Institutional Trading of Equity Derivatives By Jay Bennett, John Colon and John Feng Each year Greenwich Associates, a consulting firm specializing in financial services, interviews investment managers, hedge funds and other institutions in North America and Europe that trade equity derivatives. The 2009 study, which was conducted between April and June, revealed some significant trends in the usage of flow derivatives, a category that includes not only exchange-traded equity options and futures but also a variety of over-the-counter equity derivatives such as index swaps, OTC options, variance swaps and dividend swaps. In the following article, three of the firm s consultants describe their findings and highlight the key trends of the past year. Despite declines in asset values and a sharp fall-off in hedge fund trading, Greenwich Associates found an increase in the number of institutions that use certain types of flow equity derivatives, in particular options and futures based on equity indices. Looking forward, institutions in both North America and Europe said that they expect to increase their usage of flow equity derivatives in 2010 in terms of both the number of contracts they trade and the range of products they use. Greenwich Associates also found that a rising number of institutions are electronically transmitting their orders to exchanges for execution, rather than relying on their brokers sales desks. That said, a majority of institutions are still relying on the telephone to execute their trades, especially with respect to options. The study was based on interviews with 222 institutions in the U.S. and Canada and 190 institutions in 14 European countries. In North America, the study participants consisted of investment managers, hedge funds, mutual funds, and pension funds. In Europe, the study participants consisted of investment managers, hedge funds, mutual funds/unit trusts, banks, and insurers. The 2009 study included a new question about counterparty credit risk, reflecting the heightened concern about this issue following the collapse of several large brokers. Institutions said this is an important criteria in selecting brokers, but not as important as competitiveness of options pricing, expertise of sales professionals, and the ability to provide consistent service during volatile markets. The study indicates some important differences between European and North American institutions in their use of flow equity derivatives. Institutions in Europe are more likely than institutions in North America to use equity index futures and less likely to use options products. There are also differences in product preferences, with single stock futures more popular in Europe and ETF options more popular in North America. January 2010 27
What Are Flow Equity Derivatives? The term flow derivatives is used among derivatives industry professionals to distinguish relatively liquid products from structured products, which typically do not trade on electronic platforms and are not priced on a continuous basis. Greenwich Associates defines flow equity derivatives as including exchangetraded futures and options, exchange-traded funds, look-alike equity swaps and options products that traded over the counter, and other products such as variance swaps, dividend swaps, swaps based on market sectors or customized baskets of stocks, and vanilla dispersion and correlation trades. The grouping of these products into the flow category reflects common practices in the equity derivatives business and serves to distinguish the relatively standardized products in this category from more complex forms of equity derivatives such as structured products. Greenwich Associates also distinguishes between delta one products and options and volatility products. Delta one products are derivatives such as equity swaps, futures and forwards that have a delta of one, meaning that a one percent move in the value of the underlying results in a one percent move in the value of the derivative. With respect to execution, European institutions are less likely than North American institutions to use direct market access for their futures trades, but more likely to use direct market access for options trades. When selecting brokers, European institutions put more emphasis on understanding investment strategies or hedging needs, while North American institutions put more emphasis on the brokers willingness to commit capital to facilitate large trades. North America Usage of flow equity derivatives increased among U.S. and Canadian institutions last year across a range of commonly employed products. The proportion of institutions using options, both listed and OTC, increased to 88% in 2009 from 79% in 2008. Table 1 Equity Derivatives Product Usage - North America This table shows the percentage of U.S. and Canadian institutional investors that use various types of flow equity derivatives. The numbers in parentheses represent the number of respondents in the survey sample. All Institutions (152) Hedge Funds (68) Investment Managers (41) Single-stock listed/otc look-alike options 74% 90% 63% Index listed/otc look-alike options 72% 85% 63% Index futures 59% 51% 61% ETFs 51% 63% 41% Options on sector ETFs 44% 63% 27% Index or sector swaps 36% 28% 44% Single-stock equity swaps 25% 34% 17% Variance swaps on indices 24% 31% 17% Swaps on portfolios and customized baskets 24% 18% 32% Volatility options 21% 28% 15% Options on customized baskets 15% 16% 10% Lite exotics /structured flow options 14% 21% 10% Dividend swaps and options 14% 18% 10% Access products 14% 13% 20% Variance swaps on single stocks 11% 13% 12% Volatility futures 11% 7% 15% Vanilla dispersion/correlation trades 9% 16% 5% Product definitions: Vanilla dispersion/correlation trades are based on the implied dispersion or correlation between baskets of stocks and an index. Lite exotics include best of/worst of and barrier options. Access products include participatory notes, synthetic futures and stock-tracking warrants and certificates. 28 www.futuresindustry.com
