The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

Exchange-traded derivatives in hedge fund management

Michael Roczinski


Q2 2006


Volumes on the world’s futures and options exchanges appear to be slowing down, given that across the board, the percentage increase in volume is in the low, single digits. However, when one digs deeper, it is apparent that some major products continue to see a 15-20% volume increase, if not more. What is driving this volume increase, and should the market expect to see continued development?

At the annual Futures Industry Association Expo in November 2005, Richard Berliand, Global Head of Futures and Options at JP Morgan, suggested that global exchange traded derivatives volume will increase almost 100-fold over the next 25 years. Perhaps even more tellingly, Matt Andresen, President of Execution Services at Citadel, one of the world’s largest hedge fund groups, agreed with him. His view was that the growth of electronic trading in the absence of capacity constraints in the exchange-traded derivatives market would contribute towards even greater volumes.

At a time when there are question marks over the ability of the hedge fund industry to continue to deliver double digit returns on a continuous basis, with capacity constraints being cited as a potential hurdle to achieve such returns, it is worth investigating the relationship between these two dynamic industries further.

Who is trading?

The last couple of years in the United States have been marked by the shift in exchange traded derivatives from the traditional floor environment onto screen. This has been driven partly by the attempts of Eurex and Euronext.liffe to challenge the CBOT and CME franchises in Treasury and Eurodollar futures respectively (and more recently a move by Eurex into the FX futures arena). This led to a more than 70% transaction fee reduction in Treasury futures for end customers at the CBOT (although there has been a subsequent 50% increase), and more recently the introduction of significant fee rebates for hedge funds with given amounts of assets under management in the CME’s FX contracts.
This reduction in cost and the improved electronic distribution of these products has resulted in vastly increased volumes. So, has this volume been created by the traditional users of futures contracts or can it be attributed more directly to specific users?

These changes have come at a time when assets under management in the hedge fund industry have increased to a reported $1 trillion. Within the managed futures area specifically, assets have increased over the last three years from $50 billion to $130 billion, and hedge fund strategies such as global macro and fixed income arbitrage, which tend to be closely associated with futures and options contract usage, have come back into vogue. It is therefore appropriate to link the increase in volume on-exchange with the developments in the hedge fund industry.

Indeed, Berliand from JP Morgan is on record as suggesting that hedge funds have taken a greater interest in the futures markets as the level of liquidity and transparency has improved with the move to screen trading. Moreover, as the returns for certain hedge fund strategies have reduced, as more money and competition have come into the sector, hedge funds are looking more closely at their cost base and demanding direct market access (DMA) to enable their own execution and/or lower commissions. This has also led to some hedge funds becoming direct members of exchanges as the barriers to entry have reduced substantially.

New volumes

Taking managed futures as an example, it is possible to quantify some ballpark numbers on the number of contracts that could be generated. Given that an average turnover of 2,500 round trips per $1 million under management is not uncommon for managed futures, an increase of $80 billion under management would suggest an increase of 200 million round trips.

There is a general view that the split in terms of contracts traded under these systems is distributed 80:20 in favour of financial instruments to commodities. This would suggest that 160 million financial futures round trips would have been generated versus 40 million commodity futures round trips. This also reflects the level of liquidity that is available between the different sectors, with only some of the energy contracts having comparable liquidity to flagship contracts in the financial sector such as Treasuries or Bunds.

Meanwhile, foreign exchange trading, which can account for 20-25% of the allocation of some of the larger CTAs, is not necessarily transacted on exchange, but instead is transacted via spot FX portals such as Currenex or FXAll. However, some of this volume does come back into the organised futures market via related Exchange for Physicals, and some of the smaller CTAs are happy to use the central order books. This could reduce the potential number of round trips on the financial side by up to 40 million round trips. However, that still leaves 120 million new round trips (and the related volume spin off ) that this increase in assets under management could potentially have generated!

Types of contract

Looking more broadly at the hedge fund industry, total assets under management in Europe have grown at a faster rate over the last three years than assets in the more mature US market. European managers had about $85 billion under management, which has now increased to more than $280 billion. While the rate of growth slowed to about 10% last year, certain strategies have benefited more than others, with the largest increase appearing to be in credit related strategies, whereas exchanges will offer derivatives products in this asset class in the near future.

In addition, some of the largest individual funds launched last year, such as NYLon Trading and SemperMacro, have been in the fixed income/global macro area which has benefited derivatives exchanges’ flagship fixed income contracts.

