Two years after the global financial crisis that proved cataclysmic for investors, there are only few places in the region that banks describe as ‘happy places’ – markets where they can aggressively sell derivatives and structured products, especially to retail investors. Yet the commitment of some banks to structured products is unwavering.
In Hong Kong and Singapore, a heavy residue of suspicion and anger still lingers after numerous portfolios of high net worth individuals and institutional investors were virtually wiped out by derivative products that turned out to be toxic in the aftermath of the global financial crisis. The most significant exceptions in the region seem to be Australia, and a scattering of markets such as Korea, Malaysia and Japan where among high net worth individuals and institutions, the appetite for risk is coming back, albeit in a moderate fashion.
In view of their keen focus on managing assets and liabilities in a low interest rate environment, insurance companies have been cited by banks as the most active and most consistent in employing derivatives and structured solutions in order to manage risk and achieve yield targets. This is especially so in Korea, where a fair number of medium-sized insurance companies have outgunned some of the bulge-bracket insurance companies in using structured solutions in their portfolios. Bankers believe the former were less distracted, since they were not preparing for their IPOs.
Protecting the public
In June, Hong Kong’s Securities and Futures Commission completed a public consultation on new regulations on how structured products are to be sold to the public. Among other things, the proposed regulations require the mandatory return of cash paid for the investment, if investors decide within a certain period that a purchased product does not suit their needs or risk profile. In addition, banks selling structured products would have to report their financial strength on a regular basis, so as to enable regulators to ascertain whether such banks can stand as reliable counterparties for the products they offer.
“These days,” admits the head for global product distribution in one bank, “Hong Kong is a much less happy place for a majority of us. Near [investment] banks in Central [Hong Kong’s main business district], you still find protesters complaining of the losses they suffered two years ago from derivative instruments, including mini-bonds and accumulators. It is much different in Sydney.”
The public’s psychological and financial trauma proved less severe in Singapore, given that offending banks were ordered by the Singaporean government to promptly compensate investors when the crisis broke. In Taiwan, banks without an onshore presence have been banned from selling structured products into the market. “They put a stop to the practice where people with only their business cards boarded a plane to Taipei, sold products to investors and then left the country with the cash. When things went wrong, the investors and regulators had no one to run after.” At the height of the crisis, complaints were particularly rife against US banks that lacked a licence to operate on the island.
US$1 million a click
The majority of the leading banks in the derivatives and structured products industry managed to ride out 2009 with a respectable performance, in spite of the challenges facing the industry.
The mood was bright too in the first quarter of 2010 and turned cloudy in the second quarter over worries about the introduction of tougher regulations and the uncertainty that was creeping into markets as a result of the European sovereign debt problems.
Matthew Wong, managing director and London-based global head for retail platform distribution at RBS, recalls that the first flow products to come back into the markets after the problems in 2008 were share accumulators, instruments that in 2008 proved so toxic to investors that they shook the confidence in the private banking business. The contracts forced investors to accumulate shares at the peak of the bubble price at a time when the value of those shares were crumbling by as much as 80%. When worldwide equities markets recovered in 2009, investors who actively positioned into this type of flow product benefited handsomely.
Wong points out that the people who did accumulators in 2009 were vastly different from those heavily engaged in 2007. “Those in 2009 were strong, with a whole number of them funding at US$1 million a click.” When the Hong Kong market moved up significantly in September last year, most of the investors made a healthy profit. Wong notes that during that September month, most of the popular stocks for accumulators rebounded strongly, with the exception of PetroChina. The large hedge funds with high holding power managed to come back as well – and brought in more fire power. “Those are the reasons for the respectable performance of our flow business and private banking business last year,” explains Wong.
Wong says sellside institutions have to adjust to the reality of changed markets and regulatory conditions and should invest in systems to take advantage of the volume returning to the market once the new regimes are in place and a full global economic recovery takes hold. “In RBS, once we realized that the volume of the demand for share accumulators was rising again, we provided better service for the flow, introducing auto-pricing for the contracts.”
Considering that accumulator contracts are often generic and standardized, the trades can be automated easily, argues Wong. “Instead of they calling us or we calling them, clients can quote prices through an email instruction using a template which we provide.” Auto-pricing takes the data from a client’s email and then replies or confirms the price at once. At this juncture of market development in the region, opines Wong, derivative and structured product players ought to focus on ways to deliver products efficiently to clients rather than focussing too much on payoff innovation.
No real consensus
Pang: The most important thing is to bring back investor confidence
Henry Pang, head of derivatives and structured products in Asia ex Japan for BNP Paribas, partly faults the World Cup distraction in South Africa for the slowdown in trading activity in accumulators and other products during the second quarter of this year. He expects the rest of the summer to be quiet too, since most will be out for their holiday. In June, for example, Hang Seng Index futures turnovers were among the lowest recorded in recent years. The lack of interest, he asserts, stems from the lack of a sense of direction where the markets are heading. “The more people you talk to, the more diverse views you get.”
Typical discussions in recent weeks has been desultory at best, with the financial press focussing on the debate whether there will be hyperinflation or deflation, or whether the markets are in a bull or bear state. “There seems to be no real consensus.” Pang calls the situation “tricky” as it affects the willingness to participate in stockmarkets and thus dents the sales of equity-linked structured products.
