On 10-year anniversary, TRF market looks ahead to future innovation

The regulatory push towards clearing that followed the 2008 global financial crisis, which included Dodd-Frank in the U.S. and the introduction of Uncleared Margin Rules (UMR) globally, put enormous pressure on banks to reduce the level of uncleared OTC derivatives activity on their books. For bank hedging desks, this started a hunt for capital-efficient alternatives to the OTC market.

Launched in the year before UMR began its six year-long implementation, the total return future offered banks a tool that replicated the function of a total return swap, but eliminated counterparty credit risk. It also allowed for netting with other Eurex products that the bank traded.

At the coalface of market activity, TRFs provided a clean mechanism for traders to isolate the implied equity repo rate. This was a step-change from the pricing structure of a classic future and set the stage for further growth in the product that was driven by the trading experience.

"What began as a capital- and balance-sheet-efficiency solution for dealer banks has evolved into a diverse marketplace increasingly embraced by buy-side firms and market players seeking greater transparency, operational efficiency and rapid access to market."

"The innovative product construct, combining trading in basis points with clearing in index points, enables participants to isolate the implied equity repo rate from the underlying market exposure, making TRFs a particularly effective tool for managing and trading equity repo dynamics."

The launch also marked something of a step change in the relationship between banks and exchanges, which together began to forcefully instigate a shift from OTC activity to listed. This involved a uniquely collaborative approach between Eurex and its partner banks in ensuring that the TRF was as suited to market needs as possible. The approach gave fruit to listed innovations, such as quoting the product in basis points – a move that paved the way for future buy-side access.

Driving efficiencies

While the capital efficiencies that TRFs have offered banks are notable, the product’s operational advantages have been proven to go beyond the regulatory zone and enhance the trading experience. Before TRFs launched, market participants had to use the documentation-heavy and, under UMR, increasingly margined OTC swap market, to trade equity repo rates, or execute complicated synthetic trades.

The simplifications of the exchange-traded format, which cuts documentation review through standardization, have over the last decade expanded the products' appeal beyond the sell-side to a range of buy-side firms. These market participants have found the listed path to trading market dynamics such as equity repo rates much smoother than through OTC channels.

Another key attraction of the offering has been the transparency that its listed nature naturally provides to the TRF product. Whereas Total Return Swaps (TRS) users had to trade in an opaque market with limited visibility on financing levels, the TRF has provided the market with an easily accessible on-screen spread to reference. This has also been a foundation to build liquidity, with greater transparency opening up the market to more participants.

Expanding ecosystem

The TRF market started life with EURO STOXX 50® Index TRFs and these remain the most traded product in ecosystem. Substantial supply comes to the market from exotics desks’ need to hedge autocallable exposures and liquidity has begotten liquidity as a widening range of buy-side strategies see a fit with the product.

However, markets have also arisen in FTSE 100 TRFs and MSCI TRFs, each with distinct dynamics in areas such as financing. The STOXX family of TRFs has also expanded in the last decade, with EURO STOXX® Banks Index TRFs, EURO STOXX® Select Dividend 30 TRFs and STOXX® Europe 600 TRFs. Since launch, Eurex TRFs captured most of the OTC swaps interdealer volumes with currently ca. EUR 140 billion outstanding notional across the products. 

Product innovation has spread beyond the index though, with ever greater convergence between listed and OTC markets. Basket TRFs (BTRFs) allow users to bundle single stock contract exposures into a packaged product that allows for customization that is closer to the OTC experience, while providing the capital and margin savings of the listed format. As with an OTC basket swap, portfolio managers can also transfer single names in and out of the basket in response to strategical or tactical shifts, or more mundane causes such as corporate actions. BTRFs have also gained strong momentum recently with over EUR 230 billion notional traded since inception and current outstanding notional of EUR 10.5 billion.
 

In the second article of this series, we will delve into the index TRF ecosystem and how it has been powered by sell-side efficiencies and growing buy-side appeal.