription for how any particular instrument should trade. But to the extent that there is a rigid prescription, for example with an RFQ five or a central limit order book mandate, then it would be preferable that only the most liquid non-block instruments Sonali Das Theisen have to trade on the SEFs. Therefore, the test for liquid and non-blocks have to be dynamic and granular enough to adapt to the markets. For example, for the on-the-run five-year IG index, RFQ five is not going to be an issue because we’ve already moved beyond that— we’re already streaming prices in that market. But the RFQ five may be problematic for an off-the-run series or a non-five year tenor. In those situations you would hope that either: the block threshold or the “made available to trade” test were able to take that trade off the SEF, or, alternatively, that a more flexible trading protocol was allowed on the SEF such as RFQ one. We really hope that the final SEF rules work logically in conjunction with the “made available to trade” test and the block trade thresholds. This is one of our biggest concerns. All three of those pieces have to function together. Ryan Sheftel: If we take as a given what the different scenarios might be, then I think one that has been pointed out is that the markets are already moving to products that are inherently biased to being ok to be traded electronically, such as index CDS. I don’t know what the market estimates are, but I think 70-80% of index CDS is probably electronically traded between dealers and clients. So I think, in most scenarios for SEF rules, the products that are highly standardized, that trade in a higher turnover might even end up being accelerated to trading electronically. I think the market will determine how it wants to trade those products, because at the end of the day the markets will determine everything. The SEF rules just lay the groundwork. So I think on one end of the coin you might just see an acceleration of an existing pattern of behaviour that’s already been around. And then on the other side, when you talk about liquidity, then you could just 14

see that, if the rules make it difficult for the buyside to affect their trading, then they just choose an alternative way to express their view or perform their risk transfer. So you could see the result being that the liquidity in those products dries up, because what the liquidity providers need now in terms of compensation to providing the liquidity ends up exceeding what the buysiders are willing to pay. And then moving on you could see a move to more proxy hedges, proxy positions—people might move away from the securities/derivatives that give them the exact exposure that they want, and instead move towards things that are more proxy. So we’ll end up pushing more of that basis risk onto the buyside and they’ll have to accept more approximate hedging in their portfolio. Sam Priyadarshi: I agree with the other panellists. In my opinion most of the standardized OTC products will gravitate towards central limit order books while much of the bespoke swaps or cash-flow hedges or asset-swaps will gravitate to RFQ. We do have an issue with the minimum of five RFQ, as that will deter liquidity and impose transaction costs, also because of our fear of exposing investment strategies to market participants who could use this to the disadvantage of our clients or other dealers. So we think that the minimum five RFQ will result in lower liquidity and increased costs. An important issue that Sonali mentioned is made-availablefor-trading issue and I think we need to be very careful as to what is

“By definition, I think central limit order books will have standardized products because you have to show the depth of market on either side, so that’s an important issue.” —Sam Priyadarshi, Vanguard Group

made-available for trading—it shouldn’t just be left to the SEFs and DCMs. It should be a joint effort between the SEFs, DCMs, buyside and sellside as well as the regulators. We think there will be a tremendous amount of market fragmentation on SEFs because there are currently over 20 SEFs. Eventually there will be consolidation as buyside firms look for liquidity and they will go to where there is the most liquidity. Right now there is an RFQ model already in place for U.S. Treasuries and FX, and buyside firms, go to those platforms and seek liquidity. Dealers provide liquidity and are market-making in a RFQ manner on those platforms. We already see some prototypes of SEFs with the RFQ models and we’ve seen the central limit order book model. These will work very well for standardized products, less so for bespoke products. Eventually, we think that dealers will become agents rather than principals—that is one part of the market structure evolution.





Electronic Trading Roundtable And standardized products will trade on central limit order books while bespoke or non-standard swaps will trade via RFQ’s. Again, we feel that dealers will become SEF aggregators and might provide cross-trading opportunities across different SEFs and DCMs. Jim Rucker: In terms of SEF rules, we obviously expect changes but we don’t think there are going to be a lot of significant changes to the existing draft rules. But one of the areas that is still open to debate is the extent to which voice trading will, or will not be allowed, under the CFTC rules—clearly that’s going to have a significant impact. I think it particularly impacts the distinction between the interdealer and the buyside to dealer SEFs. That is an important issue that is still out there that has not been raised so far. In terms of central limit order books, I think I agree with what has already been said. I think it is very likely that some of the most liquid contracts—whether that be index or single-names—do over time migrate to central limit order books. Diplas: As a clarification, I think we should be making the differentiation more between liquid versus illiquid products, not so much standardized versus bespoke. Especially in the credit markets, all products are already standardized—there’s no difference between one index and the other. The only difference is that one might be a lot more liquid than the other one, but it’s an identical widget, so this is Athanassios Diplas not a standardization issue in terms of the differentiating factor, but rather the liquidity, and I think that’s what’s going to make the difference between whether something resides on a central limit order book versus whether something resides on a RFQ. I think that the topic of what is made available-to-trade is extremely important, and the sensitivities of both buyside and sellside are going to equally determine how these things pan out. DW: Athanassios, can we quickly go back to the industry survey on RFQs. What proportion of the buyside saw five RFQs as problematic for their business? Diplas: So 84% of the respondents found the five RFQ proposal problematic and that it would increase transaction costs. Around 70% mentioned that they would migrate to different markets if that kind of rule takes effect. However, we have to see how some of the other rules pan out as well because, if the block is set very low, you don’t care

