Total Return Futures referencing the EuroStoxx 50 have traded over €1bn notional since their launch last December, putting the instruments on track to become a viable alternative to over-the-counter equity swaps.
More than 30,000 TRF contracts have traded over the Eurex derivatives exchange, defying the notoriously low success rate for new futures launches even as mandatory margining of uncleared derivatives drives a shift to listed alternatives.
“The contracts have taken off surprisingly well, with a very busy January and a quieter February as volatility went down,” said Stuart Heath, director of product R&D at Eurex.
“We still have a limited number of participants ready to trade and most of the activity has come from dealers that are caught by uncleared swap margin rules, but we’ve been pleasantly surprised by the amount of customer activity.”
The contracts, which were developed in conjunction with BNP Paribas, replicate the payoff of OTC total return swaps that gained traction as a means of trading implied equity repo.
Equity repo - a measure of equity secured funding - has suffered extreme dislocations in recent years as a consequence of stringent capital rules and market positioning.
“For some customers that don’t have access to OTC markets, the TRF product has enabled them to trade equity repo for the first time,” said Heath.
OTC-FUTURES BALANCE
Designed to align with OTC clearing systems, Eurex’s TRF contracts are quoted in basis points over Libor and have proven to be a natural shift for OTC users. For some futures users, however, the OTC structure makes the contracts more complex to trade, requiring updates to trading systems before adoption becomes widespread.
“Clients are very receptive, but they need sometimes weeks or months to get the relevant instructions to trade new products,” said Antoine Porcheret, equity and derivative strategist at BNP Paribas. “Activity is picking up each week and we’re confident that volumes will pick up further in the second quarter.”
US-based exchange CME, opted for a more futures-like structure for its S&P 500 Total Return Index Futures contract that launched last August. The quarterly contracts have almost 13,000 of open interest and have traded over 20,000 contracts since launch.
While OTC traders are keen to avoid the 15% upfront margin associated with uncleared trades, which translates to 7bp–12bp of additional cost according to CME estimates, standardised futures can also benefit from margin offsets. Users can net TRFs against other listed instruments such as equity index futures and options.
US dealers have been subject to initial and variation margin requirements on uncleared swaps exposures since September last year, while similar rules got underway in Europe on February 4.
Pressure will mount on all OTC participants from March 1, when all uncleared trades become subject to daily variation margin. Many buyside firms are struggling to re-paper credit support annexes in time to continue trading OTC swaps after the deadline.
“The fact that buyside firms have to post IM is going to make life more difficult for many of them,” said Porcheret. “Many counterparties we speak to are switching to listed markets before those rules kick in.”
The second Markets in Financial Instruments Directive, which becomes effective in January 2018, provides further incentive to switch.
REPLACEMENT
With the regulatory tide pushing activity towards listed markets, Eurex’s Heath believes that TRFs could ultimately overtake the OTC market for EuroStoxx 50 equity swaps - estimated at €100bn notional - over the next two years.
“EuroStoxx 50 index total return swaps aren’t a huge OTC market and the TRF is already firmly on the radar of that community, but the real growth comes in promoting the product to additional participants,” said Heath.
“Asset managers have got a lot on their plates dealing with best execution among other MiFID II requirements, but TRFs should gain traction once liquidity gains traction and the margin benefits become clear.”
Three market-makers are currently providing continuous quotes in the instruments; BNP Paribas, JP Morgan and UniCredit, with at least one other looking to jump on board.
According to BNPP, TRFs can offer savings for large pension funds and insurers, which are typically short quarterly EuroStoxx 50 futures as they sell the contracts to tactically hedge cash equity portfolios.
“Institutions using EuroStoxx 50 futures as an overlay to hedge their long equity positions could save money by replacing short quarterly futures positions with one-year TRFs as you have to trade it less often so you save the rolling cost,” said Porcheret.
“By doing this replacement you are implicitly monetising the structural steepness of the term structure of TRF as three-month contracts are structurally cheaper than the one-year contracts and you can capture that rolldown.”