The market came together in 2016 to design and launch total return futures and has continued to work closely to ensure it continues innovating, as panellists of the Product Innovation: Equity & Index Futurisation session at the Eurex Derivatives Forum 2023, discussed last week with FOW's Luke Jeffs
Implementing initial margin (IM) requirements for non-centrally cleared derivatives was a key component of the Basel Committee’s Uncleared Margin Rules (UMR), a significant piece of post-financial crisis regulation.
Tightened IM rules have meant more oversight on posting collateral for over-the-counter (OTC) derivatives transactions, making these products more expensive to build and trade.
This led to a wave of innovation for alternative products that can be cleared in an exchange-traded environment, cutting costs and complexity in the process.
European exchange Eurex responded to these market developments by launching a listed product suite that targeted derivatives with a large OTC market and no listed alternative. Among these were the dividend futures and total return futures (TRFs) on the EURO STOXX 50 index, which launched in 2008 and 2016 respectively, followed in 2019 by an equity iteration for basket TRFs.
The TRF was built to hedge the implied repo risk of equity markets and provides returns analogous to an OTC total return swap. It made active trading of equity repo much simpler, according to Natasha Sibley, Fund Manager in the Diversified Alternatives group at Janus Henderson.
“We had traded repo using OTC swaps for some years but switched to TRF when Eurex launched this product. The standardisation of the listed contracts meant that we could trade in and out without the operational hassle of novating,” she says.
Eurex TRFs are now entering a mature phase with a market size of EUR 120 billion outstanding notional and almost 50 active members. In the past few years, index TRFs have grown annually on average by 85%, with almost 38 million traded contracts since their introduction. The segment had a record year in 2022, with over EUR 540 billion in notional traded, surpassing the 2020 pandemic year. Basket TRFs activity started accelerating as well, with volumes last year three times higher than in 2021, and over EUR 20 billion in notional traded since launch.
According to Elena Marchidann, Vice President, Equity & Index Product Design at Eurex, demand for the TRFs and for additional products available in a listed and cleared environment, took off relatively quickly, attracting a diverse set of market players and use cases.
“The launch of the first index TRF opened the door for a whole range of other opportunities – we went on to launch subsequent TRFs on other indices, including an FTSE 100 TRF, as well as single name baskets of equity TRFs,” she said. “The futurization further evolved with the introduction last year of thematic index futures which provide more granular exposure to structural trends.
“The focus continues to be on innovation, jointly with our members, by bringing some of the more bespoke OTC financial products into a more standardized listed framework, not only to create efficiencies from a cost perspective but also to grow the market by encouraging more participants to join.”
Serkan Batir, Managing Director, Global Head Index Product Development and Benchmarks at Qontigo, adds that the combination of innovation and regulatory requirements catalyzes for the ecosystem.
“We have seen a growing number of products act as the launchpad for others in the industry: we have seen that with ETFs
While that trend started with benchmarks such as the EURO STOXX 50®, Batir explained, a similar pattern is unfolding with more targeted strategies. He singled out the thematics segment, where Eurex has introduced futures on the STOXX® Global Breakthrough Healthcare, STOXX® Global Digitalisation and STOXX® Global Digital Security indices, as an example.
“As interest in such as thematics continues to grow, I expect more investor demand for products that support their entire trading and hedging environment,” said Batir.
When creating a TRF as a futurized alternative, the main requirement was to have a product that mitigated banks’ concerns as they were the main firms impacted by UMR phase one in 2016. Demand was driven by banks needing to hedge the implied repo risk originating from structured products. A wider set of firms, including an increasing number on the buy-side, would find themselves in scope of the latter stages of UMR, culminating in phase six in September 2022.
“The fast adoption that happened in the TRF space in a relatively short period of time was because of the margin netting benefits,” says Omar Bennani, Head of EMEA Delta One Trading at J.P. Morgan, adding the stage was set for futurization as far back as 2008 when there was a shift from OTC dividend swaps into futures. “A listed product can also be more effective with publicly available rules set beforehand, and due to its liquidity and visibility in terms of pricing and volumes.”
Eurex designed the TRF in close partnership with the banks. But the process was not without its complexities as TRFs are not plain vanilla products in themselves, having never been traded before in a similar construct on a derivatives exchange.
TRFs aimed to combine the best of both worlds: the flexibility seen in some aspects of swaps trading within a listed environment. Recreating this duo in a product relied on the collective work of multiple groups of stakeholders at all stages of the product workflow – all with potentially differing requirements.
But during the initial stages of the product design phase, some aspects needed to be considered to achieve a broader market consensus.
One such situation occurred when a decision had to be made regarding if the TRF product should be an OTC cleared swap or listed future, and how it should be quoted. The TRF product was initially a centrally cleared OTC swap. During multiple iterations with the Eurex members, it became obvious that a listed version of a swap would better consolidate liquidity and provide more synergies for the market.
