It can take years and considerable sums of money to build a warrants business in Hong Kong. The investment can begin to unravel in a mere one-millionth of a second.

The derivative warrants market in Hong Kong, with its paper-thin spreads and zero stamp duty, has long been a target for high-frequency trading firms on the hunt for fleeting differences between the price of the structured product and its underlying stock. If an issuer’s technology is not up to scratch in this market, the lost basis points can quickly add up to a perennial bleed on the revenues of the business.

“We are talking not just about milliseconds, but microseconds,” says Kenny Chong, head of derivatives trading at Haitong International, a securities firm that issued its first warrant on the Hong Kong Stock Exchange in 2016. “In that microsecond issuers can be easily picked off if their systems do not have low enough latency.”

Latency is a system’s lag in executing orders. Low latency can be achieved by locating a trade matching engine within the premises of the exchange, to minimize the physical distance that trades must travel, or by increasing the calculation speeds of in-house trading systems.

Both options are expensive. Yet the costs are not deterring a new group of banks from attempting to crack a market that grew by over a quarter in 2018 and sees more than HK$15 billion ($1.9 billion) per day in trade volumes. As Risk.net revealed in May, two US investment banks—Morgan Stanley and Citigroup—and the Hong Kong arm of Guotai Junan International, are now readying to join the fray.

Market participants warn that new entrants will have to be resilient enough to absorb the high initial outlay on tech when the return on investment is by no means guaranteed. They cite the example of the post-financial crisis years, as an equities slump in Hong Kong caused warrants to fall out of favor with investors and forced some issuers, including Dresdner Bank and Standard Bank, to withdraw from the market.

“If you look back at the peak of the industry—in 2007—a lot of banks wanted to join,” says Ivan Ho, head of warrants and CBBC sales at Credit Suisse. “There were over 20 issuers in the market. Almost all of the new entrants had shut down within two or three years.”

An equities derivatives head who worked for one of the many banks that exited the business in the past decade blames the collapse of that venture on the bank’s quoting platform. A failure to invest in latency meant the bank had to widen its spreads, but this left the business at risk of losing ground to rivals.

“They closed it when I was there because they weren’t spending enough on technology, and you have to be committed to spending that money,” the head says. “It was just a basket case.” The bank in question is not Dresdner or Standard Bank.

Need for speed

Issuers say the sight of some banks making decent money in the warrants market, as many have over the past three years, is bound to attract the attention of other investment banks and securities houses.

The three likely new entrants will join a market currently occupied by 12 active issuers of derivatives warrants in Hong Kong. The largest issuer across warrants and CBBCs—or callable bull and bear contracts—measured by turnover in 2018 was US investment bank JP Morgan, according to Bloomberg data. The next largest issuers include Hong Kong’s Haitong International, and European banks Credit Suisse and Societe Generale.

Bank-issued warrants, which can have a broad range of underlying securities, including single stocks and equity indexes, have become a mainstay of the retail investment market in Hong Kong over the past two decades, and represent nearly 15% of overall equities-related trading activity in the region.

Issuers add a premium to the intrinsic value of the warrant and, after hedging and slippage costs are accounted for, this represents the profit for the issuer. According to data provided by a current warrants issuer, the average annual profit for issuers in 2018 was HK$206 million ($26 million).

However, the prevalence of high-frequency trading firms seeking arbitrage opportunities means such profits are not realised easily. Derivative warrants are not usually held to maturity, but sold back to the issuer or market-maker beforehand. If an algo trader uses its latency advantage to pick off the trade, that would mean less profit for the issuer when the warrant is sold back.

The extent of day trading in the Hong Kong warrants market provides some idea of arbitrage activity. On May 20, for example, HK$11 billion was traded in warrants on Hong Kong’s HKEX exchange. The value of warrants held overnight on that date, however, was HK$72 million, or 0.65%.

“Over 99% of the trading volume is intraday, and [arbitrage] activities contribute to this,” says a European bank’s director of equity derivatives sales in Asia. 

