Derivatives are securities which derive their value from an underlying asset. For example, a bond option is classified as an interest rate derivative as its value changes with interest rate movements. An increase in market rates would decrease the value of a callable bond as the issuer will have little interest in calling back the bond early due to the higher financing cost associated with issuing new ones.
Equity derivatives, on the other hand, are securities which derive their value from the underlying share. A call option gives the buyer the right but no obligation to buy the stock at a determined price before the expiration date. Buying options can be cheaper than investing in actual equity as they allow more leverage to the buyer; this is because the amount of capital required is much less than a similar long/short position bought on margin.
Leverage and reward come with increased risk; even though an investor can increase his exposure for less through options and receive higher returns on the same capital if the price swings in the wrong direction the investor loses all his initial investment and is left with no actual shares to sell. Essentially, options are a way of gaining exposure to equity without actually purchasing the shares; you either profit or you lose everything, this makes it more like a bet on the direction of share prices than normal vanilla investing.
Structured Equity Pricing
Structured products are tailored to meet specific risk/reward ratio requirements for clients which are not possible through standard market securities such as standard shares or bonds. Structured equity derivatives often provide exposure to different underlying assets such as shares, a basket of stocks, and indices while incorporating features such as caps on profits and multipliers to achieve the specific reward/risk ratios.
Structured equity derivatives are complex products and so is their pricing; models vary from bank to bank, but the majority follow the structure below. Pricing is broken down into three different stages: the mid-market, walk away, and the markup stage.
- The mid-market price is derived by using the bank’s internal pricing models and quantitative tools. These applications use a mixture of market data alongside in-house sourced research for essential features of the calculation for a derivative trade, for example, the spot (current) price and volatility.
- The second stage is the walkway price which is the minimum price the bank is willing to accept before walking away from a deal. To arrive at this price, traders make a number of adjustments to the mid-market price. The first adjustment is related to the model itself; adjustments are made to take into account the specific features of the structured trade, for example, whether the trade includes a downside protection in the form of put options or a look back feature. The price is then adjusted to how risky the trade is for the bank and hence how difficult it is to hedge. Banks usually hedge equity options by investing in the underlying share itself, an index tracking the share, or by buying options in the opposite direction. Liquidity can greatly vary depending on the duration of the trade, its size, and the underlying shares; a very large trade on an unpopular stock during high volatility can be relatively illiquid and hence difficult to hedge. This further increases the walkway price. A transaction taking place at the walkway price could either make a profit or loss, depending on market movements.
- The last step is when the sales team adds a markup price associated with winning the deal and selling the derivative to the client. This is called the markup price.
The Conflict Of Interest
The conflict of interest becomes apparent at the walk away and markup stages, which are dealt with by the trading and sales teams respectively. While the traders keep a larger share of the profit generated during the walkway price, the clients facing sales team are allowed a larger share of the markup price.
This creates tension and internal politics between the two sides of the investment bank as each fight to increase their bonuses by increasing their share of the profit while keeping the opposite side’s profit to a minimum: the trading team would try to maximise price adjustments during the walkaway phase by overestimating hedging risk or model adjustments while reducing the additions during the markup stage and vice versa.
This creates an environment where the trading and sales teams view themselves as different subunits fighting for profit allocation generated on the same trade.
Consequences And Solutions
If not controlled appropriately, this can lead to overcharging clients with the intent to increase bonuses and profit, which is a criminal offence in certain jurisdictions. State Street recently paid $500m to settle allegations brought forward by a class action lawsuit through the Department of Justice (DOJ) for overcharging clients for FX trades by adding a hidden markup.
BNY Melon paid over $700m to settle similar charges for overcharging pension funds last year. A good solution would be for management and compliance to spend a significant amount of time dealing with conflicts of interest between traders and salespersons regarding the level of profit in the markup and walkway prices. Perhaps aligning bonuses more with value realised by the client rather than predominately making it dependent on individual profit could help resolve this.
If not addressed early, firms can find themselves under scrutiny from the Securities Exchange Commission, the DOJ, the FBI and other federal departments. Firms such as Linkbrokers Derivatives making headlines for million dollar fines and criminal charges due to hiding markups through commission can prove detrimental to day-to-day business and cost the firm far more in bad publicity than the actual fine.
In terms of transparency, the regulatory landscape in banking is almost unrecognisable compared to what it used to be before the 2008 subprime mortgage crises; financial services firms who reform their reward, compliance and management systems to meet modern expectations while separating bonuses from individual profits are the ones likely to avoid accidental overcharging and survive today’s increased scrutiny.