1 00:00:10,720 --> 00:00:14,240 Speaker 1: Hello, and welcome to another episode of the Odd Loots Podcast. 2 00:00:14,360 --> 00:00:18,640 Speaker 1: I'm Tracy Alloway and I'm Joe wisn't Paul Joe? Do 3 00:00:18,720 --> 00:00:26,720 Speaker 1: you know what a super lizard is? What a super lizard? No? 4 00:00:27,040 --> 00:00:30,040 Speaker 1: I have no idea, literally none. Do you know what 5 00:00:30,080 --> 00:00:34,320 Speaker 1: a flash lizard is? Nope? A double chat with these? 6 00:00:34,560 --> 00:00:38,080 Speaker 1: Were these animals that you encountered on your vacation? Like 7 00:00:38,080 --> 00:00:41,120 Speaker 1: with these? Like New Year? Did you vacation somewhere exotic 8 00:00:41,200 --> 00:00:44,519 Speaker 1: and see these lizards? I did, well, I was in 9 00:00:44,640 --> 00:00:47,600 Speaker 1: Marrakech and I did see some chameleons. Um. But no, 10 00:00:47,920 --> 00:00:50,879 Speaker 1: this actually has nothing to do with the animals. Uh. 11 00:00:51,720 --> 00:00:55,760 Speaker 1: It has to do with one of my personal favorite 12 00:00:55,960 --> 00:01:02,640 Speaker 1: financial topics. Okay, So what is a super lizard? Super lizard? Uh? Okay, 13 00:01:02,720 --> 00:01:06,479 Speaker 1: So super lizard or flash lizard or a double chance 14 00:01:06,640 --> 00:01:11,200 Speaker 1: or any number of these interesting and exotic type names. 15 00:01:11,480 --> 00:01:15,160 Speaker 1: Is actually a type of structured product known as an 16 00:01:15,200 --> 00:01:20,400 Speaker 1: autocollable or an equity linked security, and these are a 17 00:01:20,440 --> 00:01:25,520 Speaker 1: type of product where investors basically by an interest bearing 18 00:01:25,640 --> 00:01:29,200 Speaker 1: note that's linked to a particular index like the Hang 19 00:01:29,319 --> 00:01:32,840 Speaker 1: Saying or the nick or something like that. Sometimes they're 20 00:01:32,840 --> 00:01:36,640 Speaker 1: also linked to currencies and they basically do it in 21 00:01:36,840 --> 00:01:40,320 Speaker 1: order to make a profit, so they're sort of exotic 22 00:01:40,600 --> 00:01:43,840 Speaker 1: structured products for retail investors, and they come with these 23 00:01:43,880 --> 00:01:49,440 Speaker 1: great names like super or flash Lizard. I am kind 24 00:01:49,480 --> 00:01:52,720 Speaker 1: of aware of these things called structured products. I kind 25 00:01:52,760 --> 00:01:56,280 Speaker 1: of get how they work. But I have to say 26 00:01:56,320 --> 00:01:59,480 Speaker 1: I'm very excited that I'm this is not an episode 27 00:01:59,520 --> 00:02:03,040 Speaker 1: that I'm doing solo, because I have a feeling there's 28 00:02:03,040 --> 00:02:05,400 Speaker 1: going to be one of those ones where I sort 29 00:02:05,440 --> 00:02:07,640 Speaker 1: of sit back and getting a question here and there, 30 00:02:07,680 --> 00:02:12,120 Speaker 1: but mostly I just listened because this is um tough stuff. 31 00:02:12,960 --> 00:02:16,519 Speaker 1: I think, right, it's complicated. I mean literally, just the 32 00:02:16,520 --> 00:02:19,679 Speaker 1: way you're describing it, I get it. I only because 33 00:02:19,720 --> 00:02:21,840 Speaker 1: I've been doing some reading on these I get what 34 00:02:21,960 --> 00:02:26,480 Speaker 1: these notes are. But this is above my head. I 35 00:02:26,520 --> 00:02:29,160 Speaker 1: think you're under selling yourself, Joe. But I mean, the 36 00:02:29,200 --> 00:02:32,680 Speaker 1: reason these structured products are pretty interesting is because you 37 00:02:32,720 --> 00:02:35,760 Speaker 1: see them pop up every once in a while, and 38 00:02:35,840 --> 00:02:39,360 Speaker 1: usually not in a good way. So, for instance, I 39 00:02:39,360 --> 00:02:42,600 Speaker 1: think the most recent example was in you had a 40 00:02:42,639 --> 00:02:47,160 Speaker 1: French bank, Natixis that had a massive blow up because 41 00:02:47,160 --> 00:02:50,840 Speaker 1: it was selling these structured products and had failed to 42 00:02:51,200 --> 00:02:54,000 Speaker 1: hedge them properly or had gotten the hedge wrong. And 43 00:02:54,040 --> 00:02:56,040 Speaker 1: then before that, I don't know if you remember. This 44 00:02:56,120 --> 00:02:58,680 Speaker 1: was when I was in New York and actually sitting 45 00:02:58,720 --> 00:03:01,760 Speaker 1: next to you, But in twenty fifteen, we had a 46 00:03:01,840 --> 00:03:06,120 Speaker 1: big structured product blow up on a type of product 47 00:03:06,200 --> 00:03:10,120 Speaker 1: known as a TARF uh Target Redemption forward I think 48 00:03:10,160 --> 00:03:13,160 Speaker 1: that's called. That was linked to the Chinese un and 49 00:03:13,240 --> 00:03:17,040 Speaker 1: you remember China unexpectedly devalued the u N and it 50 00:03:17,080 --> 00:03:20,440 Speaker 1: caused all sorts of turmoil in these structured products. I 51 00:03:20,480 --> 00:03:22,240 Speaker 1: don't know if you remember, but I think I actually 52 00:03:22,240 --> 00:03:24,840 Speaker 1: wrote a post at Bloomberg at the time that was 53 00:03:24,880 --> 00:03:27,400 Speaker 1: called the TARF BARF. I'm not sure how I got 54 00:03:27,400 --> 00:03:31,000 Speaker 1: away with that. That's a good one. But basically, the 55 00:03:31,080 --> 00:03:34,160 Speaker 1: idea behind these structured notes, and they're sold mostly to 56 00:03:34,480 --> 00:03:39,200 Speaker 1: retail or high net worth investors, is this idea that 57 00:03:39,440 --> 00:03:42,240 Speaker 1: there's some underlying index, like you said, maybe the Hang 58 00:03:42,400 --> 00:03:46,760 Speaker 1: Sang or maybe something in Europe or whatever, and someone 59 00:03:46,800 --> 00:03:49,160 Speaker 1: will pay money. They'll buy one of these notes and 60 00:03:49,200 --> 00:03:53,680 Speaker 1: get some sort of guaranteed return, except if something happens, 61 00:03:53,680 --> 00:03:55,720 Speaker 1: like maybe it goes down too much or whatever. And 62 00:03:55,760 --> 00:03:57,960 Speaker 1: on the flip side, the bank has to buy or 63 00:03:57,960 --> 00:04:01,240 Speaker 1: sell a bunch of derivatives to actually be to deliver 64 00:04:01,320 --> 00:04:04,720 Speaker 1: this guaranteed return. That kind of how it works. Yeah, 65 00:04:04,800 --> 00:04:07,360 Speaker 1: and see, I knew you were under selling yourself before 66 00:04:07,440 --> 00:04:12,160 Speaker 1: I knew you've been because I've been cramming. Okay, But 67 00:04:12,360 --> 00:04:14,280 Speaker 1: the thing I was getting at is the reason they're 68 00:04:14,320 --> 00:04:16,520 Speaker 1: interesting is because they pop up every once in a while, 69 00:04:16,640 --> 00:04:19,600 Speaker 1: and as you mentioned, they're sort of linked to the 70 00:04:19,720 --> 00:04:23,719 Speaker 1: wider financial system because when stuff starts to go wrong 71 00:04:23,760 --> 00:04:26,480 Speaker 1: with them, you do get a wave of what's known 72 00:04:26,520 --> 00:04:29,960 Speaker 1: as delta hedging at the banks, at the issuing banks, 73 00:04:30,000 --> 00:04:33,200 Speaker 1: and that can impact the market itself, and you can 74 00:04:33,240 --> 00:04:35,600 Speaker 1: sort of get a bad spiral. But we're going to 75 00:04:35,680 --> 00:04:39,200 Speaker 1: get into all of those details. We have the perfect 76 00:04:39,240 --> 00:04:42,760 Speaker 1: person to discuss it. I want to bring in, Ben Effort. 77 00:04:43,000 --> 00:04:47,760 Speaker 1: He runs a QVR Advisers, which manages volatility and derivatives 78 00:04:47,760 --> 00:04:51,120 Speaker 1: for big investors. He's also very good on Twitter, so 79 00:04:51,160 --> 00:04:53,880 Speaker 1: you should check them out there. Ben. It's so good 80 00:04:53,880 --> 00:04:56,560 Speaker 1: to have you, Tracy, it's great to be here. Hey, Joe, 81 00:04:56,600 --> 00:04:58,359 Speaker 1: how are you good? How are you doing? Thanks for 82 00:04:58,400 --> 00:05:03,120 Speaker 1: coming up? Not bad about absolutely so. Joe and I 83 00:05:03,160 --> 00:05:06,039 Speaker 1: were trying to sort of lay the scene just then, 84 00:05:06,080 --> 00:05:09,000 Speaker 1: but I think maybe it would be best to start 85 00:05:09,040 --> 00:05:11,680 Speaker 1: with a sort of potted history of how the structured 86 00:05:11,720 --> 00:05:15,440 Speaker 1: products came into being, because the way in which UH 87 00:05:15,600 --> 00:05:19,520 Speaker 1: they initially got sold and the places where they got sold, 88 00:05:19,760 --> 00:05:22,240 Speaker 1: which is mostly in Asia, kind of gives you an 89 00:05:22,279 --> 00:05:26,599 Speaker 1: idea of the underlying dynamics. So give us a short 90 00:05:26,720 --> 00:05:31,120 Speaker 1: summary of how these things came into being. Yeah. Absolutely, So. 91 00:05:31,160 --> 00:05:33,320 Speaker 1: This is an industry that you know here in the 92 00:05:33,440 --> 00:05:35,440 Speaker 1: US and in New York and even in London to 93 00:05:35,520 --> 00:05:38,120 Speaker 1: some extent. You know, you don't think about as much 94 00:05:38,200 --> 00:05:42,159 Speaker 1: unless you're really directly involved, because your average American investor, 95 00:05:42,360 --> 00:05:44,640 Speaker 1: you know, own some stocks and own some bonds, maybe 96 00:05:44,640 --> 00:05:48,240 Speaker 1: own some ETFs around some mutual funds, but doesn't really 97 00:05:48,279 --> 00:05:51,080 Speaker 1: see much of this type of thingum. But when you 98 00:05:51,120 --> 00:05:55,279 Speaker 1: look at more frontier markets, particularly in Asia and and 99 00:05:55,480 --> 00:05:58,440 Speaker 1: earlier in Europe to a large extent, you know, there 100 00:05:58,440 --> 00:06:02,480 Speaker 1: are markets where you're average retail investor or high net 101 00:06:02,480 --> 00:06:07,560 Speaker 1: worth private bank client historically has been very involved in 102 00:06:07,560 --> 00:06:10,880 Speaker 1: in retail structured products sold out of banks. So you know, 103 00:06:10,920 --> 00:06:12,360 Speaker 1: you go go down to your local B and P 104 00:06:12,520 --> 00:06:15,760 Speaker 1: parab wealth manager and UH and he would be helping 105 00:06:15,880 --> 00:06:19,360 Speaker 1: helping suggesting these types of products to retail. So a 106 00:06:19,400 --> 00:06:21,720 Speaker 1: lot of the history. You know, there's there's i think 107 00:06:21,800 --> 00:06:25,000 Speaker 1: myriad reasons for the different development of these products in 108 00:06:25,279 --> 00:06:28,600 Speaker 1: different markets. But in some of the Asian countries is 109 00:06:28,640 --> 00:06:31,000 Speaker 1: a great example where you know, you don't necessarily have 110 00:06:31,040 --> 00:06:34,960 Speaker 1: a long history of traditional equity and bond markets, so 111 00:06:35,000 --> 00:06:37,719 Speaker 1: like in Korea for example, right, but you had a 112 00:06:37,839 --> 00:06:41,440 Speaker 1: very rapid process of wealth creation in the seventies and 113 00:06:41,480 --> 00:06:45,080 Speaker 1: eighties as as these countries industrialized and as you know, 114 00:06:45,120 --> 00:06:50,359 Speaker 1: many middle class rapidly developed and a class of of wealthy, 115 00:06:50,480 --> 00:06:53,520 Speaker 1: wealthy folks, and they were looking for places to put 116 00:06:53,560 --> 00:06:56,720 Speaker 1: their money, and these type of products presented the very 