FISL Europe: Total Return Futures advance across participants and regions

Total Return Futures are establishing themselves as an alternative to swaps, and at our upcoming Finadium Investors in Securities Lending Conference in Paris on 24 September, we are gathering Crédit Agricole CIB, Eurex, Euronext and Natixis to take a closer look at how this market is evolving as the futures product spreads from Europe to US and Asia, and from sell- to buy-side.

Natixis is one of the biggest players in trading TRFs for the CAC40 and Eurostoxx50. Matthieu Létang, head of securities optimization for the French bank, said that TRFs are the best way to cover “repo sensitivity” of the books in an age of EMIR (European Market Infrastructure Regulation) and are largely a general collateral (GC) cost efficiency play. Specifically: initial margin for OTC derivatives is charged at some 10%, depending on the credit profile of each counterparty using Total Return Swaps, compared to between 1% and 3% using TRFs: “It’s a big consideration in terms of cash consumption,” Létang said.

The TRS market on the Eurostoxx and CAC indexes is large and liquid, so launching an auction is enough for price transparency for institutionals, said Romuald Orange, global head in Natixis’ client strategy unit, Still, as a listed product, TRFs are available on screen: “It’s making life easier from that aspect,” he noted.

The next step for Natixis’ team, said Létang, is trading TRFs based on customizable baskets. Today, the TRS market on baskets is used by banks for refinancing purposes and to optimize balance sheets, and with EMIR and initial margin consumption, markets are trying to do the same as what has been accomplished on the index side with TRFs: transfer part of the OTC exposure to clearing houses. He also expressed hope that other indexes, such as Nikkei and S&P 500 Total Return indexes be included by Eurex.

Orange added that customization is geared to the needs of the banks, and the product is constructed such that hard to borrow stocks are excluded so as to not jeopardize pricing. The challenge, he said, will be to find a common ground: what is a customized basket, and what is acceptable as a customized basket for different actors? “They might have different opinions on what should be in there,” he said.

Go-to markets

The ability to pick and choose basket constituents and agree them with counterparties is exactly the way Eurex has designed the product, said Stuart Heath, an executive director in Product R&D for Equity and Index at Eurex.

Eurex was the first to launch TRFs for the Eurostoxx50 in 2016, and has since watched similar products launched on the CME in the US and Singapore Exchange in Asia. Uptake on Eurex has grown steadily with August breaking records at a notional value of €3 billion ($3.3bn) and 96,000 contracts traded on the day. Year-to-date for August-end stands at 2.1 million contracts traded versus 792k for the same period in 2018.

A final launch date for customizable TRFs is yet to be set, but the plan is to have individual equity TRFs on some 250 euro-denominated names, with upgraded functionality to trade in these baskets and an increasing focus on the equity financing space in Europe.

“Our historic go-to market from the derivatives exchange side is very much meeting the repo collateral financing side, whereas our next products are more supporting equity financing as a business in Europe,” he said, adding that it’s a shift away from the traditional core delta one and vol-targeted businesses.

The TRF on CAC 40 index is the best product launch made by Euronext in the past years, said Charlotte Alliot, co-head of Equity Derivatives at Euronext: “This is due to the increased regulatory pressure on OTC trading, in particular since the implementation of EMIR which has impacted the level of collateral linked to the transactions.” The product was launched at the end of 2018, and at August-end €11 billion notional value has been traded with open interest registered on all December maturities.

Banks are the first users of the product, which attracts market participants who need to hedge long term equity positions: “Clients have been especially pleased by the very strong level of margin efficiencies LCH SA has succeeded to put in place. Indeed, the offset with the CAC40 futures contributes to reduce the immobilized capital at 0.58%,” she added. The contract currently has maturities up to 5 years, and this is expected to increase to further cover structured products exposure.

So far, nearly ten members have traded the contract at Euronext, and some of them have only done one trade to test the trading to clearing workflow. New members are expected to be onboarded by the end of the year, she said: “We are far from being at full speed, and we expect the activity to speed up next year.”

Euronext has also started to see more activity from end users, and in particular pension funds, which need to optimize their long term equity exposure, for example, French PEA funds (Plan d’Epargne Actions) that carry long term equity portfolios: “Ultimately, we believe that this community of users will contribute to create a liquidity pool which will establish the CAC40 TRF as a reference rate,” said Alliott.

Buy-side participation

In the US, the CME launched TRFs in 2016, and expanded the indexes they offered in late 2018. The CME TRF model has a different structure in that it provides only the equity total return without the floating leg rate: 2019 average daily volume at August-end was at 2,140 contracts, up 20% compared to 2018, and open interest on the same day was 229,480 contracts. SGX figures were not available at time of publication, but with the launch being very recent, it’s likely volumes will require more time for any meaningful analysis.

One source asked Finadium if there was any insight to be gleaned from the widely diverging TRF rates across the regions – Europe tends to go negative, the US positive, while Asia is mostly flat. Heath said that the mechanisms making that happen are structural in nature, an analysis shared by Natixis’ Orange and Létang.

At the front end of curve, demand comes from short covering or immediate market moves, but there’s also clients hedging longer-dated forwards, with some out to December 2028, Heath explained: “The key is looking at where demand is driven: we can see that there is an inverted curve on dividends in Europe, whereas a positive one in the US, and it’s more to do with how the market itself trades and where the end use of these products are.”

In terms of buy-side use of the products, Natixis’ Orange and Létang both observed that only the largest players are trading TRFs, and that there are a number of constraints on uptake: buy-side firms don’t have the same initial margin levels so are lacking such cost pressures, while trading on exchange is more expensive.

One of the key drivers for buy-side use is uncleared margin requirements (UMR), which at present only impacts the largest players. The number of funds covered by UMR, however, will increase over time, and Eurex’s Heath noted that while major sell-side banks and broker-dealers make up the bulk of participants, there are smaller funds as well because access to exchange trading is easier than for OTC swaps. Eurex buy-side participation peaked at some 25% of open interest in notional outstanding.

“We have anecdotally heard this product being taken up by hedge funds on a global basis as an alternative to OTC Total Return swaps,” said Heath. “Our customers are major clearing members and banks, and it’s been interesting that they are promoting this product, trying to effectively distribute them amongst their client base,” said Heath.

Please join us for the Finadium Investors in Securities Lending Conference in Paris on 24 September 2019. This programme, free for asset managers and asset owners, will deliver best in class education and peer discussions for optimising securities lending programs. Crédit Agricole CIB, Eurex, Euronext and Natixis will be on a panel discussing TRFs as a growing product entity, whether securities finance should turn to cleared futures, and the value of bilateral versus cleared futures.

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