The future of listed derivatives

  
Hedge Funds Review: Bruno, your career began in the structured products markets and now you’ve moved – you’ve started your own hedge fund and you’re focused in terms of solutions on listed derivatives products. So your career is tracking the ascent of listed derivatives and, perhaps, the decline of structured products. Is that a fair way of summing it up?

Bruno Pannetier: That would be a fair way to sum it up. I started in the structured products world in the mid-1990s, and I have enjoyed witnessing the growth of the structured products market, especially on the equities side of the business. This was my area of expertise. I took part in the sophistication of the payout in structured products in the 1990s and also over the last decade. I could see along the way the frustration of some investors regarding the way the valuation of structured products could affect a portfolio. Often, there was a clear understanding of how the structured product would benefit the portfolio at a given point in time, at a given horizon, which is the investor’s horizon.

This is what the structured product is about, actually to work with the investor on a customised solution to define the payout of a product at a given point in time. But what happens between now and this point in time is that the product valuation may behave in a way that the investors do not actually expect. Along the way, there can be a lot of frustration in terms of the valuation and mark-to-market of the product. Obviously, this has been emphasised with the financial crisis, which started in 2008 and led to a number of surprises for investors in terms of transparency, in terms of valuation of the product and in terms of counterparty risk associated with a structured product.

Taking the lesson of this and having been pushed by some investors who had been involved along the years, I decided to form Old Park Capital with some people from my team in 2009, to focus on providing investment, which gives investors control and transparency – but not only at a given point in time, but also to control the path of performance and to control the mark-to-market valuation of their product within some parameters. This is what Old Park Capital specialises in. Old Park Capital is an alternative investment manager specialising in dynamic systematic strategies using listed derivatives, futures and options, which enable investors to have full control of their investment strategies.

Hedge Funds Review: We’ll perhaps talk about some specific examples of how listed products can achieve that control a little bit later. But the other part of the story, Renaud – about the increasing volumes in the listed world – is, of course, regulation and the wave of regulation that has followed the financial crisis, Dodd-Frank in the US and the European Market Infrastructure Regulation (Emir), here in Europe. Could you give us your overview from Eurex on what the regulatory landscape looks like now, why it’s encouraging listed products, and how that landscape is going to change going into 2015?

Renaud Huck: The answer to this question comes down to two elements that Bruno just spoke about transparency and counterparty risk. The current incoming European regulation has as an objective to address those two elements. As outlined in the famous G20 commitment from 2009, standardized OTC derivatives shall be traded and cleared on regulated markets and CCPs. Why so? Purely, as Bruno said, clearing houses have processes in place that allow them - on listed derivatives - to give a net asset value (NAV) at the end of the day, a mark if you want, the possibility of seeing where the value of an instrument is at any given time.

From a buy-side perspective, there’s nothing more you could wish to have, which is to give transparency to your investors on the products that you are invested in. I think that’s maybe the big picture that the European regulators and US regulators want to address, to give a bigger framework for the industry to be able to achieve transparency to achieve good NAV and good valuation of their portfolios. Also to give it to entities, clearing houses, which by nature are very conservative and have processes in place and can process and have a good idea of where those products trade or should be at the end of the day. Equally, on the trading side to offer a very different trading avenue than the OTC space.

On the one side, you have the processes but, on the other side, you have exchange-listed liquid products or products that will be liquid at some stage, to give the trading community two possible trading alternatives, whether the OTC space or the listed derivatives space. These avenues are in parallel and I’m sure that later we will elaborate a bit more about the futurisation of products. Why is there such a trend in the market place? Why do buy-side clients want to go towards those products, the listed products? How is it going to modify the market place, the regulatory field, but equally the rules of engagement between the buy side and the sell side whenever they transact?
    

Hedge Funds Review: What’s the next big change that Bruno and his clients should expect?

Renaud Huck: The next big change is definitely the futurisation trend on the trading side, meaning that exchanges like us will launch new listed instruments that will replicate the OTC space and will give more transparency, but equally – at the end of the day – a mark, a settlement price and an independent settlement price in order for them to market their books but will also give them tradable instruments. This can be seen in different asset classes, so, for example, in fixed-income or equity, but also the foreign exchange space. I think the regulation is going to cover all relevant asset classes, a lot of processes, to hopefully help – that’s the ultimate objective of this regulation – the buy and sell sides in the way they transact and in the way they trade products and have choice, because this is all about choice.

Bruno Pannetier: I completely agree with Renaud and the three points he made regarding why I also believe listed derivatives and futures should prosper and take more and more market share in the overall derivatives space. The first point, which I believe is the most important point, is transparency – to have a market price, an undisputed price for a given instrument at the end of the day or during the day, as opposed to a value based on the model given by a counterparty with all the problems that may derive from this, as we have seen during the crisis, where we had a number of OTC products, especially in the credit space, but also in respect to other asset classes, which were difficult to value.

