Derivatives markets thrive on volatility. If ever that market maxim needed justifying, October provided all the evidence anyone could need. Partly fuelled by the panic that took place in the US Treasuries market on 15 October, a number of derivatives exchanges posted record volumes.
As the yield on the 10-year US Treasury bond suffered its biggest decline since 2009, activity in US Treasury futures traded on the CME Group doubled from the previous day’s volumes. Overall, almost 40 million contracts were traded on the world’s largest derivatives exchange that day, with interest rate futures and options volumes reaching new highs.
The Chicago Board Options Exchange – home of the VIX volatility index – reported all-time record trading volumes in October. The exchange saw an average trading volume of more than seven million contracts a day, up 29% from October 2013 and 37% higher than September 2014, with VIX options and futures scaling new peaks. October was extraordinary, but not necessarily a blip. November’s average daily volume in VIX futures was 11% higher, year-on-year, propelling year-to-date volumes 24% ahead of the same period in 2013. Frankfurt-headquartered Eurex Group saw total volumes soar in October too, to an average daily volume of 9.9 million contracts, compared with 7.9 million in October 2013. Equity index derivatives volumes grew to 86.4 million contracts compared with just 52.9 million 12 months ago, while volatility derivatives set a new monthly record, doubling volumes year-on-year, reaching a total of just under 1.5 million contracts.
Diverse demand drivers
Overall, however, 2014 has not been the most volatile of years, certainly not compared to the preceding half dozen. What other factors are pushing exchange-traded derivative (ETD) volumes through the roof? Certainly, post-crisis regulatory reform is migrating OTC derivatives onto exchange-like platforms and established trading venues are undergoing an intense period of innovation and competition with the aim of capturing opportunities offered up by the new rules. But it’s too early for new instruments like swap futures to be spurring volume figures. After all, Europe hasn’t even started clearing OTC swaps, let alone trading them electronically.
The derivatives markets cater for so many different needs and encompass so many different types of market participants that it is hard to pinpoint precisely new drivers of demand. But one contributor to the overall picture could be the breadth of uses to which derivatives are being put in the investment strategies of long-only institutional investors. Andy Nybo, head of derivatives research at TABB Group, has witnessed a shift in investor sentiment over the last three to five years. “Use of derivatives is now more strategic. Portfolio managers are driving new ways of expressing views through derivatives. Once restricted to hedging, we now see application of derivatives by investment managers to express directional views both long and short,” he says.
Compared with hedge funds, perceived as being nimbler and more innovative in their use of financial instruments in pursuit of returns, traditional asset managers have typically taken a more cautious approach, often constrained by the terms of their client mandates. For some time however, hedge funds have also taken on ‘conservative’ institutional clients and long-only asset managers have run hedge funds and other alternative investment strategies. Although traces of caution still remain in the approach of long-only firms to ETDs, they are increasingly comfortable using futures and options, not just for defensive hedging purposes, but also to contribute to alpha generation, in an ever broadening range of tactics.
Candriam Investors Group, a pan-European multi-specialist asset manager owned by New York Life Insurance with Ä78 billion assets under management, use derivatives for both alternative and traditional funds. Brussels-based global head of trading Fabien Oreve says risk management and alpha generation are the key objectives for derivatives usage, both for fixed-income portfolios and asset allocation funds, which invest across a wider array of instruments. “Derivatives can also be used in the context of tactical asset allocation to take advantage of market opportunities,” he says. October’s volatility spike resulted in a big increase in equity derivatives volumes, with Candriam trading 50% more listed equity futures than the same period the previous year. But although the firm’s asset allocation funds have integrated a tactical use of derivatives into their process to exploit short-term inefficiencies, Oreve emphasises a strict controls environment. “Any fund cannot trade any type of derivatives and any derivative order cannot exceed a certain percentage of the fund value,” he says.
