Equity derivatives house of the year: JP Morgan

Conservative approach helps US bank deliver extra value through its QIS business

Rui Fernandes

The resilience of US stock markets in 2023 took many banks by surprise – not least JP Morgan. Like many of its peers, the dealer started the year with defensive positioning, which weighed on equity trading revenue as markets surged in the wake of Silicon Valley Bank’s collapse.

Yet the bank has few regrets. Its more conservative approach allowed it to provide firms with life-or-death financing as a crisis gripped the US regional banking sector. The clients who spoke to Risk.net praised it for consistent pricing, refreshing transparency and superior technology, and for a quantitative investment strategies (QIS) business that was “a world of difference” from its competitors’.

“We were very conservatively oriented in terms of risk positioning,” says Jason Sippel, JP Morgan’s global head of equities, credit, public finance and credit portfolio lending. “Part of our secret sauce through the cycle is, whenever there’s turmoil, to have the capacity to provide risk and liquidity to our clients.

“We went through Covid with very long convexity, and at the point of dislocation it gave us enormous latitude to make markets and lean in on risk. If there’s one thing we hear, it’s clients look at us to be there through thick and thin.”

Part of our secret sauce through the cycle is, whenever there’s turmoil, to have the capacity to provide risk and liquidity to our clients

Jason Sippel, JP Morgan

In one transaction, JP Morgan provided critical liquidity to a US regional bank that had been left floundering in the wake of SVB’s demise. Using its fund and derivatives financing expertise, the US dealer underwrote a multi-billion dollar portfolio of revolving credit facilities to private equity funds – so called ‘sub-line financing’. A concurrent synthetic securitisation of a first loss piece to a third-party investor also meant improved pricing for the regional bank, and better regulatory capital treatment for JP Morgan.

“That’s an area of the world where we excelled because I think we stepped in at the right time,” says Sippel. “We committed more capital and I think we showed consistent pricing.”

This year JP Morgan provided billions of dollars of hedges on concentrated stock positions for high-net-worth and institutional clients. These transactions, in which a client would typically buy a collar on the equity position while JP Morgan advanced financing, helped unlock scarce liquidity without the need to divest positions.

Scott Mitchell, JP Morgan

“When you have a market stress, and in a scenario where equities themselves didn’t really tumble, that tends to be when you have clients think about hedging,” says Scott Mitchell, the bank’s co-head of equity derivatives sales and marketing. “In some cases, if other sources of liquidity are drying up, we can use that structure as a way to generate liquidity for clients.”

With its ‘fortress balance sheet’ and tight credit spread giving it an edge when it comes to financing, term equity finance is an area in which JP Morgan is looking to expand.

“Where that matters is the ability to scale that business – more so when you think about the financing activity being a core part of our strategy going forward,” says Rui Fernandes, global head of equities and credit structuring. “It’s not just about growing it from a balance sheet deployment standpoint. It is also about being smart around how we optimise balance sheet and capital treatment around some of these financing activities.”

The decision to ramp up equity financing was no quick fix for revenue growth, but a long-term bet on the increasing need for liquidity solutions.

“Lending businesses tend to be accrual businesses,” says Rachid Alaoui, JP Morgan’s head of global volatility. “So even if you grow it in a very substantial way, as we have done, the revenue tends to come over time. We think that sets us up well in the quarters and years to come.”

‘Yes’ to QIS

In a year when equity trading revenues were down across the board, some parts of JP Morgan’s business posted strong growth. Buy-side clients of all stripes valued diversification and low-cost bets on market dislocations. Clients also wanted fresh thinking, and they got it from the bank’s QIS juggernaut.

With $81 billion of client notional by the end of Q3, the strategic index business was on track to match the previous year’s record levels of revenue – an impressive showing in a low conviction environment and at a time when the bank’s flagship vol strategy had to take a backseat.

“We have been consolidating our market-leading position with market share wins,” says Arnaud Jobert, co-head of global strategic indices. He adds that sovereign wealth funds in Asia, large multi-asset managers and hedge funds have all shown increasing interest in the bank’s QIS business.

