Market Risk – North American Equity Derivatives, Financial Crisis Leaves
Market in Flux
Trading volumes of highly liquid “flow” equity derivatives surged last year in North America as hedge
funds, asset managers and other institutional investors shifted strategies in response to mounting
turbulence in global equity markets, according to the results of Greenwich Associates'2008 North
American Equity Derivatives Research Study. With investors retreating to safer and better-understood
instruments in the face of historic volatility, however, the use of structured or securitized equity
products fell sharply.
Over the past five years, equity derivatives have evolved into standard and in many cases essential
tools for investors, including both hedge funds and cash portfolio managers. Long-only funds have
used derivatives to diversify their investment strategies and many of them now use options and
futures as a way to take positions on a more efficient or tax-effective basis, to leverage or hedge
positions, or even to create artificial short positions. Just how commonplace have derivatives become
in institutional portfolios?
Two-thirds of North American institutions targeted for Greenwich Associates research use equity
derivatives as an overlay to their equity investment strategy.
60% use equity derivatives to express directional views on individual stocks, sectors, or markets; that
share jumps to 83% among hedge funds.
Over 40% say they employ more complex strategies that include equity derivatives as a core
component.
With the spike in volatility from last summer though the second quarter of 2008 — the research period
for the 2008 study — institutions ratcheted up their use of “flow” derivatives products. Commission
payments by North American institutional investors on equity options trades soared some 50% during
the period. In a shift from prior years, however, the proportion of institutions using certain flow
products was flat or actually declined year-to-year, even as the volume of trading business was
increasing.
Big Pullback in Use of Structured Securitized Equity Derivatives
In the run-up to the outbreak of the current financial crisis, North American institutional investors
were stepping up their use of structured securitized equity derivative products. As recently as 2006,
only 20-25% of investors used these products; by 2007 that share had jumped to more than 40%.
That trend reversed itself in dramatic fashion last year: Only 20% of North American institutional
investors did any structured business with equity underlyings from 2007 to 2008. “Investors of all
types reverted back to simpler, more vanilla trades,” says Greenwich Associates consultant Jay
Bennett. “Regardless of whether this shift turns out to be a cyclical response to market conditions or a
more secular turn flowing from this severe market event, it is safe to assume that the growth of this
business has been derailed for at least the near term.”
Greenwich Associates Rankings
Prior to the market events of September and October 2008, Goldman Sachs was North America’s
preeminent broker-dealer in flow equity derivatives. Behind Goldman Sachs was a closely grouped
quartet of brokers made up of Morgan Stanley, Merrill Lynch, Credit Suisse, and Lehman Brothers.
However, the competitive landscape has been dramatically transformed in just a few short months.
Obviously, institutions that included Lehman Brothers among their top three derivatives dealers have
been affected most acutely and, looking ahead, the composition of this market will depend in large
part on where Lehman Brothers’ derivatives clients end up and on how good a job Banc of America
and Merrill Lynch are able to do in retaining existing clients.
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More broadly, the existential challenges facing many large banks are affecting nearly all market
participants by causing broker-dealers to trim their capital commitments. “Broker-dealers are
becoming more conservative and cautious with respect to their P&L,” observes Jay Bennett. “We saw
a number of them pulling back in capital commitment and not being as aggressive with their pricing.
Both of those shifts represent potential challenges for institutions that have become reliant on
derivatives as part of their core portfolio management strategies.”
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