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Hedge Funds Review: Renaud, how does this scenario translate into demand for Eurex products that you have, and what are you doing in terms of the evolution of your product base? How are you responding to this demand?

Renaud Huck: That’s a crucial question to ask and to give clear answers about it. I think it is fair to say that part of the role for exchanges and the European exchanges like us is to offer our client base tradable instruments. But, as you just talked about, instruments and the marketplace, are changing constantly. The needs are different. Before, the needs were to list plain vanilla bond futures, plain vanilla equity index futures. Now those products have been launched, there is a need for more sophisticated instruments, but still structured in a simple way.

As Bruno said, you can be sophisticated using simple instruments - and that’s what we want to offer. We want to offer sophisticated, niche products, but in a simple and pragmatic way that allows the trading community to have access to these asset classes and the opportunity to have the exposure that their investment strategy requires. So, concretely, what have we done? We have spoken to the industry. It has to be a very collaborative approach, purely because, now with the incoming regulation, it is obvious to say and it is quite an easy observation to make that, going forward, if you are a small- to medium-sized buy-side entity - and I would say it would be the same for a sell-side entity - it will be very difficult going forward to trade OTC instruments.

Economically speaking, it is going to be more of a challenge for smaller players to keep accessing the OTC space. Why? Because, if the most liquid OTC products, such as interest rate swaps, have to be cleared at the end of the day, as it is the wish of the regulators. I’m not sure that all the clearing members will be in a position to offer clearing of OTC products to their clients. It has to be economically viable for the clearing member and for the dealers, but equally for the buy-side clients. So, at some stage, when Emir is implemented, the different parties will have to assess what makes most sense for the business to continue transacting, whether to stay in the OTC space, but at the same time to trade listed products, or to shift their OTC trading habit into a listed trading environment.

So in order to prepare for that transition, we have engaged with the buy side and the sell side on some of the products that we knew were going to follow that trend. Quite simply, interest rate swap futures, which we launched in early September, are those kind of products because now you have the possibility of trading a two-year, five-year, 10-year, 30-year plain vanilla swap on exchange. Before it was a purely OTC bilateral transaction. Now this is changing.    

To name another instrument, we’re about to launch repo futures in mid-November. Why? Because we know that the trading community going forward might face some difficulty in refinancing or finding liquidity in order to finance their positions. So we have to be innovative enough to read the market and to see how the market is going to change with the new incoming regulations and to explore new avenues that other exchanges haven’t.

In July, we launched FX futures, foreign exchange being the most actively traded asset class in the world. FX futures already exist in the U.S., but now it has been launched by a European exchange, so you now have the possibility of having FX futures under a compliant European regulatory regime. That’s also something that will grow. Going forward, we can see that other asset classes, such as inflation, will potentially have to follow that road.  In the equity space in late September we also launched variance futures. We already have dividend futures.

So these products, which before were very OTC-driven, now have equivalents in the listed space. Once again, it is to offer choice to the trading community and progressively, as those products find momentum and find liquidity, it makes more sense for the trading community to use them and to have the possibility of coupling them with OTC products and, as Bruno was saying, the possibility to create structured instruments, having a product that has an OTC look but potentially with a listed flavour, so combining the best of both worlds in order to provide transparency, compliance and NAV to such a product.

Hedge Funds Review: Some of the largest ‘mainstream’, for want of a better description, asset managers – firms such as Blackrock – are talking about volatility as an asset class. Volatility is a cheap asset class, particularly in the situation we’re anticipating arising in rates and where volatility is beginning to return to foreign exchange markets. Is that something that’s part of your thinking, your planning, in terms of your product range?

Renaud Huck: Yes, we offer volatility futures and options based on VStoxx already. There are similar products on the other side of the Atlantic to measure volatility on equity. For a few weeks now, we have also been offering variance futures. It’s true that this is a constant dialogue with the buy side and with the sell side - in order to calibrate the best possible products and in order to offer choice and alternatives.

It takes some time in terms of research, formatting, calibrating the products and then marketing and promotion, but I think that what we have seen recently is that it has a purpose, and once you really put a finger on the needs of the industry, you really give a good service to the trading community. We did it recently with the launch of the French bond futures OAT. There was a void, we filled that void and now the bond futures on the French debt is very liquid, so it fulfils a role, which is, for any French bond-holder, the possibility of hedging the yield curve.

Hedge Funds Review: Bruno, what sort of developments would you like to encourage in terms of the development of new products, the services provided by exchanges such as Eurex?

Bruno Pannetier: I think that exchanges such as Eurex are a key instrument in terms of refining the market price discovery of a number of asset classes. For example, this is true for volatility and this is true for dividends. I remember trading dividends for hedging purposes at the end of the 1990s, and there was no market view of the dividend. So even if you had the largest institutions, the largest bank, it had a completely different view on what the dividend of the Euro STOXX, for example, over a five-year period would be worth.

This is the same thing with correlation as with volatility at the beginning of the 1990s, and the fact that you have a number of people coming together – of market participants on the buy side and the sell side coming together on exchange, it is a way to reveal the actual market price of a particular instrument or asset class. In fact, the so-called hidden asset classes with an exchange, do not become hidden any more. The purpose of the exchange is also to reveal the asset price and to transform a hidden asset class into an asset class that can actually be traded by a variety of market participants.