In response to the increase in business, there is a drive to increase understanding of where hedge funds and exchange traded derivatives interact by commissioning independent research papers from academic groups such as the Centre for International Securities and Derivatives Markets in the US, French business school EDHEC, and Harry Kat at Cass Business School in London.

A number of new hedge funds have been either spun out from investment bank proprietary trading desks or launched by former senior proprietary traders from such firms. The majority of such traders have been used to trading against flow orders in the cash/OTC market and then laying off risk into the exchange traded market, so they are very comfortable with expressing their exposure purely via the derivatives market, which is another boon for exchange volumes.

Long/short equity managers still maintain the lion’s share of assets under management both in Europe and globally and are mainstays of the equity index futures and options business. Exchanges active in equity index futures and options have seen further growth off the back of these assets.
Several initiatives are underway that should greatly increase the level of business that is traded on exchange. In addition, the introduction of volatility futures for the DJ EURO STOXX, DAX and SMI markets is an attempt to provide more efficient volatility hedging for both traditional equity hedge fund managers and the more nascent volatility arbitrage hedge funds which have around $1billion under management.

Future growth

Finally, looking toward Asia, it is clear that some of the derivative exchanges in the region have already experienced phenomenal growth, with South Korea coming to mind immediately with its Kospi contracts. This is despite the fact that the Asian hedge fund industry is much less mature than the European and US industries, with assets growing about 30% in the first half of 2005. Therefore, if the other geographical regions are a potential guideline, and if the level of hedge fund activity continues to increase in the region, the expected increase in Asian derivative exchange volumes could be even greater than market commentators suggest.

Not all of the increase in exchange traded derivatives should be attributed to hedge funds, of course. The differences between the activities of some ‘traditional’ managers and hedge fund managers are converging, as money managers seek absolute return strategies.

Traditional fund managers are now using techniques aimed at producing absolute returns and increasing the returns on their traditional portfolios. One way of achieving this is via portable alpha, where traditional managers use bond or equity index futures to replicate the beta exposure of their portfolio and then take the excess cash available (as they can achieve the same nominal exposure via futures with only an initial margin requirement) and invest in hedge fund-like techniques to achieve additional alpha returns for the portfolio. It is also possible to generate alpha using derivatives but it would be fair to say that few managers take such a sophisticated approach.

Academic papers suggest that hedge fund return replication using only derivatives is possible, which may perhaps increase business in derivatives going forward.


In summary, it appears that while assets under management in the hedge fund industry continue to increase, the exchange traded derivatives business will continue to flourish. It is clear that the liquidity and transparency that is provided by flagship bond and equity index futures contracts will continue to be the focal point of hedge fund industry activity. The levels of open interest on such contracts are even more impressive than the average traded volumes, which is a good sign that there is a healthy mix of all types of end customer/agency business that are holding positions and providing a cornerstone for further increased activity.

Hedge funds are a major source of liquidity for the global derivatives marketplace, but equally, derivatives are a major source of ongoing returns for hedge funds.

