Odd Lots - How An Exotic Investment Product Sold In Korea Could Create Havoc In The U.S. Options Market

Episode Date: January 20, 2020

What's the connection between low global interest rates, Korean retail investors, and the U.S. options market? On this week's Odd Lots podcast, we discuss the fascinating world of Korean structured notes with Benn Eifert of QVR Advisors. He explains how a very exotic type of investment sold to Korean retail investors could, through a series of hedging requirements, end up causing massive volatility in the market for S&P 500 options.See omnystudio.com/listener for privacy information.

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That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Hello and welcome to another episode of the Oddlots podcast. I'm Tracy Allaway. And I'm Joe Weissenthal. Joe, do you know what a super lizard is? A what? A super lizard. No, I have no idea. Literally none. Do you know what a flash lizard is?

Nope. A double chance? Were these animals that you encountered on your vacation? Like, were these like New Year? Did you vacation somewhere exotic and see these lizards? I did. Well, I was in Marrakesh, and I did see some chameleons. But no, this actually has nothing to do with the animals. It has to do with one of my personal favorite financial topics.

Okay, so what is a super lizard? Super lizard. Okay. So super lizard or a flash lizard or a double chance or any number of these interesting and exotic type names is actually a type of structured product known as an auto callable or an equity linked security. And these are a type of product where investors basically buy an interest-bearing note that's linked to a particular index like the Hangseng or the Niki or something like that. Sometimes they're also linked to currencies. And they basically do it

in order to make a profit. So they're sort of exotic, structured products for retail investors, and they come with these great names like Super or Flash Lizard. I am kind of aware of these things called Structured Products. I kind of get how they work. But I have to say, I'm very excited that this is not an episode that I'm doing solo, because I have a feeling there's going to be one of those ones where I sort of sit back I can get in a question here or there, but mostly I just listen because this is tough stuff, I think, right?

It's complicated. I mean, literally just the way you're describing it. I get it only because I've been doing some reading on these. I get what these notes are, but this is above my head. I think you're underselling yourself, Joe. But, I mean, the reason these structured products are pretty interesting is because you see them pop up every once in a while. and usually not in a good way. So, for instance, I think the most recent example was in 2018.

You had a French bank, Natixis, that had a massive blow-up because it was selling these structured products and had failed to hedge them properly or had gotten the hedge wrong. And then before that, I don't know if you remember, this was when I was in New York and actually sitting next to you, but in 2015, we had a big structured product blow up on a type a product known as a tarf, target redemption forward, I think that's called, that was linked to the Chinese UN. And you remember China unexpectedly devalued the UN and it caused all sorts of turmoil in these structured products. I don't know if you remember, but I think I actually wrote a post at Bloomberg at the time that was called the tarf barf. I'm not sure how I got away with that.

That's a good one. But basically, the idea behind these structured notes and they're sold mostly to retail or high net worth. Investors is this idea that there's some underlying index, like you said, maybe the Hengsang or maybe something in Europe or whatever, and someone will pay money, they'll buy one of these notes and get some sort of guaranteed return except if something happens, like maybe it goes down too much or whatever. And on the flip side, the bank has to buy or sell a bunch of derivatives to actually be able to deliver this guaranteed return. Is that kind of how it works? Yeah, and see, I knew you were underselling yourself before. I knew you've been studying that on this topic.

It's only because I've been cramming. Okay, but the thing I was getting at is the reason they're interesting is because they pop up every once in a while. And as you mentioned, they're sort of linked to the wider financial system because when stuff starts to go wrong with them, you do get a wave of what's known as Delta hedging at the banks, at the issuing banks. And that can impact the market itself and you can sort of get a bad. spiral. But we're going to get into all of those details. We have the perfect person to discuss it. I want to bring in Ben Eiffert. He runs QVR advisors, which manages volatility and derivatives for big investors. He's also very good on Twitter, so you should check him out there. Ben,

it's so good to have you. Tracy, it's great to be here. Hey, Joe. How are you? Good. How are you doing? Thanks for coming on. Not bad at all. Absolutely. So Joe and I were trying to sort of lay the scene just then, but I think maybe it would be best to start with a sort of potted history of how the structured products came into being, because the way in which they initially got sold, and the places where they got sold, which is mostly in Asia, kind of gives you an idea of the underlying dynamic. So give us a short summary of how these things came into being. Yeah, absolutely. So this is an industry that, you know, here in the U.S. and in New York, and even in London to some extent, you know, you don't think about as much unless you're really directly involved because your average American investor, you know,

