Towards mainstream

GI I would like to start off the discussion by getting an understanding of the status quo of the derivatives market currently. What is happening in terms of products and volumes, and how has interest developed in the last two years?

MB We’ve seen very substantial growth worldwide over the past five years. This is reflected in the trading volumes across asset classes and across products. I think that the industry knowledge and feel for derivative products in general has improved enormously.
From an educational point of view, we see fund managers and institutional investors who are becoming more active in coming towards exchanges and institutions that are already in the market, to get more education, and to get more intelligence on how to use derivatives. We see a lot of asset management operations hiring from the pool of skills in the major financial centres.

CW Several things jump out from the last time that we got together and I think that the biggest single change has been that volatility has emerged as a separate asset class. This wasn’t so prevalent first time round and the change is reflected in the published research, the increased focus on volatility indices and the development of volatility products. Secondly we have seen a convergence in styles as the boundaries between traditional asset management and hedge fund style trading have become blurred. Institutional fund managers have become more volatility aware and meanwhile many hedge fund traders have become increasingly focussed on direction as true arbitrage strategies become more crowded.
Finally, in terms of product development and coverage, the market has become better at asking for what it wants. The providers and the exchanges have become better at listening and trying to proactively deliver.

AD I’m coming from the over-the-counter (OTC) market perspective rather than the exchanges. All OTC markets have seen growth in the last two years. The last year has taken the credit derivatives market beyond the volume of the equity derivative market. It is still nothing compared to the scale of the interest rate credit derivative market, which has over $200trn (e167trn) outstanding, whereas the credit derivative market has just gone through the trillion mark in terms of traded volumes. There are several reasons for that. There is the development of non-bespoke, flow products that will actually lend themselves at some point to be exchange traded. For example, let’s look at the development of indices. There are very liquid, tradable credit indices which did not exist a little while ago. They are a good complement to the benchmarks that the asset managers may trade. So all these developments are what is driving volumes.
Even with that increase in volume on the credit market, there is still very little involvement with exchanges, although there are discussions about having products that are exchange quoted. And I think that is the next big development that we’ll see.
It is one of the things we’re looking forward to, to having a dialogue with exchanges and putting more products on there from the perspective of the end-user.
Another thing has happened already is that data providers have come to the market. But there is a limited amount of official data available, all the data out there is market-player data. As soon as you start getting official numbers you can rely on for risk management purposes, then you can move onto the next phase.

GI How are we using derivatives, let’s get a perspective from the users?

TB I am involved in the management of various kinds of equity portfolios at Erste Sparinvest and in the past we had the traditional long only fund management perspective. For us the use of derivatives was primarily for buying portfolio protection, managing exposure at the portfolio level and maybe in some cases override strategies on the single stock side. It has developed in recent years towards using leverage and more sophisticated strategies for market exposure or exposure to changes in volatility, for example directional or relative value.
There’s a broad range of interest for such investment techniques from institutional clients for several reasons. There is a search for yield in times of historically very low government bond yield. So every asset class that can offer some sort of yield pick-up attracts interest.
On the other hand, equity is still viewed as very risky by clients, who are still looking for protection, or some kind of insurance, or at least diversification and, on top, need an investment strategy that matches their liabilities. Products are needed that are not the same as the traditional asset classes, and therefore have low correlation not just in normal times, but also they have to be low correlated when it comes to extreme events. What one can observe, from historical uncorrelated products like corporate bonds up to emerging markets equity, is that, when it comes to extreme events, because of the flight to quality, the correlation spikes up and you don’t observe the wanted insurance or diversification. You don’t have the diversification right at the time when you need it.

