Global Volatility on the Rise and the Biggest Traders Out There (w/ Mike Green and Andy Scott)

Global Volatility on the Rise and the Biggest Traders Out There (w/ Mike Green and Andy Scott)


MIKE GREEN: 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 stock, 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 this barring totally exigent circumstances? ANDY SCOTT: Pretty much the day I moved into
sales. MIKE GREEN: Right, exactly. And so, when that occurred, post-2009, we
actually saw the vol surfaces explode. And so, when you and I first met, it was around
this time period. And if I looked at the 10-Year or 15-Year,
options surface, it would have suggested that all hell was going to continue to break loose
for the rest of time, right? You and I both remember variants, contracts,
pricing, 10-Year variants, contracts, pricing and the equivalent of a 45 on the VIX. Right? Just put that in context. ANDY SCOTT: That didn’t play out. Okay. MIKE GREEN: Yeah, exactly. It didn’t play out. And for those who know me, that was when I
was a big vol seller, but just to put that in concrete terms, that was implying that
every day for the next 10 years, it was going to average something like the events around
9/11. Right? ANDY SCOTT: Yeah, that’s a good way to think
about it. MIKE GREEN: Okay, so seems like an unlikely
environment to invest. That was on the demand side, right, or on
the supply side, right, basically, people’s ability to provide that risk. So, it went away, it disappeared gave the
opportunity for individuals like myself to sell into that market. Those who were trying to offload this risk,
the insurance companies subsequently restructured, right? They changed the products. And that’s what you’re talking about when
you introduced this vol control dynamic. ANDY SCOTT: So, part of it is regulation,
part of it is just the absence of a natural supply on that end. What you can argue as a regulator, you can
argue multiple things, but they had to redesign just like the retail structure products, had
to redesign because they need clean liquidity and that brought everything down the term
structure. There’s 10-Year S&P options as little as 10
years ago, traded every day, FX options every hour. But fast forward to today, and we barely see
anything trade seven years in FX that’s not a corporate. So, the market has shifted so dramatically
that all the concentration of risk is really inside three years from an equity bucket. And insurers have had to come and meet that
offset with liquidity. They could retail, could match them out to
maybe five years in the past, maybe a little bit longer for certain clips. But they’re certainly not there today. And so, retail, sorry, insurers have had to
adjust to the new market structure. But that brings with it many challenges. It brings with it many, many structural flows
that are too large for certain markets. In a very liquid market like an S&P, you can
get away with things for a lot longer. But in certain smaller markets like HSCI,
for instance, you can almost blow up the index. We almost got close to it in 2015. The Korean regulators were so nervous about
just nevermind the vol argument, the delta argument that the day open and the day close
was now like so tied to retail structure product rehedging that they suggested, perhaps we
should diversify, perhaps we should put caps on these types of markets in terms of issuance,
because at one point, half of the Korean issuance was going into HSCI. And we all know what happened in 2015, Chinese
equities are now on half. And that triggered that risk that we said
earlier. We feel comfortable with our market went half,
we got there. And that made regulators very nervous. So, just like we had the GFC from an insurance
perspective, from a retail perspective, I would say 2015 was really the year where everything
changed. And I was a big part of that. I was based in Asia at the time, helping them
redesign their industry, diversify the underlying, restructure the mechanisms that trigger the
outs or the ins of these products to an order to ensure a safer market that can be restructured,
that can be reissued. And that’s what we’ve seen in mass scale,
which has brought the vol risk right down from a three plus year risk bucket into the
one year and even six-month bucket for some single stops. MIKE GREEN: So, so let’s break that down into
some simpler terms for people, right. So, functionally, what you’re describing is
the demand for yield enhancement strategies, the idea that they need to earn something
in a fixed income type environment in excess of the risk free rate in regimes like Japan
and Korea had traditionally gone to Asian markets, primarily because of location, geography,
to source, the selling of that insurance, right? They became large enough in those markets
that they actually began to tangibly impact it. Similar to what we saw with XIV, for example,
in February of 2018. When you say diversify, what they really did
was they began selling insurance on other indices around the world. So, the S&P being a primary one, right? ANDY SCOTT: Correct. And that spread around Asia, originally. We saw more- AS51, for instance, we sawMIKE
GREEN: Right. Australia? ANDY SCOTT: Yes, we saw a little bit more
career and a little less Hong Kong, we saw HSI which is the domestic Hong Kong Index. So, we did what we could within an Asia construct. And then it started to move to Europe in scale,
it’s always been in Europe, in the US, to some extent, but it’s never a big percentage
of allocation. So, a lot went into Europe, a lot went into
the US, less in global EM. We very rarely see an Asian retail investor
structure something on the Brazilian equity market, but bizarrely, we do see them trading