maybe owns some ETSs or own some mutual funds, but doesn't really see much of this type of thing. But when you look at more frontier markets, particularly in Asia, and earlier in, you know, there are markets where your average retail investor or high net worth, you know, private bank client historically in retail structured products sold out. out of banks. So, you know, you go down to your local B&P Paraba, you know, wealth manager, and he would be helping, helping or suggesting these types of products to retail. So a lot of the history, you know, there's, I think, myriad reasons for the different development of these products. And in some of the Asian countries is a great example where, you know, you don't necessarily have a long history of traditional equity and bond markets. So like in Korea, for example, right? But you had a very rapid process of wealth creation. Countries industrialized.

and as, you know, many, you know, a middle class rapidly developed and a class of wealthy, wealthy folks. And they and these type of proactive opportunities had both to get involved in because, you know, we'll get into some of the details. But, you know, there's many good optics around the investment characteristics of the product. And also, you know, typically, typically they can be, you know, currency hedge type of exposures, which matters a lot, right? As like a local Korean investor, you're not trying to get involved in U.S. market someplace and take a bunch of current. risk. So you tended to see, you know, Japan very early developed a big structured products market was one of the first in Asia and then eventually Korea, China also. And you also see a reasonable amount of structured products historically coming out of Europe as well,

Swiss private banks, for example. So let's just break this down like super vanilla to start and then we'll get into sort of the complicated aspects of why these products are interesting in the ramifications. But just in terms for so that people understand what the buyer of these products are getting. So take us through like a very like prototypical, I don't know, 50 year old person comes in and they have some money and they want to make an investment, but they're a little worried about risk and volatility. Maybe they're going to retire. What is the basic offering that maybe someone at the bank is telling this person why it may might make sense for them to buy some structured product? And what are they sort of being told

about the upside and the potential risks? Absolutely. So first I'll give you an example of really where the industry got started, and then maybe an example from more recent times of where the industry has evolved to. So a lot of the growth of structured product markets, say, in the 80s and 90s, what you would typically see was just variations on the good old fashion principle protected note. So this would just be exactly the person you said walks into their local wealth manager and they get shown a note that gives them. effectively the ups up say it's a Swiss private bank. So, you know, they're going to put $100 down. If the euro stocks goes up, you know, 10% by the maturity of the note, they're going to get, they're going to make 10%.

But importantly, they are going to get their principal back no matter what, a whole different story. There's effectively, to the end investor, they say, hey, this is great, right? This is kind of like getting involved in the equity market, but I'm a little worried that it might go down. And from an investor's perspective, it's basically like buying a zero coupon bond and a call option. And this worked, right, this was attractive to the investor because you got some downside protection. You got, you know, reasonable upside. Often investors often depreciation of the stocks when actually dividends are really important, right? They're not getting dividends.

So that's already one way that they're paying for it even if they're not really thinking about it. Exactly. And so often you'll have those type of assets. where there's some slightly subtle trade-offs in the economics of the note that your typical retail investor might not always think about. But, hey, they're getting some upside in the equity market. They have limited downside. You know, they like this type of thing. And in the old days, when interest rates were 6% or 8%, this worked, right?

Because you could buy that zero coupon, or the bank that's structuring this product could fund it by buying a zero coupon bond that was going to generate that capital, that sort of principal protection, and then use some money to buy a call option. So that's a pretty simple structure, pretty easy to understand for the most part. Now, the interesting, you know, a big part of the evolution of this market over the... So what do you do with this industry when, you know, there's no more 6 or 8% of investors, right? These days, you think more of the problem, or one problem facing investors of all types, right, is how on earth do you generate a decent yield on a fixed income style investment, right?

You've got, you know, if you want to get a 7% yield and look in the credit. markets at the quality of credit, you know, that you have to, credit risk that you have to take in order to generate a 7% yield, it's pretty skilled. In this world of very low interest rates, effectively what they can offer, they found various ways to effectively sell in a world with low interest rates, the way that you generate yield for the most part is you either take credit risk. A more typical type of product these days is what you might call the reverse convertible auto call.

