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US institutions increase use of highly liquid equity derivatives

US institutions increase use of highly liquid equity derivatives

US institutions are increasing their use of highly liquid "flow" equity derivatives, but declines in asset values and a sharp falloff in hedge fund trading activity have driven down the volume of equity derivatives trades and the amount of commissions paid s, according to a report from Greenwich Associates.

Usage of flow equity derivatives increased among US institutions last year across a range of commonly employed delta-one and option and volatility products. The proportion of institutions using listed/listed "look-alike" options increased to 88 per cent in 2009 from 79 per cent in 2008.

While a stable 74 per cent of institutions traded single-stock options in 2008 and 2009, the use of index options increased to 72 per cent of U.S. institutions from 59 per cent.

Despite this increase in use, the amount of commissions paid by US institutions to brokers on trades of options products declined 20-25 per cent from mid-year 2008 to mid-year 2009.

"This decline can be attributed to two factors, 1) the sharp drop in institutional assets under management last year, and 2) hedge fund deleveraging," says Greenwich Associates consultant Jay Bennett. "Although the share of hedge funds using these options products remains high and actually increased in cases year-over-year, the absolute number of hedge funds active in the market fell, and those remaining had much smaller positions to hedge as a result of the deleveraging process."

The research results suggest that both commission payments and notional trading volumes will increase in the coming year. Fifty-two percent of institutions say they expect to increase their use of flow equity derivatives, including approximately ten per cent of institutions reporting that they plan to increase usage significantly.

Investment managers and hedge funds appear more bullish in their intentions than mutual funds or pensions.

"These results seem to suggest a cautious optimism among US institutions," says Greenwich Associates consultant John Colon. "There is no doubt that institutions expect to be doing more hedging in the next 12 months. But if the market recovery proves sustainable, it appears that institutions expect to increase their use of equity derivatives in order to gain liquidity and desired exposures, in addition to downside protection."

After the dramatic events of the past 18 months, concerns about counterparty risk and creditworthiness are playing a more prominent role in institutions' decisions about equity derivatives trades and strategies.

Almost 30 per cent of US institutions in 2009 cite the creditworthiness of potential counterparties as one of the most important criteria used in selecting brokers on trades of flow derivatives products.

Although competitiveness of options pricing is by far the most important criteria used by institutions in picking a broker for a flow product trade (with 63 per cent of institutions citing it as an important consideration), institutions are also seeking out and rewarding brokers who stepped up during the crisis. Forty-five percent of US institutions cite "consistently strong service during volatile markets" as an important broker selection factor in flow products, up from just 34 per cent last year.

The creditworthiness of potential counterparties now ranks as the third most important factor considered by US institutions when selecting a broker for a structured equity/securitized equity derivatives trade, behind only competitiveness of pricing and the broker's understanding of the institution's investment strategy and hedging needs.

Among investment managers, almost one third are using credit default swap spreads as a means of measuring the creditworthiness of counterparties, 42 per cent are using credit ratings from agencies, and almost half are doing their own proprietary credit analysis.

Goldman Sachs is the leading broker of equity derivatives in the US, as measured by the share of institutions citing the firm as an important trading relationship in these products. Credit Suisse ranks second, followed by J.P. Morgan, third, and Bank of America Merrill Lynch and Morgan Stanley who are tied for fourth.

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