Regulation around Uncleared Margin Rules (UMR) was introduced in response to the global financial crisis of 2008/9. One particular area of reform focused on initial margin (IM) requirements, tightening the rules around the posting of collateral for over-the-counter (OTC) derivatives transactions.
The phased approach to UMR implementation has posed legal, operational and technical challenges, with an increasing number of buy- and sell-side entities in scope of the new rules since they came into effect in 2016. But one area where questions also remain is how some practical challenges around UMR are driving product innovation and finding exchange-traded alternatives to those swaps contracts subject to UMR.
“What we mean by innovation is, in practice, how you shave the corners off an OTC product, move it into a centrally cleared, exchange-traded environment, and make it beneficial for all parties involved,” says Stuart Heath, director, equity product design at Eurex, who is also a panellist on the Eurex Derivatives Forum 2022’s Product Innovation in the light of UMR session, in Frankfurt on May 25.
Eurex has worked with clients which have been impacted by UMR since September 2016, and more buy-side clients are coming on board as the latest deadline approaches (known as phase 6 and set for September 2022). A common denominator for all has been the costs and complexity associated with the updated IM rules: from managing the collateral and funding it, to risk modelling, and arrangements with multiple counterparties and custodians.
As such, firms have been looking for cleared and listed alternatives to swaps, which would minimise their margin obligations and counterparty risk, and be more efficient on the balance sheet.
According to fellow panellist Axel Lomholt, chief product officer, Indices and Benchmarks at Qontigo, listed products are becoming central to investor portfolios.
“There’s a lot of new product development happening in this segment, which brings risk, cost and collateral management benefits, as well as opportunities in trading and equity financing for investors,” he says. Qontigo is the administrator of STOXX and DAX indices.
Back to the future
One such product launched by Eurex in 2016 is the index total return future (TRF). It was designed to hedge the implied repo risk of on equity markets and provides returns analogous to an OTC total return swap. An equity version of the TRF (ETRF) followed in 2019.
Put simply, the buyer of a TRF will benefit from the price movement of the underlying index or stock in addition to 100% of its dividends from the seller. In return, they pay the euro short-term rate €STR plus the equity financing rate.
There are key benefits to TRFs such as the ability to cross margin the product against other positions held in equity and indexes, which frees up a bank’s balance sheets.
While they started as a product in support of repo structured product hedging, they have now become acknowledged as a key part of institutional investor portfolios.
“Listed products have been one way to access previously inaccessible markets for a whole host of investors,” says Lomholt. “Additionally, ETFs have helped drive down fees because traditional active funds have historically been expensive.”
“You can now build portfolios with a variety of listed products and use them as a great cost-control mechanism. On top of that, in many of those products you get the transparency and neutrality of an index underlying.”
Eurex went from introducing a TRF based on the EuroSTOXX 50 index in 2016 to recycle the risk from structured products, to now effectively having most of the interbank market in that product.
“The OTC swap is effectively more a bespoke bank-to-client product now as a lot of the flow has moved to the listed alternative,” says Heath.
More recently, Eurex introduced basket TRFs (BTRFs), also as an equity financing tool. It’s also based on its OTC swap equivalent product but with the added benefit of optimising IM and lowering costs.
The basket trade functionality, launched in December 2020, allows market participants to construct and ‘modify a basket swap position in a set of underlying reference equities for the first time,’ according to the Deutsche Boerse-owned exchange. The basket TRF was lauded as leveraging the advantages of futures contracts and the flexibility of baskets while also being traded on an exchange.
The trend towards the ‘futurisation’ of products also saw the introduction of thematic index futures earlier this year. These can be considered as a natural evolution of the BTRF. As investing in thematic indices – which reflect structural trends such as, for example, ESG, artificial intelligence, automation or healthcare - becomes more widespread, it’s expected that the market for BTRFs will grow.
The earlier rounds of UMR targeted banks and larger buy-side firms, leading to a change in trading behaviours.
Initially aimed at the sell-side, many of these futures-based products have seen increasing uptake from buy-side firms looking to benefit from centralised clearing and added transparency linked to futures. As more buy-side firms have come into the scope of UMR in the latter phases of the rules being rolled out, they turned their attention to exchange-traded versions of swaps.
“The last phase will continue this theme, with smaller buy-side firms, hedge funds and corporates further moving the dial in favour of listed products such as TRFs, thematic equity derivatives and other exchange-traded products,” says panel moderator Luke Jeffs, managing editor of Global Investor – FOW.
In fact, nearly three-quarters of participants to a survey conducted by the TABB Group in 2014 said they expected their listed futures trading volumes to increase in the next year. Specifically, buy-side firms noted they would expand the use of ‘futures in equity-related products and expect to increase their activity in equity options by as much as 89%’.
Futures have become a source of additional liquidity for the buy-side, who considers these products as a complement to their OTC counterpart.
“What we are seeing now is some firms deciding to do a listed alternative under a futures agreement,” says Heath. “They would maybe trade swaps with their core counterparties because they’re going to rely on them to give them the liquidity they need out of that swap, but for other products, they can trade them as a future. That flexibility is coming through.”
The certainty brought on by clearing, more standardised processes around the trading of futures products and more pricing options (beyond a bilateral trade) are also factors contributing to more demand from the buy-side.
“I think some of the buy-side is quite surprised at how innovative some of the on-exchange products can be,” says Heath. “There are some different products they can potentially use for Beta replication in their portfolios, not just use them for a little bit of peripheral hedging and cash management.”
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