What are total return futures (TRFs)?
Total return futures (TRFs) are centrally cleared and exchange-listed alternatives to total return swaps (TRSs). They’re a synthetic cash instrument whereby one party receives the total returns on an underlying index, or security, until expiry, while at the same time paying the financing costs to the counterparty for providing those returns.
In comparison to classic futures, TRFs are more explicit in terms of how they are priced. With a classic future, a lot of the pricing needs to be implied, including which dividends are coming before expiry and what repo rates are implied in that price. With TRFs, dividends are explicit; all dividends are received and priced versus the implied repo. It is a lot easier to price than a regular future. TRFs are designed to pay the returns analogous to a total return swap. Of course, being a listed product, it has standardised features, including fixed expiry dates -the standard third Friday of the expiry month in Eurex’s case- and it’s equivalent to a daily resetting swap. A normal TRS may be against a fixed term rate like EURIBOR. The listed version is against the overnight rate, €STR. This avoids the issues associated with over-the-counter (OTC) TRS’s such as having unrealised profit and loss. By using TRFs, one can realise profit and loss daily through variation margin.
How have TRFs been successful in the market so far and what is driving growth in demand?
The initial success of the TRF has been based on their benefits, but a push from regulation has also driven demand. There are key benefits for Eurex clients in including TRFs in its product suite, such as the ability to cross margin the product against other positions held in equity and indexes, which frees up balance sheets for participants. Demand has also been steadily growing since the end of 2016 when uncleared margin requirements (UMR) were announced, impacting sell-side banks in particular. These requirements have made a centrally cleared product more efficient on the balance sheet. We designed the product with those banks, so it was designed for their specific need at the time; hedging the implied repo risk of forward positions. It was that initial supply of implied repo risk that led to the demand for the product.
How do TRFs complement the actual toolbox?
The benefit is that participants can use the TRFs alongside other instruments at Eurex to isolate specific risk factors. One could use a TRF to go long or short on an index – a pure beta replacement product – but more specific uses include isolating parts of the repo curve. That would be the primary interest from certain counterparties where they would go long on a total return future for a date a long way forward, and they would trade a regular future against it as the delta hedge, therefore, isolating and hedging implied repo risk. This brings the other side into the trade, where there is now a repo curve in this product. We have maturities going out to 10 years. That is attractive to certain members of the buy-side community who would trade the spread on that curve, for example, selling longer-dated/buying shorter-dated and taking a financing spread out of it. There are benefits and uses for both sides. Still, the most important thing is that it provides another tool alongside the other products at Eurex that was only previously available OTC.
What are the current ways TRFs can be used?
The primary use of TRFs is to hedge long-dated forward exposure generated through options positions and for those institutions that have large structured and synthetic product books. The inherent nature of those products that turn equity risk into a more fixed income-like product means that participants have exposure a lot further out along the curve and that exposure varies depending on market movements. If markets move up, it can shorten their exposure, but if markets move down, then it can extend that exposure as puts become more involved in the picture.
How do you think the TRFs segment will evolve in the upcoming years?
The benefits of the TRF product lie in its inherent flexibility. It started as a market for a specific hedge and this has developed into multiple uses. There are now ways of using it as a straightforward beta replacement product. If you want to go long or short on an index – if you have a structural position in that index – you don’t have to do that using a short-term product. That can now be done for a longer-term product that is now matching a participant’s expiry. A TRF is effectively a synthetic cash instrument. Because of this, it can be used for many other forms of activity in the finance world, including synthetic financing and synthetic repo products, where if a participant wants to raise financing and has an asset, then it can simply sell the asset and buy or receive the total returns on it and pay its financing charge. Participants can effectively raise financing using the underlying securities as collateral. That is not just in the equity or index market. That can extend to any securities markets available. That could be shares, it could be ETFs, it could be bonds. There’s not really a limit to it. It is the returns on an asset. That is where I see the product developing in the coming years across the whole spectrum of the asset classes also traded at Eurex.
This is still a growing and nascent market. We’re three to four years into the product, which is quite new for a listed derivative, and despite it being early days, 35-40% of all exposure to the EURO STOXX 50® index, the benchmark index in Europe, is now in total return futures in Delta terms at Eurex. It has grown quickly and the benefits are still being discovered. The uncleared margin requirements will attract a lot more interest from the buy-side going forward as they begin to be impacted by stage five and stage six of UMR.
How will the TRF adapt to become more applicable to the fixed income market?
The key to the product is that where there is currently a TRS market that is used for either financing or, more importantly, for specific repo products – for example, if you want to borrow a bond and you are happy to pay financing on it – it can be used to replicate the OTC transactions. Those OTC transactions could be physical, so a participant could be buying and selling the product and that could be replaced by a synthetic version of it. Because we have the key benefit of a centrally cleared product, it makes that a lot more plausible to be done using a derivative rather than a traditional cash instrument and in fixed income, you’ve got some very long-dated bonds and very long-dated needs to use those bonds. TRFs with their longer maturity horizon will probably be extremely useful in the fixed income space.