from an FX perspective historically. It’s a country they’re comfortable with but
from whatever reason for an equity perspective, they just went into two listed liquid market,
not that they trade listed, but as in, they were most comfortable with those risks, I
believe, because they’re essentially 24-hour markets. MIKE GREEN: I think that’s right. I think ultimately, it becomes very hard to
explain to somebody what the actual risk is of taking a 50% drawdown in Brazil, [inaudible]
for example, but it’s relatively easy to say, the largest liquid markets around the world,
right? Similar to the dynamic that we talked about
to open this with Warren Buffett selling on large liquid markets around the world, right. And so, this is really the same trade. ANDY SCOTT: You’re exactly right. That’s what I was going to say. All Warren Buffett did was take the highest
point of premium in that product, and trade it directly. And monetize the fact that you have very,
very high skew down 50%. So, there’s more to monetize from a coupon
yield enhancing perspective. And that’s all he did. MIKE GREEN: Right. And so, when you use the phrase skew, what
you’re describing is the premium that is paid for way out of the money insurance, right? ANDY SCOTT: Exactly. MIKE GREEN: So, to put it in traditional insurance
form, right? It’s way after the deductible has been paid,
right? It’s like this is catastrophic insurance. But Warren Buffett does a great job of pricing,
right? How did the liquidity dynamics play out in
these types of products when the market begins to fall, right? Because this is a key component of Warren
Buffett’s observation, is he didn’t want to have to post collateral. So, what happens to the retail market or to
the insurance market if markets begin to fall? ANDY SCOTT: So, as markets begin to fall,
obviously, the mark to market from the retail perspective goes down. They will see that on their statement. But they’re not really thinking about this
trade as something they’re actively managing, they think about it very differently from
you and I, it’s I’m going to own this trade over a period of time, and I assume the worst-case
scenario will not happen. If it gets too close to the worstcase scenario,
I may think about restructuring it, I may think about monetizing whatever that implied
loss is. But very seldom does that actually happen. I’m making this number up. But I assume it’s something like 99% doesn’t
get restructured. So, it either triggers or it doesn’t. And we know mathematically over meaningful
periods of time, you will make money by taking in, doing it, trading it enough. But what actually happens to the hedge profile
is that essentially without getting complicated on the mast of it, they’ve got an embedded
put at that 50% strike, let’s say, but it’s actually at the money strength, it’s just
the trigger is the 50%. So, at 51%, I have a coupon that I’m clipping
away quarterly, monthly, at 49%. On an observation date, I suddenly am short
from 100. So, only 50% of my capital over that shift. So, that’s why that retail structure product
has very different grid profile in terms of how we’re thinking about managing the risks
of that product, then let’s save and just bought or sold that 50% put. And it’s that mismatch in the vanilla hedge
versus the retail structure product that I own that generates a trading risk that as
I said now, formulaically needs to be traded. So, getting back to what happens when a market
sells off, there’s a period where the selloff sees the retail structure product pick up
in its exposure to volatility more than the vanilla hedge. That period, we call right into peak figure,
which is the highest sensitivity of that retail structure product. Along that path, as a bank, I keep needing
to rehedge. So, I need to keep selling more volatility
until we get to this inflection point in the dynamic where I’m getting too close to where
I might have that horrible scenario. And it’s that inflection when it shifts that
turns for a seller, me, investment bank into forced buyer, post that level. And so, while we think about these products
very simplistically, in reality, in terms of it’s a pickup over the risk-free rate,
the trading nuances are very, very important. And so, you can be very comfortable selling
volatility as a hedge fund, over, let’s say, 10, 20, 30% periods. But you certainly want to own the tail beyond
that if the retail structure product exposure is too dramatic. MIKE GREEN: And there are any number of players
that are involved in this, some of them have different attachment points. All right. So, one of the big players last quarter or
the fourth quarter of 2018 were players involved in like iron condor strategies, right. So, those would be players who would typically
have a strike somewhere, a long strike position somewhere down 20%, right? And so, knowing each of these individual profiles,
each of these individual positions is the technical or qualitative data that often you
need to understand when we’re talking about this data collection. From a purely mechanical standpoint, which
you’re describing, this idea of the market falls and the initial reaction to that is
actually from those who are hedging is they buy equities, right? They initially, basically are involved in
a vol dampening exercise. Once you cross over that point, right, then
suddenly, you’re forced to actually be- because you no longer have protection from the retail
player, you’re just playing alongside them effectively, you then need to buy all that
back and more, right? And so, it effectively becomes like trying
to trade hurricane futures in the middle of a hurricane in Miami. Right? There is lots of players involvedANDY SCOTT:
I’ve done that. MIKE GREEN: I know. Yeah, exactly. So, those sorts of switching characteristics,
