Every week, another alarm about European sovereign and banking
risk. Is the euro tottering? Could European states default?
Derivatives are central to managing credit, interest rate and
currency risks – but in this unsettling new
environment, those risks are changing.
Elise Coroneos asks whether
the derivatives market is fit for the
Mounting debt, a common currency entering new waters of
instability, disparate fiscal polices across the euro zone,
countries on the verge of default and fears that others could
follow – the architecture of European finance is being
shaken as it has not been for decades.
Derivatives were invented to cope
with these kinds of risks – but they can only do their
job if firms are still willing to use them. And as the risks
change, market participants may find they need to use
instruments in different ways, or even invent new
On the horizon is another threat – that regulators
will reshape the market too radically, making it harder for
participants to achieve their objectives.
But even before we know how regulations are likely to be
redrawn, dried-up money markets have already been reshaping
derivatives markets all on their own.
The shocks to European government bond markets, especially
those of Greece, Spain and Italy, and quantitative easing by
the ECB, have reverberated in a flight to quality, resulting in
the yield on German bonds dropping across the curve to record
low levels over the last few weeks, according to Basil Kaye,
head of strategy at London-based proprietary trading firm Met
Exchanges on a roll
Eurex, where the 10 year Bund, five year Bobl and two year
Schatz futures are traded, had a record month in May as
interest rate volumes surged alongside equity
So did NYSE Liffe, where interest rate trading hit a new high
of 71.4m contracts, including 17.5m Three Month Euribor
Options, 28.1m Three Month Euribor Futures and 12.9m Three
Month Sterling Libor Futures.
"Options volatility has really come in from the cold," says
Paul MacGregor, director of fixed income derivatives at NYSE
Liffe in London. "Certainly, on the short term interest rate
futures and options trading, we are averaging very high volumes
The reason, he argues, is that many participants are taking
stances on future European Central Bank policy by trading
Euribor options. "While it is not all about situations like
Greece – we have been seeing this flux in volatility
for a while now – certainly the uncertain environment
created by the destabilising of economies in southern Europe
has generated even more options volatility," MacGregor
The flight to quality has stimulated trading in
Eurex’s futures on the ultimate safe haven asset
– German government bonds. Bund, Bobl and Schatz
futures volumes have all risen since February, when the
upheavals in market sentiment towards European sovereign debt
But after a big dip in late 2008 and 2009, the products are not
yet back to record volumes.
"Our Bund and Schatz futures have both reached the volume
levels from 2007, which reflects the flight to quality during
this sovereign risk crisis," says Nadja Urban, product manager
for fixed income derivatives at Eurex in Frankfurt. "Volumes
have benefited from recent developments around Greece, Italy
Hedging to the fore
The river of European interest rate trading may be running at
fuller spate, but beneath the surface its character has
changed. There has been a marked shift in flow dynamics in the
market, says Don Smith, head of strategy and economics at
interdealer broker Icap in London.
"One of the biggest changes in recent months has been a shift
from trading derivatives for the purposes of speculation, to
trading becoming much more of a hedging-related activity,"
Smith argues. "This is due to the fact that Europe has seen a
significant number of proprietary derivatives trading desks
close, which has had consequences in the type of flow that is
going through the market and the type of trading that is being
A research paper published by Massachusetts-based Tabb Group in
April 2010, entitled European Derivatives 2010: The
Buy-Side Perspective on Equity Options, Futures and Swaps,
revealed hedging to be the biggest driver of European equity
derivatives activity this year.
Second was 'exposure’, followed in third place by
'equitisation for cash management’. Leverage was a
distant fourth on the list.
Miranda Mizen, head of European research at Tabb Group, says
that of those surveyed, a majority expected to have a higher
equity derivatives turnover this year than last. Many said it
would be as much as 20% to 40% higher.
"We got many comments indicating that people are looking for
new avenues of alpha in the wake of the credit crisis," Mizen
Yet despite the vogue for hedging, there is still much trading
of the yield curve, according to Peter Herrmann, a broker at
the London office of JB Drax Honoré, the
world’s largest broker of Liffe’s
short term interest rate options.
Many comparisons can be drawn, Herrmann argues, between the
current situation in Europe and that of Japan in the 1990s,
when there was a pronounced flattening at the front of the
money market curve.
"Then, as now, all the activity is in the five and 10 year
sectors because people simply do not know what to expect in the
short term. So we were seeing a lot of people putting on trades
that roll up the curve to the front contract," he
In interest rate swaps, the largest derivatives market, volumes
have not been much impaired by the European debt crisis, says
Smith at Icap – but the nature of flows has changed,
from speculative to hedging-related.
