The global market rout has dealt a particular blow to a trade that intertwines Silicon Valley stock-market favorites with cautious Asian savers and European asset managers.
Designed to boost returns during the 11-year bull market, Wall Street’s hunt for yield hatched a multibillion-dollar business betting on volatility itself. The idea functioned well, until the coronavirus pandemic blindsided investors and sent markets swinging at levels unseen since the financial crisis.
The Cboe Volatility Index, or VIX—Wall Street’s fear gauge—surged above 80 from 13 over the past month, the S&P 500 and other major indexes plunged and even the Treasury market, usually a stalwart in market turmoil, faced disruptions so severe that the Federal Reserve intervened to prevent further chaos.
As the declines force banks and money managers to sell assets to raise cash, hedge funds such as La Française Investment Solutions and LMR Partners are pulling back from one particular once-hot trade, with losses estimated in the hundreds of millions across Wall Street. La Française and LMR didn’t respond to requests for comment.
Salespeople at banks familiar with pricing say it can cost such funds millions at a time to exit. Unwinding one bespoke deal alone could run over $5 million. There is little public data available because trades are executed bilaterally between hedge funds and dealers rather than through an exchange. Many also expect the pain to hit savers as far away as Japan.
“It will take approximately four to six weeks for [retail] investors to begin to realize what’s happened to their investments,” said Andrew Stoltman, a Chicago-based securities and lawyer. “When we see extreme volatility, these things typically do not react the way Wall Street anticipates.”
Known by the innocuous-sounding name “risk recycling,” the practice was the latest concoction of financial engineers at banks including Bank of America Corp., Citigroup Inc. and Société Generale SA .
Here is how it works: Dealers transform bets on global stock-market indexes and tech darlings such as Apple Inc. and Amazon.com Inc. into fixed-income notes paying low but steady interest. They market them to individual investors in Asia through outlets including Japan Post Bank Co. Sales of these structured notes amounted to more than $10 billion in Japan alone last year.
Risk Recycling
One way to earn carry in a low-yield world
BANKs
Banks transform bets on global stock indexes or Apple and Amazon into fixed-income notes...
...using options to boost their steady interest payments.
LOW
HIGH
$XXXX
MEDIUM
exposure
PUTS
Apple
$XXXX
CALLS
$XXXX
CALLS
Tesla
$XXXX
PUTS
RETAIL INVESTOR
Hedge funds
Yield!!!
Retail investors in places like South Korea buy the notes.
Hedge funds buy the risk from banks, using volatility-linked derivatives.
BANKs
Banks transform bets on global stock indexes or Apple and Amazon into fixed-income notes...
...using options to boost their steady interest payments.
LOW
HIGH
$XXXX
PUTS
MEDIUM
exposure
Apple
$XXXX
CALLS
$XXXX
CALLS
Tesla
$XXXX
PUTS
RETAIL INVESTOR
Hedge funds
Yield!!!
Hedge funds buy the risk from banks, using volatility-linked derivatives.
Retail investors in places like South Korea buy the notes.
BANKs
Banks transform bets on global stock indexes or Apple and Amazon into fixed-income notes...
...using options to boost their steady interest payments.
LOW
HIGH
MEDIUM
exposure
$XXXX
PUTS
Apple
$XXXX
CALLS
$XXXX
CALLS
Tesla
$XXXX
PUTS
Hedge funds
RETAIL INVESTOR
Hedge funds buy the risk from banks, using volatility-linked derivatives.
Retail investors in places like South Korea buy the notes.
Yield!!!
BANKs
Banks transform bets on global stock indexes or Apple and Amazon into fixed-income notes...
...using options to boost their steady interest payments.
LOW
HIGH
MEDIUM
exposure
$XXXX
PUTS
Apple
$XXXX
CALLS
$XXXX
CALLS
Tesla
$XXXX
PUTS
RETAIL INVESTOR
Yield!!!
Retail investors in places like South Korea buy the notes.
Hedge funds
Hedge funds buy the risk from banks, using volatility-linked derivatives.
Along the way, banks dispose of the risks accumulated by bundling stocks and options into a security by selling volatility-linked derivatives to investors, mostly hedge funds. Banks say risk recycling enables them to satiate ordinary investors’ demand for structured notes, which are popular with savers seeking to capture elevated stock-market gains in a low interest-rate environment.
While the strategy has been around for some time, the risk-recycling market grew in size and complexity over the past few years as the bull market extended its run and price movements varied little.
Demand soared for the retail product—structured notes dubbed “autocallables,” which deliver capped stock-market returns to purchasers while giving the issuing bank the right to “call” or retire the note when the underlying shares hit certain levels. International banks sold over $10 billion of notes linked to equity markets in Japan last year. That is up from approximately $2 billion a decade ago, according to data from MTNi.
