Institutional Trading of Equity Derivatives

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.

espite declines in asset values and a sharp institutions are still relying on the telephone Institutions said this is an important criteria in Dfall-off in hedge fund trading, Greenwich to execute their trades, especially with selecting brokers, but not as important as com- Associates found an increase in the number of respect to options. petitiveness of options pricing, expertise of institutions that use certain types of flow The study was based on interviews with sales professionals, and the ability to provide equity derivatives, in particular options and 222 institutions in the U.S. and Canada and consistent service during volatile markets. futures based on equity indices. Looking for- 190 institutions in 14 European countries. In The study indicates some important ward, institutions in both North America and North America, the study participants con- differences between European and North Europe said that they expect to increase their sisted of investment managers, hedge funds, American institutions in their use of flow usage of flow equity derivatives in 2010 in mutual funds, and pension funds. In Europe, equity derivatives. Institutions in Europe terms of both the number of contracts they the study participants consisted of invest- are more likely than institutions in North trade and the range of products they use. ment managers, hedge funds, mutual America to use equity index futures and Greenwich Associates also found that a funds/unit trusts, banks, and insurers. less likely to use options products. There rising number of institutions are electroni- The 2009 study included a new question are also differences in product preferences, cally transmitting their orders to exchanges about counterparty credit risk, reflecting the with single stock futures more popular in for execution, rather than relying on their heightened concern about this issue following Europe and ETF options more popular in brokers’ sales desks. That said, a majority of the collapse of several large brokers. North America.

January 2010 27 With respect to execution, European What Are Flow Equity Derivatives? institutions are less likely than North American institutions to use direct market The term “flow derivatives” is used among derivatives industry professionals access for their futures trades, but more likely to distinguish relatively liquid products from structured products, which typically to use direct market access for options trades. do not trade on electronic platforms and are not priced on a continuous basis. When selecting brokers, European institu- Greenwich Associates defines flow equity derivatives as including exchange- tions put more emphasis on understanding traded futures and options, exchange-traded funds, “look-alike” equity swaps investment strategies or hedging needs, and options products that traded over the counter, and other products such as while North American institutions put more variance swaps, dividend swaps, swaps based on market sectors or customized emphasis on the brokers’ willingness to com- baskets of stocks, and “vanilla” dispersion and correlation trades. The grouping mit capital to facilitate large trades. 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 North America structured products. Greenwich Associates also distinguishes between delta one Usage of flow equity derivatives increased products and options and volatility products. Delta one products are derivatives among U.S. and Canadian institutions last such as equity swaps, futures and forwards that have a delta of one, meaning that year across a range of commonly employed a one percent move in the value of the underlying results in a one percent move products. The proportion of institutions in the value of the derivative. 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. Source: Greenwich Associates

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While the survey found no change in the use “Although the share of hedge funds using appear more bullish in their intentions than of options based on single stocks, the propor- these options products remains high and mutual funds or pensions. tion of institutions using index options actually increased in cases year-over-year, “These results seem to suggest a cautious increased to 72% from 59% during the same the absolute number of hedge funds active optimism among U.S. institutions,” said time period. (See Table 1) in the market fell, and those remaining had Greenwich Associates consultant John Among delta one products, the propor- much smaller positions to hedge as a result Colon. “There is no doubt that institutions tion of institutions using equity index futures of the deleveraging process.” expect to be doing more hedging in the next rose to 59% from 54%. On the other hand, 12 months. But if the market recovery proves the use of exchange-traded funds slid to 51% from 57%. (Although ETFs are not derivatives, they are included in the study because Fifty-two percent of North American institutions they are often used as substitutes for other delta one products.) say they expect to increase their use of flow Despite the increase in the number of institutions using flow equity derivatives, equity derivatives, including 10% that expect to declines in asset values and a sharp fall-off in hedge fund trading activity have driven make a “significant” increase. Investment down both the notional amounts of equity managers and hedge funds appear more bullish derivatives trades and the commissions paid on trades of these products. The amount of in their intentions than mutual funds or pensions. commissions paid by U.S. institutions to brokers on trades of options products declined 20-25% from mid-year 2008 to mid-year Increased Use in 2010 sustainable, it appears that institutions expect 2009. (The survey did not collect informa- The research results suggest that both to increase their use of equity derivatives in tion on the commissions paid on trades of commission payments and notional trading order to gain liquidity and desired exposures, other products.) volumes will increase in the coming year. in addition to downside protection.” “This decline can be attributed to two Fifty-two percent of North American institu- factors: the sharp drop in institutional tions say they expect to increase their use of assets under management last year, and flow equity derivatives, including 10% that Specialists Gain Influence hedge fund deleveraging,” said Greenwich expect to make a “significant” increase. As hedging rises to a top priority for Associates consultant Jay Bennett. Investment managers and hedge funds U.S. institutions, derivatives specialists

