The $300 Billion Structured Notes Market Is Booming

Market sentiment, positioning & volatility

• Alex Micalizzi · Nomura

  US SEC-registered structured note issuance is on track for about $300B this year, up from about $200B.

  Alex says the US structured product business has grown quickly. SEC-registered notes this year are on track to reach about $300 billion, against about $200 billion last year. The biggest contributor is S&P-linked product, but the fastest growth is in worst-of autocallables tied to S&P, Nasdaq and the Russell. Those notes are a growing source of options flow and hedging demand in longer-dated index options.

  “SEC registered notes this year are on track to hit about 300,000,000,000 versus approximately 200,000,000,000 last year.”at 10:18

• Alex Micalizzi · Nomura

  Dealer hedges on structured notes could leave dealers short and amplify a small rally.

  Structured notes sold by banks carry embedded put-spread and knock-out exposures. Dealers hedge the delta, then hedge the vega with listed options. When markets fall, implied vol rises and counterparties outside the listed market pull back, so dealers must sell more optionality at the same time. The asymmetry runs the other way too: if indices rally again, notes with three-month knock-outs can terminate quickly. Dealers keep their short hedges while the new note supply that would offset them has not yet been issued, so they can be left short into a small rally.

  “But all of a sudden, if these indices start to rally again, we could have a situation where this product knocks out in three months. And I am left just with my short hedges in the market, and the supply is not yet there from my auto callable. So there's a situation where dealers can be left short.”at 30:01

• Alex Micalizzi · Nomura

  A spot-up, vol-up regime is shaped by structured-note flows, most visibly in single stocks.

  Alex agrees with his Nomura colleague Charlie McGilligan's description of a spot-up, vol-up regime. He says it is most prevalent in single stocks. In index markets it shows up in longer-dated options, driven by the growth of worst-of autocallables and US SEC-registered notes. Less capital is committed to that part of the vol curve, and fewer participants understand what is driving it. The structured-note hedging flows are the main reason the pattern persists.

  “On the index side, we are definitely seeing that just because of the growth of the worst of and the growth of the US SEC registered notes.”at 30:48

• Alex Micalizzi · Nomura

  US structured-note buyers treat the product as income and downside protection; Asian buyers chase maximum yield.

  Alex says the market structure differs between the US and Asia. Asian demand began in Japan when rates went to zero, with the uridashi concept adding factors to raise the coupon. US investors are more used to equity participation, and the US registered market is smaller than the total return on the underlying stocks. He reads this as US investors taking part of their return as income, like a dividend, so the notes act as a participation trade that diversifies and protects against downside, especially when equity performance has stalled. In other markets, buyers focus more on the highest return and shorter maturities, and they reinvest proceeds more often.

  “this is a participation trade, and this is something that diversifies and gives some protection to the downside. ... whereas in other markets, it's more about how can I get the highest return.”at 44:46

• Alex Micalizzi · Nomura

  Structured note issuance follows market direction; sideways or falling markets cut demand for new notes.

  Alex argues that the direction of the market is the main driver of structured note issuance. If markets go sideways and there are fewer autocallables, or if markets fall, investor demand for new notes tails off. He says the earlier collapse in issuance reflected portfolios that had been buying call options to protect themselves; as those portfolios shrank, the large buyers who had pushed up option premium disappeared. He adds that US capital markets are far more liquid than anywhere else, while Hong Kong and Australia have hedgeable two-, three- and five-year equity markets, so issuance is still possible outside the US. When a two-year US registered note is pushed out to five years by a market decline, the issuer is left short a hedge that no longer matches the exposure.

  “I would say, ultimately, what drives issuance is the direction of the market. ... if we do go sideways and there's less auto callables or we go down, you're just not going to get the demand for more.”at 46:33

• Alex Micalizzi · Nomura

  Barrier-linked structured notes can flip dealers short gamma near strike levels, amplifying market moves.

  Alex explains that when a client buys a knock-in put or a put spread, the dealer starts out long gamma. As the market approaches the barrier, the dealer's position can flip to short gamma, so the dealer has to trade with the market and amplifies the moves. Near those levels, the binary outcome of knock-in or knock-out creates exacerbated swings. He says this is seen more often with knock-outs because there are more of them, and that the same mechanism works on the other side of the barrier. On the question of slow grinds versus sharp falls, he says both can be painful. A slow grind can hurt when the hedge is wrong, volatility keeps falling, and the skew flattens. A hedge that is locally right can also fail on a large move, because the sold position has value beyond the bought put spread or call spread.

  “I'm now short gamma. Which means that I'm more susceptible to market moves, and I exacerbate the market moves.”at 49:13