Investors’ trepidations could keep the often opaque derivatives markets down for the time being, according to the results of a recent study by BNY Mellon and InteDelta.
This is important to financial services firms, many of which made selling lucrative derivatives contracts to their asset management clients their main goal in 2000, when the Glass-Steagall Act was repealed in mid-1999. The Glass-Steagall Act required financial services firms to separate their retail, asset management and investment banking units.
Derivatives have been slumping since the U.S. housing bubble burst in 2008. According to a bi-annual survey taken by the International Swaps and Derivatives Association (ISDA), the outstanding notional amount in the notorious credit default swap (CDS) market fell to $26.3 trillion in the first half of 2010, from a high of $62.2 trillion in the second half of 2007.
A credit default swap allows a bondholder, in exchange for a fee, to buy guaranteed protection against default and credit risk from a counterparty. Put simply, the counterparty agrees to pay the buyer of the contract both the principal and the interest in the event that the underlying bond defaults.
One of the reasons banks got into so much trouble during the housing bubble was that they sold CDS contracts on bonds backed by the subprime mortgage market, and didn’t figure that many of those bonds would default simultaneously. Thus, firms such as American International Group (NYSE: AIG) were left holding the bag on the cost of those bonds.
Additionally, according to the ISDA study, the notional amounts on equity (stock) derivatives, such as futures and put and call options, fell to $6.4 trillion in the first half of 2010 from $11.9 trillion in the first half of 2008.
Equity derivatives contracts allow investors to profit off the future price of a security, such as a stock or a bond, without requiring the investor to purchase the actual security. Therefore, in certain types of derivatives contracts, if the underlying investment or security plummets, the notional amount would be the amount owed.
In general however, derivatives, such as put and call options, are meant to hedge the inherent risk of an existing investment portfolio by cushioning losses in the event of a market downturn or by enhancing returns during a market upswing.
Another type of derivative is a future, which allows investors to buy the returns of a security or index without actually having to fully purchase the security or index. In other words, a future allows an investor to obtain the returns of a $100-million S&P 500 portfolio without actually having to put up the entire $100-million.
The inherent risk of a future, however, is that if the underlying security or index falls, the investor is left owing the difference in cash.
The last two years have been hard on financial institutions, which spent much of the decade feverishly pitching derivatives-based strategies to investors in order to keep up with the high fees charged by competing hedge funds.
For example, ING Group (NYSE: ING), following the burst of the housing bubble in 2008, shut down its newly-formed property derivatives trading desk in London, after signing high-profile derivatives traders Rawle Parris and Jose-Luis Pellicer from ABN Amro and Goldman Sachs, respectively.
Equity derivatives-based strategies pushed by investment banks have barely gotten off the ground or have lost interest among institutional investors since the bubble. For example, institutional assets in portable alpha strategies, which typically buy futures of an index while simultaneously investing in a low-risk portfolio to enhance the returns of the index, fell to about $24 billion in 2010 from about $36 billion a year earlier, according to Pensions & Investments annual survey of U.S. pension plans.
Additionally, buy-write strategies, which typically buy S&P 500 index futures while simultaneously buying call options on the index, were pitched hard to pension plans and other institutional investors by firms such as Goldman Sachs (NYSE: GS) and JPMorgan (NYSE: JPM) as a way of curbing downside risk, but never really got off the ground.
“We’re seeing now that investors generally are still a little scared of derivatives,” said Max Ansbacher, president of Ansbacher Investment Management in New York, which manages buy-write portfolios for institutional investors.
“But I think it will bounce back once we crawl out of the recession.”