23 May 2022

Eurex | Eurex Clearing

Building the market for ESG derivatives

ESG is among the fastest growing segments of capital markets today. However, many challenges remain from fragmentation of data to low liquidity in listed instruments. Eurex spoke with Julien Nizard, European Head of Equity Derivatives Trading at J.P. Morgan, about the market for ESG derivatives in equities and how the firm was helping clients meet their mandate.

What involvement has J.P. Morgan had in the development of ESG derivatives in Europe?

J.P. Morgan has been an active providers of derivatives with ESG related themes for many years, following the launch of a dedicated trading desk focused on thematic indices more than 10 years ago. Our involvement since then has been on three main fronts: structured products, delta one and listed derivatives.

Last year, we created a dedicated team, the Global Markets Sustainability Center, headed up by Neven Graillat. That team is engaging with clients to further develop our ESG offerings around their needs and represents a major step forward in our overall client ESG strategy in the trading and sales businesses.

How do you work with clients to help them develop tradeable product for their ESG requirements?

One of the key challenges our clients face is accessing products and indices that meet their ESG specific mandates as well as product coverage. J.P. Morgan’ Nexus Platform allows clients to build tailor made solutions for their specific mandates, selecting what underlying they want in the indices they trade.

We are also working actively with index providers and exchanges to develop ESG Indices that meet the demands of our clients. Our role as the investment bank is to guide clients and index providers on assessing the tradability and risk parameters of indices and associated derivatives products.

For example, following a client request, a third party index provider would propose certain screenings and ESG scores or criteria for an index. On the trading side, we make sure that the index is tradeable from a liquidity perspective but also “hedgeable” from a volatility and forward risk perspective.

Majority of the activity has been on structured and OTC products but there is a growing market for listed futures and options. Some listed products are launched because a successful OTC product has become liquid or popular enough to be standardized on an exchange and have more participants involved. Another route to market is where an index provider, after gathering feedback from institutional investors and banks for tradability, will launch an index specifically designed for listed exposure.

Where do you see the most demand from your client base?

In terms of regions, most of the demand has originated from Europe. Demand from US and Asia has been lower to date but is rapidly increasing. The bulk of interest in Europe is on the environmental side with growing interest in areas such as bio-diversity or nature based solutions.

In the US, we see more interest in the social part of ESG with diversity, equity and inclusion being a major focus for investors. There are fewer indices focused on the “S” of ESG compared with the “E” currently but that is changing as index providers respond to the growing demand.

From a product perspective the demand has been strong in the autocall market. Demand for listed products has been lower but it is increasing and liquidity is building.

What have been the challenges in building out the market and how are they being overcome?

One of the main challenges is that each client has its own internal ESG guidelines, targets and benchmarks, and there's a lack of homogeneity across all investors. There is also a fast evolving regulation landscape especially in Europe: SFDR, ESG labels and forthcoming MiFID ESG related requirements will have an impact on client demand. At a local level, countries introduce different regulations for their internal market. As a result a multitude of indices are being created to adapt to the varying types of demand. Harmonization will be needed to ensure common product development, and increase in liquidity.

Clients can use our Nexus Platform to rebalance the underlyings of a trade if they no longer aligns with their internal guidelines or regulations.

In order for the market to develop further, we need to continue to develop indices that are in the intersection of liquidity, client requirements and suitable tracking error from benchmark indices.

How is the regulatory environment evolving and what more needs to be done?

In Europe the landscape is evolving quickly with the development of numerous regulations and guidelines, which is helpful. Regulation is positive because it allows the market to develop common frameworks but it is currently being developed in a fragmented way between a global and local level. We will need more harmonization to ensure that we can achieve common product development and optimize liquidity.

What more can be done to boost liquidity in listed ESG futures and options?

We need more market makers in listed ESG products to improve the liquidity. Currently clients have to execute in blocks and therefore only small number of trades can be executed electronically. We need to work actively with exchanges to develop more products for clients that can only access listed products and respond to their demand. More futures and options contracts focusing on specific topics can be created in addition to the broad ESG themes that we have today.