Exchange of the year: Eurex

For many years, large derivatives exchanges have tried – and failed – to get credit futures off the ground. This year, Eurex finally pulled it off. Its credit futures contract, launched three years ago, caught fire in the second half of 2024, boosted by increasing participation from buy-side investors, favourable tailwinds and thoughtful product design in alliance with market participants.

Robbert Booij, chief executive officer of Eurex Frankfurt, says the exchange’s new suite of credit index futures – providing leveraged exposure to broad fixed income benchmarks – has seen "real traction in the last four months, when volumes have substantially picked up due to activity from real-money clients".

It's been a long time coming. Eurex, CME and Ice all experienced a profound lack of interest when launching similar instruments more than 15 years ago.

But, with good timing and well-considered design, Eurex has delivered a product that has found true fans among dealers, non-bank liquidity-providers and, most importantly, the buy side – in the process, spurring other exchanges to revive the idea.

In June, volumes for the four most popular Eurex contracts broke through the $10 billion mark for the first time, with over 120,000 contracts traded. They broke new ground again in September, when more than 140,000 contracts traded. Eurex has meanwhile doubled the number of liquidity providers in its order book – there are now 12 of them – with major banks and electronic liquidity providers offering off-book liquidity. There are also more than 40 clients with positions in the products – double the number a year ago.

The head of derivatives at a large asset manager is an advocate of Eurex's initiative and predicts its credit index futures have the same potential as those on the Euro Stoxx 50. Helpfully, Eurex is at least 50% cheaper in fees compared to rival exchanges, he adds.

Among several applications, the major one is replacing the asset within a fund more cheaply than can be achieved by buying underlying bonds or an exchange-traded fund (ETF), which have more expensive manager fees and worse tracking error, says the derivatives head.

Added benefits are that futures get better capital treatment and are simpler to trade than over-the-counter products, such as credit default swaps (CDS) and total return swaps (TRS). When an asset manager buys the future, the market-maker buys the underlying, then lends it and passes on part of that carry to the investor.  

As the product gains momentum, it may well cut into the markets for both CDS and TRS.

It helps that Eurex picked a timely point to launch its credit futures three years ago, around the time when rates were going from zero to 5%. Having control of cash was becoming very important. Buy-siders saw renewed value in beating their index with cash-on-deposit at an enhanced money market yield. At the same time, markets benefited from an increase in bond transparency through trade reporting and composite pricing – as well as renewed appetite for credit as an asset class.

Eurex’s current product suite includes the EUR investment grade, EUR high yield, USD emerging markets and GBP investment grade segments, based on Bloomberg's fixed income index family. In September, Eurex added US dollar credit index futures.

Lee Bartholomew, global head of fixed income and currencies exchange-traded derivatives product design at Eurex, says its 2007 iTraxx index futures – the exchange's first attempt at a credit futures contract – had a more complex structure than its current market offering. But long-term tailwinds in the form of changes in regulation of margin rules and the electronification of corporate bond trading have helped the new vehicle's uptake.

A more recent factor, contributing to the peaks in June and September, is a meaningful increase in buy-side users. "End-users with real use cases who want solutions to risks that they have," offers Bartholomew.

He is proud of the "hugely significant launch," which he likens in scale to Eurex's successful rollout of equity total return futures (TRF): "I think the difference between what Eurex achieved in TRF and dividends, versus what we are seeing in credit index futures now, is that the regulatory tailwind of capital pressure on banks helped to flip that market to listed. We don't necessarily have that same lever now. The team has a unique opportunity to do something that others haven't in this space. Is it as big as Ice doing credit default swap clearing? I think it has the potential to [be] that, yes."

Pulling ahead

The competitive advantage for Eurex is partly as a result of a collaborative attitude. The head of futures execution at a large bank providing liquidity says Eurex took a progressive approach and realised that in order for new futures products to succeed, they needed to partner with banks when it came to design, marketing and launch: "The engagement that we're having from clients on this product as a replication or hedging vehicle is phenomenal."

Eurex knows who the major players are in any given asset class, he says, and is keen to do marketing trips to promote its products. “We often come up with ideas of things that we think would be helpful for clients to make products successful. And they are usually very quick to turn these things around.”

An executive at a second large bank says there has never been a more opportune time to launch futures products for systematic credit trading “as they’re potentially cheaper and have cross-margining benefits versus other futures portfolios”.

"Having one currency is not optimal for clients managing a global portfolio"

^{Lee Bartholomew, Eurex}

CME and Cboe also have corporate bond futures. A fixed income ETF trader at a liquidity provider compares the Eurex product favourably to these rivals.

Cboe has had products in the US dollar credit space for about five years “and is kind of hit and miss,” says the trader. “Maybe $50 million to $80 million across two contracts per day. Whereas Eurex IG would be €150 million ($161 million) on its own, plus another €30 million to €50 million in high yield.” Cboe also “fell into the trap” of trying to cut costs with its index, he says, picking one for which composition data is not as freely available as it is for Eurex's.