117 00:06:56,720 --> 00:06:59,320 Speaker 1: attractive opportunities that both for banks to sell and in 118 00:06:59,360 --> 00:07:02,440 Speaker 1: some ways for those investors to get involved in. Because 119 00:07:02,520 --> 00:07:05,000 Speaker 1: then we'll get into some of the details. But you know, 120 00:07:05,000 --> 00:07:08,479 Speaker 1: there's many good optics around the investment characteristics of the 121 00:07:08,520 --> 00:07:12,480 Speaker 1: product and also you know typically typically they can be 122 00:07:12,640 --> 00:07:15,360 Speaker 1: you know, currency hedge type of exposures, which matters a lot, 123 00:07:15,440 --> 00:07:18,040 Speaker 1: right as like a local Korean investor, you're not trying 124 00:07:18,040 --> 00:07:20,400 Speaker 1: to get involved in US market someplace and take a 125 00:07:20,400 --> 00:07:23,080 Speaker 1: bunch of currency risks, so you tended to see you know, 126 00:07:23,160 --> 00:07:26,520 Speaker 1: Japan very early developed a big structured products market, was 127 00:07:26,560 --> 00:07:28,960 Speaker 1: one of the first in Asia, and then eventually Korea, 128 00:07:29,080 --> 00:07:31,880 Speaker 1: China also, and you also see a reasonable amount of 129 00:07:31,880 --> 00:07:35,280 Speaker 1: structured products historically coming out of Europe as well, Swiss 130 00:07:35,320 --> 00:07:39,680 Speaker 1: private banks for example. So let's just break this down 131 00:07:39,720 --> 00:07:43,160 Speaker 1: like super vanilla to start, and then we'll get into 132 00:07:43,240 --> 00:07:46,280 Speaker 1: sort of the complicated aspects of why these products are 133 00:07:46,320 --> 00:07:50,600 Speaker 1: interesting in the ramifications, but just in terms so that 134 00:07:50,640 --> 00:07:54,360 Speaker 1: people understand what the buyer of these products are getting. 135 00:07:54,400 --> 00:07:57,800 Speaker 1: So take us through like a very like prototypical I 136 00:07:57,800 --> 00:08:00,960 Speaker 1: don't know, fifty year old person comes in and they 137 00:08:01,000 --> 00:08:03,120 Speaker 1: have some money and they want to make an investment, 138 00:08:03,240 --> 00:08:05,680 Speaker 1: but they're a little worried about risk and volatility, maybe 139 00:08:05,680 --> 00:08:10,000 Speaker 1: they're gonna retire. What is the basic offering that maybe 140 00:08:10,040 --> 00:08:12,240 Speaker 1: someone at the bank is telling this person why it 141 00:08:12,280 --> 00:08:16,240 Speaker 1: may might make sense for them to buy some structured product, 142 00:08:16,600 --> 00:08:18,720 Speaker 1: and what are they sort of being told about the 143 00:08:18,840 --> 00:08:22,520 Speaker 1: upside and the potential risks. Absolutely, So, first I'll give 144 00:08:22,560 --> 00:08:25,280 Speaker 1: you an example of really where the industry got started, 145 00:08:26,040 --> 00:08:28,840 Speaker 1: and then maybe an example from more recent times of 146 00:08:28,840 --> 00:08:31,520 Speaker 1: where the industry has evolved to. So a lot of 147 00:08:31,560 --> 00:08:34,120 Speaker 1: the growth of structured product markets, say in the eighties 148 00:08:34,120 --> 00:08:37,080 Speaker 1: and nineties, of what you would typically see was just 149 00:08:37,280 --> 00:08:42,960 Speaker 1: variations on the good old fashioned principal protected note. So 150 00:08:43,040 --> 00:08:45,320 Speaker 1: this would just be exactly the you know, the person 151 00:08:45,360 --> 00:08:48,079 Speaker 1: who said walks into their local wealth manager and they 152 00:08:48,120 --> 00:08:51,920 Speaker 1: get shown, um, a note that gives them effectively the 153 00:08:52,000 --> 00:08:56,199 Speaker 1: upside price return of the index. Let's call it the eurostock. 154 00:08:56,280 --> 00:08:58,960 Speaker 1: Say it's you know, a Swiss private bank. Um, so 155 00:08:59,120 --> 00:09:01,319 Speaker 1: you know they're going to put a dollars down if 156 00:09:01,360 --> 00:09:04,160 Speaker 1: the eurostocks this goes up, you know, ten percent by 157 00:09:04,160 --> 00:09:06,439 Speaker 1: the maturity of the note. Um, they're gonna get They're 158 00:09:06,440 --> 00:09:11,240 Speaker 1: gonna make ten percent. But importantly, they are going to 159 00:09:11,280 --> 00:09:14,960 Speaker 1: get their principle back no matter what, unless, of course, 160 00:09:15,000 --> 00:09:18,080 Speaker 1: the bank default, which is a whole different story. There's 161 00:09:18,080 --> 00:09:21,240 Speaker 1: some counterparty risk here, but right, So effectively, to the 162 00:09:21,440 --> 00:09:23,440 Speaker 1: end investor, they say, hey, this is great, Right, this 163 00:09:23,520 --> 00:09:25,959 Speaker 1: is kind of like getting involved in the equity market. 164 00:09:26,000 --> 00:09:27,600 Speaker 1: But I'm a little worried that it might go down. 165 00:09:28,400 --> 00:09:31,240 Speaker 1: And from an investor's perspective, it's basically like buying a 166 00:09:31,320 --> 00:09:34,720 Speaker 1: zero coupon bond and a call option. Right, And this 167 00:09:34,720 --> 00:09:38,720 Speaker 1: this worked, right, This was attractive to the investor because 168 00:09:38,760 --> 00:09:43,040 Speaker 1: you've got some downside protection because typically you've got you know, 169 00:09:43,120 --> 00:09:47,679 Speaker 1: reasonable upside. Often investors often don't think about the fact 170 00:09:47,800 --> 00:09:50,440 Speaker 1: that they're getting the price appreciation of the stocks, when 171 00:09:50,480 --> 00:09:53,319 Speaker 1: actually dividends are really important. Right, They're not getting dividends, 172 00:09:53,320 --> 00:09:56,080 Speaker 1: so that's already one way that they're paying for it, 173 00:09:56,080 --> 00:09:58,880 Speaker 1: even if they're not really thinking about it exactly. And 174 00:09:58,960 --> 00:10:01,800 Speaker 1: so often you have those type of aspects where there's 175 00:10:01,840 --> 00:10:04,440 Speaker 1: some slightly subtle trade offs in the economics of the 176 00:10:04,440 --> 00:10:07,480 Speaker 1: note that your typical retail investor might not always think about. 177 00:10:07,679 --> 00:10:09,520 Speaker 1: But hey, they're getting some upside in the equity market, 178 00:10:09,600 --> 00:10:12,800 Speaker 1: they have limited downside, uh, you know, they like you know, 179 00:10:12,840 --> 00:10:14,319 Speaker 1: they like this type of thing. And in the old 180 00:10:14,400 --> 00:10:17,160 Speaker 1: days when interest rates were six percent or eight percent, 181 00:10:17,440 --> 00:10:19,720 Speaker 1: of this worked right because you could buy that zero 182 00:10:19,760 --> 00:10:23,880 Speaker 1: coupon bond effectively, or the bank that's structuring this product 183 00:10:23,960 --> 00:10:26,040 Speaker 1: could fund it by buying a zero coupon bond that 184 00:10:26,120 --> 00:10:28,640 Speaker 1: was going to generate that capital that sort of principal 185 00:10:28,679 --> 00:10:30,960 Speaker 1: protection and then use and then use some money to 186 00:10:30,960 --> 00:10:34,200 Speaker 1: buy a call option. So that's a pretty simple structure, 187 00:10:34,200 --> 00:10:37,560 Speaker 1: pretty easy to understand for the most part. Where now 188 00:10:37,600 --> 00:10:39,280 Speaker 1: that the interesting. You know, a big part of the 189 00:10:39,280 --> 00:10:42,880 Speaker 1: evolution of this market over the last ten years has been, 190 00:10:43,440 --> 00:10:45,480 Speaker 1: so what do you do with this industry when you 191 00:10:45,520 --> 00:10:47,679 Speaker 1: know there's no more sixth rate percent interest rates to 192 00:10:47,800 --> 00:10:51,240 Speaker 1: fund this type of principal protection that was so attractive 193 00:10:51,280 --> 00:10:54,760 Speaker 1: to a certain set of investors. Right these days, you 194 00:10:54,800 --> 00:10:59,319 Speaker 1: think more of the problems or one problem facing investors 195 00:10:59,320 --> 00:11:01,320 Speaker 1: at all types, right is how on earth do you 196 00:11:01,360 --> 00:11:04,360 Speaker 1: generate a decent yield on a on a fixed income 197 00:11:04,480 --> 00:11:07,120 Speaker 1: style investment? Right, You've got you know, if you want 198 00:11:07,160 --> 00:11:09,079 Speaker 1: to get a seven percent yield, and look in the 199 00:11:09,120 --> 00:11:11,320 Speaker 1: credit markets at the quality of credit, you know that 200 00:11:11,400 --> 00:11:13,160 Speaker 1: you have to credit risk that you have to take 201 00:11:13,200 --> 00:11:16,520 Speaker 1: in order to generate a seven percent yield. It's pretty scary. Um. 202 00:11:16,600 --> 00:11:19,679 Speaker 1: And so in this world of very low interest rates, 203 00:11:20,160 --> 00:11:24,559 Speaker 1: effectively what structured products businesses at banks that manufacture these 204 00:11:24,559 --> 00:11:27,640 Speaker 1: products andthink creatively about, you know, what they can offer. 205 00:11:28,120 --> 00:11:32,160 Speaker 1: They found various ways to effectively sell options to generate yield, 206 00:11:32,440 --> 00:11:34,320 Speaker 1: right in a world with low interest rates on the 207 00:11:34,320 --> 00:11:36,200 Speaker 1: way that you generate yield for the most part, as 208 00:11:36,240 --> 00:11:38,400 Speaker 1: you set you either take credit risk or you sell options. 209 00:11:38,880 --> 00:11:43,000 Speaker 1: And so a more typical type of product these days. 210 00:11:43,040 --> 00:11:45,240 Speaker 1: That has grown very rapidly over the last ten years. 211 00:11:45,280 --> 00:11:48,240 Speaker 1: Tracy alluded to it is what you might call the 212 00:11:48,280 --> 00:11:52,080 Speaker 1: reverse convertible auto call, and and what that of those 213 00:11:52,240 --> 00:11:55,400 Speaker 1: products effectively are a zillion different variations on a very 214 00:11:55,440 --> 00:11:58,520 Speaker 1: simple idea, which is, you know, the investor is going 215 00:11:58,559 --> 00:12:01,160 Speaker 1: to put down their hundred dollars, they're going to get 216 00:12:01,200 --> 00:12:03,800 Speaker 1: a coupon, an annual coupon, just like a bomb, so 217 00:12:04,000 --> 00:12:07,880 Speaker 1: call it six percent or eight percent, but in exchange, 218 00:12:08,280 --> 00:12:11,160 Speaker 1: they're going to take the risk that if something bad happens, 219 00:12:11,200 --> 00:12:13,040 Speaker 1: they're going to lose a bunch of money. Typically it 220 00:12:13,040 --> 00:12:16,640 Speaker 1: would be if the underlying index or the worst return 221 00:12:16,760 --> 00:12:20,120 Speaker 1: within a set of underlying in disease was down, say, 222 00:12:20,920 --> 00:12:22,880 Speaker 1: or thirty five percent at any points in the next 223 00:12:22,920 --> 00:12:25,760 Speaker 1: few years, they're just going to lose that get knocked 224 00:12:25,760 --> 00:12:29,280 Speaker 1: out of that note, and lose their So effectively, they're 225 00:12:29,360 --> 00:12:31,520 Speaker 1: they're selling that option to the to the to the 226 00:12:31,520 --> 00:12:34,320 Speaker 1: bank in exchange for getting that coupon, and then they'll 227 00:12:34,320 --> 00:12:36,320 Speaker 1: come with all kinds of other bells and whistles on them. 228 00:12:36,480 --> 00:12:38,800 Speaker 1: But that's the very basic idea, is you get a 229 00:12:38,800 --> 