ANDY SCOTT: We've never seen any Asian retail investor impact North American vol markets as much as they do today.
And it's that rapid shift that's encouraged increasing amounts of vol monetization, of vol selling, whatever you want to call- it in these retail structure product notes.
And it's entirely because we didn't get through that breaking point that which bands would have to become very aggressive buyers the volatility.
We did, however, get through a lot of those points for select single stops.
MIKE GREEN: Mike Green. I'm here in Las Vegas at the Equity Derivatives Conference again. This time, I'm getting to sit down with Andrew Scott of SocGen. Andrew is a fantastic strategist in the equity derivatives space. He's worked across multiple regions and is a key contact for me as I try to understand who is actually selling volatility, who is buying volatility, what are the forces that are playing out in the evolution of this market. Hopefully, you can handle this really technical discussion. But we're going to really try to dig in and understand both the evolution of the volatility selling market as well as the capacity constraints that ultimately may begin to influence the underlying markets themselves.
Mike Green, I'm here for Real Vision. I'm sitting down with Andrew Scott. Andrew, one of my favorite dapper, proper Englishman. But you and I have met through the years primarily in your involvement in the equity derivatives space, which some of the Real Vision viewers have heard me talk an awful lot about. We're here at the Equity Derivatives Conference in Las Vegas, the EQDT Conference, where both you and I have presented a number of times. And you have spent a ton of time in particular talking about a subject that's near and dear to my heart, which is the idea of short vol. All right? And volatility suppression, I think is what you are spending a lot of time talking about in your presentation.
How did you get here? What brought you into the equity derivatives world? And then let's talk about how that market evolved alongside your career.
ANDY SCOTT: Yeah. Sure. We take it going back to school, you read the FT every day onto being a dapper English gentleman. You just know you're exposed to equities until you have a mortgage, it's very difficult to have a conceptual understanding of bonds and fixed income. So, I think you're just naturally brought into that environment. Everybody goes to a supermarket, everybody goes to a bank, it's just more tangible. So, that was really it. As simple as that was why I started out in equities, obviously, to broaden out over the years. And I just loved trading.
And in a pre-Volcker environment, when you could still do fun things, it was a wonderful job. I traded for still the better part of my career, and then transitioned into more of sales roles, which I very much enjoyed as well, the more advisory type jobs, speaking to people like yourself. Essentially, I've tried to just spend my career speaking to people smarter than myself every day, and that makes me good at my job. And then naturally, because I was so bad at trading and sales, I now run a strategy team.
So, on my side now, I have spent the last three years- part of that in Asia, now, in New York- talking about structural dynamics in equity derivatives, because now, I feel like there's an awful lot of data that's available that wasn't necessarily there a decade ago to truly under understand and explain some of those structural anomalies in why the markets move the way they do. So, that's about it. And that got me here today.
MIKE GREEN: And just you're being a little bit humble, because you actually started at 19 as an intern at [inaudible]. And you're now 29. Right?
ANDY SCOTT: Yes, very fast.
MIKE GREEN: Yes. So, you have been doing this for a very long time and have a lot more experience than your few gray hairs might suggest. That's actually a fascinating segue. You talked about the emergence of data. And so, you've seen some of my data sets where I've attempted to replicate stuff much further back than most though. But we're still operating in a regime in which the data sets are relatively parse in terms of volatility- both equity and other markets and respond to that.
ANDY SCOTT: I think on my side, I took that as part of my responsibility in the role I have, which is to- in a more friendly fashion, communicate what that data means. You can get access to various data dumps from websites these days. There's various vendors that provide some of that public data. But I think the nice thing I like about the seat I have today at SG is that I get a lot of that private data too. Increasingly, we take historically, the largest retail structure product market in the world, something like Japan. Half of that market now is private auction. So, if you're not very close to that, you'll miss a lot of the subtleties and a lot of the structural dynamics and the flows that are coming increasingly to North America.
We've never seen any Asian retail investor impact North American vol markets as much as they do today. And so, I've really spent a lot of time trying to aggregate this, understand what it means, look at all the structural participants and think about what their goals are, what their ambitions are, and then trying to deliver a message back to clients rather than just saying, I think you should buy S&P calls. We're trying to explain with an awful lot of powerful data why we want you to own this exact strength for these structural reasons. And I think that's something I've really tried to do- spend a lot of time doing a better job on.
MIKE GREEN: Well, and so when we talk about data, and I think it's important for people to understand what data means in the context of derivatives, right? So, data helps us in a couple of different ways. One, it helps us to try to understand the distribution of possible outcomes, right? Because when you're pricing a derivative, you're pricing the probability of all potential outcomes and some embedded distribution, right? And unfortunately, we very rarely have the history that allows us to create that entire distribution. We certainly can't observe everything that's ever going to happen, right? And so, that's part of the data set that you're talking about.
