A Delta One trader sits on a bank’s Delta One trading desk, but what does this desk do? It’s one of the industry’s hottest trends post-financial crisis and has been shrouded in mystery for years. Here’s a primer on Delta One trading to help get you up to speed.
Delta One Products
The Delta in Delta One refers to the financial term delta (one of the “Greeks”) that represents the sensitivity of the price of a derivative to a change in its underlying index.
A delta value of one implies a like for like change in relation to the underlying asset. If the underlying goes up in price by 5%, the derivative with a delta of one will also go up by 5%.
Delta One trading desks in banks provide clients with the return of a given index without the hassle of buying each underlying security. They accomplish this by buying the underlying securities, or a basket of derivatives, to gain the equivalent exposure themselves.
Exposure to a broad array of different underlying securities is packaged into a single bespoke product that makes life easier for clients of the Delta one desk. These clients are typically asset managers, hedge funds, pension funds, insurance companies, family offices, or sovereign wealth funds.
Delta One operates broadly from a product perspective: ETFs, sector swaps, dividend swaps, thematic baskets, warrants, and options are all fair-game for coverage from delta one. As long as the client is provided one-to-one performance, almost anything is possible to include.
How Do Delta One Traders Make Money?
We’ve covered the benefit to the client from a Delta One desk, but how does the bank make money if they’re just mirroring performance?
Banks profit from Delta One in a couple different ways, the simplest being from client fees for the service provided.
However, delta one traders also make money on top of client fees via a mixture of both flow and prop trading.
Delta One activities generate additional revenue from repo, securities lending, funding, and centralized execution. These are more vanilla offerings that support the desk’s products, but also bring in real revenue at high volume.
Another method is via simple price arbitrage in the trading required to support the delta one product. Small percentage gains on large volume trades can add up quickly.
Additional strategies focus on the idea of “sweating” assets. Explained simply, the concept of “sweating” refers to taking on X amount of assets while providing a promise to the client to return X performance. Any upside performance over the promised benchmark as a result of utilizing the assets is simply additional profit for the bank.
This sounds complicated, but often the money is made from creative and innovative hedging strategies. The cheaper the better, with the bank pocketing any outsize performance as a result of the unconventional hedging.
The best Delta one traders have the ability to blend successful market timing, creative hedging, and institutional access to funding and flow to generate a unique, multi-sourced return for the bank. Often, the direction of an individual stock or the market becomes entirely irrelevant to the Delta one desk.
Given the varied approaches available to different delta one traders, it’s no surprise that these desks and individual strategies are tightly-guarded secrets amongst each firm.
Why Do Banks Have Delta One Traders?
Clearly Delta one trading provides a unique revenue stream for an investment bank. The strategy is able to achieve this in part because Delta one trading desks are not covered under proprietary trading restrictions put in place after the financial crisis. This helps drive exceptional returns for banks, particularly when compared against other more regulated businesses within Sales & Trading units.
The flexibility of the offering also appeals to banks. Each financial institution views the Delta one desk differently. Some teams sit on equity desks, others are embedded in the prime brokerage unit, and some operate independently.
Strategy-wise, some Delta one desks act as pure brokers or market-makers, while others are more focused on the funding side or cater to the focus of the internal asset management or structured products divisions. Each bank has the ability to focus the offering around the institution’s core strengths and competencies.
How Risky is Delta One Trading?
That all sounds great, but weren’t restrictions on prop trading put in place for a reason? How risky really is Delta one trading?
The complexity, opaqueness, and flexibility of Delta one strategies are highly attractive, but also present downsides.
Outside the core team on the desk, few individuals at the bank truly understand the specifics of what the Delta one desk is doing. This particularly applies to senior executives, who are both far removed and are responsible for the organization as a whole (not a good combination).
More specifically, many Delta one trades are executed over-the-counter (OTC). This means they occur outside of a traditional stock exchange, which makes valuing positions more difficult and opens up potential pitfalls.
The nature of the desk also incentivizes delta one traders to take outsize risk. Performance-based compensation rewards returns, but greater returns often involve greater risk. The opaque nature of Delta one activities makes this more dangerous as it becomes harder to manage risk appropriately. There is ample room for less-than-honest traders to exploit the system.
Depending on the specific product, Delta one desks also involve significant counterparty risk. With most exposure achieved through swaps and various derivatives, the holder is relying on the firm on the other side of the trade. If they experience liquidity issues and are unable to meet obligations under the swap agreements, there is potential for widespread financial contagion.
The intertwined global financial system is only as safe as its weakest link.
The Most Notorious Delta One Trader
Société Générale rogue trader Jérôme Kerviel has become the poster child for what can go wrong on Delta one desks.
While on the desk, Kerviel began making bets on market direction, rather than follow Delta one’s market-neutral approach. Following initial wins, Kerviel increasingly grew his exposure, reaching levels far above his allowed risk parameters.
Starting relatively small, in 2005 he made €4 million for SocGen, followed by €11 million in 2006. The Financial Crisis struck in 2007, driving Kerviel’s positions out of control. Figuring that the only direction markets could go was down, he did what all great rogue traders do and bet big.
Over a period of a few months Kerviel managed to build a €28 billion exposure. Shockingly, he made the correct call and raked in profits of €1.4 billion.
Unfortunately, the initial successes were emboldening, and Kerviel proceeded to build up a €50 billion position in 2008, a sum greater than the value of the entire bank. This time, however, he bet that markets would rise.
We all know what happened in 2008 – the global economy was incinerated, along with Kerviel’s position. Final losses for SocGen totaled €4.9 billion.
Undoubtedly the best part of the ordeal was Kerviel’s victory in a wrongful termination suit against SocGen. The court ruled that, given the size of the trades, it was clear that SocGen and Kerviel’s superiors knew about the risks being taken and were fine with what was occurring (until they stopped making money). Never mind that Kerviel managed to nearly blow up the entire bank.
His €450k wrongful termination award helped offset a €1 million fine levied against him for his actions. With only five months behind bars, it was really quite a good outcome, all things considered.