To what extent is greater derivatives use driven by liquidity challenges in the underlying cash equity and debt markets, increasing an existing tendency toward buy-and-hold strategies, finessed through careful use of derivatives? For some years, active managers have complained about their ability to move large blocks of stock in equity markets characterised by low post-crisis trading volumes, with liquidity spread across multiple lit and dark trading venues. Liquidity concerns are even more pronounced in the debt markets. Restrictions on sell-side prop trading under the Volcker Rule and the higher capital costs for market making imposed by Basel III have withdrawn liquidity in the bond and other fixed income markets. Indeed, the dramatic peaks and troughs in the US Treasuries market on 15 October appear to have been caused in part by a lack of market depth. According to Federal Reserve data, the 22 primary dealers authorised to trade directly with the US central bank had slashed their holdings to US$ 46 billion at the end of October, a huge cut from their US$146 billion record levels of 12 months ago.
Bond market funds, which habitually face the problem of liquidity fragmentation across multiple issues and instrument types, are seeing the most innovation. Eaton Vance’s head of global trading, Mike O’Brien, says low levels of liquidity and higher volatility in the cash markets in the last two to three years have been a factor in the increased buy-side appetite.
“Particularly for large firms, cash liquidity has been insufficient. Asset managers regularly use interest rate swaps to hedge interest rate risks or credit default swaps to manage duration risk. But they might also use derivatives on a temporary, tactical basis in order to quickly ‘put to work’ a sudden cash flow, while building up a cash position slowly and carefully to avoid market impact. This isn’t new, but it is perhaps more common as the size of asset management firms grows in parallel with declining balance sheet capacity on the sell-side,” he explains.
O’Brien also suggests that buy-side trading desks are resorting to the derivatives markets to respond quickly to new investment ideas from a portfolio manager. “If the liquidity simply isn’t there or volatility increases the risks before we can put the full position on, we might decide to use a derivative, rather than enter the underlying market, even if it’s not the perfect exposure.”
Differences between jurisdictions on the timing and detail of new central clearing rules for swaps could also drive listed derivatives volumes. As Figure 1 demonstrates, trading has grown steadily in swap futures contracts launched by US derivatives trading venues CME Group and Eris Exchange in response to migration of swaps onto swap execution facilities. “The futures markets are benefiting from increased derivatives activity by asset managers, in part due to their robust and well-established infrastructure but also due to innovations such as swap futures. Liquidity in swap futures has grown substantially in a relatively short period of time,” says O’Brien.
Swap futures volumes may be nowhere near those of swaps yet, but Nybo points out that derivatives liquidity by nature is much slower to move than that of the underlying securities. He also asserts that the post-crisis regulatory emphasis on transparency could also be playing a key role in encouraging the buy-side onto exchanges.
According to a new study from TABB Group, equity index derivatives may be the next beneficiary of the buy-side’s greater exploitation of derivatives. Based on interviews with 26 institutions managing assets worth US$6 trillion, the report found that 90% of asset managers expect their equity derivatives volumes to increase. Long-only firms cited the value of equity index derivatives when managing the impact of volatility on portfolios, while portfolio managers also appreciate their utility in handling cash flows, securing exposures in new markets and for tactical purposes during rebalancing exercises. TABB Group notes that equity derivatives are a low-cost way to get in and out of markets quickly, especially those that are remote or lacking liquidity, adding that growing automation will further ease use by buy-side firms.
Demetrio Rojas, an equity derivatives trader with Citi in London, confirms that volumes in exchange-traded equities derivatives have picked up steadily since 2008 at the expense of OTC alternatives, and says they can play an important part in the ability of buy-side firms to handle volatility. “If a PM wants to re-evaluate a portfolio in light of major market moves – such as those we saw in October – they might initially want to hedge against the downside by reducing his stock positions. But if a lack of liquidity made the cost of selling an individual stock too high, they might instead decide to hedge his portfolio by using equity index derivatives (such as futures or options) which are much more liquid,” he says.
But will we see the extensive use of exchange-traded derivatives in equity funds, replicating the innovations by liquidity-starved bond funds? Rojas is less convinced. “I don’t think liquidity issues in the underlying equity market are having a major impact on exchange-traded equity derivatives volumes. There are simply a lot of highly liquid opportunities in both the cash and the derivative equity markets,” he says.