Hedge funds and traditional institutional investors are increasingly turning to total return futures (TRFs) to get exposure to the repo market related to an underlying index such as the EURO STOXX 50® Index. Antoine Deix, Senior Equity Derivatives Strategist at BNP Paribas, discusses how firms are currently using TRFs, the benefits they gain compared with total return swaps (TRS) or index futures, and how he sees the space developing in the next year.
What are the main differences between TRFs, TRS and regular futures?
EURO STOXX 50® Index Futures and EURO STOXX 50® Index TRFs both provide a way to get exposure to the performance of the underlying EURO STOXX 50® index. Futures are a listed solution, which benefits from high liquidity and transparency. They are fungible contracts and compensated, which mitigates counterparty risk. They also have the very important benefit of allowing the netting of exchange margin.
TRS are an OTC solution, which provide access to long-term maturities and allow users to lock in the long-term financing spreads and remove quarterly roll risk. Compared with EURO STOXX 50® Index Futures, with a focus on total returns, TRS remove the dividend exposure risk that exists with EURO STOXX 50® Index Futures.
TRFs benefit from the best of both worlds. They have the same features as TRS but are listed, meaning they have the same advantages as EURO STOXX 50® Index Futures. It's a listed solution that allows the netting of exchange margin, the lock in of long-term financing spreads and also the removal of quarterly roll risk and dividend risks.
How are asset managers and hedge funds using TRFs today and what is the motivation for using them?
Institutional investors, such as asset managers and pension funds, as well as hedge funds, are focused on the trading of calendar spreads to capture the expected alpha from the downwards-sloping repo term structure.
The TRF term structure is upwards-sloping, driven mostly by the repo term structure. Flows impacting the short-end of the repo curve differ from flows impacting the long-term part of the curve. It creates a new opportunity to generate alpha by doing a calendar spread between the short-term and the long-term maturities. Institutional investors and hedge funds have been active in trying to capture this alpha from the calendar spreads on the TRF repo term structure.
Initially the expectation was that hedge funds would focus on the calendar spread, while traditional asset managers would be more active in beta and security replacement. However, both have been quite active in the calendar spread. Investors have been focusing on the alpha generation that can be generated through calendar spread arbitrage. We continue to believe TRFs offer further benefits for institutional investors as beta replacement with the short-term TRFs (1Y) or to optimize portfolio hedge with longer directional TRFs.
What are the expected benefits that firms would expect to achieve using TRFs?
The benefits from using EURO STOXX 50® Index TRFs compared to EURO STOXX 50® Index Futures are the removal of the dividend and quarterly roll risk as short-term repo can prove volatile, depending on market conditions and market performance. Also, TRFs allows an investor to lock in the long-term financing spread.
The benefit of using TRFs compared to TRS include all the benefits of using a listed product such as futures, including netting of exchange initial margins.
In addition to the benefits brought by the product specificities, TRFs allow you, through the calendar spread, to benefit from isolating the repo parameter and the generation of alpha – what you can get from the carry of the financial spread difference and the expected roll down on the TRF curve.
And focusing on the hedge funds, can you talk a little bit about how they might be using this to generate alpha?
If you look at the repo term structure, the short-term repo can prove volatile because it is driven by market performance, evolving regulation and collateral availability. Also, the long end of the curve is impacted by issuance from structured products and distortion in exotic books.
The most common structured products are auto-call products. The end client will sell a put down-and-in at the maturity of the product and up-and-out at each anniversary date of the product. By selling these products, the structured product desk is getting a short forward exposure on their book and they need to buy or replicate long forward to hedge that exposure. It's the same then for dividends. This creates selling pressure on the repo rate and pushes TRF spreads higher on mid to long-term maturities. The average duration of auto-call product issuance in terms of impact on the repo curve is between four and five years.
A sharp market downturn will push short-term repo higher, as it will drive higher demand to sell physical shares. This creates a spike in short-term repo, which will drive short-term TRFs lower. At the same time, a sharp market downturn will increase forward exposure from the exotics desk and thus drive selling pressure on mid to long-term maturities on the repo curve. Thus, it will drive TRFs on mid to long-term maturities higher. So, the slope of the TRF term structure will increase and this will create opportunities to get a spread difference, generate alpha from the repo differences and the potential normalization of the repo curve after the stress.
What is the current process for how hedge funds execute these strategies?
There are two ways to trade TRFs with a dealer. One is Trade at Index Close (TAIC), which means they strike on close and don't exchange the delta. If they trade with just one leg, they get a longer TRF position and they strike on close and don't exchange the delta of the future position. However, the most common way of trading TRFs is a Trade at Market (TAM) trade. It's during the market, not on the close, and they strike at the pre-agreed price and exchange the delta. That's the most common way of trading TRFs, for two reasons. First, because they exchange delta – for calendar spread the delta is very low but there's still residual delta coming from the repo rate difference between the long and the short-term maturity.
However, the main reason that funds prefer TAM trades is when they want to switch from futures to TRFs, they can do so at a pre-agreed financing level. They don't have any risk on the execution because they know exactly at what price they will exchange the delta – the pre-agreed TAM price.
Are there any different benefits that they would expect to achieve?
For hedge funds, it's mainly how to arbitrage repo term structure. When doing a calendar spread, if they get long short-term maturities and short long-term TRFs, they will net their market exposure or the exposure to the underlying Index.
When they do a long short on the TRF term structure, they will basically cancel out the index performance and dividends. They will also cancel out EONIA so they will just be left with the difference in financing spread between the two maturities.
By shorting long-term maturities that are somewhat inflated by the flows from structured products and by buying the short-term maturities that can be pushed lower when there is a market stress because there is a pick up in the repo rate, they want to look at the spread difference between the two maturities and potentially also to benefit from the normalization of the curve as the curve is getting flatter.
How do you see TRFs evolving in 2019?
New regulations like the European Market Infrastructure Regulation (EMIR) have been driving more futurization of the market with OTC trading switching to listed solutions. Interest in EURO STOXX 50® Index TRFs has reached more than 700,000 contracts open interest. That is equivalent to roughly EUR 25 billion notional and the volume traded is over one million contracts or above EUR 35 billion notional.
We believe volumes will double over the next year with a full transfer of OTC volumes to listed contracts. The calendar spread arbitrage has been driving an important part of the product volume so far and we believe the future replacement of equity and future exposure by TRF exposure could be the next big driver of volume increases. That increase will come mainly from institutional investors such as asset managers and pension funds who could benefit from the dislocation in the repo term structure and from locking in financing spreads and repo levels on longer maturities.
As we have seen during the development of dividend futures, another area for open interest growth and TRF volumes could come from the listing of TRFs on new indices beyond the EURO STOXX 50® Index or even on single name stocks. This could drive TRFs to become their own distinct asset class.
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