The QIS business has been quick off the mark when it comes to embracing new trends. Over the past 12 months, US equity options markets have undergone something of a revolution, with the meteoric rise of daily or zero days to expiration (0DTE) options. These ultra short-dated contracts have become a favourite among retail investors, who view them as low-premium bets on intraday moves, and now represent more than 40% of all options volumes on the S&P 500.

We have been consolidating our market-leading position with market share wins

Arnaud Jobert, JP Morgan

Some worry that the increased use of 0DTEs could exacerbate the ‘gamma trap’, where hedgers are forced to make larger adjustments to neutralise their exposure as markets move up and down. Banks and hedge funds have pored over patchy data to understand the flows and possible risks, and JP Morgan’s QIS business has been at the forefront of efforts to put theory into practice.

“Our view was to try and move away from the ongoing debate of: ‘Who’s driving the flows, retail or institutional? Who’s long? Who’s short?’” says Jobert. “We very much view 0DTEs as a great expansion of the toolkit we have in terms of risk mitigation techniques for a lot of the strategies we’re building.”

Intraday momentum strategies were the first to benefit from having 0DTE options as an input. These well-known quant strategies reflect an expectation that trends seen during the day will accelerate towards the close, when passive investors and dealers rebalance their portfolios. Traditional versions involve buying or selling futures contracts on early trading signals, then exiting towards the end of the day.

In JP Morgan’s latest iteration of this strategy, the dealer buys S&P 500 0DTE puts or calls based on the same signals. The result, according to Jobert, is a more defensive tilt.

Rachid Alaoui, JP Morgan

“Instead of going long or short futures, you can just enter and buy options,” he says. “So, by definition, you have a maximum loss which is known on a given day.”

The unprecedented intraday reversal of January 24, 2022 – when the S&P 500 shed 4% during the morning but ended the day marginally up – was a case in point. Long/short intraday momentum strategies took a hammering, with JP Morgan’s own index shedding 3%. The 0DTE version, however, lost just 50 basis points – the premium spent on the day.

“It’s an extreme example, but definitely an interesting one because that’s exactly the type of intraday reversal this implementation was meant to protect,” says Jobert.

At least one sovereign wealth fund has already invested in the strategy, and other buy-side firms have said they are impressed. “The combination of risk management and leverage make it quite compelling,” says one buy-side client.

JP Morgan believes the strategy offers an effective means of controlling gamma risk and drawdown risk. “I view it as a risk mitigation tool, including it as an overlay on some existing successful vol carry strategies that JP Morgan runs,” says Jobert. “Buying equity vol per se is not a great trade if you see the market, but 0DTEs provide a great way of extracting that convexity at a lower cost of carry.”

Options open

One of the most striking developments in the QIS sector over the last 18 months has been the growing interest from hedge funds. Alternative asset managers across Wall Street have flocked to banks’ systematic index products, driven by a need for diversification and their lack of conviction for more directional trades.

JP Morgan is one of a small group of dealers taking this trend a step further, with options on QIS baskets. For multi-asset hedge funds, QIS options provide an opportunity to gain low-cost access to an asset class or strategy in which a portfolio manager may lack expertise. The bank has sold contracts worth hundreds of millions of dollars in notional.

Jobert says: “For hedge fund managers who haven’t necessarily developed the expertise doing commodities risk premium – or don’t have expertise in trend, but want to have a view on bear steepening, for example – the option format in the QIS space allows them to get into risk premium across multiple markets with a floor, which is embedded in the option.”

Arnaud Jobert with Ludovic Peiron

JP Morgan’s clients have singled out the bank for the broad-based nature of its offering.

“These indexes are very uncorrelated, so when packaged together the risk/reward is even better,” says one hedge fund client. “With individual QIS strategies, because they’re thematic, you have to be in at the right time, which is hard in an uncertain environment.”

As part of a wider effort to attract hedge funds, JP Morgan devised a series of pure equity factor indexes for clients to manage their exposures. Constructed using Barra risk factors – the primary model used by hedge funds to analyse the overall risk of securities relative to the market – the indexes are also optimised for liquidity, thus ensuring that hedge funds can trade in and out efficiently.

