Autocall curbs hit long-dated Nikkei and HSCEI options

Collapsing Asia structured products inventory saps market-makers of long-dated vol supply

Long-dated options on popular Asia stock indexes are becoming a rare sight on exotics desks lately. The reason, dealers say, is that Mrs Watanabe is no longer supplying volatility. 

Regulatory clampdowns on the sale of retail structured products in Japan and South Korea have seen autocallable bond issuance on once-popular underlyings including the Nikkei 225 and China’s HSCEI come to a near standstill, choking off the supply of longer-dated volatility on these indexes.

“We’re really not going out – and I don’t think the rest of the street is going out – past two years in terms of market-making now. Why? Because there’s no longer any supply there,” says Nicholas Lent, head of APAC equity derivatives at Societe Generale in Singapore.

“The ability to hedge with longer-term options has dissipated drastically, given the reduction in terms of retail structured product populations,” he adds. “That’s a big thing for Asia.”

As of December 2024, the volume of outstanding autocallable products in South Korea had plummeted to $828 million from $29 billion a year earlier, according to Korea Securities Depository data. Dealers report a similar drop in autocallable sales in Japan, where the region’s Financial Services Agency clamped down on the instruments in July 2022. The South Korean regulator took similar action in response to mis-selling allegations at the start of 2024.

Maybe what happens now is we go back to that era of real risk discovery

Mohammed Apabhai, Citi

“Volumes have massively, massively decreased,” says a structuring head at a US bank in Hong Kong. “The immediate effect is very much a lack of liquidity. On HSCEI, for example, anything beyond one year is practically no longer available – at least not for size.”

Nikkei volatility supply has also reduced significantly, according to Shane Carroll, derivatives strategist at UBS. “We still see vol supply on two to three years, albeit 70–80% lower than what we saw before,” he says.

Autocallables are popular yield enhancement products that leave issuers with a long volatility exposure stemming from a down-and-in put they buy from investors. The structure pays above-market coupons as long as the underlying index remains between two barriers and knocks out if spot moves beyond the upper bound. Investors’ principal is at risk if the index falls below the downside barrier.

Products in these two retail markets were typically sold with three-year maturities. This left bank exotics desks with an ample supply of vol to offset risks associated within their market-making activities for Nikkei and HSCEI options.

“Clearly this big supply of volatility that we had coming into the market has now pretty much evaporated,” says Mohammed Apabhai, head of Asia-Pacific trading strategies at Citi.

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Longer-dated options can be particularly expensive to warehouse since they incur high market risk capital charges due to the increased sensitivity to volatility, as well as theta, or time decay.

“When you’re quoting that far out, a lot of times you’re going to either have a natural position on the book or you’re going to warehouse some risk, which not everybody can really do, especially that far out,” says Societe Generale's Lent. 

Carroll at UBS adds that while there is some liquidity on longer-dated Nikkei 225 options, market-makers are now quoting at much wider spreads than before. This has had led to “increased trading costs”, which in turn has “reduced the attractiveness of some trading strategies”, he says.

Silver linings

While the cutoff in vol supply has had a knock-on effect for end-user hedging in the two indexes, the impact has so far been cushioned by recent trends in Nikkei and HSCEI volatility term structures.

“The hedging flow that was coming from insurance companies, pension funds and the macro funds running long positions has transitioned to different instruments. In some cases, they have changed the way that they are hedging,” says Citi’s Apabhai.

He adds that the relative flatness of the respective curves means it is easier for insurance companies to switch their hedging to more liquid shorter-dated options and roll them forward as they expire.

“If a big institutional fund wants to hedge [long-term equity liabilities], three-year long term puts might not be so attractive anymore,” Apabhai says. “But given what’s happening with the term structure being relatively flat, they might be happier buying shorter dated puts and then rolling those a number of times and then just running some of that risk.”

The autocallable scarcity may also have helped dampen any hedging chaos around a market selloff last August.

The need to dynamically hedge the products as spot moves between the barriers has often been the cause of exotics blow-ups. To balance their long vega exposures, dealers need to sell volatility as spot on the underlying index falls. But when issuance is concentrated around particular strike prices, dealers can see their sensitivity to volatility flip from long to short, creating huge one-way demand for volatility, pushing up costs, and leading to heavy mark-to-market losses.

The Nikkei 225 plunged nearly 20% between August 2 and 5 last year, while three-month at-the-money volatility soared to historic levels. Exotics desks, however, appear to have emerged largely unscathed.

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“I do think that the selloff in August was not so catastrophic because we had less autocall hedging,” says a structuring head at a US bank in Hong Kong.

Autocall books can also be tricky to manage in sharp rallies as dealers rush to buy back their hedges en masse, sending volatility higher. UBS’s Carroll believes a 40% surge in Hong Kong-listed Chinese stocks last September could have been more challenging for exotics desks had they still been holding sizeable inventories of HSCEI-linked autocallables.

The rally, which came on the back of a raft of new monetary and fiscal stimulus measures from the People’s Bank of China, was accompanied by a big spike in volatility, with the HSI Volatility Index going from 18.55 to 44.50 on the day of the announcement.

“Even without HSCEI index autocallable exposure, implied vols got bid across the curve,” says Carroll. “If dealers also had to buy back their autocallable hedges, this would have likely exacerbated the vol move even more and made it quite costly to hedge.”

Citi’s Apabhai sees a further benefit of the new status quo.

Volatility selling pressure created by the sale of autocallable products has long had a distorting impact on options term structure in these markets, pushing down the volatility premium in longer-dated contracts. With this selling pressure removed, the longer end of the volatility curve might start to become more reflective of institutional sentiment rather than structured products hedging, he says.

“If you look back to the years 2000 to 2010, long dated volatility was a very good indicator of what was happening in the real economy,” he says. “But then autocallables basically suppressed that. Maybe what happens now is we go back to that era of real risk discovery with longer-dated volatility adjusting back to levels that are more reflective of economic risk without the impact that retail investors have had [further out on the curve].” 

Editing by Helen Bartholomew