Charles Ostroumoff explains how IPD segment futures offer portfolio managers the ability to hedge and rebalance quickly and cheaply
Banks, financial products and financial markets are all undergoing a period of metamorphosis. The financial landscape is being redrawn by changing regulations. These reforms, instigated by UK prime minister Gordon Brown at the inaugural meeting of the G20 in Pittsburgh in September 2009, are wide-reaching and onerous on the companies that are obligated to implement them.
The reforms that have focused on derivatives markets in the US are known as Dodd-Frank; in the EU, the combination of EMIR and MIFID is having a similar effect in terms of transparency, accountability and traceability. Prevention of further crises is the goal. Now ESMA has laid down the timelines for all entities that trade derivative products to fall in line with.
When Lehman Brothers collapsed, roughly 80% of its derivatives exposure was in bilateral agreements traded over the counter (OTC). Systemic risk existed as none of the other investment banks knew what their competitors’ exposure to Lehman Brothers was, let alone how exposed they were at the bank level. PwC is still going through agreements and finding new bilateral agreements between Lehmans and other counterparties.
By contrast, Lehman’s exchange-traded futures contracts were all closed out or auctioned off to other clearing banks within five working days. The regulators were quick to jump onto the benefits of exchange-listed futures vis-a-vis OTC-traded swaps – transparency of trading information (in other words, who has traded what product, in what size and with which counterparty).
A direct response by the lawmakers of Dodd-Frank and EMIR was therefore that all OTC-traded derivatives should go through a central trade repository, thus giving a full paper trail of all these transactions. The other key tenet of this regulation is that OTC trades should be cleared through a central counterparty clearer (CCP) thus mitigating the risk in the event of an end-user default. This is done through the ‘margining process’ (‘initial margining’ and ‘daily margining’) and through ‘collateral management’, ensuring that all trades are sufficiently covered. If a clearing bank does default, the risk is mitigated by being ‘socialised’ with the other member clearing banks of the CCP.
In the case of property – the last major asset class without a mature and ‘functioning’ derivatives market – these regulatory changes have had, perhaps, the most dramatic effect on market volumes out of all asset classes (although, given that it is such a new market, it affects few counterparties). Between 2006 and 2008, average quarterly volumes were about £1bn (€1.2bn) and open interest peaked at £7.1bn in 2007. These trades were predominantly OTC swaps traded bilaterally between banks. By contrast, in Q3 of last year and Q1 of this year more than £250m traded as IPD futures on the Eurex Exchange between end-users. This is a significant development in the market and since the property derivative market is so nascent it means its legacy issues can be more readily dismissed.
The market has been reinvented and all the barriers to entry for end-users that were associated with trading OTC swaps have been removed with the introduction of on-exchange IPD futures: ISDA agreements are not required; counterparty risk is mitigated; there is daily transparent pricing, and any end-user can trade with any other entity.
To date, the types of end-users that have traded are multi-asset funds, property pension funds, life funds, property unit trusts, hedge funds, banks and even high-net-worth individuals. The product has proven popular with high-net-worth individuals since you can trade a minimum of one contract and each contract has a notional value of only £50,000. In addition, when trading you are only obliged to lodge a minimum of 7.5% initial margin to the trade (that is, to cover a £100m trade you would only need lodge £7.5m) making it a highly geared product if gearing is what you are after. Given that the contract only covers a period of one calendar year, the downside to this gearing is time-limited. Property pension funds are not mandated to use gearing and so they fully fund their positions.
Investment houses are using the products in ever more sophisticated ways. One house has recently stated that it sometimes uses IPD futures to reduce exposure – in other words, ‘sell’ down the current value of its asset or portfolio and then asset manage over a one, two or three-year time period before selling the asset or portfolio. As long as the business plan generates a net profit, including the swap loss versus the sale option, it will deliver outperformance. So even if the futures trade were to lose money, the business plan is still delivered upon and this would not have been guaranteed without the derivatives trade.
The introduction of IPD segment futures will give property fund managers a tool to use for short-term beta risk management. This is something that has not been available to real estate practitioners in the past. IPD segment futures will enable property fund managers to effectively hedge, rebalance or switch IPD segments in annual chunks quickly (by the day) and cheaply (less than 0.5% in fees). Compare this with trying to rebalance by buying and selling bricks and mortar assets in the direct market in both timing (buying and selling in the direct market can take months) and costs (8% when you buy and sell a direct asset compared with less than 0.5% for IPD futures). In this regard, a direct portfolio is like an oil tanker, which can be slow and difficult to manoeuvre, whereas IPD futures could be likened to a speedboat. It is easy to see that the early adopters of IPD segment futures will be at a serious competitive advantage to their counterparts.
Charles Ostroumoff is an independent consultant