TL I agree with my colleagues. There has been a constant growth in the derivative market concerning volumes and new products and the usage of derivatives by asset management companies. I think the major issue in the last 12-15 months which boosted the derivatives business in Germany was the implementation of UCITS III into national law. The new German investment law opens up great opportunities for a manifold usage of derivatives in the portfolios especially on the institutional side. UCITS will pave the way for a more united approach of using derivatives in pension funds across Europe.
We try to achieve four main goals by using derivatives in our portfolios: transaction cost minimisation, yield enhancement, portfolio optimisation and hedging strategies.
Our company uses mainly listed products. The OTC world is more challenging for the asset managers because of the counterparty restrictions you are limited with, the credit lines and ISDA agreements that have to be in place. Nevertheless we see constant growth on both the OTC and listed business.

JH I would probably say that I’ve seen slightly less growth from my end, partly because I’m a UK asset manager and partly because we’ve had a number of mergers, and that doesn’t help from a systems point of view. We are heavy users of derivatives. Several years ago, when the market was high and it started falling, all of our big institutional clients were looking for hedges and we used them a lot. Once the market value increased, then quite rightly a lot of clients have stepped away from that. I would still say that our derivatives usage is more client driven than fund management driven, but the difference between traditional asset managers and hedge funds is reducing, as the two have essentially become more alike. The hedge funds have become bigger and in a sense more institutional like. And similarly institutions have tried to retain key staff by giving them hedge funds.
On the pension fund side, a lot of the schemes were in disarray, a lot of funds were in deficit when the market was down, but since the rebound a lot of these schemes are getting closer to surplus or to a much healthier state so they are looking for ways to hedge. They probably don’t just want to sell futures, they want maybe some put option exposure.

RV In terms of usage, I would like to make a distinction between different points of view. In the alternatives investment business it is usual to have OTC and listed derivatives. If you look at the traditional management side, which is really the long only, I think it’s still quite new. It is, however, more and more used in the management of funds. UCITS III is also helping. If we are looking from all sides, on the institutional mandates, I think the use of derivatives is growing but it is still limited. There are still big institutional clients who are very defensive on the usage of derivatives and they still want it to be easy. They want to have simple products and I must say that between OTC and listed, we are doing quite a lot of OTC because there we offer a package, and in terms of accounting this is easier for the clients. So I’m not so convinced that a lot of institutional clients are using derivatives very actively.

SK I started my career about eight years ago as a cash trader for Goldman Sachs New York, and then after a couple of years I went to trade options at Lehman Brothers for five years. I’ve been at KBC for three years, and my biggest observation is really the increase in the degree of sophistication by the end clients. When I started off as a cash trader in New York, we had the options market in the US. The single stock options, were very much dominated by the mutual funds, these guys who were coming for a leverage bet on a stock. They might buy some puts for downside protection, they might buy some upside calls because they want to get involved in the name. And these guys were purely directional. If they paid 50 cents, if they paid 60 cents for that call, they weren’t really so bothered.
And the investment bank community really held the keys, held the power, and they controlled that market. To a degree, in the US market, that is still very much the dynamic. In Europe, what you have seen is a lot more development of secondary effects, volatility for example, as an asset class. So you have dispersion players, people who hedge out the directional moves. And they are looking to take advantage of sharp moves one way or the other in a stock. Hence the European options market became a lot more developed.
Now end-users have very sophisticated dealing systems. They are looking at multi-asset class, what’s going on in equity derivatives and credit derivatives. They are all over the correlation between the tranches of the CLOs, the CDOs, etc, and I think it’s the European market that is a lot more developed, particularly in the last two or three years.

MC I would certainly agree with that. Certainly from an asset management house which runs both hedge funds and long only, I know the push from above is to generate alpha, alpha being the absolute additional return for management decisions. That obviously applies to hedge funds, it applies to long only as well. The pressure is such that managers would be penalised either with losing their job or other penalties like not getting paid a lot if they don’t produce this alpha.
So I think there’s a certain need to find this diversified return. Now fund management as a whole is upskilling. In the past you would make a company visit, you like the stock, you would go and buy some and sit with it for four years. It has moved on from there now, because of the requirements of both holders of the funds, shareholders of the asset management business, and demand consistent returns. The only way you can actually provide consistent returns is by diversified sources of non-correlated return. So the pressure is on finding various sources of this outperformance, it could come from volatility, it could come from alternative assets, it could come from credit risk. The job is for the fund manager to seek those ways to create that alpha. Derivatives are probably the easiest way to do that.

