Société Générale’s world leadership in Equity Derivatives: Société Générale is recognised as the world leader in equity derivatives. How do you explain your lead over the major English-Speaking banks?
The first advanced postgraduate degree in financial maths was launched in France by Mrs. Nicole El Karoui in the 1990s. Most of the financial engineers or academics have followed this discipline for training in modelling any type of underlying asset. Nicole El Karoui’s strenuous efforts to make this training possible gave France a pioneering role in this field. Admittedly, Fisher Black & Myron Scholes, the inventors of the Black & Scholes model, are not French. However, the use of their work remained in the realm of theory. In view of the technical competence and background required to fully understand derivatives, it has to be acknowledged that this French training was more than a necessity. Its effect was positively seminal, encouraging other institutions to follow suit (financial-maths advanced degree courses at Dauphine, Paris VII, etc.). People soon flocked to these training courses.
The derivatives business remained for a long time largely a French affair. This field boasts a massive presence of French-trained financial engineers on the trading floors of the foremost English-speaking banks.
The very first engineering team to exist in its own right was set up at Société Générale Corporate & Investment Banking, in the Equity Derivatives department
Sofiene Haj Taieb
In more practical terms, let us look at the engineering teams: they consist of specialists in designing made-to-measure solutions in order to optimise clients’ finance, tax, accounting, investment, asset-liability hedging... The very first engineering team to exist in its own right was set up at Société Générale Corporate & Investment Banking, in the Equity Derivatives department. It is there to serve clients and provides the link between the client and the market, as well as between sales and trading.
Would it only be necessary for the other banks to boost recruitment from France’s best postgraduate institutes in order to reproduce the Société Générale model? What do you view as the barriers on entry to equity derivatives activities?
To the first, no, it isn’t enough. Some of our competitors have attempted to win market share in the equity derivatives segment. Unfortunately, their recruitment efforts were unavailing, or only partly successful. The bottom line is that one needs to acquire a derivatives culture, and acquiring a culture takes time. We have never taken a stop-go line on derivatives; we simply never stopped. Even the briefest halt is extremely damaging for an activity, particularly in our markets. Our extensive, uninterrupted experience in this area gives us the strength to better withstand market shifts. I also think we had some luck on our side in choosing to remain in Paris. People generally come here to stay, unlike London, where turnover is faster because of cultural factors. To develop an activity requiring close links between sales, engineering and trading demands firmly-established credibility and skills, which in turn takes time to develop. Many professionals who are still with us were recruited in the 1990s. And that’s one of our strengths: they are "young old hands" who are conversant with the systems, the activities and the market risks, as well as being well-acquainted with our clients.
Among Société Générale’s innovative achievements, a few years ago it was one of the earliest to launch products such as Mountain Range Options, Timer Options, Variance and Correlation Swaps: what drives Innovation at Société Générale? Is it your clients’ needs? Improving your margins?
There are two viewpoints, "corporate", and "market". From the corporate viewpoint, we have to adapt, as a matter of survival. From the market viewpoint, we must be able to look back and learn what the past has to teach us. In the past fifteen years, the market has undergone several major shifts. All these periods were reflected in our parameters and our trading prices. As an example, in 1995, the markets were lack-lustre, with very low volatility. We were selling guaranteed-capital products for retail networks. Société Générale was the first bank to launch products linked to the major indices of the time, enabling us, also thanks to the very low volatility, to offer indexed returns of up to 150%.
Sofiene Haj Taieb
The LTCM collapse in 1997, then the emerging-countries crisis in 1998 caused volatility to soar to new heights. 5-year volatility reached an enormous, unprecedented 42%. Thus, the index-linked return on guaranteed-capital products fell from 150% to 40%. Accordingly, we put our heads together to find the product best designed to get out of this situation. This thinking formed the basis of the "Mountain Range" options, which were created with a reverse sensitivity to volatility. Thus we were offering our clients the benefits of volatility on guaranteed-capital products: a first! We conducted simulations on payoffs and profitability levels – a far more interesting prospect to our clients.
Some thought that by launching these products, you were seeking to hedge certain risks in your own structured-products portfolio...
Not at all; far from selling products to hedge funds and then hedging our own portfolio risks on the backs of our long-standing clients, it’s quite the opposite!
Continuing with the "Mountain Range" example, we offered these products to retail networks because they were the product geared to the moment. Next, we found ourselves massively selling correlation. It was at this point that we turned towards hedge funds: these are fast-acting, sophisticated clients with needs differing from those of conventional clients such as retail banking, private banking, insurers or conventional financial institutions.
Obviously, there is an OTC market between the various trading floors, but that provides no solution if everyone is taking the same position. Working with Hedge Funds enables us to hedge our risks effectively with informed, sophisticated professionals. And it also enables us to continue serving our clients effectively.
Sofiene Haj Taieb
Regarding Variance Swaps, did you suffer as other banks did during the crisis?
The variance swap has existed in theory for some fifteen years; it involves buying or selling variance. Academically, this product can be demonstrated to be replicable using plain-vanilla options. Selling a variance swap enables one to purchase options on all the strikes and maturities and be perfectly hedged. In practice, though, it proves to replicate imperfectly.
That is just what happened in 2008, when the market went out of control, and reached extreme levels. The banks found themselves in volatility selling positions on the variance swap, but with shortfall buyer positions on the hedging options.
In our Equity Derivatives department, our internal models predicted this type of extreme effect. This enabled us, in a sense, to attract fewer flows and hence, incur less of the risk arising on this type of instrument.
