Structured Products Europe Awards 2016
During this period of political and macro uncertainty, market trends are hard to spot. Popular structured products based on strong trends, such as traditional equity index-linked autocallables, are therefore less attractive to investors. They still crave yield, though, so have looked to alternative underlyings – and fixed income has been one of the big growth areas.
Societe Generale was in a strong position to take advantage of this trend. Around four years ago, the French bank set up a central desk to handle not only derivatives valuation adjustments (XVAs), but other regulatory-driven pricing metrics such as the leverage ratio and net stable funding ratio.
Thomas Decouvelaere, head of pricing, fixed income, at Societe Generale in London, says this allowed the bank to have a clear insight into its usage of what it calls "scarce resources", allowing it stay in fixed income while others were retreating. For instance, the bank has been rising up the Bloomberg rankings for euro, US dollar and sterling interest rate swaps, and in its third quarter results recorded a 42.2% increase in fixed income, currencies and commodities revenues compared with the same period last year.
Staying in the market allowed the bank to capture more flows, which created axes that could be offloaded via structured solutions to yield-hungry investors.
"A better understanding of all those metrics helps. If you can stay committed to your client, you get more requests from that client. Some are vanilla flows or structured flows. Then we have a good understanding of risks on our balance sheet and resource consumption, and from there, we need to have capacity to offload those risks," says Decouvelaere.
"That won't always be done in a vanilla trade, it will often be done in a more structured trade, as investors are looking for ways to find higher yields in lightly structured or synthetic credit. We have the ability to transfer credit risk to private wealth or to insurance, for instance," he adds.
One example of this saw Societe Generale utilise its XVA and risk-transfer expertise to help connect a rival European bank that wanted to offload an awkward counterparty risk capital exposure, with an insurer who was looking for yield.
The European bank had long-dated exposure to a large French corporate that generated significant credit valuation adjustment (CVA) value-at-risk – the Basel III capital charge for future volatility of derivatives counterparty credit risk. The corporate had a credit default swap (CDS) contract, but liquidity was not available at a long enough tenor for the bank to be able to perfectly match the derivative with the CDS hedge, which meant it was not hedging the CVA VAR charge.
Societe Generale wrote a bespoke CDS at a non-standard tenor with a notional of more than €100 million for the European bank, then warehoused the position until it found an insurer willing to take on the risk via a credit-linked note (CLN). Societe Generale also posted government bonds to the insurer as collateral on the trade. From the insurer's perspective, this instrument had the same Solvency II capital treatment as a nominal bond, but with a much higher rate of return. From Societe Generale's perspective, the CLN counted as an efficient CVA VAR hedge of the CDS position.
"We found the level provided on this protection was interesting value versus the corresponding bond. The bank was very happy with the fact we offered this protection. We were happy to keep this risk and to offload this risk to real money in a Solvency II-friendly transaction," says Decouvelaere, adding that Societe Generale is in discussions with other banks to conduct similar transactions.
Another hallmark of the bank's offering this year has been its ability to marry up fixed-income underlyings with exotic instruments traditionally seen on the equity side. For instance, given the uncertainty around the Brexit vote and the US election, many investors wanted to invest directly in foreign exchange volatility, as this was likely to rise through these events.
While the bank suggested directional volatility trades on euro/US dollar, given this cross was expected to rise through these events, it also suggested forex volatility spread trades for other pairs. This trade involved getting long realised volatility of one pair, for instance euro/sterling, and short the realised volatility of another pair, such as sterling/US dollar.
Similarly, Societe Generale looked to introduce equity-style contingent events to bond options to give investors another way to hedge European government debt holdings.
The so-called contingent bond options would only trigger if both a bond yield and foreign exchange target are reached. For instance, an investor playing the December 4 Italian constitutional referendum might strike an option betting on a 'No' vote, that would be generally negative for eurozone stability. This may be structured to only pay out if Italian government bond yields jump and the US dollar rises against the euro. Including a second scenario can reduce the premium on short-term bond options by 50–70%.
"If you combine the two calls into one transaction, you end up reducing the cost of the premium, as you have increased the number of conditions you need to fulfil to make a return. As a global macro investor, it's your job to create a certain path for what you think will be the outcome, but this is one very efficient way of playing your views," says Decouvelaere.