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 prod- ucts 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 paren- theses 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 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 Preliminary Topics • Mechanics of OTC Clearing • High Frequency Trading • New Clearing Platforms • Direct Market Access • User Perspectives on OTC Clearing • Risk Management Technology • OTC vs. ETD • Global Technology Challenges • Position Limits • Changes in Collateral • Plus Workshops Clearing 101 and OTC 101 and New Regulatory Reporting Requirements For the latest information, visit www.futuresindustry.org. Sponsorship and exhibit opportunities are available. Contact Toni Vitale Chan at [email protected] or 312.636.2919. 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 deriva- tives, 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 bro- kers 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.