actually whether the five RFQ applies to you because if every trade you do is a block then you don’t have to do five RFQs. Also, going back to Ryan’s point, the market would like to determine how it wants to trade, but the question is will it be allowed to determine how it wants to trade. Sheftel: Just going back to the point previously made on RFQ and central limit order books, I think it is a combination between standardization and liquidity and I think its two-step because in the CDS market it’s already gone a step. The idea of having a central limit order book where a person trades, generally leads to smaller trade lots. If someone wants to do a USD100 million interest rate swap trade and they do it in a 100 one lots each with their individual fixed coupon, that’s just not a practical outcome. The CDS markets have certainly solved that problem but with interest rate swaps you do have the risk of the inability to do some of these trades, more because of your back-office processes. It’s just the nature of that market doesn’t fit into that model. Priyadarshi: I think that the points that have been made about liquidity are very important. So there are two issues here. One is standardized versus non-standardized, and the other one is liquidity. Just to point out, for example, the RFQ model for U.S. Treasuries. Treasuries are standardized—about as standardized as they get—but still they work on the RFQ model, especially for electronic trading. Therefore, there is no central limit order book for Treasuries and people trade several billions of dollars every single day. Single trades can be over half a billion or a billion or so. It’s very difficult to have a central limit order book for bespoke products even if they’re liquid. By definition, I think central limit order books will have standardized products because you have to show the depth of market on either side, so that’s an important issue. Other issues with the RFQ model which will hamper the growth of SEFs is the resting bids and offers and the fifteen second waiting for the crossing of the trades. Those are some of the other issues that will impact the development of SEFs for the RFQ model. Rucker: I think the only thing that I would add, specifically in an area like trading protocols, is that what’s most appropriate are rules that are principles-based, not overly prescriptive. What we all want is that market participants are able to determine what is the most appropriate way of trading, and that the SEF platforms are allowed to be innovative and creative in setting those trading protocols. We’ve talked of two protocols – RFQ and central limit order books, but there is also plenty of variation in between those. In my personal view, what we want to avoid are rules that are overly prescriptive, that don’t allow for the way the market trades today, but also don’t allow platforms to evolve and develop as the market does.


15

Derivatives Week



Electronic Trading Roundtable Theisen: I certainly agree with that point. In and of itself, the requirement to build a central limit order book is not overly concerning so long as there’s not a mandate to have to trade a particular instrument exclusively on it. But ultimately, SEFs are in the best position to determine which segment of the market they’re looking to service or cater to. So, if a given instrument is suitable to migrate to trading on a central limit order book, and if a particular SEF hasn’t built a central limit order book, then they’re going to be at a competitive disadvantage to other SEFs. But, likewise, if certain SEFs only want to service a specific niche or less liquid segment of the market, then they should be free to do so. This would allow a natural progression in the marketplace for less liquid instruments to first start trading electronically, and then potentially advance to more competitive trading protocols over time. If you look at what’s happened with on-the-run CDS indices, they have had a natural migration over the past several years, and we do believe that ultimately some portion of this market will trade on a central limit order book. We launched our own market-making algorithm in 2011 to prepare for this likelihood. But it has taken some time for clients to become acclimated to breaking up their trades into smaller lots. It didn’t happen overnight. So you want to allow stepping stones in the development of SEFs that support appropriate market structure evolution.

not happen overnight, but index clearing could be the impetus for clients to start trading some single-names electronically. Diplas: I definitely agree with Sonali. I think credit in particular has had some of the most unintended reverse consequences of DoddFrank, in that it was split as an asset class between swaps and securitybased swaps. So, currently, if you were to create what any market participant would consider to be a very market neutral portfolio for 125 single-names versus the identical index, anyone would say that should obviously have less margin than if you want to trade one side or the other. But given the fact that Dodd-Frank considers the index to be a swap, and 125 names to be a security-based swap, then you

“If the rule went through in its current form, then there would be a substantial impact on liquidity as it will create an adverse condition for buyside participants that are initiating a query, in addition to the dealer respondent.” —Athanassios Diplas, ISDA

Diplas: If you look at other markets such as the DCM framework, the service providers basically are given a lot more latitude in how to determine their own protocols, block sizes, etc. The SEF framework is a lot more restrictive in that sense. I think that by actually following a similar approach to the DCM market would be healthier and we can see how well that framework has worked. Clients definitely vote with their feet and will vote on what offers them the best combination of flexibility, safety, liquidity etc.

are forced currently to margin separately. So you margin basically for these two trades as being completely separate and you have more or less doubled the margin that you would have if you had done only one side of the trade where the margin would be close to zero. It’s inhibiting clients from actually doing what is rational from a risk perspective. But right now it creates a disincentive. So the sooner the SEC approves that rule change then we will see a lot more activity from the client side.

DW: We’ve talked about index CDS in some detail, but looking more specifically at credit, how is the single-name market going to develop once clearing goes live for indices and clients have segregated pools of collateral?