Back to Listing

Main Menu

  1. Home
  2. About
    1. Our Core Objectives
    2. AIMA's Policy Principles
    3. Meet the team
    4. AIMA Council
    5. Global Network
    6. Sponsoring Partners
    7. Opportunities at AIMA
    8. AIMA’s 25th anniversary in 2015
  3. Join AIMA
    1. Benefits of Membership
    2. Membership Fees
    3. Application form
  4. Members
    1. AIMA DDQs
    2. AIMA Annual Reports
    3. AIMA Governance
    4. AIMA Logo
      1. Policy note
    5. AIMA Members' List
    6. AIMA Review of the Year
    7. Committees and Working Groups
    8. Weekly News
    9. Update Profile
  5. Investors
    1. AIMA Investor Services
    2. AIMA Members' List
    3. Investor Steering Committee
  6. Regulation
    1. Asset Management Regulation
      1. EU Asset Management Regulation
        1. AIFMD
        2. European Capital Markets Regulation
        3. MiFID / MiFIR
        4. UCITS
        5. European Venture Capital Directive
        6. Shareholder Rights Directive
        7. European Long Term Investment Fund Regulation
        8. Loan Origination Funds
        9. Capital Raising
        10. AIFMD-Related Events
      2. US Hedge Fund Adviser Regulations
        1. Registration and Reporting
        2. Incentive-Based Compensation
        3. JOBS Act
      3. Asia Pacific Asset Management regulation
      4. Other Jurisdictions’ Asset Management Regulation
      5. Private Placement Regime
        1. Canada
        2. Dubai
        3. Finland
        4. Germany
        5. Hong Kong
        6. Japan
        7. Saudi Arabia
        8. Sweden
        9. United Arab Emirates
      6. Systemically Important Financial Institutions ('SIFIs')
      7. Remuneration
        1. UK
        2. United States
        3. CRD IV and CRR
        4. AIFMD
        5. MiFID
      8. Shadow Banking
      9. Volcker Rule
      10. Other
      11. Systemic Risk Reporting
      12. Dealing Commission
      13. Corporate Governance
      14. Securitisation
    2. Markets Regulation
      1. Bank/Capital Regulation
        1. Capital Requirements Directive
        2. EU Bank Structural Reforms
      2. Capital Markets Union
      3. Derivatives/Clearing
        1. EMIR
        2. MiFID II / MiFIR - Derivatives
        3. MAD / MAR
        4. Dodd-Frank Act Title VII
        5. Hong Kong
        6. IOSCO
        7. Singapore
      4. High Frequency Trading
        1. EU automated trading
          1. ESMA Guidelines
          2. Germany
          3. MiFID II / MiFIR - HFT
        2. US automated trading
          1. SEC Regulation SCI
          2. CFTC Automated Trading
        3. IOSCO
        4. Flash Crash
      5. Insurance Regulation
        1. Solvency II
      6. Market Abuse
        1. MAD / MAR
        2. Indices as Benchmarks
      7. Position Limits
        1. MiFID II - Commodities
        2. CFTC Position Limits
      8. Resolution of Financial Institutions
        1. Europe
          1. EU Bank Recovery and Resolution Directive
          2. EU Non-Bank Recovery and Resolution
        2. CPSS-IOSCO
        3. Financial Stability Board
        4. UK
        5. USA
      9. Shadow Banking
        1. International Shadow Banking
        2. EU Shadow Banking - SFT reporting & transparency
      10. Short Selling
        1. EU Short Selling Regulation
        2. Hong Kong Short Selling Regulation
        3. US Short Selling Regulation
      11. Trading
        1. Dodd-Frank Act
        2. MiFID Portal
        3. REMIT
        4. Securities Settlement
    3. Tax Affairs
      1. Automatic Exchange of Information (AEOI)
        1. FATCA
        2. EU - AEFI
        3. OECD - Global Standard on AEFI
      2. Australia - Investment Manager Regime (IMR)
      3. Base Erosion - Profit Shifting (BEPS)
      4. FIN 48 and IAS 12
      5. Financial Transaction Tax (FTT)
      6. UK Investment Management Exemption (IME)
      7. UK Offshore Funds Regime
      8. Other
    4. AIMA's Policy Principles
    5. Search
    6. Resources
      1. Guidance Notes
      2. Jurisdictional Guides
      3. Noticeboard
        1. AEOI: FATCA and other regimes
        2. AIFMD
        3. Bank/Capital Regulation (including NSFR)
        4. BEPS
        5. CFTC Registration and Exemptions
        6. Corporate Governance
        7. Dealing Commission
        8. Derivatives
        9. FTT
        10. High Frequency Trading
        11. MiFID / MiFIR
        12. Other Hot Asset Management Topics
        13. Other Hot Markets Topics
        14. Other Hot Tax Topics
        15. Position Limits
        16. Trading
        17. UCITS
        18. UK Partnership Tax Review
        19. US State and Local Taxes
        20. Volcker Rule
      4. Hedge Fund Manager Training
      5. Quarterly Regulatory Update
      6. Webinar Programme
      7. Regulatory Compliance Association
        1. About the Regulatory Compliance Association
        2. RCA Curricula and initiatives for alternative investment firms
        3. Meet the regulators and Sr. Fellows
  7. Education
    1. Research
      1. AIMA Research
      2. Industry research
      3. Search research documents
    2. "The Case for Hedge Funds"
      1. Global Hedge Fund Industry Paper: The value of our industry
      2. The Value of the Hedge Fund Industry to Investors, Markets and the Broader Economy: Research commissioned by AIMA and KPMG
      3. The Evolution of an Industry: KPMG/AIMA Global Hedge Fund Survey
      4. Contributing to Communities: A global review of charitable and philanthropic activities by the hedge fund industry
      5. Beyond 60-40: The evolving role of hedge funds in institutional investor portfolios
      6. The Cost of Compliance: Global hedge fund survey by AIMA, MFA and KPMG
      7. Capital Markets and Economic Growth: Long-term trends and policy challenges
      8. Apples and Apples: How to better understand hedge fund performance
      9. The Extra Mile: Partnerships between hedge funds and investors
      10. Key articles by AIMA on the case for hedge funds
    3. AIMA Journal
      1. Recent issues
      2. Search AIMA Journal articles
      3. AIMA Journal Archive
    4. AIMA Guides to Sound Practices
    5. AIMA guides for institutional investors
    6. CAIA Association pages
      1. Fundamentals of Alternative Investments
    7. Regulatory Compliance Association pages
      1. About the Regulatory Compliance Association
      2. RCA Curricula and initiatives for alternative investment firms
      3. Meet the regulators and Sr. Fellows
    8. Certified Investment Fund Director programme
    9. Services to Start-up Managers
    10. Glossary
  8. Events
    1. AIMA Events
      1. AIMA Annual Conference
        1. AIMA 25th Anniversary AGM & Annual Conference
      2. AIMA's Global Policy and Regulatory Forum
        1. 2015 Forum - Review
        2. 2015 Forum - Photos
        3. 2015 Forum - Agenda
        4. 2015 Forum - Sponsors and Supporting Organisations
    2. AIMA webinars
    3. Industry events
  9. Media
    1. Press Releases & Statements
    2. AIMA's blog
    3. Media Coverage
      1. Articles by AIMA
        1. Archive
      2. AIMA in the news
      3. Video interviews
      4. Industry news
    4. Media Contact
    5. Press Materials