And what that, I'm just like a bond. But in exchange, they're going to take the risk points in the next few years. They're just going to lose that, get knocked out of that note and lose to the bank in exchange for getting that coupon. And then they'll come with all kinds of other bells and whistles on. The basic idea is you get a coupon, a fixed income stream. In exchange, you take that risk of the bad scenario. So, Ben, you mentioned the issuers behind these products, which are usually banks, often French ones, oddly enough. walk us through exactly how the banks sell these products and where their profits come from

when they're selling this sort of panoply of offerings, you know, autocolables, equity link securities, tarfs, whatever you want to call them. Absolutely. Several layers of the value chain and distribution, right? So the client, the end retail investor will be sitting or with a financial advisor of some kind, right? And typically, when the client buys that note, typically loads on mutual funds. So there might also be an upfront effectively commission. Then within the bank, there's probably a that was involved in the creation of the security

that might get a cut, which is going to make a price for that note. So effectively, some bid ask spread. Usually the upfront to the end investor, you know, the commission to the broker typically would not be. certainly the bid-esque spread or value of this note would not be transparent to the embedded cost. So one of the benefits to the banks who are issuing the products is that they get all these fees and commissions, as you describe, and they also sort of get a cheap form of funding via the retail investment.

But it doesn't come for free for the banks in the sense that they actually have to offset the exposure that they're taking on by selling the products. And this is where I promise auto callables and EquityLink securities start to get really interesting. It's actually through the relationship with the issuing bank. So how exactly do the issuers go about hedging their exposure? Yeah, no, that's exactly right, Tracy. So banks are not in the business on the other side of these type of transactions, right? The bank ideally wants to generate this set of fees for the service that it's providing to the end investor and then to isolate that and to hedge out the market risk, right? So the bank, right, where it's promising to pay the end investor

according to the terms of the note. In the case of, you know, the old-fashioned very protected note, if it's a very vanilla one, let's say, you know, a eurostocks effectively call option plus embedded bond, that's quite simple to hedge, right? The bank might issue this principal protected note. It might buy some zero coupon bonds and it might buy some call options on the eurostock. and that might actually be, you know, quite a good hedge, right? In the case of, in this case, sell downside puts typically longer term in order to be a first order of magnitude hedge for these type of securities, the trick really comes in and how complex these notes get quite quickly, right?

So, you know, the simple example is, again, just take the eurostocks again, maybe the client puts down $100 and is going to get a 8% coupon unless the eurostock is down 30% at some point upon which they get knocked in. One subtlety there, just being sure to put trickier because the client doesn't actually lose money unless it's actually something that's called a knock-in put option. And right away, that's like a tricky thing that doesn't have any easy replicating portfolio and

option. And then as implied volatility fell and yields fell, banks had to add more and more features to these notes to make them still generate that six or seven or eight percent yield. like the clients wanted, right? So typically these days, you'll see that type of product. It won't just be linked to the eurostocks. It'll be linked to the Eurostocks and the H.S.C.E.I. and the NECA, for example. And it will act as if whatever the worst performing index of that whole basket is. Right. So that introduced a managed risk from the perspective of a bank. So, you know, typically if you talk to

to anybody who runs one of these portfolios managing these risks, you know, they'll, they have very complex models. And at the end of the day, they'll describe their risk as sort of a reasonable gas. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person and global squad of sector specialists, analysts, and traders.

These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. So before we go on, there's a couple key points of clarification that I just want to wrap my head around in terms of how these things work. the first question that I have, can you explain for people, and maybe including me who don't

totally understand it, when you say they have to sell options to generate yield, just this basic concept, is the idea essentially that you're selling downside protection, you're selling puts to people who are sort of natural hedgers or people who want to buy downside protection, they pay for that downside protection, and that becomes the de facto yield or that becomes a de facto yield for the client. Is that essentially what you're saying? Yeah, exactly. So when you sell an option, right? So if you go out into the market and you sell a three-year, you know, 30% out of the money put on the euro stocks, you're going to get paid some amount of euros for that. And if the market, you know, it'll have a price that'll fluctuate, but if you go throughout the life of that