Arbitrage of warrants can take several forms. Sometimes arbitrageurs look to buy a warrant when a move in the underlying is yet to be reflected in the price of the instrument. Others, meanwhile, deploy algorithmic-driven proprietary pricing models to detect possible inconsistencies between pricing components of the instrument and the price of the warrant itself.

Investors want a very tight spread. They think issuers must provide that for them but they don't take into account the costs issuers need to pay for, and high-frequency traders, with all that in and out, can increase costs for issuers

Ivan Ho, Credit Suisse

Both methods are made possible by the way in which derivative warrants are structured. Similar to an options contract, a warrant gives investors the right but not the obligation to buy or sell an underlying security such as a stock at a preset price prior to a specified expiry date. For a call warrant, if the five-day moving average of the underlying is higher than the warrant’s exercise price, the product is automatically exercised at expiry. If it is equal to or lower than the exercise price, it will expire worthless.

The embedded optionality means the instrument’s fair value can be affected by a number of factors including changes in the price of the underlying, price volatility, and the time left to expiry. Arbitrageurs exploit momentary value differences in those components and the price of the warrant.

It is not clear how many high-frequency trading firms are actively arbitraging derivative warrants in Hong Kong, but two sources name Jump Trading and Tower Trading Group as two firms thought to be using these strategies. Jump Trading and Tower Trading Group did not respond to an emailed request for comment.

Issuers say one of the big attractions for such firms is the typical size of issuers’ bid/ask spreads. Exchange rules and taxation also play a role: all parties can trade on the same server through co-location, without speed bumps that slow down trade orders and erode the advantage of high-frequency traders. Also, derivative warrants in Hong Kong are exempt from stamp duty.

High-frequency traders always have a latency edge in the warrants market, issuers say. They point out that throughout any given trading day a typical issuer’s systems are posting quotes consistently across hundreds of products – a heavy lift, even for the most state-of-the-art platforms.

“Investors want a very tight spread. They think issuers must provide that for them but they don't take into account the costs issuers need to pay for, and high-frequency traders, with all that in and out, can increase costs for issuers,” says Ho at Credit Suisse.

Derivative warrants in Hong Kong can trade at extremely thin spreads compared with other markets. For example, JP Morgan lists a call warrant on Chinese company Tencent on HKEX, with an expiry of September 2 and exercise price of 380—about 14% above the current price of the stock on the exchange. The bid price is HK$0.052 and the ask is HK$0.054—so a spread of HK$0.002.

Deutsche Bank’s listed call warrant for Tencent on the Frankfurt Stock Exchange, with a similar exercise price and expiry, has a bid of €0.07 and ask of €0.09—a spread of €0.02, an order of magnitude larger.

Hit the tech

To minimise the effect of arbitrageurs, issuers need to invest continually in technology: hosting services, including co-location with HKEX markets; the development of a market-making platform providing automatic and semi-automatic quoting; and the maintenance of back-up systems.

An executive of a technology company that provides warrants trading software says the total expenditure on marketing, technology and other expenses for a new entrant often runs into the tens of millions.

“The issue with arbitrage is that it can be very costly—but it can be controlled with the right technology,” says Sylvain Thieullent, CEO of Horizon Software, in Paris.

The director of Asia equity derivatives sales agrees about the high cost of entry, pointing out that prospective issuers need to match, if not better, the speed and latency of existing issuers.

Every issuer is getting faster and more sophisticated and that means the entry barrier for new issuers is not low in the warrants business here. They must have a sophisticated system; perfect connectivity; a perfect pricing system

Asia equity derivatives sales director

“Every issuer is getting faster and more sophisticated and that means the entry barrier for new issuers is not low in the warrants business here,” the director says. “They must have a sophisticated system; perfect connectivity; a perfect pricing system.”

A listed products sales head at an equity bank in Hong Kong says that investment in fast and sophisticated market-making systems can lessen but not eliminate the threat of arbitrage.

“You have to invest in technology,” the head says. “It’s not that we can totally protect from algos but at the very least we can maintain a good service to clients and the algos will come in and you just have to try to balance that.”

The extent to which a new entrant in the market can afford the initial outlay may depend on how the technology is used across the bank, says the sales director. If the cost falls on the warrants desk alone, the profitability of the business will be under heightened pressure.