00:12:42,200 Speaker 1: coupon a fixed income stream in exchange, you take that 230 00:12:42,320 --> 00:12:46,480 Speaker 1: risk of the of the bad scenario. So, Ben, you 231 00:12:46,559 --> 00:12:51,880 Speaker 1: mentioned the issuers behind these products, which are are usually banks, 232 00:12:52,200 --> 00:12:57,520 Speaker 1: often French ones. Oddly enough, walk us through exactly how 233 00:12:57,720 --> 00:13:02,880 Speaker 1: the banks sell these products and where their profits come from. 234 00:13:02,960 --> 00:13:08,199 Speaker 1: When they're selling this sort of panoply of offerings you know, autocollables, 235 00:13:08,280 --> 00:13:12,079 Speaker 1: equity link securities, tarts, whatever you want to call them. 236 00:13:12,200 --> 00:13:15,400 Speaker 1: Absolutely so, there will typically be you know, several layers 237 00:13:15,440 --> 00:13:18,959 Speaker 1: of of the of the value chain and distribution. Right, So, 238 00:13:19,640 --> 00:13:22,960 Speaker 1: the clients, the end retail investor will be sitting down 239 00:13:23,000 --> 00:13:26,160 Speaker 1: with a broker or with a financial advisor of some kind, 240 00:13:26,280 --> 00:13:30,160 Speaker 1: right and typically um, when the client buys that note, 241 00:13:30,160 --> 00:13:33,680 Speaker 1: typically there's first some kind of commission directly to the 242 00:13:33,720 --> 00:13:37,560 Speaker 1: financial advisor, right. Um. Then often there will also be 243 00:13:37,960 --> 00:13:40,079 Speaker 1: just an upfront load, the same way you used to 244 00:13:40,120 --> 00:13:42,640 Speaker 1: see upfront loads on mutual funds. So there might also 245 00:13:42,720 --> 00:13:46,000 Speaker 1: be an upfront effectively commission that goes back to the bank. 246 00:13:47,120 --> 00:13:51,880 Speaker 1: Then within the bank, there's probably a structuring you know, 247 00:13:52,000 --> 00:13:55,120 Speaker 1: structuring desk that was involved in the creation of the 248 00:13:55,160 --> 00:13:58,000 Speaker 1: security that might get that might get a cut. There's 249 00:13:58,080 --> 00:14:02,360 Speaker 1: the trading desk itself, which have is going to make 250 00:14:02,360 --> 00:14:04,959 Speaker 1: a price for that note. So typically the note will 251 00:14:04,960 --> 00:14:07,280 Speaker 1: be structured and it will be offered, and the trading 252 00:14:07,320 --> 00:14:09,600 Speaker 1: desk will will make a price, and typically that price 253 00:14:09,640 --> 00:14:13,200 Speaker 1: will contain effectively some bit ask spread, the same way 254 00:14:13,240 --> 00:14:15,800 Speaker 1: that any trade that one was to quote a bank 255 00:14:15,840 --> 00:14:18,760 Speaker 1: on would contain some bit ask spread. You know, most 256 00:14:18,800 --> 00:14:21,840 Speaker 1: of these different pieces. You know, usually the upfront charge 257 00:14:21,840 --> 00:14:24,520 Speaker 1: on the security is transparent to the end investor. You know, 258 00:14:24,560 --> 00:14:26,920 Speaker 1: the commission to the to the broker typically would not 259 00:14:27,000 --> 00:14:29,680 Speaker 1: be certainly the bid ask spread to the traders sort of, 260 00:14:29,680 --> 00:14:32,040 Speaker 1: whereas the fair value of this note would not be 261 00:14:32,080 --> 00:14:35,880 Speaker 1: transparent to the investor. So you know, usually there's quite 262 00:14:35,880 --> 00:14:38,200 Speaker 1: a lot of embedded costs and these, you know, and 263 00:14:38,280 --> 00:14:41,280 Speaker 1: only only part of it would typically be transparent to 264 00:14:41,320 --> 00:14:45,720 Speaker 1: the end client. So one of the benefits to the 265 00:14:45,760 --> 00:14:48,920 Speaker 1: banks who are issuing the products is that they get 266 00:14:49,120 --> 00:14:52,040 Speaker 1: all these fees and commissions as you describe, and they 267 00:14:52,080 --> 00:14:56,360 Speaker 1: also sort of get a cheap form of funding via 268 00:14:56,480 --> 00:15:00,920 Speaker 1: the retail investment. But it doesn't come for free for 269 00:15:00,960 --> 00:15:03,240 Speaker 1: the banks in the sense that they actually have to 270 00:15:03,600 --> 00:15:08,160 Speaker 1: offset the exposure that they're taking on by selling the products. 271 00:15:08,240 --> 00:15:12,720 Speaker 1: And this is where I promise autocollables and equity link 272 00:15:12,760 --> 00:15:16,160 Speaker 1: securities start to get really interesting. It's actually through the 273 00:15:16,240 --> 00:15:21,240 Speaker 1: relationship with the issuing bank. So how exactly do the 274 00:15:21,280 --> 00:15:26,440 Speaker 1: issuers go about hedging their exposure. Yeah, no, that's exactly right, Tracy. 275 00:15:26,560 --> 00:15:30,280 Speaker 1: So banks are not in the business of taking market 276 00:15:30,400 --> 00:15:33,240 Speaker 1: risk on the other side of these type of transactions, right, 277 00:15:33,280 --> 00:15:36,040 Speaker 1: the bank ideally wants to generate the set of fees 278 00:15:36,120 --> 00:15:38,480 Speaker 1: for the service that it's providing to the to the 279 00:15:38,560 --> 00:15:41,000 Speaker 1: end investor, and then to isolate that and to hedge 280 00:15:41,000 --> 00:15:44,640 Speaker 1: out the market risk. Right, So the bank is issuing 281 00:15:44,640 --> 00:15:47,760 Speaker 1: a liability effectively right where it's promising to pay the 282 00:15:47,840 --> 00:15:50,080 Speaker 1: end investor according to the terms of the note. In 283 00:15:50,120 --> 00:15:53,000 Speaker 1: the case of you know, the old fashioned, very simple 284 00:15:53,040 --> 00:15:55,560 Speaker 1: thing that I described, that principle protected note, if it's 285 00:15:55,560 --> 00:15:58,400 Speaker 1: a very vanilla one, let's say you know, a eurostocks 286 00:15:58,480 --> 00:16:03,120 Speaker 1: effectively call option plus embedded embedded bond, that's quite simple 287 00:16:03,120 --> 00:16:05,720 Speaker 1: to hedge. Right, the bank might issue this principle protected note. 288 00:16:05,760 --> 00:16:08,240 Speaker 1: It might buy some buy some zero coupon bonds, and 289 00:16:08,280 --> 00:16:10,280 Speaker 1: it might buy some call options on the eurostocks, and 290 00:16:10,320 --> 00:16:12,440 Speaker 1: that might actually be you know, quite at quite a 291 00:16:12,440 --> 00:16:15,960 Speaker 1: good hedge. Right in the case of reverse auto call 292 00:16:16,320 --> 00:16:19,520 Speaker 1: type of securities where the client is actually selling options 293 00:16:19,560 --> 00:16:22,880 Speaker 1: to the bank. In this case, typically the bank is 294 00:16:23,400 --> 00:16:27,200 Speaker 1: having to go out and sell downside puts, typically longer term, 295 00:16:27,920 --> 00:16:31,040 Speaker 1: in order to be a first order of magnitude hedge 296 00:16:31,080 --> 00:16:33,400 Speaker 1: for these type of securities. The trick really comes in 297 00:16:33,480 --> 00:16:37,120 Speaker 1: and how complex these notes get quite quickly, right, so 298 00:16:37,600 --> 00:16:40,400 Speaker 1: you know that the simple example is again just take 299 00:16:40,440 --> 00:16:43,440 Speaker 1: the eurostocks again. Maybe the client puts down a hundred 300 00:16:43,440 --> 00:16:46,200 Speaker 1: dollars and it's going to get eight percent coupon unless 301 00:16:46,280 --> 00:16:49,800 Speaker 1: the Euro stocks is down at some point upon which 302 00:16:49,840 --> 00:16:53,440 Speaker 1: they get knocked in. One subtlety there the description of 303 00:16:53,480 --> 00:16:57,080 Speaker 1: that short optionality. That's not just being short of put option, right, 304 00:16:57,200 --> 00:17:00,440 Speaker 1: it's being short something trickier because the client doesn't actually 305 00:17:00,480 --> 00:17:05,600 Speaker 1: lose money unlesson until the eurostocks is down and then 306 00:17:05,640 --> 00:17:09,119 Speaker 1: they lose, right, So that's actually something that's called a 307 00:17:09,200 --> 00:17:11,639 Speaker 1: knock in put option, and right away that's like a 308 00:17:11,680 --> 00:17:16,199 Speaker 1: tricky thing that doesn't have any easy replicating portfolio and options. 309 00:17:16,240 --> 00:17:21,280 Speaker 1: And then as implied volatilities fell and yields fell, banks 310 00:17:21,280 --> 00:17:24,159 Speaker 1: had to add more and more features to these notes 311 00:17:24,240 --> 00:17:26,720 Speaker 1: to make them still generate that six or seven or 312 00:17:26,760 --> 00:17:29,560 Speaker 1: eight percent yield that the clients wanted right. So typically 313 00:17:29,600 --> 00:17:32,320 Speaker 1: these days you'll see that type of product. It won't 314 00:17:32,359 --> 00:17:34,440 Speaker 1: just be linked to the eurostocks. It will be linked 315 00:17:34,480 --> 00:17:36,879 Speaker 1: to the eurostocks and the H S C E I 316 00:17:37,119 --> 00:17:39,960 Speaker 1: and the Knik for example, and it will act as 317 00:17:39,960 --> 00:17:42,920 Speaker 1: if whatever the worst performing index of that whole basket 318 00:17:42,960 --> 00:17:45,600 Speaker 1: is right. So that introduces a bunch of very hard 319 00:17:45,640 --> 00:17:47,760 Speaker 1: to manage risk from the perspective of a bank. So 320 00:17:47,880 --> 00:17:50,479 Speaker 1: you know, typically if you talk to to anybody who 321 00:17:50,600 --> 00:17:53,720 Speaker 1: runs one of these these portfolios managing these risks, you 322 00:17:53,720 --> 00:17:56,000 Speaker 1: know they'll they have very complex models and at the 323 00:17:56,080 --> 00:17:58,240 Speaker 1: end of the day they'll describe their risk as sort 324 00:17:58,280 --> 00:18:20,359 Speaker 1: of a reasonable guess. So before we go on, there's 325 00:18:20,359 --> 00:18:23,960 Speaker 1: a couple key points of clarification that I just want 326 00:18:24,040 --> 00:18:27,640 Speaker 1: to wrap my head around in terms of how these 327 00:18:27,640 --> 00:18:30,880 Speaker 1: things work. So the first question that I have, can 328 00:18:30,920 --> 00:18:34,800 Speaker 1: you explain for people and maybe including me, who don't 329 00:18:34,840 --> 00:18:37,680 Speaker 1: totally understand it when you say they have to sell 330 00:18:37,760 --> 00:18:41,439 Speaker 1: options to generate yield. Just this basic concept is the 331 00:18:41,520 --> 00:18:47,399 Speaker 1: idea essentially that that you're selling downside protection. You're selling 332 00:18:47,440 --> 00:18:50,520 Speaker 1: puts to people who are sort of natural hedgers or 333 00:18:50,560 --> 00:18:53,199 Speaker 1: people who want to buy downside protection, they pay for 334 00:18:53,280 --> 00:18:57,439 Speaker 1: that downside protection, and that becomes the de facto yield 335 00:18:57,520 --> 00:19:00,280 Speaker 1: or that becomes a de facto yield for the line. 336 00:19:00,280 --> 00:19:03,320 Speaker 1: Does that essentially what you're saying, Yeah, exactly. So when 337 00:19:03,320 --> 00:19:06,600 Speaker 1: you sell an option, you receive a premium for doing so. Right, 338 00:19:06,640 --> 00:19:08,119 Speaker 1: So if you go out into the market and you 339 00:19:08,160 --> 00:19:11,200 Speaker 1: sell us three year, you know, out of the money 340 00:19:11,240 --> 00:19:13,159 Speaker 1: put on the euro stocks, you're going to get paid 341 00:19:13,680 --> 00:19:17,280 Speaker 1: um some amount of euros for that. And if and 342 00:19:17,320 --> 00:19:18,680 Speaker 1: that you know that it will have a price that 343 00:19:18,680 --> 00:19:21,479 Speaker 1: will fluctuate. But if you go throughout the life of 344 00:19:21,520 --> 00:19:24,240 Speaker 1: that three year option and expires worthless, you will have 345 00:19:24,280 --> 00:19:26,840 Speaker 1: collected that premium over that period of time, and you 346 00:19:26,880 --> 00:19:29,560 Speaker 1: can think of that as a yield. And then you 347 00:19:29,720 --> 00:19:34,160 Speaker 1: mentioned there's like this weird situation where Okay, let's say 348 00:19:34,240 --> 00:19:37,880 Speaker 1: the owner of the note is knocked in if the 349 00:19:38,880 --> 00:19:42,119 Speaker 1: if the underlying index against which the note is written 350 00:19:42,160 --> 00:19:46,680 Speaker 1: save if it falls, then that person loses. But if 351 00:19:46,680 --> 00:19:51,359 Speaker 1: it only falls, or if it only folvescent, then the 352 00:19:51,400 --> 00:19:54,680 Speaker 1: bank is compelled to make the note hold our whole. 