Eurex has set the pace for the develop-ment of ESG derivatives, launching its first ESG equity index products in February 2019. Now, as it gears up to expand its equity suite with the addition of four DAX 50 ESG and EURO STOXX 50® ESG futures and options, Christine Heyde, Equity & Index Product Design and Achim Karle, VP, Sales Equity & Index Derivatives, share their thoughts on the journey so far and the upcoming launch.
What is Eurex’s Role in the ESG space and what were the drivers to launch ESG derivatives?
Christine: We began our research into ESG derivatives in September 2018 following a business trip to the Nordics. We met with our partner banks and some of their asset management clients and the demand for an exchange to launch derivatives in the field became very clear. We then defined, with our client base, what an ESG index should look like and analyzed the different methodologies to develop our product suite. We decided to focus on exclusions, one of the most basic but also the most established methodologies with the highest Assets Under Management behind it. We then looked at where the standardization was for exclusions and which exclusions most asset managers had on their list. That went into the construction of the ESG-X index on the STOXX® Europe 600 and provided a broad benchmark for Europe. But, at the same time, we were also looking for where we could develop more niche products focusing on areas such as climate impact or the reduction of carbon footprints.
What were the challenges in developing exclusions?
Christine: A key challenge was developing the right exclusions for the index. For example, in our discussions with Nordic asset managers, it was clear that companies obtaining revenues from thermal coal extraction and power generation capacity was an important exclusion criterion. Therefore, STOXX decided to screen these out of the underlying index based on certain thresholds. Those are based on revenues from thermal coal mining and exploration and power generating capacities. Just recently, another index provider took the same view and excluded coal from their ESG index – in that sense Eurex is helping in setting industry standards.
Achim: One key theme we picked up in our discussions with asset managers was that risk departments had issues if the methodology of the index construction was too complicated. For example, if you take best in class indices or indices underweighting constituents because they have bad E,S or G ratings and then you overweight those who have a better rating, the index gets more and more complicated the deeper you go, which is detrimental to risk management.
Christine: Another aspect was that asset managers wanted to have a performance close to the benchmark they were using and a low tracking error. In addition, initial liquidity and price provision by market makers was an important prerequisite to allow trading in and out of positions. These were two of the initial key criteria that were met with our products.
How are ESG Derivatives going to evolve in the next twelve months and what is your strategy?
Christine: Eurex has already started to support asset managers in switching to sustainable investments by broadening its ESG derivatives segment beyond Europe. ESG screened versions of key regional and global MSCI benchmarks have been available since March 2020. EM has been the region with the most traction so far and Eurex will further focus on developing the existing ESG index derivatives. Moreover, as part of the second phase of the development of ESG products, we are looking at products that have a higher degree of ESG integration in addition to the negative and norms-based screenings.
At the beginning of November, Eurex will extend its offering to ESG versions of the DAX and EURO STOXX 50® indices. These integrate ESG scores into the index methodology, leading to improved overall ESG profiles of Eurex’s leading blue chip index derivatives. Integration is a more challenging methodology to pursue as there are different approaches between asset managers and ESG data providers that many of them use.
Achim: Phase 1 offered relatively simple, exclusion-based products such as the ESG-X index family, by far the most traded listed ESG index derivatives product worldwide. We are now launching more sophisticated products that have a specific place in the market. We can see there is strong demand for what we are doing from asset managers but now we need to build the liquidity in the products. We expect volumes to grow as EU reporting rules around ESG become more entrenched.
Christine: We are looking beyond twelve months and have only just started on this journey. The ESG-cause has a very long-term view, so we are building for the future. With derivatives, we offer instruments at an early stage that support the growth of ESG investments but we don’t want to launch products too early while the regulations surrounding some of the goals, such as carbon reduction, are not completely clear. Our options contracts go out to five years, so asset managers can trade far out to anticipate a longer-term trend and our product development will continue in line with the evolution of the marketplace.
