Why you should care
These fixed-return savings products are very stable … until they’re not.
Complex savings products with names such as Super Lizard, Cobra or Boosters are flying off the shelves in South Korea, as retail investors try to juice returns while interest rates are low. But analysts warn they are causing market anomalies, and potentially fueling wider turbulence at times of stress.
So-called auto-callables are structured notes that offer fixed returns like a bond while selling options on equity indexes, delivering a higher yield than can be earned from more conventional savings products.
Such investments have long been popular with Japanese savers who have struggled with low interest rates since the 1990s, and have in recent years grown in popularity in Europe for similar reasons. But South Korea has emerged as the powerhouse of the auto-callables industry. At about $93.2 billion, the market is now almost as big as equivalents in Europe and the U.S, put together, according to analysts.
It could become a bit of a wreck. The market is just so big now.
Peter van Dooijeweert, head of institutional hedging, Man Group
However, some investors argue that while the equity derivatives embedded in auto-callables mostly dampen market volatility, their complex structure can exacerbate turbulence when markets are particularly rocky — as banks that structure and sell them have to constantly hedge their exposure. For example, the French bank Natixis suffered a $293 million loss linked to Asian auto-callables in the fourth quarter last year.
“They are actually very stabilizing for markets … [but] they can create pandemonium when they break,” says Russell Clark, chief investment officer of Horseman Global, a hedge fund. “They create stability, and then instability .… The history of these types of products is that they always eventually blow up.”
An official at South Korea’s Financial Supervisory Service says regulators have stepped up their monitoring of the market, noting the risk of losses for local securities firms caused by “herd behavior” from customers. “If a stock index drops, we can see a large amount of futures sold, which will drag down the index further,” the official says. “We’re looking into this.”
For now, though, analysts claim that auto-callables are subduing market turbulence far beyond the shores of South Korea.
Auto-callables typically include both “put” and “call” options. The extra yield they offer is generated by selling calls — the right to buy an asset at a certain price within a certain time period — on the indexes or securities they reference, effectively capping gains in exchange for a steady premium. When the index rises above a certain level, the product automatically comes due. Similarly, put options — the right to sell — generate premiums by selling insurance against steep sell-offs.
However, the huge supply of the embedded options in auto-callables appears to be dragging down popular volatility gauges such as the Volatility Index (VIX), which are based on option prices. This, in turn, has a dampening effect on the actual volatility of stock markets.
This is becoming particularly noticeable in some markets. Euro Stoxx, the European equities benchmark, has become a popular reference for South Korean auto-callables because the region has historically been more turbulent than the U.S. stock market, and there are therefore higher coupons to collect through selling puts.
The European Vstoxx index of expected volatility was on average 4.57 points above its more famous U.S. equivalent, the VIX, between 2000 and 2018. But since then, the Vstoxx has been lower than the VIX on average, suggesting that the rising supply of options built into auto-callables is keeping the gauge subdued.
Similarly, the volatility gauge of the Russell 2000 small-cap index in the U.S. has since 2004 been 5.6 points higher than the VIX, which tracks the volatility of the large-cap S&P 500. But since the beginning of 2018 this spread has fallen by half. The average difference between the Japanese Nikkei volatility index and the VIX has also halved since the beginning of 2018.
“South Korean auto-callables have managed to go global,” says Peter van Dooijeweert, head of institutional hedging at hedge fund Man Group. “The volume is suppressing volatility in these markets.” However, the dynamics around derivatives at times of market turbulence can be treacherous to navigate.
The puts are typically heavily “out of the money” — in other words, they are triggered only when the referenced index tumbles by a significant amount. But as markets slide and get closer to the “strike price,” banks that structure the auto-callables have to hedge their own exposure, which can in extreme circumstances result in a panic.
Even when banks do not ultimately lose money, managing the exposure can be very tricky, as Natixis’ big loss last year highlighted. Inadequate hedging, meanwhile, continues to drag on the profits of local banks. The market regulator said last year it would step up supervision due to “concerns of market failure” among local investors, almost half of whom are over the age of 60.
“It could become a bit of a wreck,” van Dooijeweert warns. “The market is just so big now. As we saw in December, these are the types of products that seem to cause a lot of trouble for buyers and for the dealers who sell them in times of market stress — adding fragility to the system exactly when no one needs them to be problematic.”
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