Borrowers issuing fixed rate bonds and swapping to floating
rate, for example, has become a much more important component
of trading flow.
Futures market participants, Smith believes, have become a lot
more risk-averse, partly because there are fewer participants
and less speculative flow in the market after the closure of
prop trading desks. "We are finding that players are much less
married to their positions than they were before," he says.
"The greater risk that exists in the markets at the moment is
making people far less willing to ride out a market move when
it goes against their position."
In addition, the lower levels of overall trading in European
futures until recently meant that large players with big
positions could move the market – another factor that
created aversion in the general population of
Short term uncertainty
As proof of traders’ wariness about the short term
interest rate outlook, MacGregor at NYSE Liffe points to the
fact that open interest for sterling short term interest rate
futures two years hence is now 10%, a historic high.
"We have seen open interest migrating further and further up
the curve," MacGregor observes. "There has also been a larger
than normal interest in butterfly trading, an indication that
people know interest rates have to move at some
Another trend at NYSE Liffe has been a dramatic increase in
pack and bundle trading, both in Euribor and sterling. Packs
are sets of four consecutive quarterly interest rate contracts,
while bundles are multi-year groups of packs.
The one and two year bundles, which became more popular over
the past year in the wake of the credit crisis, are in demand
again because of the European turmoil.
"In an uncertain world, it is a good way of taking a long term
interest rate futures position in a short term interest rate
future using multi-month strategies," says
The creation of a €440bn European Financial Stability
Facility to support teetering economies and their bond markets
has highlighted the fractures within the euro zone and has many
investors asking: 'What is the exit strategy for the
"While the stand of the ECB is that an exit strategy is not
needed, just this super-fund, the reality is that the market
still has question marks over that," says MacGregor.
Basis swaps mushroom
Another result of the crisis in Europe has been the rapid
development of the basis swap market.
Traditionally, most interest rate swaps have been
straightforward fixed-floating rate swaps tied to six month
money market rates. But the contortions in money markets have
squeezed the appetite for medium term unsecured
"Banks, money market funds and sovereign wealth funds have
developed a strong preference to lend with much shorter
maturities – three months or less," says Smith. "This
has caused a dislocation between three month and six month
The standard six month swap market is still there, but there is
an increasingly large and very liquid market now in swapping
between three and six month floating rates.
"This is really a new market, which wasn’t there
in the same form before the crisis," says Smith.
Now, instead of bond issuers selling fixed rate bonds and then
swapping to six month Euribor, they are swapping to six month
Euribor and then conducting a basis swap to move the exposure
from six to three months.
"While this market has really taken off since last September,
the current European situation is lending a hand to this market
because money market conditions are still as illiquid as ever,"
Regulation: outlook uncertain
Regulation also promises to alter European markets, perhaps
profoundly. But despite a year of consultation that market
participants say has been helpful and constructive, there is
still great uncertainty about what exactly will
Some key differences have emerged between the way derivatives
are being reformed in the US and how they are likely to be
reshaped in Europe.
In the US, banks will be forced to siphon parts of their
derivatives business such as junk-rated credit default swaps,
equities and commodities (other than gold) into separate
Most OTC derivatives, interest rate swaps, currency trades,
investment grade credit default swaps and gold will be able to
remain inside US banks. However, there is no such movement to
break up derivatives desks in Europe. "In the EU, there is not
a problem with universal banks," says Anthony Belchambers,
chief executive of the Futures and Options Association in
Nevertheless, there are some clear areas of commonality between
reform in Europe and the US.
It can safely be deduced that central counterparty clearing
houses will emerge as more pivotal participants in the European
business, as in the US.
Assuming that some kinds of derivatives will be newly subject
to mandatory central clearing, the houses that perform this
function are likely to find themselves on the end of
substantially increased regulation.
"There will be a slew of new business, but it will come with a
price tag for the clearing houses themselves, so clearing fees
will inevitably be increased," according to
Regulated participants are also likely to face significantly
higher capital requirements for some derivatives trades,
especially those that are not cleared. These costs could be
passed on to the end user – especially of bespoke OTC
Another potential cost is tighter rules on collateral. "If
collateral that can support a transaction becomes cash or
near-cash, a lot of end users are going to have to acquire that
collateral from somewhere else, for example by taking out
credit lines," says Belchambers. "On top of that, companies may
be facing regular margin calls on a daily or intraday basis,
which is a cost to cash flow."