Priyadarshi: We at Vanguard think the credit index market (i.e. CDX) is already in a move towards electronic screen trading. The single-name CDS is going to be very tricky and there is the margining issue which, as Athanassios mentioned, you want to take advantage of crossmargining of portfolio level margining.

Theisen: Single-names have been lagging the index side of the business in terms of trading electronically for multiple reasons. I think it’s reasonable to believe that as index clearing becomes mandatory for clients, those clients will likewise want to clear their single-names, as well as backload CDS positions. Posting of margin is going to be a very different framework than what they’re used to. Separate pools of collateral for cleared versus uncleared positions are just not capital efficient. And so over time as demand picks up for clients to clear single-names, we think clients will increasingly think about executing these trades on a screen in some fashion to take advantage of the downstream processing that is being established for indices. It may 16

Rucker: Personally, I do think that the single-name market is going to migrate towards electronic trading, particularly in the most liquid single-names. I think once firms can see the same benefits and efficiency at the downstream processing that they get for index contracts, it will be another factor to help drive more electronic trading. To reiterate what the other panellists have said, margining is an important issue and may inhibit trading volume until it is resolved. Also, we’ve got to bear in mind that the SEC rulemaking timetable is a long way behind the CFTC. I don’t think any of us are expecting to see final rules for security-based SEFs for quite a few quarters and


Derivatives Week



Electronic Trading Roundtable therefore there is still a lot of uncertainty around that. DW: With the development of the new market structure, greater regulation and cost pressures on financial market participants, particularly banks, what are the challenges to developing and rolling out platforms and services, and how do you prioritise what to offer? Sheftel: It’s going to be a challenge, especially on the sellside, because the buyside is going to determine where the trading happens at the end of the day. The banks are going to build first, because as a liquidity provider it’s a more substantial build that you need to have, especially in an automated world. But then you don’t know which platform people are going to end up wanting to trade on. So there’s no doubt that we’ll look back and realise that some of the build was kind of pointless, but we can’t predict that. So I think what you’ll end up doing is just trying to be smart and efficient about it. It’s not the build per se in of itself, but can you build to be adaptable in the future. Regardless of where the rules come out and how we trade for the first six months, the Ryan Sheftel years after that will look different in some way, shape or form. So it moves from building something that you can predict to probably just thinking about being a lot more adaptable, which is not traditionally what banks are very good at. It causes a change in mind-set and I think that’s going to be the biggest thing. Banks are reasonably good at building towards large, known projects with multi-year horizons, but adaptable and dynamic isn’t really where they usually perform the best, so it’s changing their mentality. But at the same I think a lot of the banks are using this opportunity to recognize this fact and are thinking ‘ok can we change a lot of our processes?’ A lot of people are looking at this and saying, ‘can we be smarter about how we do this because we have a market that grew over a long period of time,’ and now you’re reaching a breakpoint where you’re forced to rethink everything. So I think the sellside will come out of this on the other side saying it was a good thing for those who used this as an opportunity to revaluate how they go about building their technology, what they have, and using it as a reengineering exercise more than just a bolt-on of a whole bunch of new stuff. My perception is that you’re going to be putting a lot more demand on the buyside in terms their capabilities. If everything is being traded electronically, one way or the other you need technology to do that, you need more systems, you need more technology. For many participants who are larger, then they probably already have that. But for some of your mid-size

participants or smaller participants who’ve generally depended upon the Street to effectively provide them with all the technology that they needed, that might not really exist much longer. They are going to need more than that. So they’re going to have to probably develop technology in-house a bit more, something what they’ve not really had to think about in the past. Priyadarshi: From the buyside, certainly a lot of it is welcome change because it allows for straight-through processing all the way from portfolio management systems to the affirmation platform, to the CCPs or SEFs or DCMs and then to our FCMs and executing dealers. So there is obviously operational efficiency but all of this comes at a cost to us and our clients so we do have to evaluate the costs and benefits. Also, getting back to Jim’s point about the evolution of the market structure in terms of what the sellside is going to offer, I think that the revenue model based on principal and market-making is dying. So dealers have to come up with new services such as clearing and execution consulting whereby they’re offering a SEF aggregation platform, where they are offering best execution capabilities to their clients as well as cross-asset trading or straight-trading across different asset classes. I think those would be some of the new platforms that dealers would be looking to build out, but all of this comes at a cost and, as was mentioned previously, the benefits to the dealers aren’t clear yet in terms of; if they do all the SEF aggregation and provide all the other services, what are the benefits to them in terms of revenue? That’s not very clear right now. Theisen: To underscore what Ryan has already said, building technology in an uncertain environment is very complicated, particularly because there is necessary lead-time for projects and we each have our own strategic views and priorities that we’re trying to work on. There are a number of industry-wide initiatives we need for market transformation that are still being vetted. For example, with the certainty of clearing workflow, there are so many different

“It may not happen overnight, but Index clearing could be the impetus for clients to start trading some single-names electronically.” —Sonali Das Theisen, Barclays

considerations and all are technology-dependent. Broadly speaking, the challenge is obviously not to be late to the party, but also not to be too early to the party and go down a route that’s not going to be


