UMR driving up volumes in total return futures as a beta replacement solution

In this feature, Stuart Heath, director, equity product design at Eurex, discusses the development of total return futures (TRFs) as a beta replacement in the context of the final roll-out of uncleared margin rules (UMR), and explores with Amy Borgquist, executive director, delta one equity structuring at Goldman Sachs, the benefits of TRFs as part of buy-side trading strategies

About Eurex

Eurex Index Total Return Future (TRF) is an exchange-listed solution for implicit equity repo trading on the Euro Stoxx 50^® index and FTSE 100 index.

The index futures complement the TRF product suite on Eurex. With this listed solution for implied equity repo trading, the equity index derivatives portfolio continues to grow. This illustrates our leading expertise in this segment.

Visit Eurex’s website for further details

Part of the UMR toolbox

TRFs have attracted more interest from buy-side firms as they begin to be impacted by stages 5 and 6 of UMR. Some investors are already using them as part of their toolbox in adapting to the new regime. Others are still aiming to trade a reduced level of derivatives to stay below the initial margin threshold or trying to find efficiencies through collateral management.

Most buy-side firms using TRFs do so independently of any concerns around UMR and margin. Hedge funds are using the product to trade the implied repo term structure as TRFs allow them to hedge or take exposure to implied repo rates.

However, TRFs were developed as an alternative to total return swaps (TRS), mainly in the context of UMR. The TRS market has been replaced almost entirely by alternate futures. The key issue with TRS is the initial margin under UMR, which can be quite punitive at 15% of the notional or higher versus around 2% with futures. But many institutional investors that are now in scope are unaware of the benefits of TRFs compared with TRS, other over-the-counter (OTC) swaps and alternate futures and how they can be used as a beta replacement. Now, as these firms all come into the scope of UMR in its final phase, they are likely to look more closely at TRFs as part of their UMR toolkit.

The vision for TRFs

Stuart Heath, Eurex

Banks knew that, under UMR, TRS would become an expensive product to trade in terms of margin requirements. So, before implementation, they asked Eurex to develop an alternative as close as possible to TRS, which would have a less punitive margin requirement. So, Eurex developed TRFs, which have been very successful and widely adopted by banks in large volumes.

However, the ultimate vision when TRFs were developed was that they would be used by the buy side as an alternative to reduce margin obligations under UMR. The idea was to make a product that would be easy for the buy side to use. Since investors are used to trading in spread terms, the product is traded in basis points in so-called ‘TRS spread’, rather than index points. It is traded in the same way as an OTC swap, which makes it more transparent.

Initially, Eurex considered designing TRFs to trade similarly to an OTC product, which would migrate into the clearing environment as an OTC-cleared contract. But, in the end, it was decided that a TRF would comprise a fully listed future.

Fungibility and usability

The fungibility of the product was one of the main drivers for switching from a cleared swap to a futures approach. Even though a cleared swap approach grants margin benefits, banks and investors must have gross positions with these, which incurs some costs. In a completely listed offering, they benefit from fungibility between positions. It’s quite easy to reduce a position by just selling TRFs. Investors can net the positions and reduce the operational burden, not only in the margin of sales but also in position keeping.

Market-makers provide daily binding prices for TRFs, which are extremely important to the market. Investors can follow this market on screen and have a valuation of positions, which is not that obvious in OTC swaps. And not all buy-side firms have the remit to trade OTC products, as the documentation and credit support annex agreements can be quite cumbersome. Thus, a listed version is easier for some investors to trade.

Cross-margining efficiencies

The margin on TRFs is in the same collateral pool as all other equity index derivatives products at Eurex. There are cross-margining efficiencies that will make the margin of the entire position less than the sum of the margins for each position. This rarely happens for institutional accounts that are typically required to post an initial margin on a trade-by-trade basis. “There is a huge suite of products at Eurex – such as SX5E, Dax (both futures and options), the existing TRF suite and the dividend future range – against which clients can net their margin,” says Borgquist. Having their margin calculated to an aggregate risk-based number offers increased capital efficiencies for investors and banks and, therefore, better pricing.

Reduced counterparty credit risk

Amy Borgquist, Goldman Sachs

The take-up in products such as SX5E TRFs is quite impressive, with current outstanding notional around €90 billion. “Exchanges like Eurex have been wisely responsive to the recent trend of banks and investors switching from OTC to listed products,” says Borgquist. In the past five years, many have switched to benefit from the capital efficiencies afforded by TRFs in removing counterparty credit risk. The requirement that variation margin is posted daily in OTC trades has added a regulatory imperative to clients’ increasing concern. So the lack of counterparty credit risk is another reason why TRFs are so attractive.

Minimal dividend risk profile

TRFs have an advantage over price return futures (PRFs) regarding their dividend risk profile. TRFs can be traded either without or with minimal dividend risk because the dividend is integrated into the daily pricing of the index, which is not the case for regular futures. The volatility of dividends seen in March 2020 brought unprecedented disruption to dividend markets. This has increased the risk charge in the pricing of PRFs and made dividend economics top of mind for investors. “There are several different factors investors consider, including order book liquidity,” says Borgquist, “but TRFs are a great way for investors to get exposure to the index with a reduced dividend risk profile and associated cost.”

Floating interest rate

The current short-dated interest rate volatility casts another spotlight on the advantages of TRFs over PRFs. TRFs have a floating benchmark, whereas PRFs have a fixed, all-in interest rate component. Until now, investors have taken a view implicitly by trading fixed or floating. The increased rate volatility may mean that investors adopt more deliberate interest rate strategies, as they affect the bottom line more. “It will take time, but TRFs have the ability to replace price return products as the go-to product once order book liquidity migrates from one to the other,” she says.

Implementation challenges

“There is still a lot of education to be done around TRFs. It’s entirely novel for futures products to have two legs – a much more swap-like rates component and an equity component,” says Borgquist. It is not easy for firms that just trade futures to understand TRFs since they were designed to be as close as possible to swaps. Even for firms that trade swaps, it is tricky to understand them. The back office needs to understand futures contracts and the fact that the product is meant to have more long-term exposure and is a replacement for a swap.

And it is not a trivial decision. To adopt TRFs, investors will need to adapt their systems and reporting and risk management tools at every stage – trading downstream, reconciling, settling, monitoring – to this new concept and new way of valuing. With such big changes, they must perform full due diligence to ensure all of this has been ratified and is interacting correctly with all of the various parts of their risk management system.

All of this will need to be rationalised because investors have been doing swaps for years, but they will need to go through an approval process to use TRFs. “This takes time – most of our clients are at some stage of that journey,” continues Borgquist. “But with some guidance, investors are likely to see that having TRFs as part of their toolbox will serve them throughout time and very often.”

Summary

There are more use cases for TRFs, and Eurex is consolidating this segment in the exchange-traded derivatives space. Investors stand to benefit from the transparency, fungibility, collateral netting and reduced counterparty risk of this product, which has managed to retain the look and feel of an OTC swap. Disruption of the dividends market and the more recent short-dated interest rate volatility will also contribute to the increasing demand for TRFs. However, UMR is the main motivation for investors to consider listed alternatives to OTC products. Investors that have been trading TRS until now will look to TRFs as a more capital- and cost-efficient alternative. Given the novelty of the product, implementation is a real logistical challenge. But, in time, investors will likely find that TRFs have a more efficient implementation relative to PRFs, total returns swaps or exchange-traded funds.

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