Issuance in South Korea totaled $57 billion in 2019, a massive jump from $3.4 billion in 2009, according to data from Structured Retail Products, a division of Euromoney Global Ltd. To keep printing, banks needed to sell more derivatives to hedge funds.
Some traders warned that the latest generation of products bear striking similarities to other derivatives strategies spawned by banks during previous good times, many of which suffered significant losses when markets soured.
Among the potential flashpoints: the extent to which the strategy’s profitability is dependent on markets remaining placid, and undermined by factors including imperfect hedging and sharply higher levels of volatility.
“Little of what is recycled to hedge funds exactly matches the profile of what is being sold on the retail side,” said Bram Kaplan, a senior equity derivatives strategist at J.P. Morgan. “The vast majority are proxy hedges designed to roughly mirror the aggregated risk profiles of the products and many of these structures use complex underlying instruments.”
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Popular trades on the back of risk recycling are called “corridor variance swaps” and “dispersion baskets.” Dubbed exotic in the world of finance, traders need to manage mathematical relationships that arise from movements in the underlying stocks or indexes.
To some extent, risk recycling was simply Wall Street’s latest response to the scourge of low interest rates and the postcrisis rulebook. Over the last decade, central banks slashed rates in response to tepid economic growth, quelling price swings and helping markets generally rise in orderly fashion. For institutional investors and hedge funds, this translates into lower returns on safe assets and a growing thirst for new ways to take risk.
Meanwhile, increased bank regulation fundamentally changed global lenders’ business model, pushing them toward fee-generating businesses.
When banks sell autocallable notes to individual customers, they embed options that give them the right to buy or sell stock indexes or baskets of global stocks at stated levels. Holding these options triggers risk limits that are the product of the financial overhaul following the 2008 crisis. Where the banks once held these risks in obscure corners of their balance sheet, now they must slice and dice them into complex volatility products that pay above-market returns to hedge funds.
“Before the financial crisis, banks could issue these products and maintain the risk,” said James Masserio, co-head of Americas equities trading at Société Générale. “Now banks are less in the storage business and more in the processing business.”
Before Lehman failed, proprietary traders at banks made gargantuan bets on stocks, bonds, commodities and currencies in a bid to fatten profits. Now giant firms such as Goldman, Morgan Stanley and JPMorgan Chase & Co. have disbanded those units, and the traders have mostly shifted their risk-taking to hedge funds. Deepak Gulati, who ran JPMorgan’s global equity proprietary-trading desk for five years, launched Argentière Capital AG in 2013 where he bought risk-recycling trades in Switzerland.
Hedge funds with experience trading correlation and volatility say the right trades can generate above-market returns. But they warn that structured volatility products aren’t as liquid as other financial instruments and are susceptible during periods of severe market dislocation such as the one happening now—especially when all assets move in sync.
Investors say that banks have become more sophisticated in terms of isolating precise risk, packaging and selling it to hedge funds over the past few years in response to heavy market demand and an increase in funds that systematically allocate capital to risk recycling trades.
But even well-experienced banks enacting these trades can miss the mark. Some lost money on the hedges in 2019 because certain strategies involved managing price movements in 50 single-name stocks. Meanwhile, hedging can have the effect of creating distortions in the market. Dealing structured notes makes banks natural sellers of long-date volatility in stock indexes up until an inflection point called “peak vega.” Once it has hit, they scramble to buy volatility, squeezing it higher.
The S&P 500 has fallen more than 25% year-to-date, even as the Federal Reserve and European Central Bank introduced fresh measures to protect the global economy. Investors are rushing for cash to meet margin calls and redemptions—and that means selling investments, particularly the complicated ones.
A person familiar with the trades says hedge funds are closing out deals done two years ago that involved betting against volatility on the S&P 500 while wagering on swings in the Nikkei Stock Average using variance swaps. Some of these trades cost as much $7 million to unwind, the person said.
Analysts say January saw the largest hedge-fund buying of certain risk-recycle trades, only a month before markets turned. In addition to hedge funds dedicated to trading volatility, large asset managers such as Capula and Lombard Asset Management often have a trader involved in the strategy.
Asset managers say the strategy can still be profitable and that current unwinding is creating new opportunities for when volatility subsides and markets stabilize.
Write to Julia-Ambra Verlaine at Julia.Verlaine@wsj.com
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https://www.wsj.com/articles/globe-spanning-volatility-trade-is-hit-hard-by-market-slump-11584876909
2020-03-22 12:35:00Z
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