17




Electronic Trading Roundtable embraced by the market. I think that having a vision on a strategic flexible architecture is more critical then ever. You can no longer tackle each project ad hoc and only look at the benefit for that specific project. You instead have to see how it fits into your overall strategic vision of how the derivatives market is going to evolve, how the cash market is going to evolve and how it’s going to help you in building the right building blocks. For example if we build something for the U.S., we should ask ourselves: can this likely be leveraged when the rules are written for Europe, or do we anticipate the requirement to change a lot? Its important to consider all the different scenarios before you embark on a build. The scoping process is really complex. Diplas: I think that’s why we have been really focussed in trying to work on the standards and frameworks rather than specific ‘build this one thing,’ etc, because we have to build this stuff globally. I’m not sellside anymore but I think it’s important to understand what role the sellside has played in the ecosystem and understand that the principle of the risk-taking model right now might be challenged, but it is still important enough in providing liquidity. So if you have a world where you take the dealers out as principle liquidity providers, you have to understand the consequences for that. Fine, if something is extremely liquid in normal market conditions perhaps they may not be needed However, in a more directional or volatile situation where dealers traditionally effectively guarantee being there to put their capital at risk and provide liquidity, that has been and is very important for the markets. It would be very difficult to say therefore, that they will only play an agency role going forward. Sheftel: I just want to add two things: markets always need liquidity providers, because while liquidity providers/market-makers maybe don’t provide ultimate liquidity, they provide the immediacy of liquidity and I think that’s really the key. If you look at the largest big-cap equity names, from the reports I’ve seen still a vast majority of the trading happens where one-side that would be deemed a liquidity provider. So there are not a lot of examples out there of markets that operate where all pure and natural crossing that takes place. Therefore, there is always going to be a place for liquidity providers and market-making because it provides a useful function to the marketplace. I think the key though is that the rules create a new business called the agency business. So it’s not really one or the other, it’s really now having a liquidity providing function and now, based upon the regulation of putting a SEF in the middle between the price-taker and the price-maker, it creates a new industry of someone helping the price-taker get to the marketplace. Where the regulation could also create a quite complex marketplace, then there could be high demand for the price-taker or the ultimate end user to really need help finding where the liquidity is. Theisen: I would add a comment with respect to credit. In thinking 18

about an agency model versus a principal model, there are a couple of things to highlight. First, in an agency model, liquidity takers need to be comfortable managing their own execution risk and breaking up trades into smaller lots. Second, if you look at equities or other markets where there is more of an agency component, they’re almost diametrically opposed to credit in terms of the number of participants to the number of instruments traded. In those markets, there are lot of participants trading relatively few products, whereas credit has relatively few participants trading large number of instruments. These two factors make the agency model argument more difficult in the credit space. This is less true with the on-the-run index market, which we’ve already said has greater potential to move in some portion to a central limit order book. So I believe there might be some agency component in the credit market in the future, but it’s not our view that the credit market will migrate predominantly towards an agency model. Rucker: Listening to the conversation, it seems that the extent of the regulations and the layers of complexity in them are creating a significant cost for all participants in the industry. I certainly know that is the case for SEFs but listening to what other people have said, I think that is the case for the sellside and buyside. In my view, that creates significant barriers to entry, and it is unclear if that is

“In my personal view, what we want to avoid are rules that are overly prescriptive, that don’t allow for the way the market trades today, but also don’t allow platforms to evolve and develop as the market does.” —Jim Rucker, MarketAxess

an intended or unintended consequence of the regulation. But it certainly seems to me that for any participant in the industry, whatever angle they come from, the rules are creating very significant costs. In terms of MarketAxess as a SEF, our priorities are two-fold. First, we obviously need to ensure that we are compliant with the regulations; and it is difficult for us to do that at the moment until the SEF rules are finalized. We’ve made some assumptions and had to invest a fair amount of technology spend to prepare for it. Secondly, another important driver of our technology spend is client demand. Therefore, we are introducing new trading protocols, in line with the style of trading that our clients want to do. Currently we have both request-for-quote (RFQ) for CDS as well as live-streaming prices and we have also built all the connectivity needed into both the swap data repositories (SDRs) and the clearinghouses.





People DataBank

M

ovement in the derivatives world was rife last week. Citigroup saw the exit of its head of equities trading for Europe, the Middle East and Africa, while, JPMorgan lost its head of trading and execution services in Tokyo. There was also a move from the sellside to the buyside, with David Gallers, the former head of credit default swaps index trading at UBS, joining investment manager Lucidus Capital Partners.