Clearing new products
Besides the costs likely to come from operating in a more
fortified regulatory environment, clearing houses will also be
dealing with a new push for them to participate in monitoring
potential threats to the system, putting another pressure on
their cost structure.
ICE Clear Europe, the Intercontinental Exchange’s
European clearing house, expects to begin clearing west
European sovereign credit default swaps in the coming
Jeffrey Sprecher, ICE’s chief executive, discussed
some of the intricacies of clearing sovereign CDS during the
company’s 2009 fourth quarter earnings
"Sovereigns present a unique risk and it’s one
that we’re debating with the market and with
regulators," he said. "For example, if you have an Italian bank
that’s writing protection against the default of
the Italian government, what is that risk? And is it possible
for an Italian bank to survive the collapse of its own
ICE’s clearing arm is also preparing to deal with
other challenges that came to the forefront as the crisis
unfolds, said Sprecher.
Already, ICE Clear Europe’s buyside solution for
CDS clearing, which will offer segregation of customer fund and
positions, is expected to be launched later this year. In the
US, ICE Trust began clearing index credit default swaps in
March 2009 and single name CDS in December 2009.
A boon for exchanges?
Pre-empting legislation, many participants are already moving
what were previously over the counter contracts on to
exchanges. "The move on to exchanges and away from counterparty
risk explains some of the fantastic turnover on derivatives
exchanges over the past months," says Herrmann at JB Drax
However, the question remains: once reforms have been
completed, what will be the percentage of derivatives contracts
traded on and off exchanges?
"It is impossible to call it," says Belchambers. "We
don’t really know what the capital costs are going
to be between all the different strands of derivatives
According to Tabb Group’s Mizen, more centralised
trading is something investors really value. "Many of them have
mandates as to whether they can trade listed derivatives or
whether they can trade the OTC," she points out.
But Steffen Koehler, head of product development at Eurex, is
yet not ready to categorically declare that regulation is going
to bring new business for Europe’s derivatives
"Right now, a serious forecast on how our volumes will be
affected by new regulations would be like looking into a
crystal ball," Koehler says. "During the credit crisis in 2008,
volumes increased, but the following deleveraging by some
participants led to lower volume in 2009. The same applies for
the upcoming regulation, as it can have a different impact on
Getting ready to grow
Despite the uncertainty as to how regulation will affect the
market, Peter Best, NYSE Liffe’s head of product
development in fixed income derivatives, says the exchange has
strengthened its core technology to be ready for higher
In terms of innovation, both NYSE Liffe and Eurex are poised to
respond to the demands of the market as the next phase of the
crisis evolves and regulation is announced and
"Going forward, the German bond futures product suite will
continue to be the benchmark for the European bond market,"
says Urban at Eurex. "However, we are following developments to
work out what the market needs. So, for example, if the EU were
to decide to launch a European government bond, then we might
consider whether it is worthwhile launching a contract with
this as underlying."
NYSE Liffe is getting ready to launch two new Gilt contracts,
one short and one medium term. "Gilts have been a flight to
quality," says Best. "Instead of concentrating on the front
months of the yield curve, which has always been typical in
futures, we have been trying to build liquidity further out on
the curve, where there was far less liquidity
Encouraged by the interest at the moment in volatility
strategies, NYSE Liffe launched multi-serial Euribor options to
enable intra-month adjustment. Best says they have so far
exceeded volume expectations.
Another minefield for legislators to tiptoe through will be
preserving end users’ ability to hedge, by
ensuring that it remains affordable, especially bespoke OTC
"If nothing else, one of the big lessons of the crisis is that
we need to have the systems and controls to manage our risks,"
warns Belchambers. "But if hedging costs go up, we
don’t want them to go up so much that some
institutions take their chances by going unhedged."
Europe’s wake-up call
Although derivative trading is thriving and clearing houses are
set for a boom, the wider outlook for Europe and its faltering
money market liquidity depends on a recovery of confidence in
the banking sector and a pick-up in economic activity, says
Smith. "It will be a fairly slow recovery, with a continuation
of these conditions at least until the end of the year,
probably even two to three years before we return to a
semblance of normality."
But despite talk of euro exit plans and hedge funds and other
players betting against the currency and the ECB, Smith
believes it will survive. "Simply put, what is happening is
providing a catalyst for major fiscal and structural reform
that needed to happen. This is just the catalyst to encourage
closer integration in economic matters."