Globally, there has been a recovery in equity derivatives trading since the financial crisis set the market back post-2008. According to figures from the Bank of International Settlements (BIS), total global turnover in exchange-traded equity index options reached $148trn last year, a significant uptick from the $96trn of turnover in 2009 and, indeed, vastly higher than the $110trn in 2013. Increased volatility this year caused, principally, by the weakening Greek and Chinese economies, is giving further impetus for investors to look at this key derivatives market, with global turnover already at $86trn in the first half of this year.
But the overall surge in volumes does not tell the whole picture. While US markets have experienced rapid growth, equity derivatives trading activity in Europe remains at low levels. According to the BIS, US exchange-traded turnover stood at $80trn in 2014 compared to just $17trn in Europe. Poor liquidity, lower risk appetite from banks, market fragmentation and increased regulation are all factors that have stunted the growth of Europe’s equity derivatives business.
Market fragmentation
“It is clear the market is much more developed in the US,” says Lauri Rosendahl, head of European cash equities and equity derivatives, global trading and market services at Nasdaq. “Post-crisis, the US is ahead of Europe in the clearing mandate as well as in electronic trading, both of which have supported equity derivative volumes.”
Historically, one of the key problems holding back Europe’s equity derivatives growth has been the fragmentation across its markets. Europe’s main derivatives exchanges— including, Eurex, Euronext, ICE Futures Europe, Borsa Italiana, Nasdaq, Mercado Español de Futuros Finacieros— operate under different rules across the continent, making it harder for investors to cross-trade instruments. While the US itself has multiple venues to trade equity derivatives— twelve at last count— users can trade the same instrument across exchanges with no currency mismatch.
“In Europe options may be listed on multiple exchanges but they are not fungible and there are different currencies to manage across venues,” says Jose Ribas, global head of derivatives at Bloomberg. “The different currencies add to the cost of options trading because you need to have the currency to settle the option transactions. This becomes a hurdle for some investors who might not have the capital, mandate or interest in trading and managing multiple currencies.”
Volatility surge
The lack of harmonisation does not appear likely to change any time soon. It may also be a reason for the stunted growth in the tenor and depth of equity derivatives in Europe. A case in point is the weekly options market which, in the US, has grown to become one of the most popular ways of trading equity derivatives since they were launched a decade ago. Weekly option volumes accounted for 27% of total US equity option volumes in the first quarter this year— compared to 23% in the same period, 2014— according to figures from TABB Group. In contrast, weekly option volumes have not taken off in Europe, constituting less than three percent of the overall market volumes.
The upsurge in volatility this year is, however, leading participants to increasingly look to trade equity derivatives, which has benefited some exchanges. Eurex, currently the biggest European exchange for equity derivatives, saw a 17% rise in volumes in the first half of the year compared to the same period 2014. Average daily volumes for equity index options rose to 1.2m in the first half of the year, from 0.87m in the same period last year. At the same time options linked to the exchange’s volatility-index, the VSTOXX, have seen a 150% jump in trading with an average 28,000 contracts traded per day in 2015. However, while this sounds promising, in relative terms the European market remains small compared to the US. For example, the Chicago Board Options Exchange’s (CBOE) S&P500 index options reached a new high in August, with 2.98m contracts traded on the 22nd. Meanwhile, Vix options which trade on average 679,000 contracts per day.
“European investors who want to trade volatility are more used to doing it through the Vix—it is the go-to fear product for investors over here,” explains Philippe Argou, derivatives manager at AXA Investments. “Using options on the Euro Stoxx 50 is trickier because liquidity and demand has decreased.”
Despite the lag in volumes, some of Europe’s smaller derivatives exchanges have been making concerted efforts to increase their offerings of equity derivatives in recent times. Euronext, which has seen volumes fall this year, has been making efforts to grow its business, launching its first single stock futures on Swiss and UK stocks this year. The exchange has also looked to boost liquidity by introducing “spotlight options”, short-term options on Euronext-listed small and midcap sized companies, listed at the request of market participants and supported by dedicated market makers to provide liquidity on the chosen names. So far, volumes remain small, with just 35,000 trades carried out on 16 underlyings, since the contracts were listed in July last year—but the idea is a positive one.
Who’s on the rise?
A more recent entrant into the market is Nasdaq, which has boosted its market share in the Nordic and Dutch markets through a 25% stake in the Dutch equity derivatives trading venue The Order Machine (TOM), established in 2012. Nasdaq Nordic volumes grew by 20% in the last year. The exchange’s Rosendahl says that the increased volatility compared to 2014 has proven a catalyst for its volume growth and could help boost its business in the future.
“Volatility is the single biggest difference between 2014 and 2015,” he says.
At the same time, however, he says that Europe continues to face the major challenge of lack of liquidity from dealers and other traditional liquidity providers as risk mandates have been pared back by regulations that came in the wake of the financial crisis.
“Risk mandates have been cut back since the financial crisis and, with the advent of new regulations like Emir and Basel III, meaning it is harder to find liquidity and prices in the market,” says Rosendahl.
In contrast, the US has been able to forge ahead faster in completing its central clearing and bank transparency requirements, which has improved the ability to facilitate customers in large block positions.
There is, however, some hope for Europe in the coming years. According to Bloomberg’s Ribas, new rules around trading transparency and a bigger drive towards electronic trading in Europe will go some way to boosting confidence and encouraging more participation into the exchange-traded market for equity derivatives.
“The biggest change to the market could come from trade reporting,” says Ribas. “The US markets are required to print trades within 90 seconds while the European markets allow much more time to pass before transactions hit the tape which can slow interest. Also, providing incentives to encourage the market-makers to quote – using pro-rata and price-time models – would help bring more players to the table to trade equity derivatives.”
Additional transparency requirements for over-the-counter (OTC) trades from a central clearing organisation like the Depository Trust & Clearing Corporation (DTCC) in the US would also increase investor comfort with equity derivatives markets and boost volumes. AXA’s Argou believes that an easing of government monetary stimulation which has dampened long-term volatility should also see greater clamour for equity derivatives in the future.
“I think we really need to change the paradigm like, for example, a change to the ECB policy,” he says. “That will see the market take off.”
At a time of increased uncertainty in the markets, providing a better basis for equity derivatives trading in Europe is likely to be welcomed by all.