three-year option and it expires worthless, you will have collected that premium over that period of time and you can think of that as a yield. And then you mentioned, there's like this weird situation where, okay, let's say the owner of the note is knocked in if the underlying index against which the note is written, say if it falls 30%, then that person loses 30%. But if it only falls 25%, or if it only falls 28%, then the bank is compelled to make the note holder whole. So what you're describing in terms of the complexity and the difficulty of like finding this perfect hedge is as a result of this fact that the risk builds for the bank as the market falls and falls until a certain point and then the risk kind of disappears and

reverses, which makes, I guess, this particularly tricky in finding the right valuation and price for these things. That's right. This is a, it's a type of, you know, barrier option. It's a very complex security, right, which is quite hard to hedge exactly, as you point out, as the market or the underlying index for one particular note, you have sort of a binary result, right? Either if the market goes down a bunch more, you're going to trigger,

and the underlying note is going to cost the underlying investor a bunch of money, but if it doesn't, if it just stays there, then it's actually, then that risk fades away. And in a complex portfolio of many and many, many of these kinds of notes with all different linkages to different indices, the hedge is quite different. These types of instruments, when they issue new structured product risk,

they'll be out in the market selling, you know, longer term, call it two or three year, 20 or 30% out of the money put options, you know, which are an okay, day one proxy hedge for the style or overall flavor of the risk. You know,

but over time, as these products age and different indices go up, or other ones go down and all of the risk, you know, moves all over the place. But then all of the, you know, the really fun stuff, when you alluded to this, is really in, you know, at this point, these are very large markets, right? So we're talking about, you know, Korea alone is well over $100 billion a year of issuance of these type of products.

Japan is large. You know, some European locations are decent sized. And these, the risk from these products are actually sort of the largest sources of buying and selling of longer term options on global indices in the world, right? So bigger than like pension funds doing, you know, hedging, for example. or bigger than hedge funds buying or selling long-term indices. And so what that means is the when you get, when something funny had a huge part of the volume of that market and all alluded to, for example, in 2015, you know, what you had was this scenario in which Chinese markets rallied very, very fast in the summer products as retail

was very involved in speculation in equity markets. And then the market suddenly fell over a few months, almost 50% in China, right, the equity markets. And what that meant was many of these products, right? So banks had been gone out and sold downside put options and sometimes variant swaps against these portfolios of market falls very fast. All of a sudden, the auto calls start, you know, get close to knocking out, some of them knock out. And the banks all have to go and buy back those headblum where they have this kind of complex security that they had an okay hedge for day one. But once you have a big market crash, all of a sudden that's not a good hedge anymore. And you had a huge short squeeze in options and boland.

utility that blew up a bunch of banks and a bunch of hedge funds. Some hedge funds made a bunch of money and some hedge funds lost a bunch of money and it was causing up very major issues in those markets. So they kind of all end up, I guess, short vol when these things get knocked in, which means they have to buy more puts and sell more futures and sort of do this imperfect hedge at exactly the wrong time. And they have to compete with everyone else to do the imperfect hedge at exactly the wrong time. Exactly. That's exactly right. So the key thing to think about is the banks, when they do these, when they issue these types of securities, they're effectively buying, you know, gated form from investors, and they're hedging them by

the things that you can hedge with between the two markets are selling off very quickly, right? When the, that risk, with that, when that volatility from retail investors start to get down close to those knockout barriers, knockout, rises very fast, and all of a sudden banks are left, you know, short a bunch of options that they've sold to hedge, but they're, but they're long option position, their protection is starting to go away. And it's all happening to all the banks all at the same time. So just regarding the hedge, one thing I've always wondered is, you know, you said that the banks, the issuers, make most of their money through commissions and fees on these products. And I get that they want their exposure to be relatively neutral for what they're selling. But is there any,

is there any motive by the banks to also generate profit through the hedge itself? Like, is there a way to creatively hedge in such a way that you can juice your returns a little bit or add a little bit of extra revenue? There is. Usually, there are many such ways to do so. Usually they involve taking, so that's, of course, one of the common themes of derivatives markets in general is usually the easiest way to juice your returns and make your boss happy is to take some hidden risk that will occasionally flare up and blow you up, right?