I think, are one of the most interesting features that exists, right? And part of what I talked about a lot is this
dynamic of nothing really happens inside a range. The minute you go outside of that range, it’s
a little bit like Tara incognito. We have no idea what’s actually going to happen,
we just know bad stuff happen. Have we hit these attachment points in your
mind? ANDY SCOTT: We have not, but we didn’t get
a million miles away in the Q4 selloff. So, if we calculated peak value, this period
where the transition shiftsMIKE GREEN: And Vega is just the dollar term for the quantity
of volatility. ANDY SCOTT: Yes. Exactly. So, that exposure to volatility, if we hit
that level on the S&P, it would have been around 2200, 2250. We were 100, 150 points shy of that. So, we got exceptionally close to it. But for those that were actually trading it,
and we’re not entirely highly on top of these nuances, it would be very bizarre to see one
played out in vol surfaces, because that volatility kept getting sold off as spots sold off. We think about, we take out all of the structural
players in the market. If equities are going down, there’s a reason
why a negative skew, this notion that vol at spot versus vol down 50% is different. There’s a fundamental reason. If my debt load hasn’t changed, but my equity
is lower, I’m a riskier entity down there than I was here. And so, when we sold off, you’d expect this
pickup and volatility in normal conditions, especially because we know the biggest buyer
of volatility for the last 10 years has been insurers. So, there’s a natural buyer already, nevermind
the protection of portfolios, which would be the additional layer of demand, yet it’s
sold off. And it’s entirely because we didn’t get through
that breaking point that which bands would have to become very aggressive buyers of volatility. We did, however, get through a lot of those
points for select single stocks. And that’s why you saw such a differential
in behavior versus single stocks, especially tech and financial volatility surfaces where
we had the biggest drawdowns versus the index itself. MIKE GREEN: So, we don’t just see this in
equity markets now. Right? This same type of feature of yield enhancement
similar to a risk parity type framework has spread to fixed income. Right? So, people are enhancing the yield on risk
free government bonds by selling insurance against the risk that those bonds go either
down in price or up in prices or both directions, all right? Typically, to the top side more often than
not. We’re seeing it in commodities. And so, we did hit actually that attachment
point in the natural gas and oil markets in the fourth quarter, right? And so, if you look at the shape of the OVX,
which is the oil volatility VIX, it underperformed, underperformed, underperformed as oil sold
off in the fourth quarter, and then completely exploded. So, the same thing happened in nat gas as
trader got caught offsides, right? That’s the thing that you would expect to
see happen if we do push past those attachment points. ANDY SCOTT: Yeah, it’s a very good mirror
of reality. Because whilst trying to achieve different
outcomes in equities, we have overwriters and the like. In commodity markets, we’ve got natural overwriters
from corporates, etc. The structural players are somewhat similar,
there are just less in commodity markets. So, that driver, that retail transmission
mechanism was very clearly seen because there wasn’t so many other participants distorting
that noise, let’s say. So, I think that’s a beautiful thing to observe
to give you a sense of what might happen for those who’ve not necessarily traded through
’07, ’08, ’09. That dynamic is very, very important. And again, this goes back to the Korean argument
that it’s just going to get larger, because the diversification will not stop. The Asia Pacific private wealth wallet will
surpass that of North America for the first time in our lifetime sometime in the next
two years by most consultant measurements. So, it’s not going away. So, we need to better understand it. MIKE GREEN: So, if it’s not going away, is
there a capacity- you highlight this issue of it was very clear the impact that they
were beginning to have on Asian markets, which by and large are in total about a half the
size of the US markets as of today with China as larger size. Is their capacity limit? Can we absorb all of this vol selling? ANDY SCOTT: I think equities have already
proven that they hit their capacities in certain markets. And that is why we’re going into other asset
classes. Back 2015-2016, back to the point you were
making about bonds being one of the products used- it was the easiest sell in the world. You’re striking something exactly the same,
50% down. So, wherever the 10-Year was then, 1%, you’re
basically saying I don’t believe US 10-Year Yields will be at 50 bips in the next one,
two, three years depending on the maturity of products. That’s a very easy argument going into the
first hike post a crisis. And so, that was something that got a huge
amount of resonance in Asia. And we saw how quickly they almost give up
equity allocation to do tactical trades like this. So, we saw so much issuance on bond markets
in the US, it actually almost created a variance swap market, which is just another volatility
product. But the fact that it was such scale that it
did that was actually going scary, but it shows you the power and the pervasive power
that these retail investors can actually have in global asset classes, because the diversification
is not going to stop. Weren’t clearly not a capacity in equity markets,
but the fear of getting anywhere near it just drives that diversification. MIKE GREEN: And so, the factors, though that