New York Marriott Downtown April 12-13, 2010 Presented by FIA Futures Services Division in cooperation with FIA Chicago and FIA Information Technology Division Preliminary Topics Mechanics of OTC Clearing New Clearing Platforms User Perspectives on OTC Clearing OTC vs. ETD Position Limits Changes in Collateral Plus Workshops Clearing 101 and OTC 101 and New Regulatory Reporting Requirements Preliminary Topics High Frequency Trading Direct Market Access Risk Management Technology Global Technology Challenges For the latest information, visit www.futuresindustry.org. Sponsorship and exhibit opportunities are available. Contact Toni Vitale Chan at tvitale-chan@futuresindustry.org or 312.636.2919. While the survey found no change in the use of options based on single stocks, the proportion of institutions using index options increased to 72% from 59% during the same time period. (See Table 1) Among delta one products, the proportion of institutions using equity index futures rose to 59% from 54%. On the other hand, the use of exchange-traded funds slid to 51% from 57%. (Although ETFs are not derivatives, they are included in the study because they are often used as substitutes for other delta one products.) Despite the increase in the number of institutions using flow equity derivatives, declines in asset values and a sharp fall-off in hedge fund trading activity have driven down both the notional amounts of equity derivatives trades and the commissions paid on trades of these products. The amount of commissions paid by U.S. institutions to brokers on trades of options products declined 20-25% from mid-year 2008 to mid-year 2009. (The survey did not collect information on the commissions paid on trades of other products.) This decline can be attributed to two factors: the sharp drop in institutional assets under management last year, and hedge fund deleveraging, said Greenwich Associates consultant Jay Bennett. Although the share of hedge funds using these options products remains high and actually increased in cases year-over-year, the absolute number of hedge funds active in the market fell, and those remaining had much smaller positions to hedge as a result of the deleveraging process. Increased Use in 2010 The research results suggest that both commission payments and notional trading volumes will increase in the coming year. Fifty-two percent of North American institutions say they expect to increase their use of flow equity derivatives, including 10% that expect to make a significant increase. Investment managers and hedge funds appear more bullish in their intentions than mutual funds or pensions. These results seem to suggest a cautious optimism among U.S. institutions, said Greenwich Associates consultant John Colon. There is no doubt that institutions expect to be doing more hedging in the next 12 months. But if the market recovery proves Fifty-two percent of North American institutions say they expect to increase their use of flow equity derivatives, including 10% that expect to make a significant increase. Investment managers and hedge funds appear more bullish in their intentions than mutual funds or pensions. sustainable, it appears that institutions expect to increase their use of equity derivatives in order to gain liquidity and desired exposures, in addition to downside protection. Specialists Gain Influence As hedging rises to a top priority for U.S. institutions, derivatives specialists January 2010 29
with particular hedging expertise are assuming control of a growing share of the derivatives trading process. The share of investment and/or trading decisions controlled exclusively by derivatives execution specialists increased to 31% in 2009 from 18% in 2008. Nevertheless, the extent to which equity derivatives have become fully integrated into institutions normal investment process is illustrated by the fact that equity portfolio managers and traders are involved in 70% of equity derivatives investing and trading decisions, said Greenwich Associ - ates consultant John Feng. Spike in Electronic Trading The share of options and futures trading volume executed via direct market access or smart order routing increased sharply last year, particularly for futures. DMA trading Table 2 Electronic versus High-Touch - North America The proportion of options and futures volume that North American institutional investors sent directly to exchanges for electronic execution, as opposed to communicating orders to broker sales desks via phone, email or other methods. 