So 2015 was a great example of that in China. several of the banks, much of their hedge portfolios against structured products linked to Chinese equity markets were in the form of variance swaps rather than options. Think of variance is the square and swap and a portfolio of options is just that when things get really bad, you lose money with a squared term sort of in the size of the amount of money that you lose, which is generally very bad. But in normal markets, you get paid if you're short them, you get paid a little bit of extra money for that. And so as a result, so variance swaps have the of the support underlying portfolios of

auto calls in the sense that the auto calls, as the market goes down and down and down, actually eventually goes away, right, because you start to knock out or you get very close to knocking out, whereas variance swaps are the opposite, where the worst things get, the more exposure of variance. Well, banks that had very heavy exposure, short side of their hedge in order to juice their returns, as you said, that made their profits look pretty good for several years, but then caused massive and outsized losses in Q3 of 2015 when the equity markets fell. So, you know, quick answer, yes, absolutely by taking some extra mismatch risk by extra tail risk. Generally, generally comes around to bite you.

Okay. I need to back up for a second and understand the risk that the bank is exposed to when the retail holder of the node is knocked in. So again, we have these notes that protect the investor from any downside risk until. say one index or maybe one of multiple index drops 30%. So then let's say that happens. And then the retail investor no longer has any protection. They're down 30% on their initial capital. Why is that bad for the bank? Why does that create a mismatch then that requires some sort of aggressive, you know, as you put it, a short squeeze in the options? Sure, absolutely. So let's go with our simple example. So we've got.

got a retail investor that bought $100 of this of this auto call that's effectively going to give them a yield unless the underlying index is down 30 percent upon which the no will just go away and they'll lose 30 percent. Right. Right. So that in of itself, from the bank's perspective, the market is down 30 percent and we trigger the knockout. What that's just going to mean is the bank is not going to have to only pay you 70 cents

back instead of, you know, $100 or $100 back. And so just in theory, the bank, would prefer a 30% decline to a 29% decline, right? Or does that? Yes, except the bank has hedged this product. Right. But the bank doesn't just sell all these products, right, because otherwise then the bank just has massive directional exposure to everything, right?

So the bank has hedged this note. And the bank has sold a bunch of, you know, 25% out of the money three-year put options. Okay. On the underlying index. Right. And so as the market starts to go down and down and down, actually that typically the, the deck will get a little bit longer volatility at first, and that just has to do with the fact of the structuring of this knock-and-put option. So often the bank will actually have to sell a little

bit more of those put options for the first, say, 10% of the market decline. But once we get, to your point, once then the market goes down and down and down and nearing this knockout point, right, the bank is still short all of those put options that it sold. Right. Right. And the only thing that's going to happen. And once that note knocks out, then the bank $100 first, that's fine. But they still have all of these. Now they're just outright short a whole bunch of put options. Right. And they've got to go buy those back. And of course, all of this in option land is sort of forward-looking and probabilistic, right? So as the market goes down and it starts to look like you're getting close to knock out, then banks are getting

worried, and they're starting to effectively get short volatility in the portfolio because the notes are losing some volatility exposure as it looks like they might knock out with with higher and higher probability. And that's this kind of dynamic where all of a sudden the banks start scrambling to cover those hedges. So this is one avenue essentially where markets can really impact the financial health of banks. And banks can also impact the markets as well. And I think there was actually a moment in time where if you looked at the Hangsang index, it was kind of tracking against the index of Korean brokerages and Korean banks. And you could sort of see that link very, very clearly. So my question is, in a long and convoluted way, why aren't regulators more focused on this?

because it seems like a pretty obvious and potentially troublesome source of a feedback loop, basically. Yeah, absolutely. So, you know, Korean regulators have paid attention to this over the years. They typically have come in usually after a blow up. Korean banks did lose quite a lot of money in 20, banks and brokerages in 2015 after the China debacle. And regulators will come in. So they restricted, for example, they restricted the percentage, of new issuance of structure products that could be linked to after that meltdown in 2015. But typically they've taken a relatively laissez-faire approach to the space. They've looked at basic investor protection, you know, whether the disclosures are adequate and so forth.