influence capacity, right, and so part of it is the actual demand for the product, right? So, if I need additional yield enhancement,
which has increased because I have a decrease in government bond yields, right, or investment
grade bond yields, which are tied to that. So, there’s less traditional fixed income
products available to accommodate my growing savings needs. Right? And perversely, that reduction in interest
rate or reduction in yield means I need to save even more in order to achieve my objectives. Right? You subsequently then have the demand side
of the equation. But perversely, you actually, by buying all
of these products, by creating this yield suppression, it means that you need to sell
even more volatility in order to accommodate, accomplish your yield objectives, right? I need to sell a lot more Vega at a VIX of
nine than I do at a VIX of 35 in order to achieve the same return components, right? Okay. So, when we think about that dynamic and this
vol suppression, one way that we bump up against capacity is that we functionally create too
much Vega supply for the market, and it gets improperly priced. Another way it happens is that the products
that we’re transacting in- indices primarily, right, reach a share of the investment markets
that they begin to influence the underlying components. Right? So, part of what drives the historical performance
and the historical data of the S&P volatility is the fact that there’s 500 stocks, this
diversified basket. If it behaves as a diversified basket, it
has different volatility characteristics than if it’s treated as a single basket on a continuous
basis, and therefore the correlation rises. So, talk about that, do you see evidence that
the trading of these index products is beginning to indicate a capacity issue? ANDY SCOTT: I’d say we’re starting to suggest
it might. And in an S&P market, it’s been the lack of
that insurer over the last two or three years that has made us question that. In other markets, we might have had much more
data points. Again, going back to the HSCI argument in
2015. It was very clear that capacity wasn’t there. And it wasn’t allowable. But coming back to the S&P, the insurer dynamic,
because of accounting changes, actually will change again, and insurers will become very,
very sizeable buyers of volatility again. So, maybe we’re okay in a market like the
S&P, but maybe a market as large as Euro stocks, maybe we can’t handle that anymore. And I think it’s interesting to look at something
I think clients who benchmark against certain indices don’t spend enough time on their own
benchmark is the evolution of that. And yeah, you mentioned it’s 500 stocks in
the S&P. But what did that look like 10 years ago versus
today? Is it more volatile? Is it less volatile? These are very important questions. I think global emerging market indices is
probably the best example of where this has happened. I owned an awful lot of Russian, Brazilian
oil and gas a decade ago. Today, I own a lot of Chinese tech. What’s the vol dynamic in that? What’s my view on these corporates? So, it’s very difficult to take these things
in isolation. There are so many nuances about what I’m trading. But I absolutely agree with you that we are
starting to get too close to capacities in certain markets. And it’s beginning to make people very nervous,
which is why again, you see that gold option being traded by retail, oil option being traded
in retail, which never ever happened in the past. MIKE GREEN: Well, and I want to start to wrap
up on that, because that’s part of just like we saw, HSCI capacity reached, and in a much
larger market in terms of the S&P into a lesser extent, the Euro stocks, buy a lot of capacity. If you’ve exhausted capacity in the S&P and
your next step is the gold market or the oil market or the soybeans market where we’re
seeing all of these players involved. Those are tiny markets relative to the S&P,
right? The aggregate quantity of commodities, I want
to say is 3 trillion, maybe on a good day. Right? So, you’re talking 10% more, but the demand
is growing rapidly. And so, we’re starting to see the indication
that effectively the cup is running over. Right? ANDY SCOTT: Absolutely. But that’s why it’s so important that markets
keep going up. And that’s the other point too today, to be
clear is these products not only cause you some issue on the downside, but they don’t
exist on the upside. That’s why these products in particular, like
auto callables, there’s a callable nature to them, which means if S&P rallies 5%, or
actually does nothing in a lot of the cases these days. Product disappears. So, that’s stress on market, that risk goes
away. So, that’s why we’ve probably got away with
this in global equity markets in the last three years, because they only went up. When we have a stressed environment is when
you see whether we’ve actually hit capacity already and just didn’t realize. MIKE GREEN: On that very frightening note. Andrew, as always, it was a pleasure sitting
down with you. I’d love to be able to do this again. Perhaps next year at EQDT, we can do a reprise. ANDY SCOTT: Love to. Fantastic. MIKE GREEN: Thank you very much. ANDY SCOTT: Thanks, Mike.MIKE GREEN: 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 stock, 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 this barring totally exigent circumstances? ANDY SCOTT: Pretty much the day I moved into
sales. MIKE GREEN: Right, exactly. And so, when that occurred, post-2009, we
actually saw the vol surfaces explode. And so, when you and I first met, it was around
this time period. And if I looked at the 10-Year or 15-Year,
options surface, it would have suggested that all hell was going to continue to break loose
