Bank of America Merrill Lynch (BAML) has been part of the chasing pack in the equity derivatives business for some years, but in 2016 it found itself challenging the leaders. Fresh thinking and new products have helped the bank to move risk between disparate segments of the customer base, bringing praise from clients and potentially helping to limit the impact of new trading book capital rules.
This was no accident. BAML has systematically invested in the business since 2014, increasing headcount by roughly 15% with an emphasis on distribution, sales and structuring.
The build-out started at the top. In 2014, BAML hired Hichem Souli as global head of equity derivatives sales from Societe Generale, with a mandate to bolster the structured solutions segment of the business and enhance the exotic products offering.
"In 2014, the bank had a lot of strengths; in research, in flow derivatives, in trading expertise. What I was asked to do was bring all of this together, and leverage this amazing franchise for hedge funds and real asset owners," says Souli, who is based in New York.
This mission prompted BAML to expand its offering into the risk-transfer business – a neat way of tying together retail and institutional clients.
Through risk-transfer products we have found a smart way to generate revenue and offload risks
Hichem Souli, BAML
As regulation has limited the amount of risk banks can warehouse, it has forced them to find new and better ways to transfer the exposure they accumulate via retail structured products – to the extent that Souli believes the sustainability of the retail business depends on banks becoming distributors of the risk.
The problem is that the positions generated by structured products have no traditional matching trade through which the exposure can be passed along; instead, it has to be broken up into components or repackaged in some way.
"Through risk-transfer products we have found a smart way to generate revenue and offload risks. While they are often good risks to keep, taking them off the balance sheet allows us to sell more retail products. Now, as soon as we serve a retail distribution client, we can turn around and sell to our hedge fund and relative value clients. This is the future of exotic products," says Souli.
BAML has applied this philosophy successfully to one of the largest markets for autocallables: Korea. The worst-of autocallable market in this country has averaged $2.5 billion per month over the last three years and can generate good revenue for international dealers. BAML accounts for between 7% and 8% of the market, and 12–16% of the most-traded baskets.
Plenty of risks accompany the potential rewards though. Worst-of autocallables reference baskets of indexes, leaving dealers with a short correlation and short covariance position. Banks have typically tried to hedge themselves by buying covariance and correlation swaps, but these are not a perfect fit as the dealer's exposure is bounded between upside and downside barriers matching those embedded in the sold autocallables, while the swap payoffs are not.
Covariance is not a perfect hedge, nor is correlation. But the VCorrel is a hybrid of both – that's the beauty of it
Hichem Souli, BAML
Dealers have tried to fix this by adding corridor features, so they would be spared having to pay out to clients when their own exposures evaporated, but over time, hedge funds became frustrated about 'selling the wings' through these products and losing potential upside. Corridor covariance and correlation products have also suffered from unattractive entry levels for clients, because of the dislocation between implied and realised levels, caused by the one-directional hedging activity of autocallable dealers across the Street.
BAML decided a new product was needed. The result was the VCorrel swap. "Covariance is not a perfect hedge, nor is correlation. But the VCorrel is a hybrid of both – that's the beauty of it. It's an enhancement of a corridor covariance swap," says Souli.
A standard corridor covariance swap payoff is the difference between a fixed strike and the sum of the volatility of the two underlyings multiplied by a correlation term, for as many days as those underlyings stay within the corridor. The VCorrel swap payoff, on the other hand, multiplies this payoff by the factor of two additional volatility strikes on the two underlyings, which scales the client's correlation exposure with the level of realised volatility, reducing the convexity of the payoff for both dealer and client.
Since its debut in October 2015, the bank has sold $4 million per correlation point – an exposure amount equivalent to a $10 billion call-versus-call position. Buyers have been sourced across BAML's roster of hedge fund and asset manager clients, and the product has been sold in clips of between $100,000 and $500,000 per correlation point.
The success of the product has allowed BAML to hedge 50% of its Korean autocallable book and free up issuance capacity.
"We quickly cut a large amount of our autocallable risk through this product, which allowed us to go back into the Korean market faster than others. Everyone was trying to cut this risk, but we differentiated ourselves by finding a product that hedge funds were comfortable with and could enter into at favourable levels," says Souli.
Clients whom Risk.net spoke to during due diligence for the awards were enthusiastic about BAML's prowess – and a little taken aback. "We didn't expect to see this kind of innovation from them," says one. Another says the bank appears to have outstripped other dealers in growth over the past year.
The constraints FRTB applies to exotic products are loosened if we distribute the risks we originate
Hichem Souli, BAML
Client surveys tell the same kind of story. BAML leapt to second place in 2016 for sales, according to the annual Extel equity derivatives survey, from seventh place in 2015; also to third place in trading from fourth, and to first from ninth for derivatives research.
Souli's team has also applied its risk-transfer expertise to the thorny issue of hedging volatility-controlled indexes. BAML is a big player in the US fixed index annuities (FIAs) market, where volumes hit $54.5 billion in 2015. These retirement products offer returns linked to the performance of an equity index and insurers have scored notable successes selling iterations based on volatility-controlled, smart beta underlyings.
BAML sells options referencing proprietary indexes to underpin FIAs distributed to some US carriers, showing a cumulative portfolio of several billion dollars.