The current uncertainty, Pang notes, is different from that of last year, when the concern was more about whether the market had gone down enough, and when the markets would recover. “There was general disbelief and a lot of people said it was nothing but a dead-cat bounce,” Pang recalls. “But back then, the momentum in the market was strong, with the ‘golden crosses’ in the moving averages indicating bullish signals.”
The market today lacks conviction, feels Pang, and investor opinions often depend on the reports they read or on the websites they happen to look at that day. The diverse views on market direction not only prevail in equities, but in currencies as well. There has even been active speculation about the stability of the Hong Kong dollar’s peg to the US dollar peg.
Volatility as an asset class
Nonetheless, Pang argues that it is in this kind of environment that investors can use derivatives as a powerful tool to achieve investment objectives. “Whenever there is uncertainty about the directions of the market, volatility becomes a good asset class to invest, and a good number of BNP Paribas client-investors take this angle.”
It has become obvious after the financial crisis of the past 18 months, believes Pang, that derivatives and structured products providers need to move on in terms of their expectations. “We are operating in a different era. We welcome changes that will lead to higher transparency and more information related to products for investor protection. We understand that as an industry we need to do more work in terms of product and design.” Once everyone has settled into the new regulatory routine, Pang is confident that the market will benefit the most and the industry will continue on its growth trajectory in the long run. “The most important thing is to bring back investor confidence.”
The result of the consultation process on the sale of structured products to retail investors in Hong Kong has just been published. The new regulations call for a cooling period to allow investors to think through whether the structures suit them, and a mandatory repurchase of products. On the part of the providers, such regulations will require additional work. Approving of the suitability aspect of the new regulations, Pang believes they will introduce a higher degree of transparency into the purchase. “The idea behind the mandatory repurchase is that after investing in the structured product, the investor can unwind a structured product over a prescribed period, subject to the investor taking responsibility for the market movement effect. That is a fair requirement.”
Share accumulators have not died
So far, notes Pang, 2010 has proven to be a year for flow business. In structured products there has been a gradual return to more medium-term products. There is significant appetite for plain-vanilla single-underlying products but other products will likely start to pick up as the year progresses. “We are still waiting for a large-scale return into correlation products. We believe that there is a cycle in the evolution of demand. If there is single underlying demand, then we are going to see demand for more vanilla products.” The interest rate environment is vastly different from 2003, while China is becoming an important asset class and so even in a relatively low activity environment, there is still demand for Chinese underlyings and for structured products linked to Chinese underlyings, according to Pang.
“Investors in this part of the world have become more sophisticated compared to six years ago, thanks to the electronic media,” Pang points out. “As far as the existence of alternative investments goes, they are switched on. The traditional equity investor in the region has ventured into the foreign exchange (FX) market and property. Of course, you therefore have competition coming from other asset classes, especially commodities such as gold. For the retail market, we have provided warrants on commodities and gold.”
Share accumulators have not died. “These are contracts that are here to stay,” Pang states, while cautioning investors to first fully understand the merits and the downsides involved, before making a move on them. “These are highly leveraged instruments – quite often about two times leverage built into the product. Investors should take the cash flow implications into account. It is often all about holding power and margin calls and one should be implementing a stop loss strategy at the time of the transaction.” The average trade size for accumulator contracts has become much lower than two years ago and a slew of players have grown conservative because of the leverage effect and so are generally less concentrated in their positions.
Committed to structured products
Garnier: The silo approach in selling products to clients is gone
More recently, accumulators in fixed income have proliferated too and there are more fancy variations because of the lower volatility, unlike in equities where there is less of a need to put in complex features because the volatility is already pretty high. “We merged the fixed income and equity derivatives structured products into one integrated platform in the middle of last year,” says Yann Garnier, head of sales, cross-asset solutions in the global markets division, Asia-Pacific, at Société Générale, “thus allowing the bank to provide a cross-asset platform where clients enjoy single access to any asset class on the product side as well as in the solution side.” The platform includes equities, commodities, FX, interest rates, credit, funds and hedge funds.
“The silo approach in selling products to clients is gone and the client does no longer talk to someone who may be biased towards a specific asset class,” Garnier explains. The solution offered to clients is based on a discussion of their needs. “Some of these companies find that the traditional interest rate products that they used to work with are not so interesting any more, in light of the current low interest rate regime and alternative products with the same type of duration,” explains Garnier. Since it has been two years since the financial crisis started, most of the valuation problems faced by institutions are behind them and the questions mostly revolve around recovery, according to Garnier who has noticed a marked return of appetite for risk among Asian institutions.
There has been no attrition of the resources at the structuring and derivatives platform at Société Générale, says Garnier. “We want to maintain the resources that we have and intend to continue hiring people in segments where we feel we need more coverage. For instance, during the crisis the group realized that it needed to enhance their investment in private banking in Hong Kong.” This explains the subsequent major recruitment drive. “Servicing private banks is taxing, because of their high demands. You have to be up to standard to become one of their preferred partners. It is about the depth and quality of service we provide.”
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