for the rest of time, right? You and I both remember variants, contracts,
pricing, 10-Year variants, contracts, pricing and the equivalent of a 45 on the VIX. Right? Just put that in context. ANDY SCOTT: That didn’t play out. Okay. MIKE GREEN: Yeah, exactly. It didn’t play out. And for those who know me, that was when I
was a big vol seller, but just to put that in concrete terms, that was implying that
every day for the next 10 years, it was going to average something like the events around
9/11. Right? ANDY SCOTT: Yeah, that’s a good way to think
about it. MIKE GREEN: Okay, so seems like an unlikely
environment to invest. That was on the demand side, right, or on
the supply side, right, basically, people’s ability to provide that risk. So, it went away, it disappeared gave the
opportunity for individuals like myself to sell into that market. Those who were trying to offload this risk,
the insurance companies subsequently restructured, right? They changed the products. And that’s what you’re talking about when
you introduced this vol control dynamic. ANDY SCOTT: So, part of it is regulation,
part of it is just the absence of a natural supply on that end. What you can argue as a regulator, you can
argue multiple things, but they had to redesign just like the retail structure products, had
to redesign because they need clean liquidity and that brought everything down the term
structure. There’s 10-Year S&P options as little as 10
years ago, traded every day, FX options every hour. But fast forward to today, and we barely see
anything trade seven years in FX that’s not a corporate. So, the market has shifted so dramatically
that all the concentration of risk is really inside three years from an equity bucket. And insurers have had to come and meet that
offset with liquidity. They could retail, could match them out to
maybe five years in the past, maybe a little bit longer for certain clips. But they’re certainly not there today. And so, retail, sorry, insurers have had to
adjust to the new market structure. But that brings with it many challenges. It brings with it many, many structural flows
that are too large for certain markets. In a very liquid market like an S&P, you can
get away with things for a lot longer. But in certain smaller markets like HSCI,
for instance, you can almost blow up the index. We almost got close to it in 2015. The Korean regulators were so nervous about
just nevermind the vol argument, the delta argument that the day open and the day close
was now like so tied to retail structure product rehedging that they suggested, perhaps we
should diversify, perhaps we should put caps on these types of markets in terms of issuance,
because at one point, half of the Korean issuance was going into HSCI. And we all know what happened in 2015, Chinese
equities are now on half. And that triggered that risk that we said
earlier. We feel comfortable with our market went half,
we got there. And that made regulators very nervous. So, just like we had the GFC from an insurance
perspective, from a retail perspective, I would say 2015 was really the year where everything
changed. And I was a big part of that. I was based in Asia at the time, helping them
redesign their industry, diversify the underlying, restructure the mechanisms that trigger the
outs or the ins of these products to an order to ensure a safer market that can be restructured,
that can be reissued. And that’s what we’ve seen in mass scale,
which has brought the vol risk right down from a three plus year risk bucket into the
one year and even six-month bucket for some single stops. MIKE GREEN: So, so let’s break that down into
some simpler terms for people, right. So, functionally, what you’re describing is
the demand for yield enhancement strategies, the idea that they need to earn something
in a fixed income type environment in excess of the risk free rate in regimes like Japan
and Korea had traditionally gone to Asian markets, primarily because of location, geography,
to source, the selling of that insurance, right? They became large enough in those markets
that they actually began to tangibly impact it. Similar to what we saw with XIV, for example,
in February of 2018. When you say diversify, what they really did
was they began selling insurance on other indices around the world. So, the S&P being a primary one, right? ANDY SCOTT: Correct. And that spread around Asia, originally. We saw more- AS51, for instance, we sawMIKE
GREEN: Right. Australia? ANDY SCOTT: Yes, we saw a little bit more
career and a little less Hong Kong, we saw HSI which is the domestic Hong Kong Index. So, we did what we could within an Asia construct. And then it started to move to Europe in scale,
it’s always been in Europe, in the US, to some extent, but it’s never a big percentage
of allocation. So, a lot went into Europe, a lot went into
the US, less in global EM. We very rarely see an Asian retail investor
structure something on the Brazilian equity market, but bizarrely, we do see them trading
from an FX perspective historically. It’s a country they’re comfortable with but
from whatever reason for an equity perspective, they just went into two listed liquid market,
not that they trade listed, but as in, they were most comfortable with those risks, I
believe, because they’re essentially 24-hour markets. MIKE GREEN: I think that’s right. I think ultimately, it becomes very hard to
explain to somebody what the actual risk is of taking a 50% drawdown in Brazil, [inaudible]
for example, but it’s relatively easy to say, the largest liquid markets around the world,
right? Similar to the dynamic that we talked about