“In a bigger house the system can be used and shared by other teams like parts of equity and fixed income and that means the cost can be absorbed by other departments, giving those banks an economy of scale that is more affordable,” the director says. “For a relatively smaller house, you build a whole new system and the cost has to be absorbed only by the warrants team. That is quite tough.”

Timing it right

Issuers say that it is crucial for new entrants to time their move on the market correctly, so that the millions of dollars of investment in technology can be recouped as quickly as possible.

Entering at a time when the stock market is booming can help the issuer to hit the ground running, they say, while entering at a time when markets are range-bound could spell trouble. 

“Market conditions are important,” says Keith Chan, head of cross-asset listed distribution at Societe Generale in Hong Kong. “If there is a bull market then interest and flows will be much bigger and that is your chance to showcase your ability. If the market is very quiet, very range-bound that might also have an impact.”

Investment volumes and new issuance in the warrants market in 2018 have given confidence to the three firms planning to become warrants issuers in the near future. The overall volume of derivative warrants and CBBCs—another type of listed structured product popular with Hong Kong’s retail investors—has increased, as has the number of issues. Last year saw 11,794 warrants issuances, up from 7,989 in 2017, while CBBC issuance rose to 26,678 products from 13,225 over the same period, according to HKEX data.

The poor performance of Hong Kong-listed stocks last year, a trend that has continued into the first quarter of 2019, complicates the picture, however. Amid escalating trade tensions between the US and China, the Hang Seng Index dropped by 13% over the course of 2018, its worst performance in seven years.

“For stocks to perform strongly they must have some very good financial figures not just in one quarter but sustainable—that is what investors want,” Credit Suisse’s Ho says. “If these factors are not occurring, then it is very difficult for the issuer to make money.”

Ho adds that it was the global selloff in equities markets in 2007 and 2008 that led to a shrinking of the number of issuers in the Hong Kong warrants market. When stocks enter bear market territory and volatility is high, warrant investment flows quickly dry up.

In a whipsaw market, the consumption of vega—that is to say the instrument’s sensitivity to changes in implied volatility—very often outweighs the delta benefit for investors, and reduces the leverage offered by the instrument. This means investors find it hard to profit even if they are right on market direction. Investment in call warrants, which offer the chance to buy the market, is also greater than investment in put warrants, which offer the opposite position. So, overall, warrant sales usually suffer in a bear market.

That loss in revenue could be compensated for by CBBCs which, unlike warrants, have a trading price that is not affected by movements in implied volatility.

Even so, investors still prefer to buy bull products than bear products, Ho says, so issuers would not be entirely immune to the effects of a prolonged bear market in equities.

There is speculation that at least one of the banks planning to enter the market—Morgan Stanley—is hesitating on the timing of its first issuance given the current market sentiment.

“Morgan Stanley are pretty much ready [to issue], but the market is not looking very promising at the moment,” an executive who works at a bank issuing Hong Kong-listed warrants said in May.

The long game

As well as choosing an opportune moment to launch into the market, new issuers must be wary of setting spreads that are so tight as to leave themselves open to arbitrageurs or so wide as to deter clients, sources warn. It is a delicate dilemma.

Ho says most successful issuers in the market—even those with adequate technology in place—“spend a lot of time and effort on striking a good balance” between quoting spreads that are attractive to investors while at the same time unattractive to arbs.

It is one year of quite strong investment, but over three years an issuer should be profitable

Sylvain Thieullent, Horizon Software

The combined efforts, from investing in technology, to surviving the ups and downs of the equity market, to establishing a deep level trust with the investor base, requires a long-term plan, issuers agree. “I think it is a really long-term investment, says Societe Generale’s Chan. “But once you’ve built that trust in your franchise it can be very solid.”

Offering his advice to the three possible new entrants, Horizon Software’s Thieullent says the firms should not expect overnight success.

“The first year will typically be a year where the retail market is discovering you, the second year will be the breakthrough year and then the third year will be the year where you are starting to get established in the market,” he says. “So it is one year of quite strong investment, but over three years an issuer should be profitable.”