The $300 Billion Structured Notes Market Is Booming

Structured notes boom leaves dealers holding unwanted vega

Structured notes are a $300bn US market where banks sell customized equity payoffs, mostly autocallables, to wealthy individuals through private banks. The products are simple for buyers and awkward for dealers, who hedge delta and then lay vega off to S&P market makers. When markets fall, notes that used to knock out extend instead, so dealers hold more vega just as market makers pull back, and their short gamma can amplify the move.

Takeaways

• Structured note issuance is booming. US SEC-registered issuance is on track for about $300bn this year, against roughly $200bn last year, Micalizzi says. Buyers are mostly high net worth individuals through private banks who cannot replicate worst-ofs and correlations in listed markets.
• Worst-of autocallables are the fastest-growing slice. The S&P is the biggest contributor, but growth is fastest in worst-of autocallables tied to the S&P and the Nasdaq. The Russell ran in a straight line after Liberation Day, knocking those structures out.
• Dealers hedge delta, then carry vega. Nomura first eliminates delta, leaving vega on the put and the quarterly knockouts, which are digitals or call spreads. The desk assigns the put's vega an expected life of about six months and sells downside to S&P market makers.
• Falling markets leave dealers holding unwanted vega. Notes that used to knock out every three months extend as spot falls, so dealers carry more vega just as market makers pull back. Worst-ofs run three to five years with an expected life near two, so a rally can leave dealers short hedges.
• Short gamma can amplify market moves. Past a certain point a dealer must buy when the market rises and sell when it falls, exacerbating moves. Dealers got into trouble in 2018 through a drift down, and Alloway warns the market is now big enough for negative gamma to wag the tail.
• Asia's structured products market is older. Structured products started in Japan when rates hit zero, with Uridashi, and Asia now carries notes such as a CoreWeave structure yielding 40% annualized. US investors use them for income and downside protection, and semis and hyperscalers are popular single-stock underlyings.

Anatomy of an autocallable

1. The investor hands the issuer $100, forgoes interest and takes the issuer's credit risk in exchange for a customized equity payoff.
2. A one-year S&P structure might set a 60% knock-in, so the investor is protected until the index is down 40%, then carries the full downside to zero while a vanilla put could lose at most 40%.
3. At each quarterly observation the note knocks out early if the index is above its starting level, returning the money plus a coupon.