to open this with Warren Buffett selling on large liquid markets around the world, right. And so, this is really the same trade. ANDY SCOTT: You’re exactly right. That’s what I was going to say. All Warren Buffett did was take the highest
point of premium in that product, and trade it directly. And monetize the fact that you have very,
very high skew down 50%. So, there’s more to monetize from a coupon
yield enhancing perspective. And that’s all he did. MIKE GREEN: Right. And so, when you use the phrase skew, what
you’re describing is the premium that is paid for way out of the money insurance, right? ANDY SCOTT: Exactly. MIKE GREEN: So, to put it in traditional insurance
form, right? It’s way after the deductible has been paid,
right? It’s like this is catastrophic insurance. But Warren Buffett does a great job of pricing,
right? How did the liquidity dynamics play out in
these types of products when the market begins to fall, right? Because this is a key component of Warren
Buffett’s observation, is he didn’t want to have to post collateral. So, what happens to the retail market or to
the insurance market if markets begin to fall? ANDY SCOTT: So, as markets begin to fall,
obviously, the mark to market from the retail perspective goes down. They will see that on their statement. But they’re not really thinking about this
trade as something they’re actively managing, they think about it very differently from
you and I, it’s I’m going to own this trade over a period of time, and I assume the worst-case
scenario will not happen. If it gets too close to the worstcase scenario,
I may think about restructuring it, I may think about monetizing whatever that implied
loss is. But very seldom does that actually happen. I’m making this number up. But I assume it’s something like 99% doesn’t
get restructured. So, it either triggers or it doesn’t. And we know mathematically over meaningful
periods of time, you will make money by taking in, doing it, trading it enough. But what actually happens to the hedge profile
is that essentially without getting complicated on the mast of it, they’ve got an embedded
put at that 50% strike, let’s say, but it’s actually at the money strength, it’s just
the trigger is the 50%. So, at 51%, I have a coupon that I’m clipping
away quarterly, monthly, at 49%. On an observation date, I suddenly am short
from 100. So, only 50% of my capital over that shift. So, that’s why that retail structure product
has very different grid profile in terms of how we’re thinking about managing the risks
of that product, then let’s save and just bought or sold that 50% put. And it’s that mismatch in the vanilla hedge
versus the retail structure product that I own that generates a trading risk that as
I said now, formulaically needs to be traded. So, getting back to what happens when a market
sells off, there’s a period where the selloff sees the retail structure product pick up
in its exposure to volatility more than the vanilla hedge. That period, we call right into peak figure,
which is the highest sensitivity of that retail structure product. Along that path, as a bank, I keep needing
to rehedge. So, I need to keep selling more volatility
until we get to this inflection point in the dynamic where I’m getting too close to where
I might have that horrible scenario. And it’s that inflection when it shifts that
turns for a seller, me, investment bank into forced buyer, post that level. And so, while we think about these products
very simplistically, in reality, in terms of it’s a pickup over the risk-free rate,
the trading nuances are very, very important. And so, you can be very comfortable selling
volatility as a hedge fund, over, let’s say, 10, 20, 30% periods. But you certainly want to own the tail beyond
that if the retail structure product exposure is too dramatic. MIKE GREEN: And there are any number of players
that are involved in this, some of them have different attachment points. All right. So, one of the big players last quarter or
the fourth quarter of 2018 were players involved in like iron condor strategies, right. So, those would be players who would typically
have a strike somewhere, a long strike position somewhere down 20%, right? And so, knowing each of these individual profiles,
each of these individual positions is the technical or qualitative data that often you
need to understand when we’re talking about this data collection. From a purely mechanical standpoint, which
you’re describing, this idea of the market falls and the initial reaction to that is
actually from those who are hedging is they buy equities, right? They initially, basically are involved in
a vol dampening exercise. Once you cross over that point, right, then
suddenly, you’re forced to actually be- because you no longer have protection from the retail
player, you’re just playing alongside them effectively, you then need to buy all that
back and more, right? And so, it effectively becomes like trying
to trade hurricane futures in the middle of a hurricane in Miami. Right? There is lots of players involvedANDY SCOTT:
I’ve done that. MIKE GREEN: I know. Yeah, exactly. So, those sorts of switching characteristics,
I think, are one of the most interesting features that exists, right? And part of what I talked about a lot is this
dynamic of nothing really happens inside a range. The minute you go outside of that range, it’s
a little bit like Tara incognito. We have no idea what’s actually going to happen,
we just know bad stuff happen. Have we hit these attachment points in your
mind? ANDY SCOTT: We have not, but we didn’t get
a million miles away in the Q4 selloff. So, if we calculated peak value, this period
where the transition shiftsMIKE GREEN: And Vega is just the dollar term for the quantity
of volatility. ANDY SCOTT: Yes. Exactly. So, that exposure to volatility, if we hit