January 2010 29 with particular hedging expertise are portfolio managers and traders are involved captured 43% of futures trading volume at assuming control of a growing share of the in 70% of equity derivatives investing and U.S. institutions in 2009, up from 33% in derivatives trading process. The share of trading decisions,” said Greenwich Associ - 2008 and 22% in 2007. The remainder were investment and/or trading decisions con- ates consultant John Feng. submitted electronically to broker sales trolled exclusively by derivatives execution desks via order management systems or specialists increased to 31% in 2009 from communicated by phone to brokers. 18% in 2008. Spike in Electronic Trading “Particularly in futures trading, which is “Nevertheless, the extent to which The share of options and futures trading a huge business with massive turnovers and equity derivatives have become fully inte- volume executed via direct market access or low margins, brokers are encouraging insti- grated into institutions’ normal investment smart order routing increased sharply last tutions to utilize electric platforms,” process is illustrated by the fact that equity year, particularly for futures. DMA trading Bennett said. DMA trading captured a smaller share of options volume, but there also the share is rising. In 2009, U.S. institutions executed Table 2 16% of their total options volume via DMA Electronic versus “High-Touch” - North America trades. In 2007 and 2008, that share was about 11%. (See Table 2) 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. Selection Factors Competitiveness on pricing is still the 2005 2006 2007 2008 2009 most important criteria used by institutions in picking a broker for a flow product trade, Futures 16% 22% 22% 33% 43% with 63% of institutions citing it as an Options 10% 12% 11% 11% 16% important consideration. But institutions Source: Greenwich Associates 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 mar- Table 3 kets” as an important broker selection factor in flow products, up from just 34% last year. Broker Selection Criteria - North America (See Table 3) Twenty-eight percent of U.S. institu- Factors cited by North American institutions as important criteria in selecting brokers for flow tions in 2009 cite the creditworthiness of equity trades. Based on responses from 68 investment managers, hedge funds, mutual funds and potential counterparties as one of the most pension funds. important criteria used in selecting brokers on trades of flow derivatives products. “Competitiveness of options pricing” 63% Mutual funds and investment managers “Willingness to commit capital to facilitate larger listed options trades” 45% were especially likely to cite this as a selec- “Expertise of flow derivatives sales professional” 45% tion criterion. Among investment managers, almost “Consistently strong service during volatile markets” 45% one-third are using credit default swap “Understanding flow investment strategies or hedging needs” 37% spreads as a means of measuring the credit- “Market judgment and sense of timing” 32% worthiness of counterparties, 42% are using credit ratings from agencies, and “Creditworthiness of counterparty” 28% almost half are doing their own proprietary “Competitiveness of swaps pricing” 25% credit analysis. “Quality of flow product settlement services” 18% “Hedge funds are much more likely to rely on CDS spreads and their own credit “DMA electronic and algorithmic trading capability” 15% analysis,” Feng said. “But it was surprising to “Quality of equity derivatives research” 13% see that about one in five hedge funds are “Quality of post-trade client service and operations support” 8% not taking any actions to monitor counterparty creditworthiness.” Note: Asked of a random sample. Electronic trading capability is becom- ing a more important factor in selecting Flow equity derivatives include listed/OTC look-alike options, futures, equity swaps, variance brokers. Although only 15% of institutions swaps, dividend or sector swaps, ETFs and access products. cited it as an important factor in 2009, that Source: Greenwich Associates was significantly higher than last year’s 7% in 2008.

30 www.futuresindustry.com Europe This pick-up in institutional demand tor considered by European institutions European markets for flow equity deriva- resulted in an increase in the overall volume when selecting brokers for trades of equity tives products expanded last year as institu- of options products traded last year, as meas- derivative flow products, followed by the tions in the U.K. and Continental Europe ured by the amount of commissions paid by expertise of a sell-side firm’s flow derivatives picked up the pace of their hedging activity. institutions for these trades. The equity sales professionals and the firm’s understand- Overall, the percentage of European options commission pool increased by an ing of the institutions’ investing strategies institutions using options products increased estimated 16% in Europe from 2008 to 2009. and hedging needs. (See Table 5) to 78% in 2009 from 66% in 2008. In partic- This growth stood in stark contrast to the 20- The financial strength of financial serv- ular, the proportion of institutions using sin- 25% decrease in U.S. commission volumes. ice firms and client perceptions of broker gle stock options, including both listed and “Hedge funds play a much smaller role in counterparty risk are having a strong impact OTC look-alike, increased to 69% from the European equity derivatives market than on the competition among sell-side firms for 59%, and the use of index options rose to they do in the U.S., so deleveraging had less equity derivatives trading business from 68% from 60%. (See Table 4) of an impact, and the increased use of these European institutions. Among delta one products, usage of index products by long-only institutions pushed More than 90% of European institu- futures increased to 81% of European institutions commissions and overall market activity tions say they are actively monitoring the in 2009 from 78% in 2008, while the share of higher,” Colon said. creditworthiness of sell-side firms, and institutions using single-stock futures increased to more than one third say the creditworthi- 44% from 30% and ETF usage rose to 51% from ness of potential counterparties is one of 43%. Usage of listed/OTC look-alike options was Selection Factors the most important criteria they consider highest in the U.K., where 87% of institutions Competitiveness of options pricing when selecting a broker for a trade of flow said they employ these products. remains far and away the most important fac- 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%