353 00:19:54,880 --> 00:19:58,960 Speaker 1: So what you're describing in terms of the complexity and 354 00:19:59,000 --> 00:20:02,680 Speaker 1: the difficulty of like finding this perfect hedge is as 355 00:20:02,720 --> 00:20:05,919 Speaker 1: a result of this fact that the risk builds for 356 00:20:05,960 --> 00:20:09,439 Speaker 1: the bank as the market falls and falls until a 357 00:20:09,440 --> 00:20:12,199 Speaker 1: certain point, and then the risk kind of disappears and reverses, 358 00:20:12,720 --> 00:20:16,520 Speaker 1: which makes I guess this particularly tricky and finding the 359 00:20:16,640 --> 00:20:20,240 Speaker 1: right valuation and price for these things. That's right. This 360 00:20:20,359 --> 00:20:23,119 Speaker 1: is a it's a type of barrier option. It's a 361 00:20:23,240 --> 00:20:25,720 Speaker 1: very complex security, right, which is quite hard to hedge 362 00:20:25,720 --> 00:20:29,000 Speaker 1: exactly as you point out, as the market as the 363 00:20:29,080 --> 00:20:33,440 Speaker 1: underlying index approaches that barrier point for one particular note, 364 00:20:33,840 --> 00:20:36,479 Speaker 1: you have sort of a binary a binary result. Right 365 00:20:36,560 --> 00:20:39,440 Speaker 1: either if it if the market goes down a bunch more, 366 00:20:39,480 --> 00:20:42,680 Speaker 1: you're going to trigger and the underlying note is going 367 00:20:42,760 --> 00:20:45,560 Speaker 1: to cost the underlying investor a bunch of money. But 368 00:20:45,600 --> 00:20:48,120 Speaker 1: if it doesn't, if it just stays there, then it's 369 00:20:48,160 --> 00:20:51,200 Speaker 1: actually then that that risk fades away. And in a 370 00:20:51,359 --> 00:20:54,040 Speaker 1: in a complex portfolio of many and many many of 371 00:20:54,080 --> 00:20:57,200 Speaker 1: these kinds of notes with all different linkages to different indicries, 372 00:20:57,840 --> 00:20:59,760 Speaker 1: you know, the hedge is quite difficult to the initial 373 00:20:59,760 --> 00:21:03,160 Speaker 1: Tipically that banks will will do an initial proxy hedge, 374 00:21:03,200 --> 00:21:05,919 Speaker 1: which for most of these types of instruments when they 375 00:21:05,960 --> 00:21:08,760 Speaker 1: issue new structured product risk they'll be out in the 376 00:21:08,760 --> 00:21:11,960 Speaker 1: market selling you know, longer term call it two or 377 00:21:12,000 --> 00:21:14,680 Speaker 1: three year, twenty or thirty percent out of the money 378 00:21:14,680 --> 00:21:17,440 Speaker 1: put options you know, which aren't okay day one proxy 379 00:21:17,480 --> 00:21:20,760 Speaker 1: hedge for the style overall flavor of the risk you know. 380 00:21:20,800 --> 00:21:23,880 Speaker 1: But over time, as these products age and different indicries 381 00:21:23,920 --> 00:21:26,080 Speaker 1: go up or other ones go down, and all of 382 00:21:26,119 --> 00:21:28,800 Speaker 1: the risk you know, moves moves all over the place. 383 00:21:29,200 --> 00:21:31,160 Speaker 1: But then all the you know, the really fun stuff 384 00:21:31,200 --> 00:21:34,720 Speaker 1: and you you alluded to this is really in you know, 385 00:21:34,800 --> 00:21:37,159 Speaker 1: the at this point, these are very large markets, right, 386 00:21:37,200 --> 00:21:39,520 Speaker 1: so we're talking about you know, Korea alone is well 387 00:21:39,560 --> 00:21:42,359 Speaker 1: over a hundred billion dollars a year of issuance of 388 00:21:42,440 --> 00:21:45,560 Speaker 1: these type of products. Japan is large, you know, some 389 00:21:45,560 --> 00:21:49,679 Speaker 1: some European locations are decent sized. And these these the 390 00:21:49,800 --> 00:21:52,840 Speaker 1: risk from these products are actually sort of the largest 391 00:21:53,040 --> 00:21:56,399 Speaker 1: sources of buying and selling of longer term options on 392 00:21:56,440 --> 00:21:58,720 Speaker 1: global indusries in the world, right, so bigger than like 393 00:21:58,800 --> 00:22:02,200 Speaker 1: pension funds doing hedging, for example, or bigger than hedge 394 00:22:02,200 --> 00:22:05,080 Speaker 1: funds buying or selling long term in disease. And so 395 00:22:05,119 --> 00:22:08,280 Speaker 1: what that means is the when you get so that 396 00:22:08,400 --> 00:22:11,000 Speaker 1: the banks that are out in the market having to 397 00:22:11,080 --> 00:22:13,840 Speaker 1: manage this risk. You know, typically are all in a 398 00:22:13,880 --> 00:22:17,000 Speaker 1: similar type of position, right, because more or less the 399 00:22:17,040 --> 00:22:20,159 Speaker 1: products that they're selling to retail have the same characteristics, 400 00:22:21,119 --> 00:22:25,720 Speaker 1: and when something funny happens, they are a huge part 401 00:22:25,760 --> 00:22:27,600 Speaker 1: of the volume of that market and all trying to 402 00:22:27,640 --> 00:22:30,240 Speaker 1: do the same thing. So Tracy alluded to, for example, 403 00:22:31,800 --> 00:22:34,680 Speaker 1: you know, what you had was this the scenario in 404 00:22:34,720 --> 00:22:37,600 Speaker 1: which Chinese markets rallied very very fast in the summer, 405 00:22:39,320 --> 00:22:41,080 Speaker 1: and there was a lot of issuance of these types 406 00:22:41,119 --> 00:22:43,840 Speaker 1: of products as retail was very involved in speculation and 407 00:22:43,880 --> 00:22:49,199 Speaker 1: equity markets. And then the market suddenly fell over a 408 00:22:49,200 --> 00:22:52,919 Speaker 1: few months almost in China, right, the equity markets, and 409 00:22:52,960 --> 00:22:55,800 Speaker 1: what that meant was many of these products, right, So 410 00:22:55,840 --> 00:22:59,160 Speaker 1: banks had been gone out and sold downside put options 411 00:22:59,200 --> 00:23:03,960 Speaker 1: and sometimes very and swaps against these portfolios of auto calls. 412 00:23:04,000 --> 00:23:06,280 Speaker 1: But then as the market falls very fast, all of 413 00:23:06,320 --> 00:23:08,800 Speaker 1: a sudden, the auto calls start, you get close to 414 00:23:08,880 --> 00:23:11,840 Speaker 1: knocking out some of them knock out, and the banks 415 00:23:11,880 --> 00:23:13,960 Speaker 1: all have to go and buy back those hedges which 416 00:23:13,960 --> 00:23:16,800 Speaker 1: they've sold, right, because they run into this this barrier 417 00:23:16,840 --> 00:23:19,320 Speaker 1: problem where they have this kind of complex security that 418 00:23:19,560 --> 00:23:22,120 Speaker 1: they had an okay, hedge four day one. But once 419 00:23:22,200 --> 00:23:24,040 Speaker 1: you have a big market crash all of a sudden, 420 00:23:24,040 --> 00:23:25,720 Speaker 1: that's not a good hedge anymore. And you had a 421 00:23:25,760 --> 00:23:28,760 Speaker 1: huge short squeeze and options and volatility that blew up 422 00:23:28,760 --> 00:23:30,840 Speaker 1: a bunch of banks and a bunch of hedge funds. 423 00:23:30,840 --> 00:23:32,320 Speaker 1: Some hedge funds made a bunch of money and some 424 00:23:32,359 --> 00:23:34,000 Speaker 1: hedge funds lost a bunch of money, and it was 425 00:23:34,040 --> 00:23:37,520 Speaker 1: causing a very major issues in those markets. So they 426 00:23:37,600 --> 00:23:40,520 Speaker 1: kind of all end up I guess short vall when 427 00:23:40,520 --> 00:23:43,000 Speaker 1: these things get knocked in, which means they have to 428 00:23:43,000 --> 00:23:46,280 Speaker 1: buy more puts and some more features and sort of 429 00:23:46,320 --> 00:23:49,720 Speaker 1: do this imperfect hedge at exactly the wrong time, and 430 00:23:49,720 --> 00:23:52,560 Speaker 1: they have to compete with everyone else to do the 431 00:23:52,640 --> 00:23:56,520 Speaker 1: imperfect hedge at exactly the wrong time. Exactly, No, that's 432 00:23:56,520 --> 00:23:59,040 Speaker 1: exactly right. So the key thing to think about is 433 00:23:59,680 --> 00:24:02,119 Speaker 1: the banks when they do these, when they issue these 434 00:24:02,119 --> 00:24:05,679 Speaker 1: types of securities, they're effectively buying, you know, downside puts 435 00:24:05,720 --> 00:24:08,880 Speaker 1: of a complicated form from investors, and they're heading them 436 00:24:08,920 --> 00:24:13,560 Speaker 1: by by selling relatively simple vanilla puts typically because those 437 00:24:13,560 --> 00:24:16,280 Speaker 1: are the things that you can hedge with, and the 438 00:24:16,320 --> 00:24:20,560 Speaker 1: mismatch between the two really arises when markets are selling 439 00:24:20,600 --> 00:24:23,960 Speaker 1: off very quickly, right when the the that risk that 440 00:24:24,119 --> 00:24:26,879 Speaker 1: with that when that volatility, when that downside protection that 441 00:24:26,920 --> 00:24:30,320 Speaker 1: the banks have effectively bought from retail investors starts to 442 00:24:30,359 --> 00:24:32,399 Speaker 1: go away because you start to get down close to 443 00:24:32,400 --> 00:24:35,280 Speaker 1: those knockout barriers, you know, the probability of those notes 444 00:24:35,280 --> 00:24:38,000 Speaker 1: starting to knock out rises very fast, and all of 445 00:24:38,000 --> 00:24:40,240 Speaker 1: the sudden, banks are left you know, short, a bunch 446 00:24:40,280 --> 00:24:42,320 Speaker 1: of options that they've sold the hedge, but they're but 447 00:24:42,359 --> 00:24:45,720 Speaker 1: their long option position, their protection is starting to go away, 448 00:24:45,760 --> 00:24:47,639 Speaker 1: and it's all happening to all the banks all at 449 00:24:47,640 --> 00:24:50,240 Speaker 1: the same time. So, just regarding the hedge, one thing 450 00:24:50,240 --> 00:24:53,360 Speaker 1: I've always wondered is, you know, you said that the banks, 451 00:24:53,440 --> 00:24:56,439 Speaker 1: the issuers make most of their money through commissions and 452 00:24:56,480 --> 00:24:58,880 Speaker 1: fees on on these products, and I get that they 453 00:24:58,920 --> 00:25:03,000 Speaker 1: want their exposure to be relatively neutral um for what 454 00:25:03,040 --> 00:25:06,640 Speaker 1: they're selling, But is there any um is there any 455 00:25:06,680 --> 00:25:10,600 Speaker 1: motive by the banks to also generate profit through the 456 00:25:10,640 --> 00:25:14,600 Speaker 1: hedge itself, Like, is there a way to creatively hedge 457 00:25:14,680 --> 00:25:17,040 Speaker 1: in such a way that you can juice your returns 458 00:25:17,040 --> 00:25:19,200 Speaker 1: a little bit or add a little bit of extra revenue. 