In our recently published report, A Step-by-Step Guide to Offering Bespoke Investment Products to Retail Clients , we explained how banks of all sizes can take advantage of the trend towards personalization in the finance industry by creating bespoke investment opportunities with structured products. The report highlighted two major pain points: price discovery for notes and options providing exposure to the underlying assets and managing the product lifecycle. In this first of a series of two blog posts exploring these pain points, we look at some of the challenges when it comes to price discovery and how automation streamlines the process.
Finding the best deal for the customer
The capability to issue structured products is mostly limited to tier one investment banks such as Barclays and JP Morgan, as they have the solid trading flow in underlying assets needed to set prices. These sell-side institutions use trade data to calculate what’s known as volatility surface, which calculates the implied volatility of an option taking into account its time to maturity and the strike price (how much buyers pay for it). The volatility surface determines how the option is priced. Any bank can buy a tool to perform this calculation, but it’s useless without a sufficient volume of data.
As volatility surface relies on trade flows, option prices vary from one provider to the next. To what extent depends on the liquidity of the underlying asset. The pricing of a vanilla option such as a ‘call’ on the S&P 500 or FTSE 100 is relatively consistent as the sell-side has clear visibility on the liquidity and exchange option chains of these indices. However, there’s greater discrepancy when pricing options for individual stocks, and it generally increases down the cap scale.
Of course, other factors influence pricing too. For example, a sell-side institution that needs to offload a specific position will be very aggressive when pricing the options offering exposure to it.
Price differences explain why it’s so important for smaller banks that don’t possess the same in-house capability as the sell-side to shop around for the best deal for their customers.
Maintaining multiple relationships also lowers counterparty risk. Banks should diversify the providers they work with because, while it may be rare, sell-side institutions have been known to go out of business (as happened to Lehman Brothers during the 2008 financial crisis). At a minimum, banks should make sure that the majority of providers they trade with are rated investment grade, which means they’re highly unlikely to default according to agencies like Standard and Poor’s and Moody’s.
The inconvenience of shopping around
The problem with shopping around for the best price is the time and effort required when performed manually. Banks typically source quotes from more than ten sell-side institutions, which involves a huge number of emails flying back and forth. The process starts all over again if the customer decides they want to test the elasticity of the option pricing by increasing the funding rate.
To make price discovery even more challenging, if a bank submits too many requests without trading, providers will eventually stop supplying quotes. That’s understandable considering every inquiry for an option price requires a fresh calculation, which takes time because the process is manual.
Automation is the answer
Futora’s multi-issuer platform makes price discovery much less painful. An automated solution streamlines the process, allowing smaller banks to price as many variations as necessary to meet their customers’ needs, all at the click of a button. What’s more, it stores quotes and responses on a central repository, which is easier to track than an email inbox.
Futora’s platform is web-based, so it doesn’t need to be integrated into legacy systems. This feature allows banks to deploy the platform quicker and at a fraction of the cost incurred by solutions that require internal development.
One final factor to consider is the bias of platforms operated by some sell-side institutions. We regularly hear complaints about how the majority of the trade flow goes to the provider of the platform. This bias ultimately reduces competition because other providers, especially the bigger players, are less likely to quote if they don’t win any business. However, Futora is strictly neutral because we’re a technology company. Our priority is simply to help banks source the best deals for their customers.