January 2010 31

Fifty-three percent of European insti- institutions to use CDS spreads to deter- Specialists Gain Clout tutions use credit rating agencies to moni- mine counterparty risk. As hedging takes on added importance for tor and assess the counterparty risk, 47% Looking ahead, approximately 70% of institutions in Europe and around the world, do their own proprietary analysis of coun- European institutions expect to increase derivatives specialists are assuming control of a terparty creditworthiness, and 35% use their use of flow equity derivatives products growing share of the derivatives trading process. CDS spreads to determine counterparty in 2010, including 11% that expect a signifi- The share of investment and/or trading deci- risk. Hedge funds tend to rely more on cant increase. “These results suggest that the sions controlled exclusively by derivatives exe- their own internal analysis of counterpar- equity derivatives business in Europe should cution specialists at European institutions ties and less on credit ratings. Hedge funds grow at (at least) a slightly accelerated pace increased to 22% in 2009 from 14% in 2008. are also more likely than other types of in the next 12 months,” Bennett said. Despite these gains, portfolio managers and equity traders still have exclusive control over nearly half of investment and trading decisions Table 5 relating to equity derivatives, and they jointly Electronic versus “High-Touch” - Europe control another 25% in conjunction with derivative specialists. “The fact is that equity derivatives have become standard tools for The proportion of options and futures volume that European institutional investors sent directly to gaining exposures and taking positions in the exchanges for electronic execution, as opposed to communicating orders to broker sales desks via course of the normal investment process,” said phone, email or other methods. Colon. “As such, portfolio managers and traders will often be the ones employing them, 2005 2006 2007 2008 2009 even as specialists assume a more prominent Options 16% 12% 13% 11% 18% role through the hedging process.” Futures 24% 23% 22% 22% 34% Source: Greenwich Associates DMA Attracts New Trading Volume “The research results reveal a significant increase in the share of futures trading vol- Table 6 ume executed via direct market access,

Broker Selection Criteria - Europe which rose to 34% in 2009 from 22% in 2008,” Bennett said. “The large turnover and Factors cited by European institutions as important criteria in selecting brokers for flow equity relatively thin margins for brokers make trades. Based on responses from 74 investment managers, hedge funds, mutual funds/unit futures trades ideal for DMA execution.” trusts, banks and insurers. The share of options trading volume executed via DMA or smart-order routing electronic “Competitiveness of options pricing” 74% trades also increased, albeit more modestly, to 18% in 2009 from 11% in 2008. (See Table 6) “Expertise of flow derivatives sales professional” 50% In Continental Europe, electronic trad- “Understanding flow investment strategies or hedging needs” 46% ing of options rose to 20% of volume, driven “Consistently strong service during volatile markets” 38% by increases in DMA use in Germany, Italy and Spain. In contrast, DMA volume in the Creditworthiness of counterparty 34% U.K. increased only to 10% as more options “Market judgment and sense of timing” 32% volume requires capital commitment. “Quality of equity derivatives research” 27% Banks, which execute 60% of their futures volume and a steady 30% of their options “Quality of flow product settlement services” 26% trading volume via DMA platforms, remain “Quality of post-trade client service and operations support” 18% Europe’s biggest users of electronic trading. “Willingness to commit capital to facilitate larger listed options trades” 14%

“Competitiveness of swaps pricing” 12% Jay Bennett, John Colon and John Feng are man- “Quality of pre-trade credit and legal/documentation approval process” 11% aging directors at Greenwich Associates. Bennett consults with the firm’s investment banking, stock- “DMA electronic and algorithmic trading capability” 3% brokerage, and equity derivatives practices in the U.S., Canada, Europe, and Southeast Asia. Colon con- Note: Asked of a random sample. sults with the firm’s investment banking and institutional stockbrokerage practices in the U.S., Asia, and Flow equity derivatives include listed/vanilla OTC options, futures, equity swaps, variance Europe. Feng consults with stockbrokerage and cor- swaps, dividend or sector swaps, ETFs and access products. porate finance clients. Copies of the reports on which this article is based can be obtained by contacting Source: Greenwich Associates Greenwich Associates at www.greenwich.com.

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