459 00:25:20,440 --> 00:25:23,879 Speaker 1: There is usually there are many such ways to do so. 460 00:25:24,160 --> 00:25:28,760 Speaker 1: Usually they involve taking more basis risk than you should 461 00:25:29,040 --> 00:25:31,680 Speaker 1: and by sort of taking some hidden risks. Right. So 462 00:25:31,720 --> 00:25:34,680 Speaker 1: that's of course one of the common themes of derivative 463 00:25:34,720 --> 00:25:37,879 Speaker 1: markets in general is usually the easiest way to juice 464 00:25:37,920 --> 00:25:40,600 Speaker 1: your returns and make your boss happiest to take some 465 00:25:40,680 --> 00:25:44,480 Speaker 1: hidden risk um that will occasionally flare up and blow 466 00:25:44,520 --> 00:25:47,320 Speaker 1: you up. Right. So was a great example of that 467 00:25:47,400 --> 00:25:51,880 Speaker 1: in China um several of the banks much of their 468 00:25:51,920 --> 00:25:56,680 Speaker 1: hedge portfolios against structured products linked to Chinese equity markets 469 00:25:57,200 --> 00:26:00,520 Speaker 1: were in the form of variant swaps rather than options. 470 00:26:00,760 --> 00:26:03,920 Speaker 1: I think of variances is the square of volatility, right, 471 00:26:04,320 --> 00:26:07,080 Speaker 1: So the main difference between a variant swap and a 472 00:26:07,119 --> 00:26:10,080 Speaker 1: portfolio of options is just that when things get really bad, 473 00:26:10,600 --> 00:26:13,600 Speaker 1: you're you know, you lose money with a squared term 474 00:26:13,760 --> 00:26:15,800 Speaker 1: sort of on the in the size of the amount 475 00:26:15,840 --> 00:26:18,520 Speaker 1: of money that you lose, which is generally very bad. 476 00:26:18,600 --> 00:26:20,879 Speaker 1: But in normal markets you get paid if your short them, 477 00:26:20,920 --> 00:26:23,320 Speaker 1: you get paid a little bit of extra money for that, right, 478 00:26:23,520 --> 00:26:26,119 Speaker 1: And so as a result, so variant swaps have the 479 00:26:26,160 --> 00:26:30,600 Speaker 1: opposite profile of of the support underlying portfolios of auto 480 00:26:30,640 --> 00:26:32,960 Speaker 1: calls in the sense that the auto calls as the 481 00:26:32,960 --> 00:26:36,600 Speaker 1: market goes down and down and down. Actually, eventually the 482 00:26:37,720 --> 00:26:40,840 Speaker 1: volatility protection from those auto calls from the bank's perspective 483 00:26:40,880 --> 00:26:42,879 Speaker 1: goes away, right because you start to knock out or 484 00:26:42,880 --> 00:26:45,639 Speaker 1: you get very close to knocking out, whereas varian swaps 485 00:26:45,640 --> 00:26:48,000 Speaker 1: are the opposite, where the worst things get the more 486 00:26:48,040 --> 00:26:51,560 Speaker 1: exposure of varian swapads. So there were several banks that 487 00:26:51,600 --> 00:26:55,120 Speaker 1: had very heavy exposure to variance swaps on the short 488 00:26:55,160 --> 00:26:57,360 Speaker 1: side as their heads in order to duce their returns. 489 00:26:57,440 --> 00:26:59,760 Speaker 1: As you said, that made their their profits look pretty 490 00:26:59,760 --> 00:27:03,000 Speaker 1: good for for several years, but then caused massive and 491 00:27:03,000 --> 00:27:06,600 Speaker 1: outsized losses in Q three when when the equity markets 492 00:27:06,640 --> 00:27:10,640 Speaker 1: found so um you know, quick answer, yes, absolutely, there's 493 00:27:10,640 --> 00:27:14,920 Speaker 1: ways to to to generate additional revenue in those portfolios 494 00:27:14,960 --> 00:27:19,480 Speaker 1: by by taking some extra mismatch risk, by effectively being short. 495 00:27:19,520 --> 00:27:23,280 Speaker 1: Extra tail risk generally generally comes around to bite you. Okay, 496 00:27:23,680 --> 00:27:26,480 Speaker 1: I need to back up for a second and understand 497 00:27:27,480 --> 00:27:31,119 Speaker 1: the risk that the bank is exposed to when the 498 00:27:31,160 --> 00:27:33,840 Speaker 1: retail holder of the note is knocked in. So again, 499 00:27:34,000 --> 00:27:37,840 Speaker 1: we have these notes that protect the investor from any 500 00:27:37,880 --> 00:27:41,760 Speaker 1: downside risk until say one index or maybe one of 501 00:27:41,880 --> 00:27:46,800 Speaker 1: multiple index strap. So then let's say that happens, and 502 00:27:46,840 --> 00:27:51,800 Speaker 1: then the retail investor no longer has any protection. They're 503 00:27:51,840 --> 00:27:56,320 Speaker 1: down on their initial capital. Why is that bad for 504 00:27:56,359 --> 00:27:59,480 Speaker 1: the bank? Why does that create a mismatch? Then that 505 00:27:59,560 --> 00:28:03,040 Speaker 1: require yours some sort of aggressive you know, as you 506 00:28:03,080 --> 00:28:06,919 Speaker 1: put it, a short squeeze in the options. Sure, absolutely so. 507 00:28:06,920 --> 00:28:09,000 Speaker 1: So let's go with our simple example. So we've got 508 00:28:09,000 --> 00:28:11,959 Speaker 1: a retail investor that bought a hundred dollars of this 509 00:28:12,280 --> 00:28:16,000 Speaker 1: of this auto call that's effectively going to give them 510 00:28:16,000 --> 00:28:19,920 Speaker 1: a yield unless the underlying indexes down, upon which the 511 00:28:20,080 --> 00:28:23,399 Speaker 1: no will just go away and they'll lose. Right, So 512 00:28:23,440 --> 00:28:26,440 Speaker 1: that in of itself from the bank's perspective, of course, 513 00:28:26,480 --> 00:28:28,560 Speaker 1: if the if the note, if the market is down 514 00:28:29,640 --> 00:28:31,800 Speaker 1: and and we trigger the knock out, what that's just 515 00:28:31,840 --> 00:28:33,440 Speaker 1: going to mean is the bank is not going is 516 00:28:33,480 --> 00:28:35,280 Speaker 1: going to have to only pay you seventy cents back 517 00:28:35,280 --> 00:28:38,920 Speaker 1: instead of a hundred or a hundred dollars back. And 518 00:28:39,160 --> 00:28:43,120 Speaker 1: they just did theory the bank would prefer at decline 519 00:28:43,160 --> 00:28:46,760 Speaker 1: to decline, right? Or does that yes, except the bank 520 00:28:46,800 --> 00:28:49,360 Speaker 1: has headed this product, right, But the bank doesn't just 521 00:28:49,400 --> 00:28:51,840 Speaker 1: sell all these right, because otherwise than the bank just 522 00:28:51,880 --> 00:28:55,520 Speaker 1: has massive directional exposure to everything. Right, So the bank 523 00:28:55,560 --> 00:28:58,200 Speaker 1: has headed this note, and the bank has sold a 524 00:28:58,240 --> 00:29:01,600 Speaker 1: bunch of out of the money three year put options 525 00:29:02,120 --> 00:29:05,440 Speaker 1: on the on the underlying index, right, and so as 526 00:29:05,520 --> 00:29:07,880 Speaker 1: with the market starts to go down and down and down. 527 00:29:08,400 --> 00:29:12,600 Speaker 1: Actually the typically the dynamics of this from a hedging perspective, 528 00:29:12,640 --> 00:29:15,600 Speaker 1: the bank will get a little bit longer volatility at first, 529 00:29:16,040 --> 00:29:17,760 Speaker 1: and that just has to do with the fact that 530 00:29:17,880 --> 00:29:20,200 Speaker 1: of the structuring of this knock and put options, so 531 00:29:20,360 --> 00:29:22,240 Speaker 1: often the bank will actually have to sell a little 532 00:29:22,240 --> 00:29:24,640 Speaker 1: bit more of those put options, you know, for the 533 00:29:24,640 --> 00:29:27,680 Speaker 1: first of the market decline. But once we get in 534 00:29:27,800 --> 00:29:30,040 Speaker 1: to your point, once then the market goes down and 535 00:29:30,080 --> 00:29:33,080 Speaker 1: down and down, and nearing this knockout point, right, the 536 00:29:33,120 --> 00:29:35,320 Speaker 1: bank is still short all of those put options that 537 00:29:35,400 --> 00:29:39,280 Speaker 1: it's sold, right, And the only thing that's going to happen, 538 00:29:39,320 --> 00:29:43,160 Speaker 1: And once that note knocks out, then the bank pays 539 00:29:43,200 --> 00:29:46,040 Speaker 1: the investor seven you know, the seventy dollars having you know, 540 00:29:46,080 --> 00:29:48,440 Speaker 1: taken in a hundred dollars first, that's fine, but they 541 00:29:48,440 --> 00:29:50,640 Speaker 1: still have all of these Now they've just outright short 542 00:29:50,640 --> 00:29:53,440 Speaker 1: a whole bunch of put options right, and they've got 543 00:29:53,440 --> 00:29:56,440 Speaker 1: to go buy those back because they have no hedge 544 00:29:56,440 --> 00:29:58,680 Speaker 1: for them. And of course all of this in option 545 00:29:58,760 --> 00:30:01,600 Speaker 1: land is is sort of forward looking and probabilistic, right, 546 00:30:01,640 --> 00:30:03,960 Speaker 1: So as the market goes down and it starts to 547 00:30:04,000 --> 00:30:06,880 Speaker 1: look like you're getting close to knockout, then banks are 548 00:30:06,920 --> 00:30:10,520 Speaker 1: getting worried and they're they're starting to effectively get short 549 00:30:10,600 --> 00:30:13,360 Speaker 1: volatility in the in the portfolio because the notes are 550 00:30:13,400 --> 00:30:16,200 Speaker 1: losing some volatility exposure as it looks like they might 551 00:30:16,320 --> 00:30:19,640 Speaker 1: knock out with with higher and higher probability. And that's 552 00:30:19,680 --> 00:30:22,200 Speaker 1: this kind of dynamic where all of a sudden, the 553 00:30:22,200 --> 00:30:26,200 Speaker 1: banks starts scrambling to cover those hedges. So this is 554 00:30:26,240 --> 00:30:31,440 Speaker 1: one avenue essentially where markets can really impact the financial 555 00:30:31,440 --> 00:30:35,640 Speaker 1: health of banks um and banks can also impact the 556 00:30:35,680 --> 00:30:38,440 Speaker 1: markets as well. And I think there was actually a 557 00:30:38,480 --> 00:30:42,120 Speaker 1: moment in time where if you looked at the Hang 558 00:30:42,240 --> 00:30:47,360 Speaker 1: Sang index, it was kind of tracking against the index 559 00:30:47,400 --> 00:30:51,840 Speaker 1: of Korean brokerages and and Korean banks, and you could 560 00:30:51,880 --> 00:30:55,680 Speaker 1: sort of see that link very very clearly. So my 561 00:30:55,760 --> 00:31:00,760 Speaker 1: question is, in a long and convoluted way, why aren't 562 00:31:00,840 --> 00:31:04,960 Speaker 1: regulators more focused on this because it seems like a 563 00:31:05,040 --> 00:31:14,200 Speaker 1: pretty obvious and potentially troublesome source of of a feedback loop. Basically, yeah, absolutely, so, 564 00:31:14,360 --> 00:31:17,760 Speaker 1: you know, Korean regulators have paid attention to this over 565 00:31:17,800 --> 00:31:21,600 Speaker 1: the years. UM. They typically have come in usually after 566 00:31:21,880 --> 00:31:24,320 Speaker 1: a blow up UM. Korean banks did lose quite a 567 00:31:24,320 --> 00:31:27,440 Speaker 1: lot of money in twenty banks and brokerages after the 568 00:31:27,520 --> 00:31:30,760 Speaker 1: China debacle UM, and and the regulators will come in 569 00:31:30,880 --> 00:31:35,360 Speaker 1: so they restricted, for example, they restricted the percentage of 570 00:31:35,360 --> 00:31:38,320 Speaker 1: of new issuance of structure products that could be linked 571 00:31:38,360 --> 00:31:43,400 Speaker 1: to Chinese indices after that meltdown in UM. But typically 572 00:31:43,480 --> 00:31:46,560 Speaker 1: they've taken a relatively las fair approach to this space. 