The ART of Risk Transfer (Part One): A flood of autocallables

The prevalence and mass demand for autocallable structured products has created something of a dilemma for the banks that have manufactured them. These investments suit a market in which interest rates have remained low for so long that investors have never been more willing to take on increased risk.

Success has bred more success – the market is now flooded with autocallables, which make up a large majority of the structured products sold to retail investors, especially in Asia, with no suggestion that the conditions stoking the demand will go away.

So far, so good, but there is a limit. Banks can create these investments but are, at the same time, booking a lot of product. Since the introduction of Basel III regulation and stricter risk guidelines in general, banks are required to hold more capital and hedge such trades more frequently. The more the market moves, the more the banks that create these products, such as Societe Generale, see their risks increase. Banks need to cover this risk more actively, giving them a negative gamma effect: currently, as the market moves, they are forced to hedge various derivatives parameters, locking in losses to cover.

The more the market moves, and the more banks maintain these positions, the greater the erosion of potential profit from these trades. Without these pressures, banks could make money, but they sit, fingers crossed, hoping the market does not move too much. In contrast, client investors holding this risk are not constrained by the same regulations and have the opportunity to extract the full value from such trades.

Responding to a tougher regulatory environment, which has started to restrict how banks use their capital, banks such as Societe Generale are moving risk off their books to make room for issuing more. The name for this practice, which has gained in popularity over the last four years, is risk transfer or, more specifically, alternative risk transfer (ART).

Creating the autocallables is easy; ART is the hard part.

Four years ago, the risk transfer universe was limited to a small subset of the hedge fund community. Some old convertible bond specialists were attracted to it because they understood the volatility component and became more relative-value volatility players. But most people ignored it.

The wonderful effects of QE

In tandem with the rapid rise of autocallables, the catalyst for risk transfer products came in April and May 2015, when the introduction of quantitative easing (QE) by the European Central Bank was followed by some weird and wonderful effects. In this case, highly correlated equity and bond sell-offs meant risk-parity portfolios suffered large drawdowns from portfolios that were supposedly diversified. Typically held by asset managers and institutions, low-volatility portfolios that included equities – with bonds as a diversifier – confounded expectations as both asset classes moved in the same direction.

The discussions that followed with smaller asset managers, discretionary fund managers, private wealth owners, and other banks and pension funds were based around the need for a more reliable diversifier to equities and included mention of a risk transfer suite, of which dispersion proved to have a good entry point. But while the numbers worked, the pitch did not – it was too complicated.

The more simple and intuitive replacement demonstrated to investors the concept of diversion, how it can act as a diversifier, and the ways in which it could fit into an investment portfolio. The target was institutional clients – mainly asset managers, discretionary fund managers and self-managed pension funds – that were offered fully funded instruments. This feature ensured access to these risk transfer products without the need for International Swaps and Derivatives Association agreements or documentation, as well as a collateralised offer allowing investors to remove bank credit risk.

Over the next two years, the new premia dispersion was a success, opening conversations with investors around a risk transfer family that existed entirely because of structural imbalances in the market arising from the hedging of structured products. Unsurprisingly, those that know this market best are the ones that create and then hedge these products. Simply put, banks like Societe Generale have the structured products inventory to create these risk transfer products with clear explanations and knowledge of the flows.

The more sophisticated proposition was not for individual products but a family of premia unavailable through the systematic or quantitative strategies investors buy ‘off the shelf’ from banks or asset managers. Instead, the premia were presented as relative-value strategies. The only restriction was that buyers must trade specific transactions with those that own the inventory.

The next step was constructing portfolios of risk transfer trades to create a diversified portfolio, collectively offering unique risk premia, uncorrelated or even negatively correlated to risk assets. As with risk premia, what was being created was similar to cross-asset risk premia baskets that were weighted in a certain way. The pitch is similar to that for alternative risk premia and based around certain characteristics:

• The mark-to-market behaviour of each risk transfer trade
• The behaviour of these trades in a realised profit and loss (P&L)
• The times when these trades make more money and when they make less
• The regime
• The strategies that are complementary
• The respective volatility of the strategy
• The ways to build a portfolio of trades to optimise Sharpe ratios, delivering maximum return for the lowest possible volume.

The second part of this article will appear tomorrow on this website.