Sub Menu

  1. Education
    1. AIMA Journal
    2. Bibliography
    3. CAIA Designation
    4. Research
    5. Roadmap to Hedge Funds
    6. AIMA's Investor Steering Committee Paper
    7. Glossary
  2. Regulatory, Tax, Policy & Government Affairs
    1. AIMA Position Papers
    2. AIMA Responses
      1. Australian Tax Office
      2. Authority for the Financial Markets
      3. Committee of European Banking Supervisors
      4. Committee of European Securities Regulators
      5. Commodity Futures Trading Commission
      6. Dubai Financial Services Authority
      7. European Commission
      8. European Securities and Markets Authority
      9. Swiss Financial Market Supervisory Authority
      10. Financial Services Authority (UK)
      11. Financial Services and the Treasury Bureau
      12. Guernsey Financial Services Commission
      13. HM Revenue & Customs
      14. HM Treasury
      15. Independent Commission on Banking
      16. IOSCO
      17. Monetary Authority of Singapore
      18. Securities and Exchange Board of India
      19. Securities and Exchange Commission (USA)
      20. Securities and Futures Commission
      21. Singapore Exchange
      22. The Takeover Panel
      23. US House of Representatives / Senate
      24. Federal Deposit Insurance Corporation
      25. Financial Stability Oversight Council
      26. Financial Stability Board
      27. US Treasury
      28. Internal Revenue Service
      29. US Federal Reserve
      30. Financial Industry Regulatory Authority (FINRA)
      31. Council of European Union
      32. Hong Kong Exchanges and Clearing
      33. House of Lords
    3. AIMA Summaries
      1. CESR
      2. European Commission
      3. Financial Services Authority (UK)
      4. HM Revenue & Customs
      5. HM Treasury
      6. IOSCO
      7. Securities and Exchanges Commission
      8. FSOC
      9. CFTC
    4. Guidance Notes
    5. Jurisdictional Resource
    6. AIMA Noticeboard
      1. EU Directive on Alternative Investment Fund Managers
      2. FSA Remuneration Code
      3. Short Selling
      4. US Dodd-Frank Wall Street Reform and Consumer Protection Act
      5. UK Stewardship Code
      6. Securities Law Directive
      7. EU Directive on Alternative Investment Fund Managers - Level II
      8. EU Directive on Markets in Financial Instruments (MiFID)
      9. International Financial Centres
      10. Bribery Act
      11. Market Abuse Directive
      12. MF Global
      13. FATCA
      14. FTT
      15. Other Tax Issues
    7. AIMA Regulatory Update
  3. Sound Practices
    1. Due Diligence Questionnaires
    2. Guides to Sound Practices
  4. Start-Up Service Providers
  5. Useful Websites