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Structured derivatives business is not a stand-alone trading or stand-alone sales business. It is an integrated risk management business. A coherent and consistent risk management business value chain consists of the key pillars in Figure 2.1.

Figure 2.1 Key Pillars of Structured Derivatives Business

The pillars consist of:

• Trading: It is much more than just buying and selling. It is about understanding the risk characteristics of derivative products and hedging the risks. Risk management should be part of its DNA. In the process of risk managing the positions, trading is putting fingers onto the market pulses and making appropriate hedging decisions accordingly.

• Hedging derivatives requires deep understanding of potential pitfalls. “Gamma trap” is a classic example. To hedge short gamma and short volatility positions, traders have to buy the underlying when it goes up and sell when it goes down. If volatility suddenly spikes, the underlying will move rapidly against them and the dynamic hedging can exacerbate the underlying movement, in particular during the downward spiral. This type of “chasing own tails” hedging can lead to sharp V-shaped underlying movement known as “Gamma trap”, which can amplify losses of the short gamma positions. If large numbers of institutions hold similar short gamma positions and perform similar hedging, the “Gamma trap” can cause wider market distortion and stress, as observed many times in the past.

• Quanting: Quantitative modelling is the core part of derivative products development. In the modern day and age, the models need to be consistent front to back for pricing and risks, to ensure consistency and transparency across the value chain. Quants should play a driving role in the development of trading and risk infrastructures;

• Marketing: This client-facing function includes structuring and sales. Client-driven product design, distribution process and channels are constantly evolving. Clients and market feedbacks play important roles in the new products development and manufacture process.

• Risk controlling: This is a four-eyes principle-based independent risk management function that should work with the front office functions very closely, to identify and control risks including market, credit and operational risks.

• Trading/pricing/risk systems underpin day-to-day derivative activities. It is actually scandalous that the derivative industry has wasted many billions on IT systems spending due to lack of integrated vision and lack of coherent business and technological management.

The pillars illustrated in Figure 2.1 are fundamental to the structured derivatives business. The whole business value chain needs to function efficiently and coherently, to ensure an effective and safe business. The widely acclaimed IPD (Integrated Product Development) management philosophy can and should apply to the derivative products development, taking into account the business as a whole.