Month-to-Date Arrivals & Departures Arrivals Firm

Name

Role

Firm

Name

Role

BAML

Arnaud Droitcourt

Equity derivatives team

Velocity Trade

Sal Provenzano

Head, institutional fx

BAML

Julien Bahurel

Equity derivatives team

Citigroup

Joseph Chang

Barclays

Richard Connell

Director and head, structured rates trading

Promotion, Head, prime finance, AsiaPacific

BlueCrest Capital Management

Yohann Freoa

Equity derivatives

Citigroup

Cornelius Griffin

Equity derivatives

Firm

Name

Role

Citigroup

Paul Mandell

Equity derivatives

ANZ Bank

David Carr

Global head, sales

Citigroup

Imran Lakha

Senior equity index options trader

BAML

Kevin Holmes

Head, U.S. dollar interest rate options trading

Credit Suisse

Victor Lin

U.S. dollar interest rates options trader

Citigroup

Ronan Connolly

Head, equities trading,EMEA

Exotix

Stephen Best

Fixed-income credit markets group

Citigroup

Nicholas Brophy

Head, US dollar interest rates trading

Exotix

Michael Rimmell

Fixed-income credit markets group

Goldman Sachs

Yohann Freoa

Senior equity derivatives trader

Exotix

Hanspeter Jaberg

Managing director, fixed-income credit markets group

Nomura

Emmanuel Slezack

Head, index flow derivatives trading, Asia ex Japan

Horizons USA

Joe Cunningham

EVP and head, capital markets

Nomura

Jean El Khoury

Head, equities trading

Lucidus Capital Partners

David Gallers

Portfolio Manager

UBS

Julien Bahurel

Co-head, equity derivatives distribution

Departures

YTD Arrivals and Departures by Location

YTD Arrivals and Departures by Asset Class Commodities

20

Arrivals Departures

Credit

Arrivals Departures

15

Equity Fixed Income

10

FX Interest Rates

5

Structured Products 0

5

10

15

20

25

30

35

0

Hong London New Singapore Sydney Kong York

Tokyo

The information is gathered from our own reporting in addition to other market sources. To supply information, contact Managing Editor Rob McGlinchey in London at [email protected], or Executive Editor Peter Thompson in Chicago at [email protected].



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Learning Curve The Financial Services Act & New U.K. Regulation Framework By Simon Crown, Partner at Clifford Chance

From 1 April 2013, a new financial regulation framework took effect in the U.K. The Financial Services Authority (FSA) is replaced by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA), the Bank of England is to have overall responsibility for financial stability and a new Financial Policy Committee (FPC) of the Bank of England is being created. However, the Financial Services Act 2012 does more than just give effect to these regulatory reforms. In this briefing we provide an overview of the new framework and summarize some of the other main areas of change, including the resolution powers under the Banking Act 2009 and the law relating to market manipulation.

1. Overview The Financial Services Act 2012 implements significant changes to the U.K. financial regulation framework by amending the relevant provisions of the Financial Services and Markets Act 2000 (FSMA). In addition, the 2012 Act will: • restructure and broaden the law relating to market manipulation and misleading statements and impressions; • extend the scope of the special resolution regime under the Banking Act 2009; • create a new category of regulated activity in relation to benchmarks (e.g. LIBOR) and credit ratings; • change the regime for the approval, supervision and discipline of sponsors under FSMA; and • allow the regulation of consumer credit to be transferred to the FCA.

2. Who’s Who The Prudential Regulation Authority (PRA) is a subsidiary of the Bank of England. It will be responsible for the prudential regulation of deposit takers, insurers and major investment firms. The Financial Conduct Authority (FCA) will be responsible for conduct regulation and also for the prudential regulation of nonPRA firms (i.e. smaller investment firms, exchanges and other financial services providers). It will replace the FSA as the authority responsible for the official list under Part 6 of FSMA. The Financial Policy Committee (FPC) will be primarily responsible for assisting the Bank of England in achieving its financial stability objective and will be given powers of recommendation and direction (to the FCA or the PRA) to address systemic risk. The Bank of England will have overall responsibility for financial 20

Simon Crown

stability. The Bank will also be the appropriate regulator for recognized clearing houses and will have the power to direct a U.K. clearing house in certain circumstances. See section 5 below for more detail.

3. Misleading Statements & Impressions Offences The 2012 Act will restructure and broaden the ambit of the law relating to market manipulation and misleading statements and impressions. The existing offence, for misleading statements and practices, under section 397 of FSMA is being repealed and replaced by three separate offences: • misleading statements (section 89 of the 2012 Act); • misleading impressions (section 90 of the 2012 Act); and • misleading statements etc in relation to benchmarks (section 91 of the 2012 Act). Together, the new misleading statements and misleading impressions offences largely cover the same ground as the existing single offence under section 397 of FSMA. However, the misleading impressions offence will be slightly broader than its predecessor in that it includes misleading impressions made recklessly in addition to those made intentionally. The new offence for misleading statements etc in relation to benchmarks is being introduced in response to the final report of the Wheatley Review of LIBOR, which recommended that the criminal law should be amended to cover manipulation of LIBOR.

4. Changes To The Banking Act 2009 Not all of the legislative change being made by the 2012 Act is scheduled for implementation on 1 April 2013. The 2012 Act will also be making changes to the Banking Act 2009, including the extension of the special resolution regime (which is currently available in respect of U.K. banks and building societies) to certain U.K. investment firms, certain group companies of U.K. banks and U.K. investment firms, and U.K. clearing houses. Implementation dates for the majority of the changes to the Banking Act 2009 have not yet been provided (although we understand, from the Treasury, that summer 2013 is a possibility).