But, you know, globally, there just hasn't been that much focus on it. I think, you know, regulators have a lot of different things to look at and they have to make decisions about what they're, where they think the biggest risks are and what they think, you know, where they think systemic risk is, it hasn't been a space that they focused on a tremendous amount. And outside of Korea, to some extent, because this is so lot, these products are so large relative to the Korean market. And when Korean banks get involved, you know, they can be huge drivers of Korean banks, you know, solvency. So something that you mentioned, you said in 2015, some hedge funds lost a lot of money, some hedge funds made a lot of money. how does an outside player who's attempting to take advantage of the potential for some sort of extreme moves in the options market as certain barriers get hit?

Or they think this is a risk out there and they want to be in position to exploit it. How do they get a handle on where the various knock-in levels are, given that there's a range of different notes with different underlying indices, all sold at different times and different days? and I'm sure every day the reprice and reset and all that, how does one start to get a handle on where the sort of key levels of risks lie and therefore when one might expect to see a short squeeze in a particular flavor of options? Yeah, absolutely. So that's exactly the right question, I think. So these days, influence of these products is building up data, all of these types of exposures.

So typically if, you know, you're involved in the space, You know, you have coverage from the various French banks that are very heavily involved, and they will typically have a set of models that, here's all the different indices that all these notes are linked to, here's what banks risk profiles look like. And what the typically very interesting questions is, you know, how much volatile calls the bank as a function of where, at the level of the indices, right? So I mentioned typically those risks grow to some extent as equity markets start to go down. But then the key question is where do they stop growing and then where do they suddenly fall off a cliff as you really start to get into and go through that knockout zone.

And so, for example, you know, these days in the S&P, you know, right now there might be out of Korea and Japan. And there's probably $100 million of exposure to one point change in volatility. So think of like the VIX as 15. That's in volatility points. So 100 million Vega means if that goes up by what fits or losses associated with that is $100 million. So that number goes up about 20 percent as the market as the S&P goes down to about 2,500. But then it starts to really fall off a cliff very fast.

and by about 2,000 or 1,800, it's going away quite quickly. And so that's, and those types, something that you can keep track of pretty well. And, you know, partly the hedge funds, but I think largely two investors and asset owners, you know, usually when you're out there looking for hedges or looking for long-term. Portfolio protection, the key question is always, you know, what is supply and demand? Are you trying to buy expensive, you know, risk protection that somebody else, that everybody else is trying to buy two, or is there really a supply of it in the marketplace? Is there a big source of selling of the risk that you're trying to get a hold of?

And this is a good example of retail investors in structured products being a large source of selling of long-term tail risk in major equity indices. And so folks will focus very heavily on what's filed from my organization as a function of equity markets, you know, and of my equity exposure. you know, where do I start to get as an organization into, you know, major distress costs? How does that map into what kind from options in this type of range, given that, you know, that banks in my... So, Ben, you mentioned the S&P 500 just then in your example. And this is where we start to get into some of the newer developments in structured product land. And something new that is happening is that we're seeing more of these that are actually pegged. to U.S. indices as opposed to sometimes obscure Asian equity markets. Why is that happening?

And what does it actually mean for the wider market? That's right. So this has been a very, very interesting trend the last few years. So first of all, to your point, there has been more and more of this underlying issue and directly linked to the S&P. Part of the reason for that is that implied the option prices and implied volatility on some of those international indices have come down and down and down over the last few years,

partly driven by the selling of these types of products and also partly driven by the fact that actually realized volatility globally has been falling. And you've had a lot, actually, most of the volatility episodes in equity markets

over the last couple years have been U.S.-centric and S&P-centric. So think of like the February, you know, all blow up and December 2018, right? These were really U.S.-centric events.

