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Retail demand drives European structured derivatives growth

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Institutional investors in Europe have stepped up their investment in customized OTC and securitized equity derivative products, according to Greenwich Associates.

Institutional investors in Europe have stepped up their investment in customized OTC and securitized equity derivative products, according to Greenwich Associates.

A new report reveals that these structured derivatives are then being sold on to high net-worth and other retail customers.

“In the United States, our research reveals that investors are making greater use of highly liquid equity derivatives as a substitute for cash equities,” says Greenwich Associates consultant Jay Bennett. “While European institutions are also using so-called ‘flow’ derivatives in this manner, the greater emphasis is on structuring customized OTC/securitized/hybrid product trades for third-party distributors that pass these products on to the retail market, particularly across the Continent.”

These comments are based on the results of Greenwich Associates’ 2005 research study on European equity derivatives, for which the firm interviewed a total of 167 institutions, including 69 investment managers, 57 banks, and 33 hedge funds, mutual funds, and insurance companies in Europe. All of the institutions are users of “flow” derivatives products including listed/vanilla OTC options, futures, equity swaps and ETF products, or customized OTC, securitized, and hybrid derivatives.

The proportion of European institutional investors active in customized OTC, securitized and hybrid derivative products increased from slightly more than 70 per cent in 2004 to nearly 85 per cent in 2005. Over the same period, the notional value of these instruments traded annually by the typical European institution nearly doubled from USD 420 million to USD 820 million.

Trade volumes in these structured products increased dramatically in all European markets from year-to-year. In the United Kingdom, the typical institution’s notional principal trading volume rose from about USD 350 million in 2004 to USD 880 million in 2005. Average Continental trading volumes in these customized OTC, structured products rose from USD 430 million per institution to USD 805 million over the same period, driven by sharp increases in Switzerland (from USD 360 million to USD 870 million) and Germany (from USD 335 million to USD 1.24 billion).

“The main reason that institutional structured trade volumes on the Continent now approach or even exceed those of the United Kingdom is that a substantial portion of Continental investors has begun to on-sell these equity derivatives products to high-net-worth and other retail customers,” says Greenwich Associates consultant John Colon.

More than 70 per cent of Continental institutions that use OTC/securitized/hybrid equity derivatives sell these products off to retail investors. Eighty percent of European banks investing in these equity derivatives have adopted the practice, as have more than two-thirds of mutual fund users and more than 60 per cent of investment managers active in the products. By contrast, only 28 per cent of UK institutional users pass these products on to retail investors.

“In Europe overall, institutions sell off nearly three-quarters of the volume of these products that they buy to high-net-worth or other retail investors,” says Greenwich Associates consultant John Webster. “Including more than 90 per cent in France, more than 80 per cent in Germany, Italy, and the Benelux countries, and 55 per cent to 65 per cent in Spain, Switzerland, and the Nordic countries.”

Many European institutions — banks in particular — re-brand the structured equity products they buy and sell them under their own name. As much as 80 per cent of the OTC equity derivatives products sold in the UK and almost three-quarters of that sold on the Continent is re-branded.

Meanwhile, the strong growth in equity derivative “flow” products that characterized the European market last year flattened in 2005, with incidence of usage by European institutional investors actually diminishing for certain products over the past 12 months.

From 2003 to 2004, the proportion of European institutions using single-stock listed or vanilla OTC options increased from 52 per cent to 68 per cent, and the percentage using index futures rose from 58 per cent to 75 per cent. In 2005, usage of the former levelled off at about 67 per cent of European institutions, while usage of index futures slipped to roughly 70 per cent. Likewise, the usage of listed or vanilla OTC index options levelled at 63 per cent this year.

“These usage trends do not seem to indicate any real reversal in the business,” says John Feng. “Rather, usage is apparently approaching a possible plateau in Europe as the market for these products matures.”


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