Building a derivatives shop from the bottom up.

In 1996, when Genbel Securities (Gensec) broke away from its parent company, South African investment trust Genbel South Africa, it was bent on expanding its core business of equity trading and underwriting. But the upstart firm quickly found that, in the volatile South African market, focusing strictly on equities produced earnings gyrations that could cause queasiness in even the most aggressive emerging-markets players. The solution: Gensec would acquire a small investment banking firm to serve as a hedging vehicle for its growing equity exposures. There was one tiny problem—after exhaustively scouring the South African financial community, Gensec could find no suitable mate.

It was time for Plan B. Gensec decided to build its own investment banking division from the ground up.

The group's early efforts were, predictably, modest. By late 1996, it had begun using plain-vanilla equity derivatives such as puts and calls for basic portfolio protection. Gradually, it began to dip its toes in the waters of the gilt and money markets. But Gensec knew that the key to commercial viability lay in developing more sophisticated equity, fixed-income and currency derivatives. It hired three financial engineers and began honing its structuring abilities.

“Our goal is to create products with enough bells and whistles to make margin on the transaction.” Mark Murning, director of structured products

When the company received its foreign exchange and banking licenses from South African regulators early last year, it was ready to put its rapidly improving financial engineering skills to work. Then last June, Gensec scooped up Sanlam Asset Management—South Africa's second-largest asset manager—and suddenly had a three-legged financial institution dedicated to proprietary market activities, structured products and asset-backed securities such as collateralized mortgage obligations. A full-fledged investment bank was born.

Gensec's quick ascendancy belies the difficult financial environment in which it operates. The listed markets in South Africa, while continuing to grow rapidly each year, are still in their infancy. The South African Futures Exchange (Safex) began trading futures only in 1990, and liquidity and open interest have grown slowly. Safex began listing options in 1992, and they too caught on slowly.

Meanwhile, the South African equity market is among the most volatile in the world. Daily market moves of 6 percent to 8 percent are not uncommon. The South African bond market has even become a proxy for emerging-market risk elsewhere in the world, attracting traders exposed to the Russian, Brazilian and Asian markets by offering a touch more liquidity than those beleaguered locales. As a result of such breathtaking volatility, Gensec has had to develop products almost on a daily basis to keep up with rapidly changing conditions.

“Our expertise is in writing derivatives on South African equities, indices and baskets of shares. We only compete when we have a competitive advantage.” Francois Oosthuizen, director of market capabilities

There is a noticeable dearth of home-grown players in the South African derivatives market. The biggest operators have traditionally been foreign firms with either a limited presence in Johannesburg or no presence at all. Heavyweights such as Deutsche Bank, Societe Generale, JP Morgan and Warburg Dillon Read have carved up a good deal of the South African derivatives market.

But Gensec is using its status as a hinterlands derivatives shop to its advantage, focusing less on the interbank market and more on client-driven business. Its biggest customers these days are what Mark Murning, director of structured products, calls the “savings” industry—known in the United States as the plan-sponsor world.

Many South African pension funds are moving away from defined benefits and toward defined contributions, creating a demand for guaranteed-capital products by sponsors and individual investors. Gensec offers a slew of these structures. Most take the form of collars that provide 100 percent downside protection while offering a good deal of upside potential. These products are usually written for five years, with the floors adjusted each year. Gensec is getting ready to launch a similar product written on a specific equity that will provide a floor and offer 75 percent upside participation. In another variation, Gensec writes contracts on equities that lock in minimum returns of, say, 13 percent and maximum returns of, say, 20 percent. These products have proved to be quite seductive to sponsors and individual investors who feel most comfortable operating in the South African market. “Our expertise is in writing derivatives on South African equities, indices and baskets of shares,” says Francois Oosthuizen, director of market capabilities at Gensec. “We only compete when we have a competitive advantage.”

But while Gensec still considers equities its core business, it prides itself on its multifaceted approach to clients' needs. “We're excited about the synergies between the bank and asset management—especially on the structured products side, which is the main aim of our banking operation at this stage,” says Murning. Chief among Gensec's synergistic efficiencies is its ability to package equity, currency and interest rate risk into a single structure. “Because, in the end, everything comes back to an interest rate risk, you can convert a currency into a commodity, a commodity into a share and a share into a currency by using derivatives,” says Murning. “Our goal is to create products with enough bells and whistles to make margin on the transaction.”

Murning offers an example of such a structure. “Say a South African gold mine wants to hedge its stock. In any hedging program we would put in place for the gold mine, we wouldn't take a view on the gold price—we would take a view on the cash flows or the economics of the transaction. This gold mine has certain requirements in order to meet dividend payments or debt repayments during the period of the transaction—let's say a seven-year period. We will, through the interest rate, currency and commodity markets, structure a product that will lock in, for example, zero percent of the downside risk in the gold mine and give it a percentage of the upside of the market—say 75 percent of the upside on the gold in rands over the period of time.” Such a deal, in essence, boils down to currency protection. “If the price the mine wants to receive is well below the forward curve,” says Murning, “we can discount all that value back and offer the mine some cash up front, if it's tax-efficient for the client to do it that way. There's a whole host of things we can do.”

Such products, of course, are sold on the firm's adeptness in currency and interest rate products. In the last year, Gensec has dramatically expanded its market presence in both. It has become a market-maker in South African government bonds, has expanded its option products on gilts, and is trying to build a big-time swaps book—not as a market-maker but to provide an efficient price- and risk-absorption vehicle for its structured deals. In addition to swaps, Gensec writes forward rate agreements, options on swaps, options on FRAs, caps and floors—at maturities of up to two years on FRAs and options on FRAs, and from one to 30 years on other products.

The currency market is a bit trickier, because the rand's forward curve is relatively illiquid beyond one year, and because exchange controls often create pricing anomalies. The results aren't always pretty. “You take some basis risk,” says Greg Thomas, head of Gensec's currency operations. “You hedge short-term and write long-term, and you make sure that you price in that margin up front to remunerate you for that risk.”

If 1998 was any indication, Gensec has positioned itself to rake in margin for years to come.

Sophisticated Risk Manager

Gensec, like its money-center counterparts, is a firm believer in risk management. With the help of JP Morgan and PricewaterhouseCoopers, Gensec developed a variation of Morgan's RiskMetrics system that it calls GenV@R, which uses Gensec's own proprietary data. Each day, the current portfolio is fully revalued. Portfolio returns are then computed using a standard portfolio-aggregation technique. First-order autocorrelation is removed from the returns and the remainder is assumed to be normally distributed. Although a correlation matrix is not explicitly computed, it is contained in the portfolio returns. GenV@R is thus a hybrid between historical simulation and variance-covariance. “In addition,” explains Tony Gouveia, Gensec's risk manager, “GenV@R looks at all equity instruments as risk factors so that equities are not mapped to an index but are individually modeled. Other risk management systems may require equities to be mapped to an index. This has meant we have had to build up an extensive database of historical closing market parameters.” On top of all that, says Gouveia, Gensec uses stress-testing to test for extreme scenarios. “We believe we are at the forefront of the industry in risk management, certainly in South Africa and also internationally. Our managers don't see it as a black box—they actually understand what's in there, and react to it on a daily basis.”

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