that level on the S&P, it would have been around 2200, 2250. We were 100, 150 points shy of that. So, we got exceptionally close to it. But for those that were actually trading it,
and we’re not entirely highly on top of these nuances, it would be very bizarre to see one
played out in vol surfaces, because that volatility kept getting sold off as spots sold off. We think about, we take out all of the structural
players in the market. If equities are going down, there’s a reason
why a negative skew, this notion that vol at spot versus vol down 50% is different. There’s a fundamental reason. If my debt load hasn’t changed, but my equity
is lower, I’m a riskier entity down there than I was here. And so, when we sold off, you’d expect this
pickup and volatility in normal conditions, especially because we know the biggest buyer
of volatility for the last 10 years has been insurers. So, there’s a natural buyer already, nevermind
the protection of portfolios, which would be the additional layer of demand, yet it’s
sold off. And it’s entirely because we didn’t get through
that breaking point that which bands would have to become very aggressive buyers of volatility. We did, however, get through a lot of those
points for select single stocks. And that’s why you saw such a differential
in behavior versus single stocks, especially tech and financial volatility surfaces where
we had the biggest drawdowns versus the index itself. MIKE GREEN: So, we don’t just see this in
equity markets now. Right? This same type of feature of yield enhancement
similar to a risk parity type framework has spread to fixed income. Right? So, people are enhancing the yield on risk
free government bonds by selling insurance against the risk that those bonds go either
down in price or up in prices or both directions, all right? Typically, to the top side more often than
not. We’re seeing it in commodities. And so, we did hit actually that attachment
point in the natural gas and oil markets in the fourth quarter, right? And so, if you look at the shape of the OVX,
which is the oil volatility VIX, it underperformed, underperformed, underperformed as oil sold
off in the fourth quarter, and then completely exploded. So, the same thing happened in nat gas as
trader got caught offsides, right? That’s the thing that you would expect to
see happen if we do push past those attachment points. ANDY SCOTT: Yeah, it’s a very good mirror
of reality. Because whilst trying to achieve different
outcomes in equities, we have overwriters and the like. In commodity markets, we’ve got natural overwriters
from corporates, etc. The structural players are somewhat similar,
there are just less in commodity markets. So, that driver, that retail transmission
mechanism was very clearly seen because there wasn’t so many other participants distorting
that noise, let’s say. So, I think that’s a beautiful thing to observe
to give you a sense of what might happen for those who’ve not necessarily traded through
’07, ’08, ’09. That dynamic is very, very important. And again, this goes back to the Korean argument
that it’s just going to get larger, because the diversification will not stop. The Asia Pacific private wealth wallet will
surpass that of North America for the first time in our lifetime sometime in the next
two years by most consultant measurements. So, it’s not going away. So, we need to better understand it. MIKE GREEN: So, if it’s not going away, is
there a capacity- you highlight this issue of it was very clear the impact that they
were beginning to have on Asian markets, which by and large are in total about a half the
size of the US markets as of today with China as larger size. Is their capacity limit? Can we absorb all of this vol selling? ANDY SCOTT: I think equities have already
proven that they hit their capacities in certain markets. And that is why we’re going into other asset
classes. Back 2015-2016, back to the point you were
making about bonds being one of the products used- it was the easiest sell in the world. You’re striking something exactly the same,
50% down. So, wherever the 10-Year was then, 1%, you’re
basically saying I don’t believe US 10-Year Yields will be at 50 bips in the next one,
two, three years depending on the maturity of products. That’s a very easy argument going into the
first hike post a crisis. And so, that was something that got a huge
amount of resonance in Asia. And we saw how quickly they almost give up
equity allocation to do tactical trades like this. So, we saw so much issuance on bond markets
in the US, it actually almost created a variance swap market, which is just another volatility
product. But the fact that it was such scale that it
did that was actually going scary, but it shows you the power and the pervasive power
that these retail investors can actually have in global asset classes, because the diversification
is not going to stop. Weren’t clearly not a capacity in equity markets,
but the fear of getting anywhere near it just drives that diversification. MIKE GREEN: And so, the factors, though that
influence capacity, right, and so part of it is the actual demand for the product, right? So, if I need additional yield enhancement,
which has increased because I have a decrease in government bond yields, right, or investment
grade bond yields, which are tied to that. So, there’s less traditional fixed income
products available to accommodate my growing savings needs. Right? And perversely, that reduction in interest
rate or reduction in yield means I need to save even more in order to achieve my objectives. Right? You subsequently then have the demand side
of the equation. But perversely, you actually, by buying all