CME launched a dollar product in June, which the trader describes as a ‘me too’ product in response to Eurex stealing a march on them. CME’s product features a duration hedge, but while that is appealing to the sell-side, who care deeply about spread, most buy-siders don’t hedge out the rates component, contends the trader.

Bartholomew says that, historically, Bloomberg Barclays is the leading index in credit markets and was the “natural starting point when we looked at partnering with providers”.

Bartholomew speculates that CME launched its product on the basis that it feels it is the incumbent dollar exchange. But the segment is still nascent in the listed space, and “having one currency is not optimal for clients managing a global portfolio”.

Useful alternative

Credit index futures have a diverse range of uses, says Bartholomew. Some clients use them to hedge a corporate bond portfolio against credit spread widening, increase the exposure of the portfolio towards the corporate bond market, or to manage daily cash inflows from clients – or coupon payments from bonds – by investing in futures before substituting the exposure with new bonds.

Several relative value use cases also exist – trading futures versus fixed income ETFs to gain exposure to market funding rates, using futures versus CDS indexes to take a view on the cash-CDS basis, or trading futures versus TRSs to exploit the difference in funding rates between the two products. Other strategies may utilise futures as a cost-effective means for intraday tactical or macro volatility positioning.

CDS indexes have traditionally been the prime instrument used to take synthetic exposures to the credit market, but they only trade in OTC markets and are made up of a select number of equally-weighted single-name CDSs, limiting market access for many market participants and increasing tracking error.

Futures are also more capital-efficient than ETFs, which are cash products. Fixed income ETFs share many of the same qualities as futures and benefit from a very liquid market. But they rely on physical securities to be fully funded to gain long exposure, and securities borrowed to go short, thereby reducing capital efficiency.

They're also more transparent and cost-efficient than TRSs. Bilaterally cleared TRSs have a similar risk-return profile to centrally cleared credit futures, but – as OTC products –may be more expensive, lack price transparency and have lower levels of liquidity compared to ETFs.

Could credit index futures ultimately replace any of these alternatives? Bartholomew is circumspect: “I think the products are primed to continue to grow, but whether they replace a market or not, time will only tell.”

Others are more bullish.

The head of derivatives at a large asset manager says credit futures are perfectly suited to replace alternatives to buying insurance on credit that would normally be done more expensively, and with more paperwork, through CDSs that are handled by expensive brokers and don’t track perfectly. The CDX is only 125 names for European IG and they’re all equally weighted – unlike the futures index which is market cap-weighted, he adds.

With the arrival of Eurex’s futures, “there is absolutely no reason why that TRS market should exist anymore,” says the ETF trader. “I think that’s the first one to be subsumed. That’s really the project for the next year-to-two-years, gobbling up the entirety of the TRS market.”

A second asset manager agrees credit futures could be significantly cheaper than alternatives. Unless a portfolio manager has a very particular use case – such as in lower credit rating products – in investment grade bonds, it is definitely more efficient to buy indexes. Futures are more efficient than TRS and less “noisy” compared to CDX, he says.

"I am really proud of our innovative design team and grateful for the fantastic support of our clients across the globe"

^{Robbert Booij, Eurex}

The ETF trader expects the Eurex product is “about to go mainstream” but that certain things have to happen first.  “What does it take to genuinely go stratospheric? I don’t think it takes a whole lot, but they need a bit of luck in terms of technology partners and buy-side order and execution management systems (O/EMSs), getting coded up to it.”

Bartholomew agrees a main growth driver of credit index futures will depend on their integration within buy-side vendor systems, portfolio and risk management systems and O/EMSs: “Most of these do already support them, but not all, and not always optimally.”

Bartholomew says more pension funds and insurance funds are also looking at using the products, and systematic commodity trading advisers and hedge funds are also a “natural transition” to developing a “truly deep ecosystem of end-users”.

But Eurex has a tried and tested process to smooth the rollout to all market participants. As well as time spent listening to what clients want and working with them to find solutions, crucially, it works in “strong collaboration” both with banks and non-bank liquidity providers, says Bartholomew. “We have been successful in differentiating ourselves by demonstrating that we can work together across the competing liquidity provider landscape, to bring them together so they don’t see each other as sell-side versus non-bank. I think that is the key difference between us and the ‘me too’ exchanges.”

For continued success, appetite for credit as an asset class must also persist. With newly elected US president Donald Trump “being arguably more inflationary” than his defeated opponent, Bartholomew thinks this will benefit the asset class, as does increased geopolitical uncertainty, increasing the likelihood of a credit event and hence the need for a product to hedge that risk.

“I am really proud of our innovative design team and grateful for the fantastic support of our clients across the globe,” Booij concludes: “I am convinced that this new Eurex product with its global approach will see long-term success.”
 

First published by Risk.net on 26 November 2024.