2005 2006 2007 2008 2009 Futures 16% 22% 22% 33% 43% Options 10% 12% 11% 11% 16% Table 3 Broker Selection Criteria - North America Factors cited by North American institutions as important criteria in selecting brokers for flow equity trades. Based on responses from 68 investment managers, hedge funds, mutual funds and pension funds. Competitiveness of options pricing 63% Willingness to commit capital to facilitate larger listed options trades 45% Expertise of flow derivatives sales professional 45% Consistently strong service during volatile markets 45% Understanding flow investment strategies or hedging needs 37% Market judgment and sense of timing 32% Creditworthiness of counterparty 28% Competitiveness of swaps pricing 25% Quality of flow product settlement services 18% DMA electronic and algorithmic trading capability 15% Quality of equity derivatives research 13% Quality of post-trade client service and operations support 8% Note: Asked of a random sample. Flow equity derivatives include listed/otc look-alike options, futures, equity swaps, variance swaps, dividend or sector swaps, ETFs and access products. captured 43% of futures trading volume at U.S. institutions in 2009, up from 33% in 2008 and 22% in 2007. The remainder were submitted electronically to broker sales desks via order management systems or communicated by phone to brokers. Particularly in futures trading, which is a huge business with massive turnovers and low margins, brokers are encouraging institutions to utilize electric platforms, Bennett said. DMA trading captured a smaller share of options volume, but there also the share is rising. In 2009, U.S. institutions executed 16% of their total options volume via DMA trades. In 2007 and 2008, that share was about 11%. (See Table 2) Selection Factors Competitiveness on pricing is still the most important criteria used by institutions in picking a broker for a flow product trade, with 63% of institutions citing it as an important consideration. But institutions are also seeking out and rewarding brokers who stepped up during the crisis. Forty-five percent of U.S. institutions cite consistently strong service during volatile markets as an important broker selection factor in flow products, up from just 34% last year. (See Table 3) Twenty-eight percent of U.S. institutions in 2009 cite the creditworthiness of potential counterparties as one of the most important criteria used in selecting brokers on trades of flow derivatives products. Mutual funds and investment managers were especially likely to cite this as a selection criterion. Among investment managers, almost one-third are using credit default swap spreads as a means of measuring the creditworthiness of counterparties, 42% are using credit ratings from agencies, and almost half are doing their own proprietary credit analysis. Hedge funds are much more likely to rely on CDS spreads and their own credit analysis, Feng said. But it was surprising to see that about one in five hedge funds are not taking any actions to monitor counterparty creditworthiness. Electronic trading capability is becoming a more important factor in selecting brokers. Although only 15% of institutions cited it as an important factor in 2009, that was significantly higher than last year s 7% in 2008. 30 www.futuresindustry.com
Europe European markets for flow equity derivatives products expanded last year as institutions in the U.K. and Continental Europe picked up the pace of their hedging activity. Overall, the percentage of European institutions using options products increased to 78% in 2009 from 66% in 2008. In particular, the proportion of institutions using single stock options, including both listed and OTC look-alike, increased to 69% from 59%, and the use of index options rose to 68% from 60%. (See Table 4) Among delta one products, usage of index futures increased to 81% of European institutions in 2009 from 78% in 2008, while the share of institutions using single-stock futures increased to 44% from 30% and ETF usage rose to 51% from 43%. Usage of listed/otc look-alike options was highest in the U.K., where 87% of institutions said they employ these products. This pick-up in institutional demand resulted in an increase in the overall volume of options products traded last year, as measured by the amount of commissions paid by institutions for these trades. The equity options commission pool increased by an estimated 16% in Europe from 2008 to 2009. This growth stood in stark contrast to the 20-25% decrease in U.S. commission volumes. Hedge funds play a much smaller role in the European equity derivatives market than they do in the U.S., so deleveraging had less of an impact, and the increased use of these products by long-only institutions pushed commissions and overall market activity higher, Colon said. Selection Factors Competitiveness of options pricing remains far and away the most important factor considered by European institutions when selecting brokers for trades of equity derivative flow products, followed by the expertise of a sell-side firm s flow derivatives sales professionals and the firm s understanding of the institutions investing strategies and hedging needs. (See Table 5) The financial strength of financial service firms and client perceptions of broker counterparty risk are having a strong impact on the competition among sell-side firms for equity derivatives trading business from European institutions. More than 90% of European institutions say they are actively monitoring the creditworthiness of sell-side firms, and more than one third say the creditworthiness of potential counterparties is one of the most important criteria they consider when selecting a broker for a trade of flow equity derivatives products. Table 4 Equity Derivatives Product Usage - Europe This table shows the percentage of European institutional investors that use various types of flow equity derivatives. The numbers in parentheses represent the number of respondents in the survey sample. All Institutions (176) Hedge Funds (19) Investment Managers (74) Banks (44) Index futures 81% 89% 89% 66% Single-stock listed/otc look-alike options 69% 95% 68% 68% Index listed/otc look-alike options 68% 