OTC-traded equity total return swaps are currently the center of attention. Since 2016, Eurex has been offering exchange-traded Total Return Futures. Reason enough for us to talk to Randolf Roth, Member of the Eurex Board globally responsible for Equity/Equity Index, and Dmitrij Senko, Board Member at Eurex Clearing and Chief Risk Officer, about transparency and risk management in a centrally cleared environment.
How do Eurex’s Total Return Futures work, compared to these swaps, and what is different?
Randolf: Eurex Total Return Futures (TRFs) are standardized, centrally cleared futures contracts aiming to replicate returns of traditional, bilaterally negotiated equity or equity index-based swaps. We started the segment in 2016 with the listing of the first TRFs on the EURO STOXX 50 Index. TRFs on 255 single equities followed in 2019.
A buyer of a TRF is analogous to the receiver of total returns (i.e. price plus dividend) in the corresponding swap and is payer of the financing leg. This leg is based on a benchmark interest rate plus an agreed spread. This spread is the “traded” level of the TRF, as it is with the swap.
As futures, they have standardized terms and features such as fixed maturities which allow for netting and support portfolio margining with the full suite of Eurex equity and equity index derivatives.
Can you please describe the safeguard mechanisms of central clearing in more detail?
Dmitrij: The key point is that when a TRF is traded, Eurex becomes the central counterparty and its rules and margins are applied with the specific aim of mitigating counterparty risk. Eurex takes a holistic approach to credit risk, eligible margin assets, as well as the overall exposure of transactions across Clearing Members (CMs).
As the direct counterpart to each of its CMs, Eurex requires them to deposit Initial Margin (IM) at the clearing house to back both their own positions and those of their clients. This is calculated at least daily and held by the clearing house, mainly as cash or high-quality liquid assets. Variation margin (VM) to cover daily profits or losses is paid/received daily in cash, preventing a build-up of exposure over time.
The discussion is very much about margin and leverage. Can you briefly explain how Eurex calculates margin and how this affects leverage?
Dmitrij: Eurex’s PRISMA margin methodology looks at the full portfolio of a CM by account, noting that house and client positions are held separately. The main driver of IM is the analysis of market risk. However, the core function of the clearing house is to eliminate counterparty risk – and the foundation of this is our default management process that would be employed in the case of a CM default. This means we have defined measures about what size positions can be effectively risk managed given a default. Where individual positions are large by comparison, the clearing house adjusts the IM upwards using so-called margin add-ons required to mitigate potential additional losses when liquidating these larger positions.
Can you give an example?
Dmitrij: Yes, let’s look, for example, at exchange traded derivatives on Vivendi, a large cap European media company. The IM on a small position would be 10-11%, determined by historic market risk. A larger position representing 1% of the outstanding shares would attract a 19% IM due to the liquidation add-on. And for an even larger position at 5% of the outstanding shares, the IM would be 36% with the liquidation add-on, and this would significantly reduce the leverage available.
Traded volume and open interest are public information at Eurex. What role does this play?
Randolf: Transparency is key for well-functioning markets. Thanks to the reporting of traded volumes and open interest in an exchange traded environment, the market can infer potential exposure information across contracts.
But more importantly, as described above, our real-time risk management, ensuring margin calls on a daily if not intraday basis, along with an initial margin model whose liquidation charge is sensitive to increasing exposures, disincentivizes a build-up of concentrated positions.
How have Total Return Futures been accepted by the market? What potential do you see here for the future?
Randolf: Eurex was the first exchange worldwide to offer an exchange-traded replacement for bilaterally traded total return swaps. Meanwhile, besides Index TRFs and individual Equity TRFs, we also offer Basket TRFs and Collateral Index TRFs. Most recently, on 29 March, we also added TRFs on the FTSE 100 Index, the EURO STOXX Banks and the EURO STOXX Select Dividend 30 Index.
Our TRFs show what the transition from bilateral business to transparent exchange trading can look like.
Since its launch of TRFs on the EURO STOXX 50 Index (TESX), for example, back in 2016, Eurex has managed to migrate over 50 per cent of the OTC market to this product. Current open interest in TRFs on EURO STOXX 50 stands at over 1.4 million contracts with a notional value of over EUR 60 billion.
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