Banks see sharp slowdown in equity derivatives business

Falling equity derivatives revenues have hit bank earnings in the second quarter this year, as a decline in merger and acquisitions (M&A) activity saw less corporate demand for equity derivatives.

US investment bank Merrill Lynch reported an 18% decline in trading revenue, which it blamed on a drop-off in equity derivatives business caused by the reduced customer flow and lower volatility during much of the quarter. Other banks did not break down their equity derivatives revenues, but acknowledge that business had dropped this year.Corporates generally look to hedge possible price volatility when carrying out M&A transactions. This type of client demand has been one of the main drivers of the equity derivatives business, particularly in the US.

"Equity derivatives revenues have been lower across the entire market, but continue to be a profitable business," said Juan-Carlos Pinilla, managing director and head of equity derivatives at JP Morgan Chase in the US.

Another more long-term trend that has resulted in a squeeze on equity derivatives margins is the increased use of equity derivatives by hedge funds. “We have seen much tighter margins in the last year,” said Pinilla. “Hedge fund use of equity derivatives has increased dramatically in the last two to three years.”

But research published by Goldman Sachs earlier this month indicated institutions had stepped up their use of equity derivatives to hedge against an increase in implied volatility in the last six weeks. In June, implied volatility rose to its highest levels since September last year, though it has subsequently tailed off, according to Pinilla.

Analysts believe the increased implied volatility could see an increase in equity derivatives business. “Derivatives trading desks like high volatility,” said Larry Chen, equity derivatives analyst at UBS Warburg in London. “Volatilities have been on the increase, so in general books should be in a better position.”