Through this business, the bank has become increasingly exposed to gap risk – the danger of realised volatility on the indexes exceeding their target volatility. When these spikes occur they play havoc with the value of the call replication, which in turn affects dealers' risk management.
A standard variance swap payoff cannot offset this risk, as it does not precisely replicate the vega and gamma sensitivity around the sold options' strikes.
"With a variance swap, you are going to end up either overhedging or underhedging, and wasting money. A client, too, may not be interested in a standard variance payoff," says Souli.
Instead, BAML constructed a gamma-weighted variance swap. Here, the daily weighting factor for each log-return is adjusted by the theoretical gamma of a hypothetical option written on the relevant volatility-controlled index. The gamma is calculated using a formula based on the Black-Scholes model. This feature ensures the swap payoff scales in line with the bank's own vega and gamma exposure, but not at the expense of shifting the volatility strike too far away from the corresponding implied volatility for a vanilla swap on the same strike and maturity, offering comfort to investors who gain access to an enhanced payoff at familiar entry levels.
"It's a win-win because it fits the exposure of the traders at BAML, while keeping it simple for buy-side clients," says a London-based portfolio manager at a hedge fund that invested in the product.
BAML expects its finely tuned hedges to help shield the bank from the worst of the incoming trading book capital regime, the Fundamental review of the trading book (FRTB), which is due to come into effect in January 2019. As it stands, the framework is predicted to be especially punitive for equity portfolios, but one way to prevent painful capital add-ons is to ensure risks are perfectly offset and dispense with proxy hedges.
"The constraints FRTB applies to exotic products are loosened if we distribute the risks we originate. If you perfectly hedge the vega, delta, gamma and all other sensitivities related to an options portfolio, you end up reducing in a significant manner the FRTB requirement. Instruments like the gamma-weighted variance swap and Vcorrel swap are exact hedges for the options we sell on the other side," says Souli.
"In addition, we have a significant balance sheet and plenty of room to grow. The potential is ahead of us rather than behind us," he adds.
Innovation in risk-transfer trades helped to separate BAML from the pack this year, but the dealer has also impressed when it comes to the bread-and-butter of the modern equity derivatives business: investable indexes.
From being a market laggard when this business took off across the Street several years ago, BAML can now boast a formidable stable of products, which have together attracted billions of dollars from institutional investors. Two years ago, assets under management totalled $4 billion across the franchise; today, it is $13.3 billion.
One particular success story is the Vortex Alpha index, a unique twist on the well-trodden short-volatility strategy popular with asset managers and pension funds. Clients like these strategies as either a proxy for long equity exposure or a volatility carry strategy. However, when realised volatility surges, the embedded downside convexity translates into outsized losses for investors. Dealers of all stripes have sought to engineer indexes that dampen this effect, with BAML no exception.
The Vortex index exposes investors to a hedged short-volatility position, replicating a strategy whereby a trader systematically sells short-term skew on the S&P and uses part of it to buy Vix convexity. The Vix demonstrates convex behaviour relative to the S&P on the downside, meaning that when the latter index falls, the former jumps up disproportionately
Recovery is quick after a drawdown, whereas other indexes have suffered as they incorporate mechanisms that de-risk when they hit the bottom
Managing director of a global asset manager that invested $400m in the index
The inflows speak for themselves. The Vortex Alpha has attracted $1.3 billion since its launch in March 2015 from asset managers, pension funds and sovereign wealth funds.
"We like it because it is a quantifiable risk premium and simple in what it is trying to capture. It does not rely on in-built signals or triggers, so operates the same in all market conditions. Recovery is quick after a drawdown, whereas other indexes have suffered as they incorporate mechanisms that de-risk when they hit the bottom," says the managing director of a global asset manager that invested $400 million in the index.
BAML has also built a formidable reputation in the competitive market for equity-linked notes. Dealers across the Street have shifted issuance off their own unsecured, in-house platforms to third-party special purpose vehicles (SPVs) able to repack all manner of debt instruments into attractive structured investments that yield more than bank-issued paper.
BAML approved of the concept, but balked at the idea of loading the associated costs and operational complexity on to clients. Instead, this year the bank developed the Merrill Lynch International & Co secured issuance programme (MLICO secured) as an add-on to its offshore unsecured platform.
Investors can access their desired credit risk through MLICO secured, along with the level and methodology of collateralisation. The chosen collateral is then handed to BNY Mellon for safekeeping. MLICO secured then issues a structured note to the investor referencing the selected credit and linked to a desired derivative payoff provided by BAML.
Daily collateralisation of the issued note's mark-to-market offsets an investor's exposure to BAML, providing for a pure exposure to the reference credit – all this at the same price and using the same channel, as if the investor were using the standard unsecured platform.
"This is attractive for the kind of small or medium-sized institutional client that is looking for derivative payoffs. With MLICO, you can manage derivatives exposures similar to how you would through an Isda, but on a securitised basis. We've recently passported MLICO secured to the US, where we can issue papers as Rule 144a offerings," says Souli.
The MLICO platform as a whole, secured and unsecured, boasted issuance of $3 billion in 2016, with the latter component making up several hundreds of millions of dollars of this total.
The week on Risk.net, October 6-12, 2017Receive this by email
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