573 00:31:46,600 --> 00:31:49,120 Speaker 1: They've looked at you know, basic investor protection, you know, 574 00:31:49,120 --> 00:31:52,680 Speaker 1: whether the disclosures are adequate and so forth. UM. But 575 00:31:53,200 --> 00:31:55,920 Speaker 1: you know, globally there just hasn't been that much focused 576 00:31:55,960 --> 00:31:57,920 Speaker 1: on it. I think, you know, regulators have a lot 577 00:31:57,960 --> 00:32:00,600 Speaker 1: of different things to look at and have to make 578 00:32:00,640 --> 00:32:03,400 Speaker 1: decisions about what they're what they where they think the 579 00:32:03,400 --> 00:32:05,640 Speaker 1: biggest risks are, and what they think, you know, where 580 00:32:05,680 --> 00:32:10,080 Speaker 1: they think systemic risk is. Historically, it hasn't been a 581 00:32:10,120 --> 00:32:12,640 Speaker 1: space that they that they focused on a tremendous amount. Again, 582 00:32:12,800 --> 00:32:15,440 Speaker 1: outside of Korea, to some extent because this is so like, 583 00:32:15,640 --> 00:32:18,440 Speaker 1: these these products are so large relative to the Korean market, 584 00:32:18,480 --> 00:32:20,640 Speaker 1: and when Korean banks get involved, you know, they can 585 00:32:20,720 --> 00:32:24,600 Speaker 1: be um huge drivers of of Korean banks. Uh, you 586 00:32:24,680 --> 00:32:29,000 Speaker 1: know solvency. So something that you mentioned, you said in 587 00:32:30,040 --> 00:32:32,240 Speaker 1: some hedge funds lost out of money, some hedge funds 588 00:32:33,360 --> 00:32:37,240 Speaker 1: made a lot of money. How does an outside player 589 00:32:37,880 --> 00:32:42,320 Speaker 1: who's attempting to take advantage of the potential for some 590 00:32:42,400 --> 00:32:46,240 Speaker 1: sort of extreme moves in the options market as certain 591 00:32:46,280 --> 00:32:49,280 Speaker 1: barriers get hit or they think this is a risk 592 00:32:49,360 --> 00:32:50,840 Speaker 1: out there and they want to be in a position 593 00:32:50,880 --> 00:32:54,520 Speaker 1: to exploit it, how do they get a handle on 594 00:32:54,640 --> 00:32:58,360 Speaker 1: where the various knock in levels are. Given that there's 595 00:32:58,400 --> 00:33:01,920 Speaker 1: a range of different notes with different underlying indicries, all 596 00:33:02,000 --> 00:33:04,480 Speaker 1: sold at different times in different days, and I'm sure 597 00:33:04,480 --> 00:33:07,680 Speaker 1: every day the reprice and reset and all that, how 598 00:33:07,720 --> 00:33:11,200 Speaker 1: does one start to get a handle on where these 599 00:33:11,240 --> 00:33:14,480 Speaker 1: sort of key levels of risks lie and therefore when 600 00:33:14,720 --> 00:33:18,120 Speaker 1: one might expect to see a short squeeze in a 601 00:33:18,240 --> 00:33:22,520 Speaker 1: particular flavor of options. Yeah, absolutely, so that that's that's 602 00:33:22,520 --> 00:33:25,880 Speaker 1: exactly the right question. I think so. Uh, these days, 603 00:33:26,320 --> 00:33:28,960 Speaker 1: much of the of the issuance of these products is 604 00:33:29,360 --> 00:33:32,880 Speaker 1: publicly observable, and what you see is is banks and 605 00:33:32,960 --> 00:33:35,840 Speaker 1: research desks at banks, you know, building up data sets 606 00:33:35,840 --> 00:33:40,320 Speaker 1: and models of all of these types of exposures. So typically, um, 607 00:33:40,440 --> 00:33:43,000 Speaker 1: if you know you're involved in the space, you know 608 00:33:43,080 --> 00:33:46,040 Speaker 1: you're you're you have coverage from the various French banks 609 00:33:46,040 --> 00:33:49,040 Speaker 1: that are very heavily involved, and they will typically have 610 00:33:49,320 --> 00:33:52,400 Speaker 1: a set of models that that try to estimate. All right, 611 00:33:52,440 --> 00:33:54,760 Speaker 1: here's all the different indices that all these notes are 612 00:33:54,800 --> 00:33:59,800 Speaker 1: linked to. Here's what banks risk profiles look like here, 613 00:33:59,800 --> 00:34:03,080 Speaker 1: and you'll and what the typically very interesting questions is, 614 00:34:03,160 --> 00:34:07,560 Speaker 1: you know, how much volatility exposure do these portfolios of 615 00:34:07,560 --> 00:34:11,759 Speaker 1: auto calls the banks hold have as a function of 616 00:34:11,840 --> 00:34:15,280 Speaker 1: where as at the level of the indices, right, So, 617 00:34:15,280 --> 00:34:20,360 Speaker 1: so I mentioned typically those risks grow to some extent 618 00:34:20,400 --> 00:34:22,560 Speaker 1: as equity markets start to go down, and then the 619 00:34:22,640 --> 00:34:25,000 Speaker 1: key question is where do they stop growing and then 620 00:34:25,000 --> 00:34:27,200 Speaker 1: where do they suddenly fall off a cliff as you 621 00:34:27,239 --> 00:34:29,640 Speaker 1: really start to get into and go through that that 622 00:34:29,719 --> 00:34:33,359 Speaker 1: knockout zone. And so for example, you know these days 623 00:34:33,360 --> 00:34:36,799 Speaker 1: in the SMP, you know right now there might be 624 00:34:36,880 --> 00:34:40,600 Speaker 1: out of out of Korea and Japan, there's probably you know, 625 00:34:40,640 --> 00:34:45,040 Speaker 1: a hundred million dollars of exposure to one point one 626 00:34:45,200 --> 00:34:47,839 Speaker 1: point change in volatility. So think of like the vix 627 00:34:47,920 --> 00:34:51,000 Speaker 1: as you know, fifteen that's in volatility points. So a 628 00:34:51,080 --> 00:34:54,600 Speaker 1: hundred million VEGA means if that goes up by one point, 629 00:34:54,960 --> 00:34:57,720 Speaker 1: the profits or losses associated with that as a hundred 630 00:34:57,719 --> 00:35:00,239 Speaker 1: million dollars, So that that number goes up about any 631 00:35:00,239 --> 00:35:02,360 Speaker 1: percent as the mark as the SMP goes down to. 632 00:35:03,840 --> 00:35:05,760 Speaker 1: But then it starts to really follow up the cliff 633 00:35:05,880 --> 00:35:08,960 Speaker 1: very fast and buy about you know, two thousand or 634 00:35:09,000 --> 00:35:12,040 Speaker 1: eighteen hundred. It's going away quite quickly. And so that's 635 00:35:12,040 --> 00:35:14,600 Speaker 1: but in those types of of estimates are modeled and 636 00:35:14,719 --> 00:35:17,480 Speaker 1: something that you can keep track of pretty well. And 637 00:35:17,760 --> 00:35:20,719 Speaker 1: you know, the the interesting question you know, partly to 638 00:35:20,760 --> 00:35:24,680 Speaker 1: hedge funds, but I think largely to tow larger institutional 639 00:35:24,719 --> 00:35:27,879 Speaker 1: investors and asset owners. You know, usually when you're out 640 00:35:27,920 --> 00:35:31,399 Speaker 1: there looking for hedges, are looking for long term um 641 00:35:31,480 --> 00:35:34,319 Speaker 1: portfolio protection. The key question is always you know, what 642 00:35:34,520 --> 00:35:37,600 Speaker 1: is supply and demand. Are you trying to buy expensive 643 00:35:37,760 --> 00:35:40,600 Speaker 1: you know, risk protection that somebody else that everybody else 644 00:35:40,680 --> 00:35:42,840 Speaker 1: is trying to buy two or is there really a 645 00:35:42,880 --> 00:35:45,279 Speaker 1: supply of it in the marketplace. Is there a big 646 00:35:45,360 --> 00:35:47,759 Speaker 1: source of selling of the of the risk that you're 647 00:35:47,760 --> 00:35:50,040 Speaker 1: trying to get ahold of. And this is a good 648 00:35:50,080 --> 00:35:53,400 Speaker 1: example of you know, retail investors instructure products being a 649 00:35:53,480 --> 00:35:56,480 Speaker 1: large source of selling of of long term tail risk 650 00:35:56,719 --> 00:36:00,160 Speaker 1: in major equity indicries. And so folks will folk us 651 00:36:00,239 --> 00:36:03,080 Speaker 1: very heavily on you know, the as an asset owner, 652 00:36:03,200 --> 00:36:06,200 Speaker 1: as a pension fund. You know, what's what's my risk 653 00:36:06,320 --> 00:36:10,400 Speaker 1: profile for my organization as a function of of equity markets? 654 00:36:10,560 --> 00:36:13,319 Speaker 1: You know, of my equity exposure. You know where do 655 00:36:13,400 --> 00:36:16,840 Speaker 1: I start to get as an organization into major distress costs? 656 00:36:16,880 --> 00:36:20,840 Speaker 1: How does that map into UM? What kinds of protection 657 00:36:20,880 --> 00:36:24,480 Speaker 1: I might get from UM from these types of from 658 00:36:24,480 --> 00:36:27,720 Speaker 1: from options in this type of range, given that, uh, 659 00:36:27,800 --> 00:36:30,759 Speaker 1: you know the banks, you know where the equity market 660 00:36:30,800 --> 00:36:34,120 Speaker 1: will be in my in my bad scenarios and whether 661 00:36:34,120 --> 00:36:35,759 Speaker 1: there's going to be you know, big squeeze and the 662 00:36:35,760 --> 00:36:37,719 Speaker 1: prices of those options. It's the kind of thing people 663 00:36:37,719 --> 00:36:41,440 Speaker 1: think about. So, Ben, you mentioned the S and P 664 00:36:41,800 --> 00:36:45,440 Speaker 1: five hundred just then in your example, and this is 665 00:36:45,680 --> 00:36:48,200 Speaker 1: where we start to get into some of the newer 666 00:36:48,239 --> 00:36:52,480 Speaker 1: developments in structured product land and something new that is 667 00:36:52,640 --> 00:36:54,879 Speaker 1: happening is that we're seeing more of these that are 668 00:36:54,880 --> 00:36:59,800 Speaker 1: actually pegged to US indices as opposed to sometimes obscure 669 00:37:00,200 --> 00:37:04,000 Speaker 1: Asian equity markets. Why is that happening and what does 670 00:37:04,000 --> 00:37:07,759 Speaker 1: it actually mean for the wider market? That's right, So 671 00:37:07,840 --> 00:37:09,960 Speaker 1: this has been a very very interesting trend the last 672 00:37:10,000 --> 00:37:12,879 Speaker 1: few years. So, first of all, to your point, there 673 00:37:12,880 --> 00:37:15,239 Speaker 1: has been more and more of this underlying issue and 674 00:37:15,600 --> 00:37:19,000 Speaker 1: directly linked to the SMP. Part of the reason for 675 00:37:19,040 --> 00:37:23,759 Speaker 1: that is that implied the option prices and implied volatilities 676 00:37:23,760 --> 00:37:26,840 Speaker 1: on some of those international industries have come down and 677 00:37:26,880 --> 00:37:29,920 Speaker 1: down and down over the last few years, partly driven 678 00:37:30,040 --> 00:37:33,239 Speaker 1: by by the selling of of these types of products 679 00:37:33,320 --> 00:37:35,960 Speaker 1: and and also partly driven by the fact that actually 680 00:37:36,080 --> 00:37:40,040 Speaker 1: realized volatility globally has been falling, and you've had a lot. Actually, 681 00:37:40,080 --> 00:37:42,560 Speaker 1: most of the volatility episodes and equity markets over the 682 00:37:42,640 --> 00:37:45,320 Speaker 1: last couple of years have been US centric and SMP centric. 