The New Face of Equity Derivatives
Six changes in the hedging world.
As Todd can attest (he helped introduce me to Wall Street) I started my career at a large bank and moved up the ranks to equity derivatives. I have worked on the derivatives desk at two large banks in my career and this seems like one of the most demanding times for my former colleagues.
The derivative business has taken off since the proliferation of thousands of hedge funds (long/short, credit, and volatility funds) and approximately $20 billion has gone into buy-write products, which has created a boon in the business.
However, as the world has changed the role and opportunity for a derivatives desk has dramatically changed. Here's the rundown:
1. Counter-party risk has risen dramatically and is the most significant. ISDAs have to be renegotiated (especially in light of the market disruptions like short-selling). Credit lines have to be reviewed with almost every client. Risk officers are preventing larger trades from being completed and demanding higher collateral levels from clients. Most important are the huge risks of counter-parties blowing up and not being able to pay their obligations.
2. Implied and realized volumes are up significantly, making market makers' jobs much harder as they constantly have to hedge their books. Recently we've seen large moves around expirations, which aren't helping.
3. Fewer players in the game means much less liquidity to lay-off positions. Spreads are widening and some think that is good for the business unless you are the one that needs to unwind a position!
4. Unknown regulatory risk creates unknown business risks. Market makers can short to hedge their short puts, but what if they themselves can't get a borrow or get bought in? What if the government decides you can't buy puts on certain names? The US financial system is operationally and philosophically based on the fact that investors can hedge. The short term ban of the ability to short stock by hedgers and arbitragers alone has created mayhem and illiquidity.
5. Leverage and risk will be brought down by the firms so bigger trades for funds will be harder to execute. Desks will have to pay more for the money they do use and more for their borrows.
6. Back-office nightmare: Funds are bringing on more primebrokers to spread out their own counter-party risk so that means trades need to get settled at 4-7 firms instead of 1-2: more internal rules, more documents to complete, more compliance, etc.
As they say, "This too shall pass" and the opportunity for the survivors could be very interesting. Instead of 10 large players competing for business, there will be only a handful and the pie could be extremely large.
The players that survive will need scale, a prime-brokerage unit to get the "easier flow," very good traders/risk managers, good client relationships and most importantly a balance sheet.
Right now most people don't have that!
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