of these products, by creating this yield suppression, it means that you need to sell
even more volatility in order to accommodate, accomplish your yield objectives, right? I need to sell a lot more Vega at a VIX of
nine than I do at a VIX of 35 in order to achieve the same return components, right? Okay. So, when we think about that dynamic and this
vol suppression, one way that we bump up against capacity is that we functionally create too
much Vega supply for the market, and it gets improperly priced. Another way it happens is that the products
that we’re transacting in- indices primarily, right, reach a share of the investment markets
that they begin to influence the underlying components. Right? So, part of what drives the historical performance
and the historical data of the S&P volatility is the fact that there’s 500 stocks, this
diversified basket. If it behaves as a diversified basket, it
has different volatility characteristics than if it’s treated as a single basket on a continuous
basis, and therefore the correlation rises. So, talk about that, do you see evidence that
the trading of these index products is beginning to indicate a capacity issue? ANDY SCOTT: I’d say we’re starting to suggest
it might. And in an S&P market, it’s been the lack of
that insurer over the last two or three years that has made us question that. In other markets, we might have had much more
data points. Again, going back to the HSCI argument in
2015. It was very clear that capacity wasn’t there. And it wasn’t allowable. But coming back to the S&P, the insurer dynamic,
because of accounting changes, actually will change again, and insurers will become very,
very sizeable buyers of volatility again. So, maybe we’re okay in a market like the
S&P, but maybe a market as large as Euro stocks, maybe we can’t handle that anymore. And I think it’s interesting to look at something
I think clients who benchmark against certain indices don’t spend enough time on their own
benchmark is the evolution of that. And yeah, you mentioned it’s 500 stocks in
the S&P. But what did that look like 10 years ago versus
today? Is it more volatile? Is it less volatile? These are very important questions. I think global emerging market indices is
probably the best example of where this has happened. I owned an awful lot of Russian, Brazilian
oil and gas a decade ago. Today, I own a lot of Chinese tech. What’s the vol dynamic in that? What’s my view on these corporates? So, it’s very difficult to take these things
in isolation. There are so many nuances about what I’m trading. But I absolutely agree with you that we are
starting to get too close to capacities in certain markets. And it’s beginning to make people very nervous,
which is why again, you see that gold option being traded by retail, oil option being traded
in retail, which never ever happened in the past. MIKE GREEN: Well, and I want to start to wrap
up on that, because that’s part of just like we saw, HSCI capacity reached, and in a much
larger market in terms of the S&P into a lesser extent, the Euro stocks, buy a lot of capacity. If you’ve exhausted capacity in the S&P and
your next step is the gold market or the oil market or the soybeans market where we’re
seeing all of these players involved. Those are tiny markets relative to the S&P,
right? The aggregate quantity of commodities, I want
to say is 3 trillion, maybe on a good day. Right? So, you’re talking 10% more, but the demand
is growing rapidly. And so, we’re starting to see the indication
that effectively the cup is running over. Right? ANDY SCOTT: Absolutely. But that’s why it’s so important that markets
keep going up. And that’s the other point too today, to be
clear is these products not only cause you some issue on the downside, but they don’t
exist on the upside. That’s why these products in particular, like
auto callables, there’s a callable nature to them, which means if S&P rallies 5%, or
actually does nothing in a lot of the cases these days. Product disappears. So, that’s stress on market, that risk goes
away. So, that’s why we’ve probably got away with
this in global equity markets in the last three years, because they only went up. When we have a stressed environment is when
you see whether we’ve actually hit capacity already and just didn’t realize. MIKE GREEN: On that very frightening note. Andrew, as always, it was a pleasure sitting
down with you. I’d love to be able to do this again. Perhaps next year at EQDT, we can do a reprise. ANDY SCOTT: Love to. Fantastic. MIKE GREEN: Thank you very much. ANDY SCOTT: Thanks, Mike.

9 Comments

  • Michael nunya

    November 3, 2019

    I love it. Way overdue.
    Time for the common man to rise up and destroy the privileged elite.
    You wealthy have Fd things up for long enough. Time to stretch necks.
    Judges and politicians first.

    Reply
  • John Bauer

    November 3, 2019

    You are all involuntary satanics, you are just don’t aware of it

    Reply
  • D Mitch

    November 3, 2019

    mike green is impressive, over all financial and non financial topics

    Reply
  • beo wulf

    November 3, 2019

    STOCKS+/- ARE PAPER=FIAT= PROMISARY NOTE … IF YOU BUY PAPER, BUY SOME VASELINE, NO GUARANTEES OF USE

    Reply
  • Wendy Bevan

    November 3, 2019

    BO ring a dingy ding

    Reply
  • Roy James

    November 3, 2019

    Nothing but old videos

    Reply
  • Wolf of Dubai Stocks Investing Channel

    November 4, 2019

    Volatility is high since 2-3 years I feel,

    That is our new standard in the stock market

    Reply
  • Greiguci Wootchie

    November 4, 2019

    Proper English man? He's chinese lol

    Reply
  • Real Vision Finance

    November 4, 2019

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