There are two elements to the development of ESG products for us. One is the creation of more ESG-compliant benchmarks but the other is for asset owners who want to make an impact by choosing their investment strategies. They want to change behavior and contribute to create leaders in a certain field in line with initiatives like the Sustainable Development Goals. There are a number of such initiatives underway to create further standardization in this area and we want to be at the forefront of this evolution. Client interest is high but has not fully materialized in trade sizes to the same extend. When clients have made themselves familiar with the ESG index methodology and reporting requirements become more pressing we will probably see more volume.
What are the benefits of screened versions compared to other more complex models?
Achim: Eurex’s ESG-screened index derivatives are based on parent benchmarks that are well established, actively traded and, as such, easy to integrate into existing trading environments. ESG-screened indexes and the respective derivatives are the first step into ESG and enable clients to be compliant with the most common norms and standards on ESG screens. Given that those ESG derivatives closely track the benchmarks, firms can swiftly replicate their strategies and achieve the same goals of their trading portfolio, just in a more compliant way. Lastly, it has been easier for market-makers to provide liquidity on-screen, since they also traded the parent products and therefore could quickly adapt to the ESG versions.
How do ESG products compare to their non-ESG equivalents in terms of performance and costs?
Achim: For the soon to launch EURO STOXX 50® product, there are several studies that show that ESG indices clearly outperform their regular comparable indices. Overall, the EURO STOXX 50® ESG index outperformed the benchmark by 3.77 percentage points between December 20, 2019 and August 7, 2020 measured in terms of its cumulative returns, while the volatility was also lower. ESG for us is also about lowering the risk for investors. A recent example is where a stock that was listed in the DAX 30 caused market turbulence due to a massive fraud which eventually resulted in its insolvency. The stock wasn’t included in the DAX 50 ESG index, owing to its low ESG score so anyone invested in the ESG index would not have been exposed to it.
How are you growing liquidity?
Christine: We have market-makers that are familiar with the classic benchmarks and are supporting our ESG versions so market participants can immediately trade the on-screen prices. And on the other hand, off-book market-makers are providing prices to clients for bilateral trades that can be entered via block trades. If you look at the March 20-expiry of the ESG-X future during the Covid-19 market turbulences, market-makers continued to support the roll with prices leading to a smooth transfer of existing open positions into the succeeding expiry.
For the new products we expect market-makers and market participants that are active in the existing suite of products to support these ESG versions. But of course, liquidity will build up over time and we won’t have the established liquidity on day 1 for all our products. A recent trade that was done by Barclays for Swedbank Robur in ESG options with a notional volume of more than €540m, shows that interest around ESG products has gone up substantially this year and should provide investors comfort around the current liquidity profile in ESG derivatives.
What about the new futures and options on DAX 50 ESG and EURO STOXX 50® ESG Indices?
Christine: It is the next step, a step forward from ESG screening to derivatives based on an integration methodology. With futures and options on the EURO STOXX 50 ESG Index, we add another European benchmark to our offering and with derivatives on the DAX 50 ESG Index we will now cover the German market for the first time. Beyond the step ahead into a new more comprehensive approach and methodology, these derivatives will be the first based on indexes incorporating ESG scores. In combination with screening out undesirable securities, ESG rankings are also considered as part of the selection process.
What are the characteristics of these sustainable versions of the DAX and EURO STOXX 50® indices ?
Christine: Companies in the DAX 50 ESG Index must pass standardized ESG screens related to Sustainalytics’ Global Standards Screening (GSS), as well as not be involved in controversial weapons, tobacco production, thermal coal, nuclear power or military contracting. The base universe of the DAX 50 ESG Index is the HDAX universe which comprises the joint set of companies included in the DAX, MDAX and TecDAX. The EURO STOXX 50® ESG Index is based on our benchmark, the EURO STOXX 50® Index. The ESG version excludes companies that Sustainalytics considers to be non-compliant with Global Standards Screening. In addition to the exclusion screens, the ten per cent of companies with the lowest ESG scores are excluded and replaced by companies with a higher ESG score from the same ICB (Industry Classification Benchmark) Supersector.
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