Selling volatility is a dangerous game. Having a little of it around is a good thing, to encourage clients to buy the stuff that your structured equity division churns out. Too much of it, however, and the hedges that sit behind that business can blow up in your face.
That’s what happened in the first quarter of 2020 at those French banks that make a business of selling structured products. But not all bad experiences were equal.
On paper, they looked similar enough. Revenues in the equities division at BNP Paribas fell to minus €87 million, a swing of nearly 120% in the wrong direction when compared with the first quarter of 2019. At Natixis, equities was minus-€32 million, a swing of 125%.
Frédéric Oudéa, Societe Generale
At Societe Generale, the business at least stayed in the black, with revenues of €9 million, for a fall of 99%. So, SocGen was the best of a bad bunch, right?
Not necessarily. Some equity derivatives folk reckon it might be more prone to stress in these conditions than its competitors.
The bank’s chief executive, Frédéric Oudéa, certainly says there is reason to rethink what it is doing. He told the Financial Times on April 30 that it would have to “accelerate the transition to simpler products to limit the impact in such incredible scenarios” as the current crisis.
A good chunk of the structured products being sold by these banks are linked to equity indices. Hedging them typically involves holding a basket of the underlying stocks. Doing that means the bank is structurally long dividends, and it’s a good job too – much of the time they are a big part of making this business profitable.
And there’s the first problem that all the banks suffered in the first quarter. European supervisory pressure for banks and insurers to cancel dividend payments for 2019, often after those dividends had been approved or when they were just about to be paid, wrecked the business model for a lot of structured products.
The failure to pay would mostly not have been hedged, since the probability of pay-out would have been close to 100% at the time when the shock came about. On top of that, many companies in other sectors also suspended dividend payments.
BNPP says it is taking a one-off charge of €184 million related to the dividend restrictions. SocGen says its hit was about €200 million, while Natixis has disclosed a €130 million mark-down.
(As an aside, that Natixis number also raised some eyebrows, given that some in the market would have expected Natixis’s basket-arbitrage book to be much smaller than its mark-down would suggest.)
But the dividend cut is not the whole story, as BNP Paribas CFO Lars Machenil acknowledged on his first-quarter earnings call with analysts. He said that after stripping out the dividend hit, the equity derivatives business lost in March roughly what it had made in January and February.
He blamed the very heavy volatility, which increased hedging costs. Selling products with embedded options requires effective dynamic hedging strategies to keep the bank’s positions as delta-neutral as possible throughout the life of the products. As volatility rises, that hedging becomes more necessary, but also more difficult and expensive. There will also be a lag.
And then on top of that there are reserves. At month-end, banks provision for the cost of closing out their positions. The day-to-day mark to market will be based on the bid/ask mid-point of the relevant securities, so the period-end accounting reserve provisions will be half of the spread.
Spreads were much wider than usual at the end of March, however, so close-out reserves are up.
The problem SocGen faces – and what Oudéa would doubtless have been alluding to – is that over the years his bank has increased the importance to its business of structured products. But good access to other avenues like flow business is crucial for unwinding of risk, so concentrating on one area can be a problem.
The choice of product also matters. SocGen has been at the forefront of pushing autocallable structures, which pay out to investors (and are terminated) when an index hits a certain level. If the product is not triggered, the coupon accumulates to the next trigger date, and so on.
Bad market conditions mean fewer payouts to investors, but also mean longer exposures for banks to manage – and likely harder conditions in which to hedge them.
The dislocations of the fourth quarter of 2018 are fresh in the memories of the French banks, when Natixis took a €260 million drubbing from exposure to Asian autocallables and BNPP took a hit in its US business.
Ironically, BNPP’s moves to cut US risk after that experience meant that it was more exposed to European risk this time around. But even so, the bank’s management is not talking about rethinking its equity derivatives business on the back of the dividend shock. COO Philippe Bordenave tells me the bank considers this an exceptional one-off situation.
But in recent years when conditions worsened for the issuance of autocallables, SocGen doubled down by finding ways to tweak the structure to make it more attractive to investors in spite of sluggish indices.
The aim of some of those changes was to make structures more likely to pay out, partly by having more frequent call dates; but if those also failed in poor conditions, then it simply means bigger and bigger positions to hedge.
All of which suggests that it is indeed exposure to elevated hedging costs that is playing on Oudéa’s mind at SocGen more than anything else when he talks about a rethink of his business.
With the dividend shock out of the way, it is the next few quarters that will show whether the French banks’ equity derivative woes are one-off or more structural – and which of them is most exposed.