Even the originator of the product – the bank originating the product – had some difficulty in valuing its own product. Obviously, in the futures market, in the real listed world, when they are assuming there is enough liquidity to create a market, then the value is the value of the market, which is the fairest possible valuation. It’s not model-based, it is an actual value. There is no underlying hypothesis underpinning the valuation of a portfolio or unpinning the valuation of a particular instrument for the investor. I think this is a huge plus for any investor.

The second point is counterparty risk, obviously. If you are in the OTC world, or in the formal OTC world where you are dealing with a given counterparty, obviously you have this counterparty that creates risk. Also, over the years, there have been a number of mechanisms to mitigate such great risk, in particular the credit support annex (CSA), but the ultimate mechanism to mitigate the great risk is to trade over an exchange. The sole reason why futures are listed options, and listed derivatives should take more market share in the future, is simply the practicalities of trading them.

Hedge Funds Review: You talked earlier on about using listed products to exercise better control on a portfolio. Can you give an example of how that works with the sort of mandates you have? Is that your active management of the portfolio, or is it more specific decision-making on market views on the part of your customers?

Bruno Pannetier: Old Park Capital is specialising in systematic strategies. So the control comes from the system and our dynamic management of the portfolio according to the system. The system is explained to investors and the system enables them to control their portfolio in a given way. So I will come back to a practical example, and I will show you one of our products, the Maestro strategy, which is our flagship product.

But, before coming to this specific example, just to make a metaphor to understand the point. If you are dealing with a taxi and you want to go from London Victoria to Piccadilly, you ask the taxi driver to go from Victoria to Piccadilly. This, I would say, is the normal way to do this, but this is a structured product because you focus on the destination point and you delegate to the taxi driver the actual route that he will take to your destination point. In fact, you have no control over the route. For example, if there are roadworks along the way that the taxi driver may not be aware of, then this can cause problems and affect the quality of your taxi journey.

Hedge Funds Review: And the cost.

Bruno Pannetier: And the cost. This is basically the structured products way of doing things. You have control of the destination point, but you may not have control of the time and you may not have control of the cost. Basically, you delegate this to the taxi driver, and it’s their ability to optimise this cost and the control for you, which in some cases may present a conflict of interests for the taxi driver. This is exactly the same between the dynamic asset management industry and the structured product.

The structured product will give investors the control over the payout at a given point in time. For example, a typical structured product is in the equity space. If I look at the structured products that were popular at the end of the 1990s and the start of the 2000s, I would give you a high coupon if all the stocks in the particular basket of stocks have been positive over three years, for example. You can have a pretty good view of what the payout would be in five years’ time but, along the way, you don’t have any control over the actual valuation of this particular product.

It will depend on the volatility of the stocks, on a number of market valuations, including the credit spread, of the structured products provider and of the issuer. This is what we feel and this is why investors come to us and people such as at Old Park Capital, investors really want to understand the distribution of the path of the return, they need to know whether the product can have a drawdown of -10% at one point in time – within one month, within one day or within one week. They may be absolutely fine with this, but they need to know.

By only controlling the destination point, you actually delegate, or you relinquish control of, the actual route. Whereas, if you have a dynamic strategy – which is a high liquid strategy and especially in what we do, we are dealing with a daily strategy, so a strategy manufacturing a return on a daily basis – then the path of the return is controlled in the sense that investors can have a clear view of what the path of the return may be, not just the destination point.

Hedge Funds Review: So you’re going back to your point about the model, and you gave the example of a correlation-based structured product; it’s very hard if you want to take a view against the provider of the product, you’ve got to have your own model. Whereas, what you’re saying is, you can test the efficiency of what you’re doing on a daily basis with listed products?

Bruno Pannetier: Yes, I think that, in a way, a structured product can be quite intuitive regarding the destination point. If I take the example of the correlation product we have just mentioned – that is, a product delivering a high coupon if all the stocks in a particular basket have a positive performance over five years – then the destination point, the final payout, is quite intuitive.

But the valuation, or the mark-to-market, of the product between now and the horizon, so a five-year time horizon is not intuitive at all to the investor because it depends on a number of variables, which are: the correlation – the way the correlation will behave; the dividends; the volatilities of the stocks; and the volatility of the correlation between the volatilities. It’s extremely complicated, whereas there is a requirement for products that are intuitive, but not only regarding their final value – the value at a given point in time – but the path of the valuation, so the dynamic of the valuation at any point in time.

 

Hedge Funds Review: But does that mean that complex products are finished? Or, because you can have an array of simple products that make a complex…

Bruno Pannetier: Yes, that’s right. It doesn’t mean that finance should stop being sophisticated. It means that the sophistication is not the enemy of simplicity and transparency. It has to be sophisticated in terms of value creation – there is a lot of fine-tuning in what we do – but we are just choosing a simple component, which can interact in an intuitive way. To come up with a simple formula, you need to put in a lot of creativity. If you want E=mc2, it’s a very simple formula, but you need a lot of work to reach this point.

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