When correlations go to one; when securities are hard to borrow; and when banks are looking to do bespoke trades rather than commoditised executions, prime brokers are increasingly turning to a common solution: Delta one.
Delta one is so-named after the Greek symbol that indicates “change”, because it strives to create derivatives for clients that replicate the performance of an underlying instrument – a change of one-to-one. It is also known as “synthetic”, as opposed to “cash”, in which the client owns the underlying instruments directly.
To the extent that the average person ever considers “delta one” – when they know it as a financial term, rather than assume it to be the name of a secret fighter jet – they probably associate it with rogue traders or high-flying prop trading that regulators are trying to rein in.
But it is an increasingly common prime brokerage service that most hedge funds and institutions demand. While it was born on proprietary desks and initially offered only to a few large accounts, the benchmark survey by Global Investor/ISF last year found that 44 per cent of hedge funds and institutions say synthetics make up at least a fifth of their prime broking.
The most popular trades are equity return swaps, according to a survey by Greenwich Associates last year of 185 hedge funds and institutions. More than a third of hedge funds surveyed by the consultancy said they used equity swaps with their prime broker. That is nearly double the rate of credit default swaps and three times the rate that use interest-rate swaps.
These derivatives aim to offer exposures to baskets of shares, to isolate one company’s performance from others in its sector, or to provide exposure to securities that are otherwise hard to own due to scarcity or national barriers.
The banks make money when they can hedge these offerings more cheaply than their clients can trade them. There are risks to such trades, notably if the hedges are imperfect (or if rogue traders are faking the hedges). But they also offer high fees. JPMorgan Chase, for instance, recently revealed that the average equity swap trade generated margins more than twice that of interest-rate swap trades.
The Global Investor/ISF survey ranked Morgan Stanley, Credit Suisse and Deutsche Bank as the providers with the largest footprints in synthetic finance. Greenwich ranked Goldman Sachs, Morgan Stanley and Bank of America Merrill Lynch as the leaders in equity derivatives.
As demand grows, a wider range of prime brokers are emphasising the offering. HSBC, for example, is specialising in building global exposures, increasingly to frontier markets, which leverages their unique local presence in many markets.
“In certain markets, clients can’t get access on a cash basis, only on a derivative basis,” says Paul Hamill, global head of prime services at HSBC. “Delta one traders have that capability and often have deeper local market knowledge.”
For now, synthetic products still must compete with traditional listed derivatives, such as options or futures. Exchange traded funds that replicate indices or attempt to deliver specific exposures, such as leveraged or inverse returns, are also major competitors.
In some instances, the over-the-counter product is cheaper. “If we can create a synthetic exposure efficiently, it’s often much cheaper and more liquid,” says Keith Skeoch, chief executive of Standard Life Investments, who says the manager’s Global Absolute Return Strategies fund generally prefers derivative positions to cash ones.
However, listed products, with their more readily understood risks, are still the default tool. According to Greenwich, about three-quarters of equity options trading is done via listed products rather than via over-the-counter trades. At present, only clients of banks with which they have documented agreements about collateral and credit risk can do swap trades with the bank.
That may be changing somewhat, as G20 countries have struck an agreement to push more derivatives trades into exchanges and central clearinghouses. The advent of electronic platforms is also streamlining the creation and clearing of swaps as a way to dampen the risk of a broadening client base and the complications of new regulations.
Some banks, such as Barclays and Deutsche Bank, have created tech-nology to carry out necessary pre-trade risk checks in fractions of a second.
“It really comes down to the institution and their internal technology step-up,” says Andrew Jamieson, head of Emea equity finance at JPMorgan. “We have traditionally had more of a cash prime brokerage bias, but have invested heavily in technology and are definitely ramping up synthetically.”
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