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Learning Curve 5. Roles & Powers Of Regulators Prudential Regulation Authority The PRA will be responsible for promoting the stable and prudent operation of the financial system through the regulation of all deposit-taking institutions (banks, building societies and credit unions), insurers and the major investment firms (together, PRAauthorized persons). The PRA’s general objective is to promote the safety and soundness of PRA-authorized persons. To advance that objective, the PRA will seek to ensure that the business of PRA-authorized persons is carried on in a way which avoids any adverse effect on the stability of the U.K. financial system. It will also seek to minimize the adverse effect that the failure of a PRA-authorized person could be expected to have on the stability of the U.K. financial system. Additionally, commensurate with its responsibility for regulating insurers, the PRA has an insurance objective: to contribute to the securing of an appropriate degree of protection for those who are or may become policyholders. In discharging its general functions, the PRA is to have regard to the regulatory principles applicable to both the PRA and the FCA and also to the need to minimize any adverse effect on competition in the relevant markets. The 2012 Act also makes provision for the setting of further objectives. Financial Conduct Authority The FCA will be responsible for regulation of conduct in retail, as well as wholesale, financial markets and the infrastructure that supports those markets. The FCA will also have responsibility for the prudential regulation of firms that do not fall under the PRA’s scope. The FCA’s strategic objective is to ensure that the relevant markets function well. Its operational objectives are: to secure an appropriate degree of protection for consumers; to protect and enhance the integrity of the U.K. financial system; and to promote effective competition in the interests of consumers in the markets for regulated financial services or services provided by a recognized investment exchange in carrying on exempt regulated activities. The FCA is tasked with maintaining arrangements for supervising authorized persons, monitoring compliance and taking enforcement action. The FCA will have a wide range of rule-making powers, which in some cases go beyond the powers currently enjoyed by the FSA. For example, the FCA will have the power to make product intervention rules, prohibiting authorized persons from entering into specified agreements if the FCA considers it to be necessary or expedient for the purposes of advancing the consumer protection objective or the competition objective (the Treasury may by order extend this to include also the integrity objective). Contravention of a product intervention rule could VOL. XXII, NO. 16 / April 22, 2013

lead to the relevant agreement or obligation being unenforceable against any person or specified person, and to the recovery of money paid or property transferred and to the payment of compensation. Co-ordination & Co-operation The PRA and the FCA have a duty to co-ordinate the exercise of their functions. In certain circumstances, the PRA may, if it considers it necessary, direct the FCA to refrain from exercising its regulatory or insolvency powers in relation to PRA-authorized persons if the PRA is of the opinion that the exercise of the power in the manner proposed may threaten the stability of the U.K. financial system or result in the failure of a PRA-authorized person in a way that would adversely affect the U.K. financial system. Both the FCA and the PRA must take appropriate steps to cooperate with the Bank of England in connection with, among other things, the Bank’s pursuit of its financial stability objective. Financial Policy Committee The FPC is a sub-committee of the Court of Directors of the Bank of England, consisting of the Governor of the Bank, the Deputy Governor of the Bank, the Chief Executive of the FCA, a member appointed by the Governor of the Bank after consultation with the Chancellor of the Exchequer, four members appointed by the Chancellor of the Exchequer and a representative of the Treasury. The FPC is primarily responsible for contributing to the achievement by the Bank of its financial stability objective (the FPC also has a role in supporting the economic policy of the Government, including its objectives for growth and employment). To this end, the FPC will identify, monitor and take action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the U.K. financial system. Those risks include systemic risks attributable to structural features of financial markets, such as connections between financial institutions, systemic risks attributable to the distribution of risk within the financial sector, and unsustainable levels of leverage, debt or credit growth. The FPC may give directions to the FCA or the PRA requiring them to exercise their functions so as to ensure the implementation of a macro-prudential measure (prescribed by the Treasury by order) described in the direction. In addition, the FPC may make recommendations within the Bank, including as to the provision by the Bank of financial assistance to financial institutions and the exercise by the Bank of its functions in relation to payment systems, settlement systems and clearing houses.


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Q&A Roger Naylor, UBS Roger Naylor is head of global equity derivatives at UBS in London. He joined in the summer from Deutsche Bank, where he was head of global equity derivatives and global head of equity risk. He spoke to Managing Editor Rob McGlinchey and Associate Reporter Hazel Sheffield regarding UBS’ growth plans, his views on the great rotation and current popular equity derivative strategies on the Nikkei.

DI: You’ve been at UBS now for around seven months. What attracted you to the firm and how are you planning to develop its equity derivative business globally? Roger Naylor: A number of things attracted me to UBS, starting with the firm’s clear commitment to global equities and equity derivatives. Leadership in structured products and the strength of the franchise were very important; especially the dominance in Asia Pacific which is a region I believe is particularly difficult to break into. In terms of areas we’d like to develop further, I see a strong future for corporate derivatives where UBS is already a significant player. For the last decade this has been an interesting and profitable business and I see no reason why it won’t continue to be a major contributor to the overall equity business. In Asia Pacific we have a very strong franchise for both linear and non-linear corporate derivatives. In EMEA we are a significant player and still growing and likewise in North America. DI: In South America, how big is the corporate derivatives market? RN: It’s an open question. There’s clearly a demand for financing structures in Latin America as there is in Asia and emerging Europe. My personal opinion is that there hasn’t been as big a revenue opportunity in Latin America but I think that may change. So it’s an area we’re watching, but it’s not currently as active as Asia and emerging Europe. DI: Looking at Asia, a lot of your competitors are looking at developing their equity derivatives presence, particularly corporate derivatives, in countries like Vietnam, Indonesia, Thailand and Taiwan. Have you already got a presence in those countries? RN: Yes, we definitely have a presence in those countries already. As I said, our Asia franchise is one of the things we’re most proud of so the fact that we already have a great corporate derivatives business and we’re strong in Asia Pacific intersects nicely. We’re well beyond just being active in one or two of the larger markets, and have deep relationships across the entire region. 22

