20 Nov 2023

Eurex | Eurex Clearing

Welcome to a new ecosystem for managing credit risk

How Eurex is using credit index futures to build the next frontier for exchange-traded derivatives

At the height of the intense volatility generated by uncertainty over the future of Credit Suisse in March 2023, trading was a turbulent experience for many. Volatility spiked, and, in the credit world, credit default swap (CDS) spreads widened significantly.

But for Stefan Schmidt, a Senior Derivatives Trader on the Multi-Asset Trading Desk at Union Investment, an active German asset manager, the experience of trading through this period, in particular managing portfolio risks, was significantly eased by his firm's use of Credit Index Futures.

Eurex introduced Credit Index Futures in September 2021 in response to client demand for listed products that could provide a new way to access the Euro credit derivatives markets. For many, Eurex Credit Index Futures carry the advantage of reducing the basis risk – known as the cash CDS basis – between corporate bond portfolios and the established CDS indices traditionally used as their natural hedging product, combined with the clearing efficiencies offered as an exchange-traded alternative to the over the counter (OTC) products.

Looking at the euro investment grade space, Eurex Credit Index Futures — such as Bloomberg MSCI Euro Corporate SRI Index Futures (FECX) — provides exposure to over 3,000 bonds and more than 700 issuers. The issuers' weight in the index is based on the bonds' notional amount outstanding.

By contrast, CDS indices do not only represent fewer issuers, but these are equally weighted in the index. This feature ensures that a Credit Index Future expresses a broader representation of the Euro corporate bond market, which is more reflective of bond portfolios managed by asset managers.

Moreover, whereas a CDS index will offer exposure only to credit risk, Credit Index Futures, being futures on total return indices, provide exposure to both the interest rate risk of the bond and its credit risk. These features mean that Eurex is able, through this product, to offer an efficient pathway for synthetic credit exposure similar to that available with OTC traded derivatives (such as CDSs and total return swaps).

This makes Credit Index Futures a more reliable hedging instrument for corporate bond portfolios, as Schmidt found during the Credit Suisse turmoil that culminated in the bank being acquired by Swiss rival UBS.

"We had some hedges in the form of a CDS Index, where you can trade billions in a very liquid manner. However, there are only 125 issuers represented in that index, so we faced a significant tracking error versus our benchmark indices," he explains.

"Credit Index Futures represent a broader universe of issuers, and therefore carry a much lower risk of tracking error when compared with our cash portfolio, so that was the reason we started trading them."

Stefan Schmidt, Senior Derivatives Trader on the Multi-Asset Trading Desk, Union Investment

During times of market stress, such as the Credit Suisse situation, asset managers can use Credit Index Futures to swiftly manage the risk of corporate bond portfolios, allowing the reduction of exposure to credit at narrow bid-offer spreads instead of potentially unwinding cash bond portfolios — thereby avoiding paying prohibitive liquidity premiums in times of distressed markets, as Union Investment found. "We were able to sell a huge credit exposure in the middle of the Credit Suisse crisis with only small discounts to fair value," explains Schmidt.

The evolution of credit index futures

So, where do Credit Index Futures, like the ones used earlier this year, fit into the wider ecosystem of credit derivatives?

In 2021, Eurex leveraged the momentum of environmental, social and governance (ESG) in the wake of the Covid pandemic to launch Bloomberg MSCI Euro Corporate SRI index futures. These products provide synthetic access to the Euro investment grade bond universe while embedding an ESG methodology.

In 2022, Eurex launched Bloomberg Liquidity Screened Euro High Yield Index Futures, completing their Euro-denominated suite of Credit index futures, which now trade alongside their established suite of global Fixed Income iShares UCITS ETF Options.

Underpinning this is a strong ambition on the part of Eurex to demonstrate to clients how the listed product suite can co-exist with the OTC credit derivatives offering.

Sell-side and buy-side users

This idea of co-existence has been key to building sell-side support, with clear signs of a mindset shift that now sees listed credit derivatives as part of the overall toolkit. For sell-side organizations, Credit Index Futures supplement their fixed income ETF and corporate bonds book and integrate seamlessly within the credit ecosystem.

"We have been very active supporters of the existing Euro products, which fit well into our integrated fixed income trading team. We manage all bond risk as a single team whether that comes to us from individual bonds, Portfolio Trades, Bond ETFs or now Credit Futures", commented Dan Philip in Jane Street's Fixed Income Group. "In particular, the correlation these Futures have with Bond ETFs - which have very significant turnover - make it very natural for us to offer continuous liquidity at competitive levels in the futures, even in stressed periods such as around Credit Suisse's acquisition."

For asset managers, there is growing interest in these products, as they find Credit Index Futures an efficient tool to attain exposure, be it long or short, to the Euro corporate bond market. Long-only asset managers might employ some tactical, macro, and hedge fund-like strategies — all areas where Credit Index Futures can play a role.

Asset managers are also using the products for traditional strategies such as market risk hedging, overlay strategies and bond portfolio equitization, beta management or expressing directional views, depending on the product mandate of end users.

Total execution cost is also a major consideration for buy-side traders and portfolio managers, as is the execution method supporting them. Settlement of credit index futures on a T+0 basis ensures that they are instantly available in clients' portfolios. This feature allows for efficient cash flow management, as clients can immediately re-invest cash coming from coupon payments or fund inflows.

While large institutional asset managers have deep relationships with banks and have advanced clearing and trading systems that allow for the integration of their strategies with OTC-traded credit derivatives products, the same may not be true for smaller organizations. This is mostly due to the scope of mandates defined by their end clients, technology restrictions, or lack of relevant International Swaps and Derivatives Association (ISDA) agreements. Eurex's Credit Index Futures aim to provide a solution for such users by offering a product that provides synthetic credit exposure similar to that of OTC credit derivatives.

Furthermore, Credit Index Futures can attract an even larger group of participants to this market. For example, CTA-type users could exploit the liquidity of these new futures markets to deploy their short-term trading strategies, adding to the total liquidity of the products and enriching the participant ecosystem.

Market maker support

It was essential to create a diverse and rich ecosystem for Credit Index Futures right from the start, so the support of liquidity providers has been a key enabling factor in their success.

Eurex has found the right mix of Investment Bank and Electronic Liquidity Providers who share the same vision and see the advantages Credit Index Futures can offer to the financial markets and, in particular, to trading participants.

"We've been very positively surprised by the breadth of client interest in the existing futures and we're excited to see the extension to GBP and EM markets and hopefully more broadly,"

Dan Philip, Institutional Sales & Trading, Jane Street's

Dealers who provide liquidity in fixed income ETFs and portfolio trades can re-use the same technology to provide liquidity in Credit Index Futures as they tap into the same underlying market. Eurex has seen dealers being able to leverage the whole credit cash and derivatives market ecosystem to ensure that the best prices were offered in Credit Index Futures.

Through their strategic partnerships with key stakeholders, Eurex has set out to create a product ecosystem for Credit Index futures that intersects with the cash bonds, ETF and OTC derivatives layer.

Building for the long-term

Eurex sees significant potential to cement its leading position in offering a full suite of credit index products, building on client adoption and the growth of the Credit Index Futures ecosystem.

Eurex is just at the start of the journey. The ambition is to be the incumbent liquidity pool for listed global credit derivatives. The vision for these products is to grow in parallel with traditional OTC traded credit derivatives, enriching this ecosystem and providing clients with new ways to manage their portfolios.