“A strategic decision had to be made between launching a centrally cleared OTC swap or as an exchange-traded product, in the form of a fully fungible TRF. Under the listed alternative, a possible approach was that the product could be quoted in index points, which in theory was much easier for the banks from an implementation perspective,” recalls Marchidann. “However, after working with a group of 13 banks and putting it to a vote, it was decided that the best approach was to have a listed TRF product that would be best suited for those end clients used to trading OTC swaps in basis points, in spread terms.
“In the end, we decided to put the complexity in the trading layer rather than in the back-office applications. We know how difficult is to change systems downstream so it was a conscious decision from the banks together with Eurex to have a product ultimately suitable for the buy-side clients.”
Bennani recalled that, back in 2016, several decisions were made to balance the requirement of having an easy to understand product with the complexity needed by the dealers for their risk management. One was the approach to use when designing a brand new dividend curve in order to match the dividend treatments on OTC swaps. A discussion between using EURIBOR versus EONIA rates also popped up as most products were found to reference the three-month EURIBOR.
“There was no obvious solution at the time, but in the end the overnight risk free rates were deemed the most practical option,” says Bennani.
How has the TRF product evolved?
According to Bennani, the way the TRF was constructed, which tried to closely match the features of standard total return swaps, facilitated the migration of interdealer trades in EURO STOXX from OTC to Eurex. For instance, buy-side firms and hedge funds also came into the market early on, and started to execute and carry trades that could generate alpha by positioning through the term structure of the TRF curve.
“Having the TRF cross margin with other positions on the exchange made trading repo more efficient than it was when we were using OTCs,” says Sibley. “It also reduces our counterparty exposure, something that is particularly valuable for our UCITS vehicles, which have explicit limits here.”
The ease of trading TRFs in a listed environment has attracted new players in the market, and as such, agrees Batir, they have replaced their swap counterparts in many other areas.
However, some clients will always require a more ‘bespoke’ product, so OTC products still have a role to play. Expanding TRF instruments to other underlyings referencing illiquid stocks or regions, or less mainstream products, could prove a challenge that some in the market are unwilling to take on.
“That being said, as trading the implied equity repo is emerging as an asset class on its own, the TRF product can prove versatile with multiple uses, depending on supply/demand dynamics and market environment,” says Marchidann. “The Covid crisis was an event that put index TRFs in the spotlight, notably because of widespread concerns about company dividends.”
Total return futures, which are less sensitive to dividends than regular futures and priced more explicitly, based on realized dividends, could be a suitable alternative for longer-term investors in such volatile circumstances.
In terms of client adoption for TRFs, Bennani highlights that term structure carry trades are executed by the buy-side (hedge funds and some asset managers), and typically offset the flows stemming from the issuance of some structured products and the dynamic hedging of exotics books.
“Put simply, there is an equilibrium between the exotics desks and buy-side or even some delta one desks,” he says. “There has not been a major shift yet towards these products for beta replacement as market participants still like trading the standard EURO STOXX futures given their high intraday liquidity and active order book, but total return futures have proved their attractiveness to directional investors during COVID given their ability to minimize exposure to dividend risk
A remaining challenge revolves around education as not all clients are fully aware of the product construct and cost efficiencies within a listed environment.
“A key task for Eurex is to keep on educating both sides of the market to make sure they understand how the TRF product works and how they can optimize margin costs at portfolio level,” says Marchidann. “The TRF together with all other equity and index derivatives can bring significant margin offsets as the hedged trades are basically using the same pool as a TRF.
“This is also something we consider: how we can improve order book liquidity, support clients during the onboarding process and make the data more accessible to foster further adoption.”
What is next in the futurization toolbox?
Looking into the future of futurization, the direction of travel is firmly from OTC to listed. In that perspective, Eurex and Qontigo are listening to their clients: innovation will likely accelerate as there is still a considerable number of OTC derivatives cross-asset classes which could be captured into a centrally cleared and exchange-traded environment.
The futurization toolbox will encompass more customization down the road. This is because there is a desire from clients to maintain the flexibility inherent of OTC products, while benefiting at the same time from the transparency, liquidity and synergies associated with listed derivatives.
This customization could cover products including bespoke basket TRFs, and thematic and systematic indices. Thematic indices are more complex to develop than their sector counterparts as they require processing of advanced and complex data sets either in-house or using data vendors. They are designed for more precise exposure management to reflect a specific view and strategy in portfolios and therefore require more education on the investor side in terms of understanding opportunities and risks.
“To compare, we saw similar developments of futures products with sector indices in the early 2000s, spreading more widely to market making activities. Today we are talking about an ecosystem with an open interest of EUR 12 billion on futures and nearly EUR 9 billion,” says Batir. “We expect to see the same path on TRFs with our thematic index range as underlyings.
“I believe that thematic indices and listed futures products on Eurex can definitely offer the right set of tools for investors and the ecosystem to manage their short- and long-term risks.”
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