Roger Naylor

DI: What are your views on two other countries that are being focused on more by the sellside and investors in equity derivatives—South Africa and Turkey? RN: These are two very different markets. South Africa is a very mature market where derivatives have been traded actively for over a decade. Turkey is a much newer market for derivatives and also for retail structured products. UBS has a good presence there, with cash traders and research analysts locally as well as some macro research coverage from London. Our cash market share has been growing and we find the market attractive. In terms of the derivative opportunities I don’t think there’s an enormous amount of flow derivative business right now in Turkey, aside from the listed futures that trade in decent volume. The business we’re doing tends to come through our wealth “For the last decade management division. We have this has been an capability in both index and interesting and single stock derivatives and profitable business and I do think it’s an interesting and growing market. Given I see no reason why it won’t continue to be UBS’s strength in retail public distribution products globally—I a major contributor think it’s fair to say we’re number to the overall equity one by volume if you consider business..” Hong Kong, Germany and Switzerland--it’s a logical next step for us to look at Turkey, and maybe for international as well as local underlyings. DI: How much of an advantage is it for UBS’ equity derivatives and structured products business to have an electronic platform such as Equity Investor? RN: It’s significant. Equity Investor gives us an advantage because transacting through it requires no manual intervention and therefore we can handle very small ticket sizes, even down to a few thousand dollars notional. It’s definitely an important part of our structured




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Q&A products business. One thing I would add is that the structured products business goes beyond servicing UBS Wealth Management, although that is clearly a critical part of it. We also provide solutions to private banks around the world. DI: What’s your current take on the great rotation, where investors are moving out of fixed income products into equity derivatives products? RN: I think it’s a bit premature to get very “Significantly though, in excited about this Europe we recently facilitated story. I’ve seen it several transactions whereby mentioned a lot, and insurance companies bought there’s continual hope within the equity world long-dated structured that this theme is real calls instead of buying the and will be sustained. underlying equities, which is At the beginning of more efficient for them under this year it did feel like Solvency II.” we were witnessing a rotation due to the dramatic pickup in equity structured product volumes. I think it’s premature to say that we’re seeing a big rotation into equities though--whilst there has been some movement out of investment-grade credit, much of this has actually been into high-yield credit. On a positive note for our business, there’s been a clear increase in demand for high-yield equity structured products, reverse convertibles and autocallables. We’ve also had a lot more requests for products based on high dividend-yielding stocks. Whilst expectations of continued low interest rates are driving a hunt for yield, I’m not sure it’s yet got to the point where we can call it a fully fledged rotation. DI: Volume in Vstoxx options and mini-futures has increased significantly over the last year. In what ways are you seeing institutional investors now use the Vstoxx not only for hedging, but also to generate alpha? RN: The main activity we witnessed so far was from institutions using Vstoxx as a proxy hedge for their equity exposures. When the VIX and the VSTOXX have been low we’ve seen interest to buy call spreads and call flies on these indices. The other activity we’ve seen on both indices has been hedge funds trading the shape of the term structure. We have a couple of new products that have launched including the UBS DOVE index which has several different forms and is targeted at institutional investors. It gives you either outright exposure to volatility or exposure to the shape of the curve. In terms of the actual volume going through the VSTOXX, it hasn’t picked up as quickly as I hoped it would. VOL. XXII, NO. 16 / April 22, 2013

While the growth rate has been impressive it’s still got a very long way to go before it becomes anywhere near the scale of the VIX. DI: What’s unique about DOVE compared to other volatility products? RN: It’s a simple and transparent way for institutions to get enhanced exposure to equity market vol. We believe our backtesting shows the algorithm behind the strategy to be lower risk and higher performance than other products in the market. DI: Have you seen an increase among institutional investors to buy convexity on the S&P 500 recently? RN: There’s more demand for convexity generally, through wing options and also variance versus vol. I wouldn’t say there’s been a huge pickup in activity yet but we’re fielding more requests for it. I think, logically, given the uncertainties in the world and the fact that convexity has recently become a lot cheaper to own, it makes sense to look at it. Relatively few people are pulling the trigger on the trade because there’s still a lot of faith in policy makers’ ability to stop us falling back into a full-on crisis. They’re also expensive positions to carry, even at the current levels. DI: This year has all been about Nikkei and Japan, when you take into consideration volumes. What do you feel is the next stage in terms of equity derivative strategies to play the increase in Japan’s equity derivative market? For example, do you expect outperformance options on the Nikkei against regional Asia indices and European indices to increase? RN: I think implied vol is too high for outperformance options to be attractive, which is why most clients have been expressing views “Whilst expectations of through vanillas. The next option continued low interest expiry will see a lot of in-the-money rates are driving a hunt calls expiring, owned in many for yield, I’m not sure cases by international hedge funds. But, perhaps surprisingly given it’s yet got to the point the size of the move we’ve had, where we can call it a there continues to be interest for fully-fledged rotation.” Nikkei upside with clients rolling call strikes up and extending tenors. The other effect of the recent rally is the volume of structured products that will now knock out if we remain at these Nikkei spot levels. If I had to estimate the proportion of total outstanding issuance that will knock out within the next three months I’d say it’s well over 65% These products are still being replaced at a reasonable rate through new issuance and I expect they will continue to dominate market dynamics.