GI Let’s look at pension funds themselves. The point was made that many of them are still very defensive. Let’s look at their problems. Over the last few years a number of issues and challenges have emerged: falling markets, falling interest rates, which are of course pushing liabilities up, funding problems, solvency issues, increasing longevity, and lower expected returns from all sides. You have regulators panicking, sponsors panicking, members panicking when difficult situations arise. And it just seems that some of these problems have been the trigger for looking at the derivatives area with a more open mind.
But looking forward now, what are the most important things for pension funds to do and how can derivatives help in solving their problems?

MC My view certainly for pension funds is first of all understand your liabilities. And really understand the dynamics of what those liabilities are. I think there was almost a myopic focus on the level of the equity market during the times when it was falling, when the real risk to pension funds was interest rates. As interest rates were tumbling their liabilities were getting bigger. They didn’t have their eye on the ball, and when they hedged their equities they suddenly realised they hadn’t hedged their bond risk and duration risk and had to really look at ways to do that. So I think understand every dynamic.

JH Pension trustees usually have consultants who advise them, but one suggestion I would have, is that you need someone on that trustee board who understands. You could argue that you need a non-executive type structure where you have one or two people who aren’t attached to the scheme, but act as advisers and are not investment consultants. I would argue you need some sophistication within that trustee board to best understand how to asset allocate and manage risk and return. That’s one of the fundamental problems with the structure of pension funds.

AD There is plenty of advice out there. Investment banks are providing advice, consultants are providing advice, the asset managers are providing advice. But the decision at the end of the day still rests, particularly in the UK, with the trustees. That decision-making power has been taken away from the corporate. The treasurer no longer has the right to make the decision. Actually, it is the corporate treasury that has a good understanding about the products. But that decision-making process goes to the trustee. It’s not as if they do not get a lot of advice but they still have to make the decision.

CW I agree. We generally find that the key decision-makers within the pension funds such as the chief investment officer, senior fund mangers or head of dealing are sophisticated and well-informed derivatives practitioners. However, many of the problems in applying best practice comes from restrictions in the mandates provided by the trustees. For example, if the portfolio manager is not allowed to sell options within the fund he is effectively going to battle with one hand tied behind his back. If he is looking to put on some downside protection, rather than buying a put spread and taking advantage of the skew, he can only ever buy puts and this is relatively and absolutely more expensive. It’s all the more frustrating for those within the fund as they understand the issues and can see the inefficiencies.

RV I think the problem with pension funds quite often is the end point. You really have to know where the end point should be and then you have to start to package your portfolio. Some years ago the focus was really on return. How can I optimise my return, what shall I do in terms of diversification to optimise my return. There was no good perspective in terms of risk budget. The problem is always if you start to use risk budgeting techniques, be it by options or other techniques, you always pay something and at the end, the question is, have I done a good job? If you don’t know your end point, and you start using options, often pension funds are thinking, have we not paid too much premium?

GI From my perspective, where things have taken longer than they should have, is looking at the risk/return profile of pension funds for the longer term. How can pension funds make use of derivative instruments in order to help them achieve their long-term objectives? What has been done, what can be done? Is the market really offering longer term instruments?

SK I think that the market is indeed offering longer term instruments but the associated fees have historically been the main issue. There is a lack of transparency on the pricing / risk managementof the more innovative structures and so for the end-user it has been difficult to ascertain what fees/edge/ costs have been incorporated in the price. With the structured products desks becoming more and more important to investment bank trading desks, there have been an increasing number of participants offering such products with the result that the structures become more commoditised and with dramatically tighter margins.

