Listed alternatives to over-the-counter variance swaps could be set for a large liquidity injection after new margin rules raised the cost of bilateral exposures.
The changes have made futures-style alternatives offered by the CBOE more viable – just as the exchange is preparing a cross-margining service that would allow traders to offset margin requirements against some of the most liquid derivatives products in the world.
The cross-margining service, which would apply across a range of index futures and options cleared by the Options Clearing Corporation, requires SEC and CFTC approval and is slated for launch in the first half of 2017.
CBOE is hoping that the service would add to growing interest in its variance futures reflecting realised volatility on the S&P 500 since new rules required non-centrally cleared OTC derivatives to be collateralised.
“There has been a significant pick-up in interest in the products in the last few weeks, since the margin rules went into effect and we’ve had a lot of enquiries from banks, end-users, brokers and asset managers,” said Michael Mollet, head of business development at the CBOE Futures exchange.
The margin rules came into effect on September 1 in the US – but the CFTC has provided an additional month for swaps participants to set up custody accounts after an eleventh-hour rush for compliance caused trading in some OTC products to grind to a halt.
“People are doing trades in small size but at this stage it feels like clients are familiarising themselves with the contract structure so that they are ready to trade on October 3, when the CFTC relief is lifted,” said Mollet.
Still, uncleared margin rules alone may not be enough to drive an OTC-to-listed liquidity shift as margin requirements on OCC-cleared contracts may be higher than OTC exposures in some instances.
“Our cost structure for trading variance futures on a CLOB is significantly lower than trading a variance swap through OTC brokers, but from a margin perspective it depends on what you are doing,” said Mollet. “The amount of margin that needs to be posted should be a lot lower as a result of cross-margining.”
Through the planned service, clients would be able to offset margin associated with variance futures against S&P 500 options and ultra-liquid futures and options on the CBOE’s VIX volatility index.
Mixed fortunes
Variance swaps are a mainstay of the OTC equity derivatives market and have been heavily traded in the OTC market since 2000 when banks embraced the product to hedge volatility risk associated with their burgeoning structured products businesses.
“We’re watching the CBOE’s plans very closely as it could be interesting, but ultimately we don’t see any let up in demand for OTC products”
Investors jumped on board in 2003 to trade dispersion, but volume disappeared in the wake of the financial crisis after some desks lost hundreds of millions of dollars on the product. Activity has clawed its way back to an estimated US$10m vega notional each day – still around half of the product’s pre-crisis heyday.
Numerous attempts to move some of that activity on-exchange have so far failed. CBOE was forced to revisit its early variance contract that launched alongside VIX futures in 2004, aligning it more closely with the OTC version.
The current structure, launched in 2012, was developed by trading firm DRW. It has also been licensed to Eurex for variance futures on the EuroStoxx 50 index, but the European version has also failed to build open interest.
Traders believe that CBOE’s margin efforts could turn the product’s fortunes around, but many remain sceptical after numerous false dawns.
“We’re watching the CBOE’s plans very closely as it could be interesting, but ultimately we don’t see any let up in demand for OTC products. If anything, clients are looking at more bespoke exposures and that doesn’t lend itself to any move onto exchanges,” said an equity derivatives head at a European house.
Some traders suggest that variance futures could revolutionise the listed volatility market if they are able to attract ample liquidity. The contracts could provide a solution for listed long-term volatility products that avoid the high value erosion associated with current exchange traded volatility funds rolling short-dated VIX futures.
“Variance has a realised volatility element in it, which throws the concept of monetisation out of the window as any spikes are captured and reflected in the price. That’s what makes variance so powerful,” said Mollet.
