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European equity derivatives markets expand despite counterparty risks

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As institutions in the UK and Continental Europe picked up the pace of their hedging activity last year, European markets for highly liquid flow equity derivatives products expanded, according to the results of Greenwich Associates’ 2009 European Equity Derivatives Investors Study.

Overall, the percentage of European institutions using options products increased to 78 per cent in 2009 from 66 per cent in 2008. This pick-up in institutional demand resulted in an increase in the overall volume of options product traded last year, as measured by the amount of commissions paid by institutions for these trades.

The equity options commission pool increased by an estimated 16 per cent in Europe from 2008 to 2009. This growth stood in stark contrast to conditions in the US, where commission volumes decreased 20-25 per cent from mid-year 2008 to mid-year 2009.

In both regions, institutions experienced significant decreases in assets under management during the financial crisis, which served to depress the size of equity derivatives trades overall. In the US, contraction and deleveraging in the hedge fund industry exacerbated the decline in commission volumes.

"Hedge funds play a much smaller role in the European equity derivatives market than they do in the United States, so deleveraging had less of an impact, and the increased use of these products by long-only institutions pushed commissions and overall market activity higher," says Greenwich Associates consultant John Colon.

Looking ahead, approximately 70 per cent of European institutions expect to increase their use of flow equity derivatives products in 2010, including 11 per cent that expect a significant increase.

"These results suggest that the equity derivatives business in Europe should grow at (at least) a slightly accelerated pace in the next 12 months," says Greenwich Associates consultant Jay Bennett.

Reported notional trading volumes in structured equity and securitized products fell by half among European investors from 2008 to 2009. At the same time, the average number of brokers used by institutions for trades of these products declined sharply last year. These declines were in part due to sell-side consolidation, in particular the demise of Lehman Brothers. However, the lost relationships were also due to pull-backs by both the buy side and the sell side.

"Concerns about counterparty risk and creditworthiness prompted institutions to reevaluate their trading relationships, while brokers operating under their own constraints were rationalizing their resources and capital among their biggest and most profitable clients," says Bennett.

The financial strength of financial service firms and client perceptions of broker counterparty risk are having a strong impact on the competition among sell-side firms for equity derivatives trading business from European institutions. More than 90 per cent of European institutions say they are actively monitoring the creditworthiness of sell-side firms, and more than one third say the creditworthiness of potential counterparties is one of the most important criteria they consider when selecting a broker for a trade of flow equity derivative products.

Currently, 42 per cent of European institutions cite the creditworthiness of potential counterparties as an important factor considered when selecting a broker for a structured equity/securitized products trade, up from 39 per cent in 2008.

"Creditworthiness was not even on the list of most important selection criteria before the start of the global financial crisis," says Colon. "Starting last year, creditworthiness became a necessary condition required by most institutions to even consider working with an individual broker. All other considerations became secondary."

Deutsche Bank and J.P. Morgan rank as the leading dealers of flow equity derivatives in Europe by market penetration, with 55-60 per cent of institutions citing the firms as an important trading relationship in these products. Morgan Stanley ranks third, followed Goldman Sachs and Bank of America Merrill Lynch and Credit Suisse, the last two of which tie for fourth place in the rankings

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