23

DerivativesWeek


DI: In the past, we have seen a lot of long-term variable annuity hedging coming out of the U.S. Yet, with Solvency II, how have you seen this type of hedging increase in Europe from an equity derivatives perspective? RN: It’s been a topic of discussion for quite some time, and one that our structuring team has been engaged in. In the U.S. the liability-hedging strategies of insurance companies have driven the long end of the market for many years, first through variance and then through vanilla put options. More recently the maturity of these trades has become shorter but it’s still an enormously influential factor in shaping the curve in the U.S. We’re nowhere near that situation in Europe. In some ways it’s a similar story to the VSTOXX versus the VIX—over time it will probably become more significant but it’s a slower process than anticipated. Significantly though, in Europe we recently facilitated several transactions whereby insurance companies bought long-dated structured calls instead of buying the underlying equities, which is more efficient for them under Solvency II. DI: There has been a lot of activity in options on emerging market ETFs, such as Mexico vs. Brazil, for example. Is that theme continuing in the market at present? RN: Yes, that’s still going on. For years now there’s been decent flow on EEM in particular, because it’s a low vol, liquid way to get exposure to global emerging markets. We’ve seen a reasonable amount of emerging market structured product flow recently, and emerging market correlation products have also traded. There’s now some liquidity in the secondary market to hedge the major pairs, so it is possible to cover the correlation risk that you sell through issuance of global emerging market products, DI: Finally, what is your biggest concern in terms of regulation? RN: If I had to pick a single issue it would be the financial transaction tax. A number of well-balanced research notes have been published on the possible unintended consequences of the FTT, but more valuable than any report is the real effect that we’re already witnessing. In Italy where a version of the FTT has been brought into law, single stock options have virtually stopped trading. When pricing derivatives in a market with an FTT there are two components to consider—the first is the tax on the derivative transaction itself, which will be detrimental to the liquidity of that market. This would be a devastating problem for high-volume markets such as repo, but for long-dated and relatively low volume products a one-off tax would not necessarily make the product economically unviable. However, if market-makers are subject to the tax every time they buy or sell stock to dynamically hedge gamma through the life of the trade, this will have the effect of widening the bid/ offer spread significantly which in turn could make the product completely unviable. It remains to be seen how the implementation of the FTT will play out, but in its current form I would expect it to be prohibitive for a lot of flow businesses. 24


CS In Best (Continued from page 1) “[In] the multi-bonus certificates, if you hit the barrier you get the worst-of. If you don’t hit the barrier you get the bonus level (100%) or if better, the basket performance. The difference is now that, instead of having a bonus of 10, 20, 30%, or whatever, you invest in a best-of call which leads to the performance of the best-of if no barrier has been touched,” Thomas Schmidlin, head of equity derivative sales, Switzerland, in Zurich, told DI. “The big difference is if you have not touched the barrier and the performance of one of the shares is positive, you get the performance of the best. So if ABB is +5, Zurich is -10 and Nestlé is +20, you get 20% on top of your notional.” The certificates, which mature May 13, 2015, are not capital protected. The underlying shares in the certificates have a barrier level of 65%, meaning one share must fall by more than 35% from its initial level for an investor’s capital to subject to a potential loss. The best-of bonus certificate is the latest innovation in structured products in Switzerland, which has seen the launch of structures such as full participation reverse convertible structured products (DI, 11/1), and collateral-secured instrument structured products, which have subsequently grown in popularity throughout Europe. Schmidlin added that the new offering from Credit Suisse fills a gap in the structured products market. “For example—from an investors point of view as to why you might be interested in this—I once had a discussion with an investor, he was very bullish on financials and he didn’t know which financial share to choose,” he noted. “So in this case, I would definitely say now, ‘Why don’t you invest in a best-of bonus certificate, as you can then get the performance of the best of a selection of financial shares.’” —Rob McGlinchey

Events • The International Swaps and Derivatives Association will hold a conference on implementing E.U. derivatives regulation on May 14 at its headquarters in London. Topics will include implementing the European Market Infrastructure Regulation clearing obligation, non-cleared trades, and potential ISDA documentation implications of EMIR compliance. • Futures and Options World will host its fifth Derivatives World Latin America conference on June 5 at the Grand Hyatt in São Paulo. The cross-asset focus of the conference will cover areas such as challenges posed by the fall in interest rates in Brazil, in addition to trends and new product launches in the region. For further information, visit www.fowevents.com.

Quote of the Week “While the growth rate has been impressive, it’s still got a very long way to go before it becomes anywhere near the scale of the VIX.”— Roger Naylor, head of global equity derivatives at UBS in London, on the Vstoxx following increased volume in mini-futures and options on the index over the last few years (see Q&A, page 23).



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