AD It’s interesting you mentioned the long dated side, and in terms of using interest rate swaps to extend duration, the liquidity at that point of the market reduces the further you go out. It’s amazing how sensitive the market is to that. If you look at when the regulations changed in Holland, and at the regulations, what happened was the market assumed there would be a big flow out of equities into fixed income products and at the same time people would look to extend duration.
People made some calculations and the market moved significantly down, but the long end, such as the curve between 10 and 30 years flattened. But then on reflection people had a look and did a bit more modelling on what the regulations actually meant, and it wasn’t the case. So the market went out a bit more. And it just shows that actually there was no net result, there was no trading activity on the back of it, but the market reacted nonetheless. So effectively the market has now priced in at some point, Dutch pension funds doing something. So they actually already have the cost despite the fact that they haven’t done anything.
The price of doing the long dated swaps is not actually that expensive necessarily – you pay a basis point. The market itself is quite efficient but will also react very efficiently to perceived new information. So that’s going to be one of the difficulties.

MC Liquidity is the key. If there is an illiquid instrument at the long end as you say, and regulations clearly says that everyone should be buying this, it pushes the price up. But then if a hedge fund comes in and says, we’ve got lots of money and we can hedge this, slowly the price begins to come down and an equilibrium is found.

CW We have seen a pick-up in the use of longer dated vanilla equity products, but volatility as an asset class has historically been split into two separate market segments: a short-dated liquid market where the flows are primarily driven by equity investors seeking protection, yield enhancement or directional plays; and a longer-dated market where the volumes are lower and the flows are driven by structured product activity.
The two markets are related and longer-dated activity ripples through to the short-end, but there is a lack of natural suppliers of longer-dated volatility and consequently a lack of arbitrageurs. Hedge funds are generally trapped into at best a quarterly or more likely a month-end type cycle, so they are gong to be reluctant to step in as sellers and then take the subsequent P&L volatility of a position that far out.
We have seen some interesting longer-dated structured ALM type products, but generally where there’s mystery there’s margin and if you create a product that’s a little bit opaque and long-dated the market can be nervous as its hard to calculate how much edge has been take out.
As discussed, pension funds may be looking for longer dated products, but the volatility market remains most liquid and efficient in the sub two-year segment and this is unlikely to change in the near term.

GI We have raised the issue of time horizons, longer term products and so on. Defined benefit (DB) plans may be on the way down, and in some countries there seems to be less enthusiasm for them, but they are still there and will be for some time. The particular issues for many now is managing their assets much closer to liabilities, and trying to get better asset diversification. In some places you have minimum return requirements which are coming in, while others are trying to find appropriate longer-term benchmarks. But there are also other issues of what you do when you are closing a plan or have to wind up a plan, which I would think is also a very fertile area for derivatives. What can the providers, the intermediaries, the fund managers, and the pension funds themselves do better in terms of using derivatives to help resolving problems on the DB side?

MC One of the things we’ve noticed is that a lot of pension funds, certainly the small ones use pooled products. A lot of people aren’t prepared to use ISDA agreements and sign up to complex agreements that perhaps they haven’t got the skills to sign up to. So the swaps market might be limited to just the largest pension funds. But pooled products, such as buckets of duration, for example, seem to be quite popular.
The basic point is those who don’t want to invest in swaps can invest in pooled products, if they want some duration going out 10, 20 years. I think you’re going to see more companies issuing pooled-type products which you can mix and match to create the best for your liabilities. And that is an opportunity for asset managers to build on.

CW What is the delivery mechanism for pooled products?

MC It could be collective investment schemes or things like exchnage-traded funds (ETFs). But obviously inside those products there will be a heavy usage of derivatives. If you’re creating a 30-year bucket of duration you need to make sure it’s a constant 30-year duration bucket. So you use swaps and futures and derivatives to do that.