Today, you’re adopting a Cross-Asset approach to clients: dedicated teams are capable of responding to all their needs regardless of asset class. Why did you opt for a strategy of this kind?
_ Our assumption at the outset was to start with the customer’s needs. Let us take the case of a pension fund: there are assets and there are liabilities. The assets side contains bonds, credit, equities and even commodities in some cases. On the liabilities side, it guarantees pensions, carries actuarial risks, on death, life, etc.
Previously, it was not impossible for several teams to go and see the client, one to talk about equities, the other about credit and interest rates, and the third about commodities. Each team would go and speak to the client about its liabilities when, in fact, they are totally hybrid. How could one best respond to the client’s needs on this basis? On the equities side, we could see the limits to our organisation and discussions with the client came to a fairly swift halt because we could not go far enough with our advice. Either we think in terms of asset allocation, in which case a comprehensive vision is needed; or we think in ALM terms (Asset Liability Management), a far more complex matter involving all the macro-economic aspects and market parameters. Obviously, the need was there!
Taking a "Multi-Asset" approach was key.
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Does this not present an enormous challenge for the organisation and competence of your teams?
With regards to organisation, we worked from the principle that sales should cover all classes of asset. We supplemented sales with advice, having one specialised advisory team for each type of client. There are banking specialists, and insurance specialists, who have detailed insight into their clients’ needs. These are sales teams in the broad sense of the term. The sales team has somewhat the role of a doctor in a general practice. Once the general practitioner has performed the diagnosis, he refers the case to the specialist. This is where financial engineering kicks in. It is organised according to a matrix structure, with engineers specialising in each type of underlying asset (equities, rates and credit), and is also organised by the nature of the structuring, with specialists in accounting, some in tax and others in regulations. At this technical level, each person retains his or her specialisation. We haven’t asked an equity-derivatives engineer to convert to being a credit engineer. Engineering means specialisation. From that point, everything translates into products handled by the trading function. This has enabled us to bring together the teams and to be the best. This approach has provided us with far more openings.
Today, you have a global vision of customers’ wants. Have their needs changed with the crisis? Are they now looking for simpler products, as we often read now? What link do you draw between the increasing complexity of products and the recent financial crisis?
Listening to the news, we hear complexity pointed out as the origin of the crisis. That may be so, but I don’t think it’s the only factor. If we take the analysis further, the origin of the crisis is a system of top-heavy financial leverage. The trouble began in the United States, where property loans were granted to people whose incomes were in many cases insufficient to repay the sums borrowed. As soon as property prices rose, the financial institutions continued to lend money to these same people in the form of consumer credit. The mistake at the outset was to lend too much money to people who were potentially insolvent. The situation in France is clearly different, because of its tighter borrowing-ratio rules.
Isn’t simplification an illusion?
The fact that some products are complex is not just to make banks happy. The point is, how can one solve a complex problem using a linear solution?
Appropriate hedging of certain institutionals’ balance sheets – for example, insurers – sometimes calls for complex solutions. An insurance company’s liabilities are convex, if only because of the discounting of cash flows.
To hedge these risks requires convexity and hence, derivatives. And here we are talking only of the simplest thing in finance: discounting future flows. We are not speaking here about complex market risk, actuarial risk or hybrid risk.
Where regulations are concerned, Basel II or Solvency II are far from easy to grasp. The regulator has developed extremely intricately-drafted texts. We have entire teams working on understanding IAS, Solvency II or Basel II for our advisory and sales teams as well as for our clients in insurance or banking.
Sofiene Haj Taieb
We don’t go to see clients and propose them complicated products just for the sake of imposing a dogma. When we see the client, we analyse its problems, its liabilities and its assets to a very carefully worked-out programme. We work with the client, supporting and advising it in the search for the optimum solution. If the solution is complex because the client’s assets are hybrid and its liabilities are convex, the fact must be accepted. Insight into an insurer’s liabilities is a complex matter; so to is understanding its capital-adequacy requirements; the regulations themselves are extremely complex. Therefore, the responses may be complex. Banks cannot be expected to find only simple responses to issues that can be of great complexity. We do not supply complexity for our mere enjoyment; a complex solution is proposed when it’s the best solution for a given problem, in our client’s interest.
With the financial crisis, volatility on stock-market indices has reached such heights that many investment products are no longer worthwhile to clients. Some players are developing quantitative strategies for transforming an underlying asset with variable volatility into an underlying with stable volatility, while exhibiting the same performance characteristics. How should one view this type of product?
These are target-volatility products. We know from experience that implicit volatility tends to follow a line that brings it back to average levels. When that volatility is very high, a fall tends to follow. We therefore advise our clients to buy less in that case. The notion of target volatility affords variable leverage on an index to give the new underlying a steady and acceptable volatility. The client pays for exactly what he consumes, making this an excellent product in conditions of high implicit volatility.
How is transparency to investors assured on fair-value quotation for these structures?
The Timer Put or target volatility are highly transparent products, since they are not dependent on the volatility of the underlying asset. An extremely simple pricing model can be used to estimate the price of these instruments.
How do you view the future for finance and its next major developments?
We are moving towards increasingly client-focused activities. This is what the regulator demands, and such is our strategy. At Société Générale Corporate & Investment Banking, the main constituent of the activity is responding to clients’ requests and needs. There are also proprietary activities, but these contribute to market efficiency and spread reduction. Last July, when we announced our new organisation scheme for trading, one of our main objectives was to intensify our client activities, and that is what we are doing; we are therefore prepared for this change.