68% 68% 68% ETFs 51% 42% 62% 41% Single-stock futures 44% 37% 43% 61% Index or sector swaps 36% 58% 42% 25% Single-stock equity swaps 36% 53% 35% 32% Swaps on portfolios and customized baskets 31% 26% 34% 25% Lite exotics /structured flow options 28% 26% 22% 48% Options on customized baskets 24% 16% 22% 39% Access products 24% 26% 26% 25% Variance swaps on indices 22% 42% 19% 18% Volatility futures 19% 32% 22% 16% Vanilla dispersion/correlation trades 19% 37% 16% 18% Dividend swaps and options 18% 37% 20% 7% Variance swaps on single stocks 13% 32% 9% 14% Product definitions: Vanilla dispersion/correlation trades are based on the implied dispersion or correlation between baskets of stocks and an index. Lite exotics include best of/worst of and barrier options. Access products include participatory notes, synthetic futures and stock-tracking warrants and certificates. January 2010 31
Fifty-three percent of European institutions use credit rating agencies to monitor and assess the counterparty risk, 47% do their own proprietary analysis of counterparty creditworthiness, and 35% use CDS spreads to determine counterparty risk. Hedge funds tend to rely more on their own internal analysis of counterparties and less on credit ratings. Hedge funds are also more likely than other types of Table 5 Electronic versus High-Touch - Europe institutions to use CDS spreads to determine counterparty risk. Looking ahead, approximately 70% of European institutions expect to increase their use of flow equity derivatives products in 2010, including 11% that expect a significant increase. These results suggest that the equity derivatives business in Europe should grow at (at least) a slightly accelerated pace in the next 12 months, Bennett said. The proportion of options and futures volume that European institutional investors sent directly to exchanges for electronic execution, as opposed to communicating orders to broker sales desks via phone, email or other methods. 2005 2006 2007 2008 2009 Options 16% 12% 13% 11% 18% Futures 24% 23% 22% 22% 34% Table 6 Broker Selection Criteria - Europe Factors cited by European institutions as important criteria in selecting brokers for flow equity trades. Based on responses from 74 investment managers, hedge funds, mutual funds/unit trusts, banks and insurers. Competitiveness of options pricing 74% Expertise of flow derivatives sales professional 50% Understanding flow investment strategies or hedging needs 46% Consistently strong service during volatile markets 38% Creditworthiness of counterparty 34% Market judgment and sense of timing 32% Quality of equity derivatives research 27% Quality of flow product settlement services 26% Quality of post-trade client service and operations support 18% Willingness to commit capital to facilitate larger listed options trades 14% Competitiveness of swaps pricing 12% Quality of pre-trade credit and legal/documentation approval process 11% DMA electronic and algorithmic trading capability 3% Note: Asked of a random sample. Flow equity derivatives include listed/vanilla OTC options, futures, equity swaps, variance swaps, dividend or sector swaps, ETFs and access products. Specialists Gain Clout As hedging takes on added importance for institutions in Europe and around the world, derivatives specialists are assuming control of a growing share of the derivatives trading process. The share of investment and/or trading decisions controlled exclusively by derivatives execution specialists at European institutions increased to 22% in 2009 from 14% in 2008. Despite these gains, portfolio managers and equity traders still have exclusive control over nearly half of investment and trading decisions relating to equity derivatives, and they jointly control another 25% in conjunction with derivative specialists. The fact is that equity derivatives have become standard tools for gaining exposures and taking positions in the course of the normal investment process, said Colon. As such, portfolio managers and traders will often be the ones employing them, even as specialists assume a more prominent role through the hedging process. DMA Attracts New Trading Volume The research results reveal a significant increase in the share of futures trading volume executed via direct market access, which rose to 34% in 2009 from 22% in 2008, Bennett said. The large turnover and relatively thin margins for brokers make futures trades ideal for DMA execution. The share of options trading volume executed via DMA or smart-order routing electronic trades also increased, albeit more modestly, to 18% in 2009 from 11% in 2008. (See Table 6) In Continental Europe, electronic trading of options rose to 20% of volume, driven by increases in DMA use in Germany, Italy and Spain. In contrast, DMA volume in the U.K. increased only to 10% as more options volume requires capital commitment. Banks, which execute 60% of their futures volume and a steady 30% of their options trading volume via DMA platforms, remain Europe s biggest users of electronic trading. Jay Bennett, John Colon and John Feng are managing directors at Greenwich Associates. Bennett consults with the firm s investment banking, stockbrokerage, and equity derivatives practices in the U.S., Canada, Europe, and Southeast Asia. Colon consults with the firm s investment banking and institutional stockbrokerage practices in the U.S., Asia, and Europe. Feng consults with stockbrokerage and corporate finance clients. Copies of the reports on which this article is based can be obtained by contacting Greenwich Associates at www.greenwich.com. 32 www.futuresindustry.com