683 00:37:45,719 --> 00:37:47,480 Speaker 1: So I think of like the February you know of 684 00:37:47,560 --> 00:37:51,120 Speaker 1: all blow up and December, right, these were really US 685 00:37:51,200 --> 00:37:55,160 Speaker 1: centric events, and so unusually from a historical perspective, actually 686 00:37:55,239 --> 00:37:59,200 Speaker 1: SMP volatility and option prices have been relatively higher and 687 00:37:59,239 --> 00:38:02,160 Speaker 1: relatively for were compared to international, which of course attracts 688 00:38:02,239 --> 00:38:04,799 Speaker 1: you know, mixing S and P and for for to 689 00:38:04,880 --> 00:38:07,600 Speaker 1: sell options to generate those higher coupons that the retail 690 00:38:07,640 --> 00:38:12,000 Speaker 1: investor wants. Now, the other really important thing that's been 691 00:38:12,000 --> 00:38:14,480 Speaker 1: happening here again, you know, think of of banks as 692 00:38:14,520 --> 00:38:18,319 Speaker 1: the manufacturers of this of this industry, of this risk 693 00:38:18,840 --> 00:38:22,359 Speaker 1: right where they're generating this fixed refew revenue and then 694 00:38:22,719 --> 00:38:25,200 Speaker 1: the price that they're effectively paying for it is the 695 00:38:25,280 --> 00:38:28,880 Speaker 1: risk that they're taking to manage these portfolios. The you know, 696 00:38:28,960 --> 00:38:32,680 Speaker 1: as we saw in particular, you know there's a lot 697 00:38:32,719 --> 00:38:35,880 Speaker 1: of it's quite difficult to manage this risk in general, 698 00:38:35,920 --> 00:38:39,840 Speaker 1: but especially in you know, Chinese equity markets, in Japanese 699 00:38:39,920 --> 00:38:43,000 Speaker 1: equity markets. You know, these are smaller option indus cries 700 00:38:43,080 --> 00:38:45,080 Speaker 1: that don't have as big a volumes where where these 701 00:38:45,120 --> 00:38:48,239 Speaker 1: markets the structured products really really dominate the risk in 702 00:38:48,280 --> 00:38:51,760 Speaker 1: these markets and where the liquidity issues are very exacerbated. 703 00:38:51,840 --> 00:38:54,080 Speaker 1: So one thing banks really started to look at in 704 00:38:54,120 --> 00:38:57,440 Speaker 1: earnest over this period was, you know, how can we 705 00:38:57,480 --> 00:39:00,319 Speaker 1: get more of this risk into an easy year to 706 00:39:00,360 --> 00:39:04,520 Speaker 1: manage format where we're not having to frantically sell more 707 00:39:04,560 --> 00:39:06,840 Speaker 1: options as markets go down for a little while and 708 00:39:06,880 --> 00:39:08,879 Speaker 1: then frantically buy a whole bunch of them back in 709 00:39:09,080 --> 00:39:10,840 Speaker 1: you know, China, where it's really hard to do this. 710 00:39:11,640 --> 00:39:15,279 Speaker 1: So what they started to do was create relatively complicated 711 00:39:15,280 --> 00:39:18,640 Speaker 1: investment products for hedge funds, called, for example, cord or 712 00:39:18,719 --> 00:39:22,280 Speaker 1: variant spread, which had the end goal and an effective 713 00:39:22,280 --> 00:39:25,360 Speaker 1: purpose of basically moving a bunch of this risk that 714 00:39:25,400 --> 00:39:29,200 Speaker 1: they had to manufacture out of those smaller indicries globally 715 00:39:29,200 --> 00:39:32,600 Speaker 1: and into the SMP, which is the world's biggest, most 716 00:39:32,680 --> 00:39:35,759 Speaker 1: liquid option market. And they do that in various, you know, 717 00:39:35,800 --> 00:39:38,040 Speaker 1: complicated ways that we don't need to get into. But 718 00:39:38,200 --> 00:39:40,720 Speaker 1: the the end effect is that even though they've issued 719 00:39:40,760 --> 00:39:43,680 Speaker 1: a lot of notes that are directly linked to the eurostocks, 720 00:39:43,719 --> 00:39:46,840 Speaker 1: to the NIQUE, to the h c I, when global 721 00:39:46,880 --> 00:39:51,120 Speaker 1: equity markets go down, banks find most of the changes 722 00:39:51,200 --> 00:39:53,439 Speaker 1: in their risk profile which they need to go out 723 00:39:53,440 --> 00:39:56,480 Speaker 1: and manage and hedge at least to first order, They 724 00:39:56,480 --> 00:40:00,080 Speaker 1: find those changes happening in the SMP, and they that 725 00:40:00,200 --> 00:40:02,560 Speaker 1: might be that initially again for that first as the 726 00:40:02,560 --> 00:40:05,000 Speaker 1: markets start to drift down, they're having to sell some 727 00:40:05,120 --> 00:40:08,439 Speaker 1: downside SMP options, but then they're going out and having 728 00:40:08,440 --> 00:40:11,319 Speaker 1: to buy the SMP options that if the if the 729 00:40:11,360 --> 00:40:13,919 Speaker 1: market crashes. So that's a very new over the last 730 00:40:13,920 --> 00:40:17,160 Speaker 1: few years. So just to be clear, is it that 731 00:40:17,239 --> 00:40:20,839 Speaker 1: the note in the basket of the indicries that it's 732 00:40:20,880 --> 00:40:23,480 Speaker 1: exposed to, is it that it has the sp it 733 00:40:24,040 --> 00:40:27,560 Speaker 1: or is it simply a mix of that? Plus also 734 00:40:27,640 --> 00:40:30,279 Speaker 1: the idea that even if the note is exposed to 735 00:40:30,520 --> 00:40:33,279 Speaker 1: the hang sing or something like that, that the bank 736 00:40:33,560 --> 00:40:37,160 Speaker 1: might find it still most expedient to hedge via SMP 737 00:40:37,280 --> 00:40:40,560 Speaker 1: options on the premise that on some level there's a 738 00:40:40,640 --> 00:40:43,600 Speaker 1: level of correlation and even if it's not the perfect 739 00:40:43,640 --> 00:40:47,720 Speaker 1: hedge for them, that that might be the place to uh, 740 00:40:47,920 --> 00:40:52,400 Speaker 1: the cheapest, most liquid place to hedge their risk. So 741 00:40:52,440 --> 00:40:55,880 Speaker 1: there has been some increasing direct link of these notes 742 00:40:55,960 --> 00:40:58,359 Speaker 1: to the SMP, but it's still a minority. It's still 743 00:40:58,440 --> 00:41:02,360 Speaker 1: going to be them or something like that. The and 744 00:41:02,480 --> 00:41:06,200 Speaker 1: they they're not typically just warehousing tons of basis risk 745 00:41:06,280 --> 00:41:09,560 Speaker 1: and only hedging an SMP. But what they're doing again 746 00:41:09,680 --> 00:41:12,520 Speaker 1: is is so i'll you know, explain a little bit 747 00:41:12,560 --> 00:41:14,439 Speaker 1: what a what a corridor variant spread it. So let's 748 00:41:14,440 --> 00:41:16,880 Speaker 1: say the bank has this auto call that it's you know, 749 00:41:16,960 --> 00:41:19,919 Speaker 1: sold to Bob and so the bank has that risk 750 00:41:19,920 --> 00:41:21,920 Speaker 1: profile that we've been talking about it. You know, it's 751 00:41:21,920 --> 00:41:23,760 Speaker 1: a proxy hedge for that was going out and selling 752 00:41:23,800 --> 00:41:26,640 Speaker 1: some downside puts on the eurostocks. But the bank's going 753 00:41:26,680 --> 00:41:28,880 Speaker 1: to go into another trade with a hedge fund, and 754 00:41:29,000 --> 00:41:32,440 Speaker 1: that trade is going to be something like, hey, here's 755 00:41:32,480 --> 00:41:35,200 Speaker 1: this volatility exposure, which is going to be a spread 756 00:41:35,719 --> 00:41:40,160 Speaker 1: between the eurostocks and the SMP, and that's that exposure 757 00:41:40,200 --> 00:41:43,440 Speaker 1: is going to be conditional on the strike level, on 758 00:41:43,520 --> 00:41:46,280 Speaker 1: the level of the index in a way that kind 759 00:41:46,320 --> 00:41:49,960 Speaker 1: of roughly matches what they think the profile, you know, 760 00:41:50,040 --> 00:41:54,440 Speaker 1: of those auto calls is. And what that does is 761 00:41:54,560 --> 00:41:57,200 Speaker 1: now the hedge fund is going to have that the 762 00:41:57,239 --> 00:42:00,719 Speaker 1: hedge fund is going to hold that weird, difficult to manage, uh, 763 00:42:00,719 --> 00:42:03,880 Speaker 1: you know risk in the eurostocks, and the bank is 764 00:42:03,920 --> 00:42:06,279 Speaker 1: going to have the same the similar type of risk, 765 00:42:06,320 --> 00:42:08,000 Speaker 1: but they're going to have it in the SMP on 766 00:42:08,040 --> 00:42:10,960 Speaker 1: a net basis. Once you're combining that trade they just 767 00:42:11,000 --> 00:42:14,200 Speaker 1: did with a hedge fund and the and the auto 768 00:42:14,200 --> 00:42:17,080 Speaker 1: call that they that they've sold to to retail, and 769 00:42:17,400 --> 00:42:19,919 Speaker 1: you know, you're adding layers and layers of complexity because 770 00:42:19,960 --> 00:42:22,279 Speaker 1: now you've got, you know, a complicated product you've sold 771 00:42:22,280 --> 00:42:25,080 Speaker 1: to retail that you've kind of tried to hedge by 772 00:42:25,080 --> 00:42:27,440 Speaker 1: selling doing another complicated trade with a hedge fund. And 773 00:42:27,480 --> 00:42:30,560 Speaker 1: so there's you know, all sorts of more just weird 774 00:42:30,640 --> 00:42:32,840 Speaker 1: bad path scenarios where you know, things go funny. But 775 00:42:32,880 --> 00:42:35,880 Speaker 1: the first order, the first order result is that the 776 00:42:35,880 --> 00:42:40,480 Speaker 1: banks that all those changes in volatility risk that happen 777 00:42:40,560 --> 00:42:43,200 Speaker 1: at banks as a result of global markets moving down, 778 00:42:43,520 --> 00:42:45,839 Speaker 1: they all happen to first order in the SMP now, 779 00:42:46,640 --> 00:42:48,600 Speaker 1: a little bit in other industries tube and much more 780 00:42:48,640 --> 00:42:52,640 Speaker 1: now in the SMP. And so that's really really important. 781 00:42:52,680 --> 00:42:56,960 Speaker 1: This is something we've never really seen before where you know, 782 00:42:56,960 --> 00:43:00,239 Speaker 1: it used to be markets that you know, typical S 783 00:43:00,320 --> 00:43:03,600 Speaker 1: centric investors and pension funds and real money guys didn't 784 00:43:03,640 --> 00:43:06,080 Speaker 1: notice as much, you know what's happening, and you know 785 00:43:06,120 --> 00:43:09,960 Speaker 1: in the HSCI option markets. But now those dynamics are 786 00:43:09,960 --> 00:43:13,000 Speaker 1: all being translated into the S and P and for example, 787 00:43:13,080 --> 00:43:15,680 Speaker 1: you know what we saw in December of last year. 788 00:43:16,000 --> 00:43:19,719 Speaker 1: You remember, markets peaked to trough, were down or so 789 00:43:19,880 --> 00:43:24,320 Speaker 1: by by Christmas eve, and everybody sitting on structured products 790 00:43:24,360 --> 00:43:27,000 Speaker 1: desks was sitting there staring at their risk profile and 791 00:43:27,080 --> 00:43:30,480 Speaker 1: thinking if the market goes down another five percent, like 792 00:43:30,520 --> 00:43:33,680 Speaker 1: we're just completely screwed, because you that was where you 793 00:43:33,719 --> 00:43:37,040 Speaker 1: were starting to get into much of this non linearity 794 00:43:37,120 --> 00:43:39,960 Speaker 1: where all of a sudden, all their risks, but their 795 00:43:40,000 --> 00:43:43,240 Speaker 1: long volatility exposure, their protection coming from those auto calls 796 00:43:43,360 --> 00:43:47,600 Speaker 1: was starting to disappear very fast. And instead we got 797 00:43:47,640 --> 00:43:51,040 Speaker 1: that six percent rally the next day and shot off 798 00:43:51,080 --> 00:43:53,520 Speaker 1: from there. But we were actually very close to a 799 00:43:53,680 --> 00:43:57,320 Speaker 1: very very major loss event, you know, across