The other data set, and this is where the private ones become important in particular, where the access to that type of information is, where individual strategies or players i.e. Asian retailers, structured product, which you referred to- what their strategies and tell them doing systematically, right, or where pressure might emerge in the market that may lead to a shape in a distribution that is different. Is that a fair assessment?
ANDY SCOTT: It's a very good and very good overall understanding of how I think about it, too. I would say, the other thing to think about, as well as the qualitative lens of that, and something you and I have had lots of discussions on in the past is that does a back test on a country like Japan's asset classes mean anything post Abbanomics? Because the macro lens has changed so dramatically that even if we do have 100 years of data in Japan, doesn't really matter if we have anything before 2013 anyway. So, I think that's a very important point we need to make clear as well. But in terms of more broadly, how we're thinking about how they're impacting those distributions, I think that's key to everything.
And understanding as well the psyche and the emotion around why they're doing things around investment banks, buy side firms, we love to deconstruct the grids into as many orders as possible. We make ourselves think we're very intelligent, dang it. But at the end of the day, the most powerful driver in the room is a retail investor sitting in Asia, who has most of their property, sorry, has most of their wealth and property and their allocation to retail. We need to understand better why it comes, why they're doing it, why it's evolved. And so, we are spending a lot of time looking at monthly data sets of how that in entirety that flow is coming to market, but also what's the decomposition of that flow?
And that's where we started to realize it was impacting the US economy dramatically in the last couple of years. And I'd argue there's several reasons for that. But if you go to the root reason why an Asian retail investor would ever trade a retail structured product, all they're doing is deciding first of all, is this market going up? So, generally, am I constructive? The S&P was the most different trade on the planet 12 months ago, and might be again, so they were very constructive US equities, they were less constructive domestic equities. So, that's answer one. Correct.
And then the second reason why you do it is the pickup above the risk-free. That interesting to me. If it's five, 10 bips, I'm just going to trade my KTV bond. Clearly in Japan, is a different argument because there's no yield whatsoever. But I would say this is why Kore has become the biggest retail structure product market in the world. It's a very simple thing. But in 2016, Korean bond yields cratered. The 10-Year went to about 1.4%. And we think about that from a US context, let's call it 4%, 5% to 1.4 doesn't seem so extreme. But Korea was double digits, it was considered by most metrics an emerging market country not so long ago.
And it's that rapid shift that's encouraged increasing amounts of vol monetization, of vol selling, whatever you want to call it in these retail structure, product notes. So, it's less that they're thinking so much about the vol argument, it's a pure coupon, yield enhancing argument for them. And what is the differentiation that I'm getting versus the risk-free rate? That is it.
MIKE GREEN: Well, so you hit on a number of important trends that have played out, all right? One is the rapid aging of Asia. So, the Korean investor equities are far less appropriate for them than they would have been 10 to 15 years ago, because the population has aged dramatically. The second is that the availability of yield in the form of risk-free both domestic and international has fallen sharply. Right? So, interest rates feels like a lifetime ago, but as recently as 2007, where six plus percent and Korea, I believe that they were almost eight at that point. Now, as you point out there, there are low ones occasionally pressing towards less than 1%-
ANDY SCOTT: They're better than Japan I guess.
MIKE GREEN: Still significantly better than Japan, which is another market, obviously, that has been pushed into this. And so, faced with relative inappropriateness of equities as a direct exposure with the relatively high variability, many of these individuals retail, broadly speaking, have chosen to engage in yield enhancement strategies, which involves some form of selling options on equities. Who developed that because it clearly wasn't the classic phrase of Mrs. Watson Obby, right? She didn't figure out that she could go out and write calls or write puts, who built these structured products, who created them?
ANDY SCOTT: Sure. I'm not going to claim our firm was the first. There were multiple people involved in these markets. But to know the data of the first retail structure product, there's several people that might know the answer, I don't know. It was before my career started. But it wasn't necessarily a big part of the market, it was still very, very small. The evolution of that was clearly from the financial engineering department that came to that exact conclusion in another cycle in another time, what can we give to the client that make them feel comfortable with the trade? And then thinking through those basic steps and those questions I'm asking them, do I think the S&P is going to half, which is often the risk embedded in a lot of these products?
Generally, people don't believe indices, maybe single stocks, but indices are going to half overnight, over a month, over two months. So, that is the embedded simplicity and the safety. But by monetizing something shown far out of the money because of where skews exist that far down on spots, that created some interesting yield that was appealing to an investor, a retail investor. And so, I assume that is how the logic played out, that it was as simply just asking ourselves several questions, once the risk-free rate was no longer that appealing, what can we do to other asset classes?
Wasn't necessarily even a volatility argument from the origination, it was just more what can we monetize that we feel comfortable with, that they feel comfortable with? And actually, unlike most derivative markets, where there's generally a winner and a loser, you can have two winners out of this outcome. And I think that's why they've been such appealing products.
