Interview: How Total Return Futures Deliver Margin Efficiency & Trading opportunities for Buy and Sell Side

Futurization enables firms to take advantage of swaps without the heavy capital and margin requirements of an OTC trade. In a Q&A, DerivSource spoke with Nicolas von Kageneck, senior vice president, sales, Equity & Index, at Eurex, and Stuart Heath, director, Equity & Index R&D at Eurex, about the newly designed Total Return Future product.

Q: What’s the difference between a Total Return Swap (TRS) and Total Return Future (TRF)?

Von Kageneck: Similar to TRS, TRFs enable investors to gain exposure to the implied equity repo rate. The repo rate is the cost to go short a security and the remainder component of a forward price after spot, interest rate and dividends have been stripped out. Linear products like futures, forwards or TRS, as well as convex products like vanilla or exotic options are all exposed to it. In general terms, the repo rate is always positive when there is a demand for a security. This is particularly the case when market participants are expecting the market to drop and they are looking to short-sell the market. As opposed to that, the repo rate is negative when there is a demand for cash, meaning market participants are willing to pay for someone to carry the security.

TRFs are listed derivatives instruments, structured to replicate the net payout profile of an index total return swap (TRS). They are traded on exchange rather than Over-the-Counter (OTC).

There are some key differences between TRS and TRF:

• TRS and TRFs are both quoted and traded in spread terms to isolate the implied repo component in a transparent manner for the dealers and clients but they are not structured the same way. From a financing cost perspective, a TRS would typically use the 3-month Euribor (Euro Interbank Offered Rate) as a reference funding rate and would exchange net cash flows quarterly. Unlike a TRS, TRFs use EONIA® (Euro OverNight Index Average) as a reference benchmark for the funding rate and as such are reset daily. With TRFs, performance and costs effect through a daily cash-flow approach using “accruals handling”. It means that total returns are incorporated into the daily settlement price and the daily profit and loss is paid as a daily cash-flow via the regular variation margin process.

• TRFs offer greater market transparency and liquidity, as market makers provide binding quotes on a daily basis via the Eurex T7 system. This enables price discovery on the screen and liquidity is consolidated on the trading platform.

• TRFs are a fully fungible product aiming to replicate in a cost efficient way the payoff profile of OTC TRS. TRS trades are kept on a gross basis, i.e. trade-by-trade, due to the lack of fungibility. Every trade is a separate contract due to different traded TRS spread or calculation period. With TRFs, given the standard specifications of the contract, you have a fully fungible product regardless of the trade type and the counterparty you are trading with.

• TRFs enable high netting effects with other equity and equity index ETDs (exchange traded derivatives) within PRISMA, Eurex’s portfolio-based risk management system. Significant margin savings versus highly liquid Euro STOXX futures can be reached, which represent a major argument to trade TRFs.

Q: What are the main drivers behind the design of this new product?

Von Kageneck: Dealer banks have been expressing interest in futurization of TRS on the EURO STOXX 50® index for several years. As we all know, most of the market players and banks in particular were affected by numerous restrictive regulations since the financial crisis, the latest one being the bilateral margining rules for non-cleared OTC derivatives. Today, banks prefer a listed solution that will help them mitigate capital, collateral as well as balance sheet pressures due to these new regulations.

Furthermore, it is becoming harder for banks to design new strategies with well-established asset classes. So this new product provides the opportunity to pitch existing clients with new trading ideas. It may also enable them to attract new clients such as pension funds or asset managers that have not traded TRS in the past due to regulatory considerations, balance sheet limitations or credit line restrictions sometimes imposed by their prime brokers.

Q: How can market participants incorporate TRFs into their trading strategies?

Von Kageneck: Banks selling structured products with long dated maturities is a classical example. In the case of a market decline, they become short longer-dated forwards and may wish to hedge themselves by selling the medium to longer-term repos.   

Typically, insurance companies often buy downside portfolio protection against a potential market decline, i.e. long-dated out-of-the money puts. They may wish to hedge their repo risk by buying the long-term implied repos, through a TRF vehicle.

Sellers of TRFs can hedge market risk and gain stable returns without the need to sell the physical assets.

Finally, a very popular strategy these days is about trading calendar spreads to benefit from the term structure of repo rates. In a TRF spread, the delta position on the index cancels out, as well as the EONIA^® payments. The investor’s cash flow depends on the levels of the short-term repo, the long-term repo and the spot level. The repo exposure changes linearly with the spot. This is a typical strategy used by hedge funds or absolute return funds to trade on the calendar spread of two repos with different tenors.

Q: How do you expect TRF usage to progress in 2017? Do you expect these products and their use to evolve in a particular way?

Heath: Bank-to-bank business was the initial driver behind the TRF product. Delta one desks hedging forward exposure and repo exposure in index products, as well as trying to mitigate the usage of margin and balance sheet, are the key initial users. These players are always looking for hedging opportunities for forward trades, often on the back of structured product business, and some are already transitioning from using equity-indexed return swaps on the EURO STOXX 50® index to using these new TRF products.

These users will also want to increase distribution in terms of their customer base, to get a better price for widening that risk, and they will be keen to use the buy side to extend the number of counterparties they can deliver this product to. While TRF usage started out mostly bank-to-bank, the bank-to-buy side business will quickly follow through 2017 and into 2018, especially as the buy side is also impacted by initial margin and bilateral margining requirements.

Q: How can firms start using these products today?

Heath: This product is designed to hedge longer-term repo risk. Within the volumes already traded, people are not necessarily rolling out of swap positions, but are introducing new forward hedging in this product directly onto the exchange-traded product. One of the major advantages of a futures product over an OTC swap is it increases the number of available participants. The notional value of trading—over three billion—has grown quickly for a product that’s still in its first trimester of development.

The uptake on the sell side was expected, but it is surprising it has gone into the buy side as quickly as it has. This reflects both the need for this kind of product, as well as the close collaboration with sell-side firms to make sure the product was well designed for both the sell side and the buy side. The end product was more buy-side friendly than an exact replacement for the OTC instruments might have been.

Q: What other trends might impact TRF usage and the way this market evolves?

Heath: The buy side will likely be supportive of putting these trades on exchange, because they understand that an exchange-traded product is less balance-sheet intensive for the market-making bank. For example, a buy-side firm may want to do a straightforward index replication trade, but they will understand quickly that they will get a better price if they use a TRF for a longer dated trade, than if they went down the traditional equity index swap route.

TRFs, incorporating the funding charge and the implied repo charge, might be more intuitive for those currently trading in OTC equity index swaps, than for traditional futures players. A key task for Eurex is to educate both sides of the market to ensure they understand how this product works.

There is a potential for this product to become an asset class in its own right, much like index dividend futures—in the beginning, banks were happy to lose a little money in order to get an immediate hedge, whereas today, half the volume is trading on-screen with heavy involvement from positional asset managers. The equity implied repo is also an asset that can be traded in its own right, and Eurex sees the potential for trading opportunities within that as a secondary development.

Source: Derivsource