And so unusually from a historical perspective, actually S&P volatility and option prices have been relatively higher and relatively firmer compared to international, which of course attracts mixing S&P to sell options to generate those higher coupons that the retail investor wants. Now, the other really important thing that's been happening here, again, you think of banks as the manufacturers of this industry, of this risk, right, where they're generating this fixing for it is the risk that they're taking to. manage these portfolios. In general, but especially in, you know, Chinese equity markets, in Japanese equity markets, you know, these are smaller option indices that don't have as big of volumes where these markets, the structured products really, really dominate the risk in these markets, and where the liquidity issues are very exacerbated. So one thing banks really started to look at in earnest, you know, how can we get more of this

risk into an easier to manage format where we're not having to, you know, frantically sell more options as markets go down for a little while and then frantically buy a whole bunch of them back in China where it's really hard to do this. So what they started to do was create relatively complicated investment products for hedge funds called, for example, Corridor Variant Spread, which had the end goal and effective purpose of basically moving a bunch of this risk that they had to manufacture out of those smaller indices globally and into the S&P bucket. And they do that in various complicated ways that we don't need to get into, but the end effect is that even though they've issued a lot of notes that are directly linked to

CEI, when global equity markets go down, banks find most of the changes in their risk profile, which they need to go out and manage and hedge, you know, at least to first order, they find those changes happening in the S&P. And they, and it might be that initially start to drift down. They're having to sell some downside S&P options. But then they're going out and having to buy the S&P option with that if the market crashes. So that's very new over the last few years. So just to be clear, is it that the note in the basket of the indices that it's exposed to is that it has the S&P 500 in it, or is it simply a mix of that plus also the idea that even if the note is exposed to the Hengsang, or something like that, that the bank might find it still most expedient to hedge via S&P options

on the premise that on some level there's a level of correlation, and even if it's not the perfect hedge for them, that that might be the place to, the cheapest, most liquid place to hedge their risk. So there has been some increased, still a minority. It's still going to be, you know, 20% or something like that. And they're not typically just warehousing tons of basis risk

and only hedging an S&P, but what they're doing, again, is so all, explain a little bit what a corridor variance spread is. So let's say the bank has this auto call that it's sold to Bob. And so the bank has that risk profile that we've been talking about. It's a proxy hedge for that was going out and selling some downside puts on the euro stocks. But the bank's going to go into another trade with a hedge fund. And that trade is going to be something like, hey, here's this volatility exposure, which is going to be a spread between the euro stocks and the S&P.

And that exposure is going to be conditional on the strike level, on the level of the index, in a way that kind of roughly matches what they, you know, of those auto calls is. And what that does is now the hedge fund is going to have that, the hedge fund is going to hold that weird, difficult to manage, you know, risk in the euro stocks. And the bank is going to have the similar type of risk, but they're going to have it in the S&P on a net basis once you're combining that trade they just did with the hedge fund and the auto call that they've sold to retail. And you know, you're adding layers and layers of complexity because now you've got, you know,

a complicated product you've sold to retail that you've kind of tried to hedge by selling, doing another complicated trade with the hedge fund. And so there's, you know, all sorts of more where, you know, things go funny. But the first order, the first order result is that the banks, that all those changes in volatility risk that happen at banks as a result of global markets moving down, they all happen to first order in the S&P now. A little bit in other indices, too, but much more now in the S&P. And so, you know, it used to be markets that, you know, typical U.S.-centric investors and pension funds and real money guys didn't notice as much, you know, what's happening in, you know,

in the HSEEI option markets. But now those dynamics are all being translated into the S&P. And for example, you know, what we saw in December of last year, you remember, right, the markets peaked at trough were down 20% or so by Christmas Eve. And everybody sitting on structured products desks was sitting there staring at their risk profile and thinking if the market goes down another 5%, like, we're just completely screwed. Because that was where you were starting to get into much of this non-linearity where all of a sudden all their risk, their long volatility exposure, their protection. coming from those auto calls was starting to disappear very fast. And instead, we got that 6% rally the next day and shot off from there. But we were actually very close to a very, very major loss event, you know, across, potentially across the street and that could have cascaded into all sorts of crowded hedge fund positioning as well.

And that's just something that's not on, I think, asset owners radar screens at all. The fact that you've had this kind of historically very, you know, historically much more normally behaving market. They used to be the places where pension funds went to hedge or, you know, what have you, that are now being very dominated by these weird, complicated, structured product dynamics. Is the implication that we might not be as lucky next time? There will certainly be a time. I mean, I know this is these days it's a controversial topic, but there's, pretty markets are down more than 20%. A day. Wait, did you say there will be a day?

No, sorry, a time. Oh, time. I don't mean like a single thing. Oh, no. Oh, no, you're saying that this is going to be like a 1980s. or something like that. That's more of a flash crash. Right. Okay. Yeah. But look, at some point, you know, there'll be a recession in the U.S.

