Return Futures (TRFs) provide a listed alternative to the Total Return Swap, seeking to replicate the flexibility of the Over-the-Counter (OTC) market with the operational efficiency of the exchange traded world. In addition to index TRFs, Eurex now offers TRFs for individual equities (ETRFs) as well as the ability to trade baskets of ETRFs. In a DerivSource Q&A, Stuart Heath, Director, Equity & Index Product Design at Eurex, explains how the new offerings work, how they may be used by Delta One and Equity Financing desks, and how he sees the market evolving.
Can you briefly explain what equity and basket total return futures (ETRF and BTRF) are?
The intention is that they are a package offering. Equity Total Return Futures (ETRFs) function very much like index Total Return Futures (TRFs), which we have listed and traded for many years. These are structured to replicate the OTC total return swap market, but in this case, it's on an individual equity level rather than an index level. In addition, there is the ability to execute basket trades of equity total return futures or BTRFs. This is a new trade entry service or block trade offered by Eurex, which allows market participants to use ETRFs as building blocks to construct a mutually agreeable basket. The combined offering provides both the standardized nature of an exchange traded derivative, and the ability to form part of a far more flexible and tailored offering that replicates what occurs today in the OTC space.
Eurex launched TRFs in 2016 to help participants manage repo risk in the equity market. What are the drivers behind the launch of ETRF and BTRFs, and are there any particular market needs that you're looking to address specifically?
Partly it's the impact, and cost, of the uncleared margin requirements in the OTC space, which makes centrally cleared offerings more advantageous. The second driver is the fact that index TRFs—based on the EURO STOXX 50—have been successful, and market participants are starting to understand the product structure and be far more comfortable with it. The target segment for ETRFs and BTRFs is slightly different to index TRFs, which aimed at Delta one desks, focused on hedging, structured product risk, and the need for the repo hedge. The new products aim to support equities financing desks, which are more focused on collateral optimization and the use of equity collateral to raise financing. Participants will enjoy the benefits of central clearing and the opportunity for cross margining against the whole equity financing portfolio and the broader derivatives portfolio within the institution, while replicating the flexibility that's inherent in the OTC market.
Is the driver for collateral optimization and cross margining part of the overarching driver for regulatory compliance and firms’ ongoing efforts to get the best use of the collateral they hold?
There is partly a regulatory drive. Regulation increases costs on a business and our aim is to try and reduce that cost, particularly in terms of capital usage. Alongside that, the optimisation of collateral is becoming a key operational benefit. More focus is being put on the most effective use of collateral in any given situation, and collateral optimisation is increasingly a key factor in trading decisions that previously wouldn't have taken any input from that area.
Can you explain a typical scenario where a market participant might use an ETRF and BTRF for the purposes that you've already outlined?
At the moment, the equity financing market is an OTC market with a simple purpose. One counterparty uses the equity it has on its books to raise financing. The other party offers that financing in return for a fee but uses the equity as collateral to mitigate counterparty risk. The party providing collateral still needs the returns on that equity because they're supporting or facilitating client trades. The ETRF / BTRF offering can replicate that because in effect, the normal borrower of cash can still receive the total returns from the market. It allows the borrower to replace the TRS (total return swaps) with the BTRF in return for a fee. It allows them to go and sell the stock into the market because the other party doesn't necessarily need that collateralization when there is a CCP as a counterparty. Having Eurex clearing as a central counterparty helps mitigate that counterparty risk.
Are there any other wider industry changes or trends at play that support the use of these instruments or are an indicator of where this market might be evolving to?
A recent International Swaps and Derivatives Association (ISDA) paper noted the close and mutually supportive nature of the derivatives business—particularly on the OTC side, and now hopefully the listed side as well—to support other business streams such as equity financing, traditional repo and securities lending markets. These lines of business are becoming far more closely aligned, although it will take some time because of the different needs and functions for each of those trading types.
ETRFs give firms the operational benefits of exchange traded business, coupled with the benefits of cross margining and having a central counterparty, to substitute for what is currently an OTC product. Optimisation has to be focused on many areas as firms look for very granular details within all trading functions about the cost of capital and the best use of collateral. This is being driven partly by regulation and partly by the ability to bring everything together in the system and align the functions. ETRFs and BTRFs provide all the efficiencies of the ETD space, but also the flexibility of the OTC space.
What is your expectation for the evolution of ETRFs and BTRFs?
Historically, futures have been measured by the number of contracts traded, but with this market it is more about the notional value of the market. This is a large notional value market, where the margins aren't necessarily outstanding. Open interest will be a better indicator than actual traded volumes. These trades tend to be for three to six months in nature, so they're not like a regular futures market where turnover is the key driver.
The addressable size of the market is assumed to be in the single digit hundreds of billions—not insignificant. The market is not fully focused on ETD at the moment, so the onboarding cycle may take a while longer. ETRFs are trying to bring flexibility to a space that is used to standardisation and there are operational hurdles that some of the banks are looking to overcome. Take-up in the first year may be somewhat slow initially, but Eurex is hopeful and has already seen its first substantive trade in the hundreds of millions in notional value terms.
Growth in this space will be driven partly by client onboarding, and partly by the adoption of more ETRFs within the product offering and the gradual build-up of open interest over the next year. The index TRF market has reached around 70 billion notional value on EURO STOXX 50 alone. Eurex is aiming for a similar market size with ETRFs, but adoption may be slowed by the Covid-19 pandemic and its impact on operations.
Eurex hopes, in conjunction with market participants, to replicate what is a fairly flexible bespoke market and bring that to the exchange-traded space for the first time. Rather than an incremental step forward, the goal is to provide more flexibility for some of the trades that are now more expensive in the OTC markets. The basket functionality has been built in such a way that it could be replicated for other futures and options, eventually enabling firms to build bespoke portfolios of trades using the basket functionality. It’s a case of using a standard instrument as a building block but wrapping it in something more functional and flexible for specific investment criteria or targeted returns.
This article was first published on DerivSource on 10 December 2020.
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