MIKE GREEN: That's a great insight- that you can have two winners out of this type of product, right? Because part of what has emerged, and particularly through post-GFC is a change in the regulatory environment that has forced banks and insurance companies to seek that type of protection against that type of catastrophic outcome. Ironically, insurance companies, for regulatory reasons need to seek protection against 50% drawdowns, 40% drawdowns as a typical attachment point if I understand it correctly, right?
So, they need to actually buy insurance. And they turn back to the retail community to purchase that. And they require- they don't necessarily think that this is insurance that they want, but they're required by regulators to buy it. Right? And so, this is a cost that they must bear in order to do business. And retail isn't taking that. Is that fair assumption?
ANDY SCOTT: Yeah. I would say from a North American argument, that's very clear. And that's why you probably have not had the scale of vol distortions that you've had in Asian vol surfaces. Perpetually, HSCI, the Nikkei. They've always had flat smiles. And they've had a very depressed long dated vol, because the offset of that which in North America is an insurer isn't necessarily present in the same scale out there. But what has changed in the last two, three years, is a huge evolution and a huge redesign of the insurance market, and specifically in the variable annuity market. And this big transition towards vol control vol managed funds.
So, if you think about around 2008, we were about a trillion dollars on the variable annuity market fast forward into today, that market has doubled, and 70% to 80% of their new issuance has come in what we would call vol managed funds. So, that's actually reducing the exposure of the insurer to that negative convexity that they've historically had, at a time when the Asian retail investor, as I said earlier, has never been more powerful in North American markets. And that offset that incremental buyer and seller where vol is reading starting to shift in North America. And that's something we've been very close to as a topic because we think it's not that well understood.
MIKE GREEN: Well, so let's push on this for a second because a lot of this, as you talk about developed in the vicinity, and I would argue, contributed significantly to the global financial crisis, right? So, in the United States, you have a natural buyer of that volatility that emerged in 2006 with revisions to the variable annuity industry, right, it was called C3P2. The traditional structure of a variable annuity at that time would have been something much longer in duration, you would have had a 10- or 15-Year observation window. And regulators in 2006 looked at that and said, that means you have a funding date 10 to 15 years off into the future, you need to buy some form of insurance.
And this is the genesis of actually the Warren Buffett trades that some people may remember if they dig into the mists of time, that Circa 2000.
ANDY SCOTT: Never heard about it.
MIKE GREEN: Yeah, exactly. Circa 2007, Warren Buffett sold significant quantities of puts on the Nikkei, the S&P, the DAX, and the- I forget what the fourth market was- probably London, for the footsie. But so, he sold these roughly 50% down puts with the idea that this was relatively cheap financing, right? And that's really what you're doing when you're selling a put is you're obtaining cheap financing. It's the same thing as buying a bond, right? Or issuing bond. What happened after that? Because you were on the front lines for some of those.
ANDY SCOTT: Yeah. That is very entertaining for a junior trader. I wasn't so Junior, I guess. So, what happened was that post not being able to prop trade, the market had not really understood what to do with that. Because whatever we want to say about prop desks, they were always somewhat the last liquidity provision of last resort. And that was very important for market structure. That didn't matter so much in a market that just continually went up, continually went up and vol was compressed for a multitude of factors, which we can talk about for hours.
But what happened was that regulations changed the way trading desk manage their risk. Before, if I took down a retail structure product from an Asian client sitting on a London trading desk at a Russian underlying, and I decided I liked the look of that risk, I could sit on that risk, see how it played out, I had a view on that risk and was allowed to take it increasingly because of stress test burdens. Because of just outright reduction of vol across the street, it's probably been 75% reduction across all investment banks. I no longer in the position to be able to take that decision, over a very small discretion maybe. But generally, I have to systematically hedge that as soon as it hits my trading book.
And that has huge ramifications for markets. Because if I want to do that on Monday in a 30 Kazakh steady stock that only really trades very well and opens through a Thursday, there's no liquidity for that. So, there is forced structural burden on the market of this depression of vol where I have to go and sell that or at least make best efforts to do so in a very systematic, short space of time. And that's why having all the data going back to our earlier points has never been more important. Because understanding how that investment bank is going to manage that risk and being on top of the evolution of those trends gives you a very good sense of the structural trigger points in vol surfaces because there's no more discretion. There's an element of discretion, but not a huge amount. So, it's somewhat formulaic how that will play out, which allows people like yourselves in the seats you're in to optimize the risk points that they own, based on those data sets.
MIKE GREEN: And so, what you're describing as a rate- there was a cost of equity that you as a prop trader had, right? And so, if you found this short vol position, right, this taking on the risk of this downside to be relatively attractive, you could hold that. Regulators took that away. And so, there is no price at which you're willing to do