Also, the more asset class material that we will use to combine dynamically and create strategy - these are the basic bricks that we rely on to combine to serve our investors. The more asset class instruments that are available in the liquid market, the better it is for us. Clearly, for today’s market and dividends, you can’t really have a dynamic strategy only based on dividends. It would be unthinkable.

Hedge Funds Review: Can you describe that strategy? Can you sum up the strategy on dividends?

Bruno Pannetier: We do not currently offer a particular strategy on dividends. I was just mentioning that, but, off the top of my head, for example, if dividends vary according to the market. So you could have a strategy based on how you trade dividends and dividend futures in a dynamic way to hedge your equity portfolio, because – according to whether the market goes up or down – then you will have an effect directly on the price, but you will have also an effect on the dividend.

So dividends are not fixed according to the price of stocks. The short-term dividends are fixed, especially if they have already been announced, but then, a dividend one-year, two-years etc., may move according to price movement. Given the importance for some investors of dividends in terms of carrier, revenues that they can get from their stock portfolio, they may want to hedge this and they use a dynamic approach using dividend futures to do this.

Hedge Funds Review: To keep things in perspective, a lot of the work you’re doing for your clients is obviously in the efficiency of the wrapper?

Bruno Pannetier: Yes, in fact, the primary product that we offer is a strategy, and volatility is quite cheap right now, and it may be interesting to take a view on an increase in volatility. What is interesting right now and one of the major themes is to have in your portfolio as a diversification product an investment strategy that will move in a particular way according to the strategy. Our mission as an asset manager, this is also the mission of structured product providers on the working side of the business, is to offer convexity to clients, to identify and enable clients to get an asymmetric position.

Otherwise, if you don’t have an asymmetric position, whether it’s asymmetry in terms of probability or in terms of outcome, it’s like gambling basically – you’re better off going to the casino. So, the name of the game from the investor’s standpoint is to take an asymmetric position in respect to a particular asset class. So, right now, what investors would ideally like is a strategy that will still benefit – so, provide a decent performance if the volatility stays stable at this very low level, historically low levels that we are in right now – but a strategy that would provide outsized performance if the volatility actually goes up, if there is a shock at some point in time, especially in the context of a possible increase in interest rates on the other side of the ocean.

This is exactly what the maximum strategy that we offer does; it provides clients with an asymmetric exposure to volatility, but without actual use of an option. You could do this by buying or selling an option in volatility, but this implies that you may have a cost in terms of the premium of the option, so what we have to try to do is provide the same kind of convexity, but at no cost or even at a gain for the client. This is what we do with our maximum strategy. We basically arbitrage the deviation of the futures price, and especially equity index futures such as EuroStoxx futures and S&P futures after hours.

Hedge Funds Review: Renaud, you’re speaking to asset managers in Europe all the time. That’s your job. Do you see growing demand for exactly that kind of sophisticated investment approach? Because we’ve talked about the decline of complex structured products, but we’re not talking about the end of complexity, we’re talking about a more sophisticated investment approach.

Renaud Huck: Definitely.  We see end-clients and European asset managers and European hedge funds interested in these very products, which are products that will help them to mitigate their risk, so whether curve risk or equity index risks. That’s what we deliver and, as Bruno was saying, that’s the very reason why we launched volatility futures, which are growing very well, and the reason why we decided to launch variance futures.

To answer your question thoroughly, we see the trading community of the buy side interested in having instruments that they can use in order to help them manage their portfolios, to catch and capture trading opportunity and market opportunity, but equally to fulfil the role of a futures instrument, which is also to hedge your position against either increasing interest rates or falling interest rates, but also a similar thing on an index side. So I think that what we see is the need from buy-side entities for exchanges to explore new trading avenues and new products, so that’s why we launched swap futures.

It’s true that, if you look at the big picture, the OTC swap market being the largest in the world in the fixed-income space, one could wonder, “why is there a need to launch listed derivatives?” But the reality is that there is a need. There is a need to have choice from the buy- and sell-side communities, and there is a need to have different tenors, different maturities in those products in order to be able to express a view on the different part of the yield curve. So I think that, going forward, exchanges will explore new asset classes, new products, they will explore products that are maybe more niche, but equally where there is a need for transparency, risk mitigation and, at the end of the day, to provide a good mark-to-market.

Bruno Pannetier: To highlight one of the aspects that Renaud has mentioned regarding the need for listed futures products, even in the space such as interest rate swaps, which is well covered by OTC derivatives, the fact is that the administrative burden of monitoring the position is mitigated with the use of a listed market. If you take a simple interest rate swap, this may be quite complex to monitor, both by the sell side and by the buy side, because you have the counterparty risk and obviously the counterparty risk is mitigated with the CSA, which is basically a bilateral margin system between the buyer of the swap and the provider of the swap, but still the correlation mechanism may be complex for some entities to monitor, but also complex in terms of valuation, for example.

During the crisis, we have seen that there was a misunderstanding of the cost of the collateral. For example, whether the collateral was paid in euros or in dollars, it mattered. In normal conditions, it doesn’t matter at all, but when the basic spread between euro and dollar, and the liquidity conditions are different between euro and dollar for example, then these kind of things matter. So, basically you have not only the administrative burden, but an economic impact on optimising the collateral process in an OTC transaction. Obviously, in a listed transaction, then the mechanism of the exchange does this for you.

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