potentially across 800 00:43:57,360 --> 00:43:59,760 Speaker 1: the street, and that could have cascaded into all sorts 801 00:43:59,760 --> 00:44:02,600 Speaker 1: of of crowded hedge fund positioning as well. And that's 802 00:44:02,640 --> 00:44:05,479 Speaker 1: just something that's not on I think acid owners ratear 803 00:44:05,560 --> 00:44:08,399 Speaker 1: screens at all. The fact that this you've had this 804 00:44:08,560 --> 00:44:12,920 Speaker 1: kind of infection of typically very historically much more normally 805 00:44:13,000 --> 00:44:16,240 Speaker 1: behaving markets that used to be the places where pension 806 00:44:16,239 --> 00:44:18,120 Speaker 1: funds went to hedge or you know what have you, 807 00:44:18,200 --> 00:44:21,160 Speaker 1: that are now being very dominated by these weird, complicated 808 00:44:21,160 --> 00:44:24,600 Speaker 1: structured product dynamics is the implication that we might not 809 00:44:24,719 --> 00:44:28,000 Speaker 1: be as lucky next time. There there will certainly be 810 00:44:28,080 --> 00:44:30,399 Speaker 1: a time, I mean, I know this is this these days, 811 00:44:30,440 --> 00:44:33,560 Speaker 1: it's a controversial topic, but there's certainly will be a 812 00:44:33,640 --> 00:44:38,080 Speaker 1: day when equity markets are down more to drop a day, 813 00:44:38,360 --> 00:44:39,879 Speaker 1: will you say there will be wait, do you say 814 00:44:39,880 --> 00:44:42,719 Speaker 1: there will be a day? No, it's sorry a time 815 00:44:42,840 --> 00:44:45,440 Speaker 1: I don't mean like a thing saying that this is 816 00:44:45,440 --> 00:44:47,920 Speaker 1: going to be like or something that's that's more of 817 00:44:47,920 --> 00:44:51,680 Speaker 1: a flash crash. But look, we at some points that 818 00:44:51,840 --> 00:44:53,799 Speaker 1: you know there will be a recession in the US, 819 00:44:53,840 --> 00:44:56,480 Speaker 1: there will global recession, and at some point you know, 820 00:44:56,520 --> 00:45:00,120 Speaker 1: equity multiples will will contract. And this is and the 821 00:45:00,000 --> 00:45:02,239 Speaker 1: the market is is very much set up to be 822 00:45:02,280 --> 00:45:05,120 Speaker 1: a time bomb in exactly that in exactly that scenario 823 00:45:05,200 --> 00:45:09,839 Speaker 1: sort of global equity markets down or more so, just 824 00:45:09,920 --> 00:45:12,040 Speaker 1: to sort of wrap it all up, what people need 825 00:45:12,080 --> 00:45:14,319 Speaker 1: to understand, I just sort of just to sort of 826 00:45:14,360 --> 00:45:18,719 Speaker 1: summarize it is that essentially these notes, they're sold all 827 00:45:18,719 --> 00:45:21,440 Speaker 1: over the world, but they're very heavily heavy in Korea 828 00:45:21,560 --> 00:45:25,640 Speaker 1: and also in Japan. And the basic idea is the 829 00:45:26,200 --> 00:45:29,520 Speaker 1: size of this market in these countries and the way 830 00:45:29,560 --> 00:45:32,400 Speaker 1: that the issuers of these products have sort of migrated 831 00:45:32,440 --> 00:45:36,800 Speaker 1: more and more of their hedging to the SMP creates 832 00:45:37,000 --> 00:45:40,960 Speaker 1: a situation in which the activity of retail players in 833 00:45:41,000 --> 00:45:46,560 Speaker 1: these countries can create some potentially extreme moves an SMP 834 00:45:47,400 --> 00:45:52,480 Speaker 1: options and presumably the main index itself. As declines, we 835 00:45:52,560 --> 00:45:55,200 Speaker 1: get declines and banks have to do all kinds of 836 00:45:55,239 --> 00:46:00,800 Speaker 1: things to keep their exposures level. Yep, that's exactly correct. Ben. 837 00:46:00,960 --> 00:46:04,200 Speaker 1: Thank you so much for for coming on. That's ben 838 00:46:04,239 --> 00:46:07,879 Speaker 1: effort from QVR Advisors. Thank you for walking us through 839 00:46:08,239 --> 00:46:11,840 Speaker 1: what is at times a complicated topic. You got a 840 00:46:11,840 --> 00:46:13,520 Speaker 1: guy who was a lot of fun. Thanks Ben, that 841 00:46:13,680 --> 00:46:27,960 Speaker 1: was great. I really appreciate it, so Joe, I really 842 00:46:28,040 --> 00:46:32,600 Speaker 1: enjoyed that conversation. Um, I love talking and writing about 843 00:46:32,640 --> 00:46:35,600 Speaker 1: structured products. It's half past midnight here in Hong Kong, 844 00:46:35,680 --> 00:46:38,399 Speaker 1: and I weirdly don't feel tired at all because I'm 845 00:46:38,440 --> 00:46:42,200 Speaker 1: so excited about talking about tarts and autocollables and all that. 846 00:46:42,560 --> 00:46:46,600 Speaker 1: But one thing that definitely crops up in that conversation 847 00:46:47,200 --> 00:46:51,000 Speaker 1: is just this notion that there's so much sort of 848 00:46:51,360 --> 00:46:56,319 Speaker 1: self reflexivity built into financial markets nowadays. And you see it, 849 00:46:56,480 --> 00:46:59,880 Speaker 1: you know, not just with these equity linked products, but 850 00:47:00,080 --> 00:47:03,080 Speaker 1: you also see it with credit markets, where there's an 851 00:47:03,160 --> 00:47:06,640 Speaker 1: argument over whether or not the derivatives indusseries can actually 852 00:47:06,640 --> 00:47:09,239 Speaker 1: affect the cash bomb prices. You certainly see it in 853 00:47:09,280 --> 00:47:15,279 Speaker 1: the volatility market with the vulpocalypse blow up of when 854 00:47:15,320 --> 00:47:19,279 Speaker 1: these two tiny exchange traded products caused this big whiplash 855 00:47:19,560 --> 00:47:22,279 Speaker 1: in the overall volatility market. It just feels like this 856 00:47:22,320 --> 00:47:26,279 Speaker 1: is something that we're seeing time and time again. Absolutely, 857 00:47:26,320 --> 00:47:29,920 Speaker 1: and obviously we should talk more about it. But I agree, 858 00:47:30,000 --> 00:47:32,319 Speaker 1: it does feel like there is this, as you say, 859 00:47:32,440 --> 00:47:36,719 Speaker 1: reflectivity in which these sort of like ongoing uh you know, 860 00:47:36,800 --> 00:47:39,839 Speaker 1: ongoing attempts to hedge and to be balanced creates these 861 00:47:39,880 --> 00:47:44,279 Speaker 1: extreme scenarios. Um, we should do another one before we forget, 862 00:47:44,320 --> 00:47:47,239 Speaker 1: we should do another episode because they're bringing back one 863 00:47:47,239 --> 00:47:49,400 Speaker 1: of those short vix et f s that blew up 864 00:47:49,400 --> 00:47:52,480 Speaker 1: and big thing on. I saw that we should definitely 865 00:47:52,840 --> 00:47:55,920 Speaker 1: do another one on this, but I thought, like Bend's explanation, 866 00:47:56,080 --> 00:48:00,920 Speaker 1: it is extremely complicated and thinking about this sort of Um, 867 00:48:01,040 --> 00:48:04,120 Speaker 1: the way the volatility or risk profile for the bank 868 00:48:04,560 --> 00:48:09,200 Speaker 1: changes as the market goes from say, from flat to down, 869 00:48:11,680 --> 00:48:14,440 Speaker 1: and then the volatility starts to collapse again as it 870 00:48:14,480 --> 00:48:18,760 Speaker 1: gets to and then the knot can happens really hard 871 00:48:18,840 --> 00:48:21,000 Speaker 1: to uh sort of wrap ones head around. But I 872 00:48:21,000 --> 00:48:24,200 Speaker 1: thought Bend did a great job of a explaining that, 873 00:48:24,239 --> 00:48:28,160 Speaker 1: but also why this is so hard for even the 874 00:48:28,200 --> 00:48:31,919 Speaker 1: expert to price and why you see desks occasionally lose 875 00:48:31,920 --> 00:48:36,120 Speaker 1: a bunch of money, right, And I guess the the 876 00:48:36,200 --> 00:48:39,440 Speaker 1: corollary to that, you could say is that if it's 877 00:48:39,480 --> 00:48:43,440 Speaker 1: that hard for the issuers to price the risk of 878 00:48:43,480 --> 00:48:47,360 Speaker 1: selling these products, then should they really be going to 879 00:48:47,480 --> 00:48:50,200 Speaker 1: retail investors in the first place. And I don't know 880 00:48:50,360 --> 00:48:53,640 Speaker 1: if you've ever looked at the advertising for some of 881 00:48:53,680 --> 00:48:57,839 Speaker 1: the equity links securities, but like it gets very creative 882 00:48:58,000 --> 00:49:00,799 Speaker 1: and colorful. So I remember there was one that was 883 00:49:00,840 --> 00:49:05,160 Speaker 1: sold in Korea that had like side from Gangnam style 884 00:49:05,800 --> 00:49:09,799 Speaker 1: on it and made all these Gangnam neighborhood references. So 885 00:49:10,480 --> 00:49:13,799 Speaker 1: I don't know, should retail investors really be diving into 886 00:49:13,840 --> 00:49:16,480 Speaker 1: these things or or do the majority of them actually 887 00:49:16,560 --> 00:49:19,000 Speaker 1: understand how they work. I mean, I was gonna we 888 00:49:19,040 --> 00:49:21,000 Speaker 1: didn't get to it, but that was something that's been 889 00:49:21,000 --> 00:49:23,279 Speaker 1: on my mind thinking about this is how could a 890 00:49:23,320 --> 00:49:29,440 Speaker 1: retail investor, unless they're extremely sophisticated, have any idea whether 891 00:49:29,480 --> 00:49:32,600 Speaker 1: they're getting a good value or not. Given how complicated 892 00:49:32,640 --> 00:49:36,520 Speaker 1: the various payoff matrices are, especially when they include multiple 893 00:49:36,560 --> 00:49:38,600 Speaker 1: index how would you ever know whether you're getting a 894 00:49:38,600 --> 00:49:41,480 Speaker 1: good value? And Furthermore, I feel like if you were 895 00:49:41,520 --> 00:49:45,799 Speaker 1: in a position to know, okay, this is actually a 896 00:49:45,840 --> 00:49:50,600 Speaker 1: good product for me, you're probably sophisticated enough to trade 897 00:49:50,640 --> 00:49:54,359 Speaker 1: options yourself and just create some sort of bespoke risk 898 00:49:54,600 --> 00:49:56,600 Speaker 1: risk set up on your own. But that's kind of 899 00:49:56,600 --> 00:49:59,880 Speaker 1: for a different discussion. Maybe yeah, or work on a 900 00:50:00,040 --> 00:50:03,480 Speaker 1: Delta one desk, a large French bank or something. Right, 901 00:50:04,080 --> 00:50:07,120 Speaker 1: all right, this has been another episode of the All 902 00:50:07,160 --> 00:50:10,000 Speaker 1: Thoughts podcast. I'm Tracy Alloway. You can follow me on 903 00:50:10,040 --> 00:50:12,960 Speaker 1: Twitter at Tracy Alloway and I'm Joe Why Isn't All? 904 00:50:13,080 --> 00:50:16,000 Speaker 1: You can follow me on Twitter at the Stalwart, and 905 00:50:16,120 --> 00:50:20,200 Speaker 1: you should follow for sure our guest Ben Effort. He's 906 00:50:20,200 --> 00:50:23,960 Speaker 1: on Twitter. He's really awesome. His handle is Ben with 907 00:50:24,080 --> 00:50:28,359 Speaker 1: two ends pe Effort. So definitely check out uself one 908 00:50:28,360 --> 00:50:31,640 Speaker 1: of the great follows, and you should definitely follow our 909 00:50:31,719 --> 00:50:35,640 Speaker 1: producer on Twitter. She's back in studio with us Laura Carlson. 910 00:50:35,719 --> 00:50:39,160 Speaker 1: She's at Laura M. Carlson. And follow the Bloomberg head 911 00:50:39,160 --> 00:50:43,360 Speaker 1: of podcast Francesco Leavie She's at Francesca Today, and follow 912 00:50:43,400 --> 00:50:47,799 Speaker 1: all of Bloomberg's podcasts on Twitter at the handle at Podcasts. 913 00:50:48,120 --> 00:50:48,920 Speaker 1: Thanks for listening,