There will be a global recession. And at some point, you know, equity multiples will contract. And this is, and this market is very much set up to be a time bomb in exactly that, in exactly that scenario. Sort of global equity markets down, you know, 25 or 30 percent or more. So just to sort of wrap it all up, would people need to understand, and I just sort of, just to sort of summarize it, is that essentially, these notes, they're sold all over the world, but they're very heavily heavy in Korea and also in Japan. And the basic idea is the size of this market in these countries and the way that the issuers of these products have sort of migrated more and more of their hedging to the S&P 500 creates a situation in which the activity of retail players in these countries can create some potentially extreme moves in S&P. 500 options and presumably the main index itself as declines we get declines and banks have to do all kinds of things to keep their exposures level. Yep, that's exactly correct. Ben, thank you so

much for coming on. That's Ben Eifert from QVR advisors. Thank you for walking us through what is at times a complicated topic. You got it guys. It was a lot of fun. Thanks, Ben. That was great. Really appreciate it. So, Joe, I really enjoyed that conversation. I love talking and writing about structured products. It's half past midnight here in Hong Kong, and I weirdly don't feel tired at all because I'm so excited about talking about tarfs and auto callables and all that. But one thing that definitely crops up in that conversation is just this notion that

there's so much sort of self-reflexivity built into financial markets nowadays. And you see it, you know, not just with these equity-linked products, but you also see it with credit markets where there's an argument over whether or not the derivatives indices can actually affect the cash bond prices. You certainly see it in the volatility market with the volpocalypse blow up of 2018 when these two tiny exchange traded products caused this big whiplash in the overall volatility market. It just feels like this is something that we're seeing time and time again. Absolutely. And obviously we should talk more about it. But I agree it does feel like there is this, as you say, reflexivity in which the sort of like ongoing, you know, ongoing attempts to hedge and to be balanced creates these extreme scenarios. We should do another one. Before we forget, we should do another episode because they're bringing back one of those short VIX ETFs that blew up. Oh, yeah. big thing on. So I saw that. We should definitely do another one on this. But I thought like Ben's explanation, it is extremely complicated and thinking about the sort of the way the volatility or risk

profile for the bank changes as the market goes from, say, from flat to down 15% to 25%. And then the volatility starts to collapse again as it gets to 30%. And then the knockin happens really hard to sort of wrap on's head around, but I thought Ben did a great job of A, explaining that, but also why this is so hard for even the experts to price and why you see desks occasionally lose a bunch of money. Right. And I guess the corollary to that, you could say, is that if it's that hard for the issuers to price the risk of selling these products, then should they really be going to retail investors in the first place. And I don't know if you've ever looked at the advertising for some of the equity link securities, but like it gets very creative and colorful. So I remember

there was one that was sold in Korea that had like sigh from Gangnam style on it and made all these Gangnam neighborhood references. So I don't know. Should retail investors really be diving into these things or do the majority of them actually understand how they work? I mean, I was going to, we didn't get to it, but that was something that's been on my mind. Thinking about this is, how could a retail investor, unless they're extremely sophisticated, have any idea whether they're getting a good value or not, given how complicated the various payoff matrices are, especially when they include multiple index, how would you ever know whether you're getting a good value?

And furthermore, I feel like if you were in a position to know, Okay, this is actually a good product for me. You're probably sophisticated enough to trade options yourself and just create some sort of bespoke risk set up on your own. But that's kind of for a different discussion maybe. Yeah, or work on a Delta One desk at a large French bank or something. Right. All right. This has been another episode of the All Thoughts podcast.

I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway. And I'm Jill Wisenthall. you can follow me on Twitter at the stalwart. And you should follow for sure our guest, Ben Eifert. He's on Twitter. He's really awesome. His handle is Ben with two ends, P. Ifert.

So definitely check out us up one of the great follows. And you should definitely follow our producer on Twitter. She's back in studio with us, Laura Carlson. She's at Laura M. Carlson. And follow the Bloomberg head of podcast, Francesca Levy. She's at Francesca today. and follow all of Bloomberg's podcasts on Twitter at the handle at podcasts. Thanks for listening.

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