Alternative Investment Management Association
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.
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.
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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.
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.