JP Morgan traded billions of dollars linked to these strategies with more than a dozen hedge funds, including through options. Many buyers seized the opportunity to take tactical bets on factors such as equity beta, low vol and momentum following periods of dislocation.

Ludovic Peiron, co-head of equity derivatives sales and marketing, describes the factor indexes as “a bit of a gamechanger” for the bank’s delta one business, which also benefited from JP Morgan’s financing advantage.

“Financing our delta one has been an integral part of our business strategy to diversify revenue away from the volatility products,” he says. “It’s really bearing fruit this year, given our balance sheet strength.”

In the equity derivatives world, delta one is often seen as a commoditised business driven by reverse enquiry, but Fernandes takes a different view: “There’s a lot of scope for innovation, customisation and data integration in constructing a best-in-class delta one business, and that’s how we differentiate ourselves.”

Delta one clients also welcomed new portfolio hedging analytics tools in JP Morgan’s Vida platform. Vida, which is used by more than 400 institutional clients, provides data and analysis for the creation and risk management of customised strategies. The latest tools enable clients to view the risk in their delta one baskets and identify baskets of stocks that might be used to hedge or reduce risk across their portfolios.

One client describes the tool as “crucial,” noting its flexibility compared with competitors’ offerings: “It’s a great part of our process to ensure we’re sticking in our limits and isolating the idiosyncratic performance within our portfolio.”

Vintage data

Sharp increases in interest rates and inflation, as well as rising geopolitical risks, mean the macroeconomic backdrop is increasingly determining how strategies are constructed and how well they perform. This is powering demand for cleaner data. “From a QIS standpoint, it’s absolutely crucial,” says Jobert.

JP Morgan’s readiness to collaborate with innovative third-party vendors has been documented. In the QIS space, an exclusive partnership with specialist data provider Macrosynergy has been critical in enabling the bank to gain an edge when it comes to constructing and backtesting new strategies.

The advantage lies in a new macro-quantamental data processing system, JPMaQS, which addresses a major flaw with historical macroeconomic data. The fact that such data gets revised over creates ‘look-back bias’, in which indexes are constructed based on historical statistics that do not reflect the limited information known at the point when a transaction took place.

The most sophisticated quant hedge funds tackle this problem in-house. Macrosynergy, founded in 2009 by two former BlueCrest partners, began as a macro hedge fund and used its own macro-quantamental computing system to transform vintages of macroeconomic data into indicators for capital allocation. Over time, the firm switched its focus towards data capabilities, and began partnering with JP Morgan in mid-2020.

The system, rebooted as JPMaQS, covers more than 10,000 indicators from around 40 countries. The focus on unrevised point-in-time indicators sets its data apart from that of traditional vendors, which incorporate statistical revisions to metrics such as GDP or inflation.

There are public sources and data vendors that already provide historical macroeconomic statistics on metrics such as growth or inflation. However, Robert Enserro, founding partner and chief executive of Macrosynergy, says these “conventional economic data series” are not suitable for developing systematic trading strategies.

“They can’t be used in backtests, because the information may have been revised many times after the statistic’s original release date,” he says. “By contrast, JPMaQS’ macro-quantamental indicators capture the daily information states of macro information based on vintages, or what the market knew at the point in time when the statistic was originally released.”

Enserro says this represents a “breakthrough” that enables market participants to integrate macroeconomics and systematic trading, and that JP Morgan is now in a position to develop novel “macro-aware” financial products for its institutional clients. The first products to benefit from the data include an economic trend strategy designed to complement commodity trading adviser exposures. JP Morgan has also launched Time Traveller, an asset price forecasting model that compares today’s macroeconomic environment with various points in history, dating back more than 50 years. The bank has released JPMaQS to its buy-side clients so they can backtest their own strategies.

“It’s probably the cleanest data set out there, with the most indicators,” says one buy-side user. “It’s about an improvement in conviction. For any systematic strategy, if you’re unsure about the cleanliness of the data, you would naturally haircut it. With better, cleaner data, you can be sure that what you see is what you get.”

The past year may not have offered the greatest conditions for equity derivatives trading, but it has enabled JP Morgan to adjust its offering and give clients what they require.