You win some, you lose some. As ICAP pulls out of the property derivatives market, LaSalle enters it. What should investors make of this? Shalya Walmsley reports

Even derivatives' champions are talking about the market as if it were once a promising rugby player coming to terms with a catastrophic leg injury.

Last year's record low volumes in the UK didn't help. Global trading volumes in 2010 were £1.8bn (€2bn), compared with £3bn in 2009. In Q4 only the UK recorded any trades at all - 52 of them, worth £192m, according to IPD.

Then ICAP, the interdealer broker, pulled out of the UK property derivatives market altogether. As it exited, ICAP - of significant symbolic value because it had carried out the record £100m series of property swaps between Prupim and RBS at the end of 2009 - blamed the slow development of the market.

But no sooner had ICAP announced its decision to pull out of the market than LaSalle announced its intention to enter. LaSalle claims that - despite a fall in volumes in the market in Q4 2010 driven by increased activity in the physical property market and uncertainty around regulatory change - appetite is growing. The firm points to a straw poll conducted at the recent IPD quarterly briefing, in which a (less than overwhelming) majority said they were considering property derivatives. It could also cite the entry of new investors, such as CBRE Investors, into the market.

"As with any market, it can take five, 10 or 15 years to get going," says Charles Ostroumoff, property derivatives trader at BGC, which partnered LaSalle in the creation of its new derivatives platform. "The inflection point can come at any stage. Given uncertainty in the property market, the demand is there - if latent. Five years is not a long time in the life of a market."

Ostroumoff identifies several potential sources of appetite for derivatives. First, there is an appetite among investors who can't buy the assets they want, for example if demand for London office is such that assets are hard to come by and overpriced. Second, there are investors looking to leverage income off trophy assets. Third, investors who find the fundamentals out of kilter with valuations can instead of selling their assets rebalance their portfolio.

He describes LaSalle's entry into the derivatives market as "very significant" because it is a big player with clout in the asset management industry and the fact that it manages a sizeable pension fund assets. "It's a vote of confidence in the market," he says.

This emphasis on LaSalle's top-down approach - with every fund manager authorised to trade derivatives - suggests that in the past the resources needed to trade derivatives had been underestimated. "If you're serious about it, it's [top-down] the only way to do it," says Ostroumoff. "Without doubt, this is an issue that has held up the derivatives market. Derivatives are not something you can do sitting on the sidelines. The whole organisation needs to understand them, especially the one pulling the trigger on the deal."

Something to measure by
In any case, say those property derivatives champions left in the market, there are exceptional reasons for the slow development of the market, and none of them is insurmountable.

Jim Clayton, vice-president of research at Cornerstone Real Estate Advisers and a professor of real estate at the University of Connecticut, claims derivatives are no different from interest rate swaps - a far more familiar product to pension funds. In the US, he says the market would have a better chance if it used property investment certificates. Then it would look more like a ‘real' investment - that is, like a bond.

"The institutional mindset is that derivatives are a foreign, strange thing and not really real estate," he says. "In fact, it is more like buying REITs - but investors may be concerned about pricing, the lack of long-term options, and a lack of liquidity."

Just as there are reasons why pension funds might engage with the derivatives market, there are equally good reasons why they haven't. Many of these are longstanding and won't be resolved any time soon. The quality of indices, for example, makes pricing derivatives a tricky business in most markets outside the UK.

Kiran Patel, global head of strategy and business development at AXA Real Estate, expresses scepticism over the valuation approach taken by indices and the absence of mark-to-market pricing.

"The UK isn't so bad but I'm not sure you get full transparency in valuations elsewhere," he says. "Mark-to-market could show up volumes and give us the right level of information we need to trade. I'm supportive of derivatives as a tool but you need the right information in the right place."

Even in the UK, the IPD captures less than 50% of the market. "We don't need the full 100% but we need more than 48%," says Patel. "It's like mistaking the 20% of a company that's free-floating for the price of the whole company. It just isn't the price of the company."

The absence of reliable indices is one reason why property derivatives have gained little traction in the US. Clayton points out that not only does the US have potentially competing indices, but it has a much more heterogeneous market.

"One feature in the US is that you can't get information on trading volumes. The only way to get information is to call up and ask broker-dealers," he says. "There are no readily available figures on transactions."

Another barrier to growth of the property derivatives market is uncertainty in anticipation of regulation - for instance, over whether EU regulators will classify investors using derivatives as financial institutions. "There's no point in setting something up if it's all going to change next year," says Jon Masters, head of the property derivatives desk at BGC.

The cost of trading swaps - another obstacle to take-up - has been addressed by the standardised contract introduced by Eurex, the European derivatives exchange, that will allow property derivatives to be traded easily on the exchange. This could well signal a move away from swaps.

"We've used funded notes and total return swaps and would like to be able to use them across a number of sectors as well," says David Skinner, head of property research at Aviva and a former academic economist. "If Eurex can support that, it can only be a good thing."

How deep is your market?
Even if there are good reasons to invest in the derivatives market, in a sense they're irrelevant: without market participants, there is no real market to invest in. As Masters points out, all markets need end-users. "You can't just pass the risk around," he says. "Look, when you're growing a market, you don't want players dropping out," says Masters of one of his firm's competitors.

Unless there is a mix of end-users - speculative investors and pension funds, say - everyone is on the same side. You can't replicate the underlying indices. You can't arbitrage pricing, and a hedge is expensive and difficult to deploy.

As Douglas Crawshaw, senior investment consultant at Towers Watson, points out, when trading volumes and the number of participants in the market is still small, "if you do use them in a big way, you could move the market".

Does this mean that pension funds, which have been looking at derivatives but have done little investing in them, should give up on them altogether - at least until the market provide sufficient volumes to make it worth their while?

Investors who've stayed in the market, albeit tentatively, haven't necessarily stayed in it for the same reasons they entered it. Aviva, for example, entered the market in 2006-07 and did substantial trades - even by the standards of the higher volumes of that time. Skinner points out that the fund manager's interest in derivatives at that time was largely about asset allocation, in expectation of a decline in property values.

Since then, Skinner has used derivatives intermittently to manage cashflow, and to share the exposure to large assets across funds.

Now the fund manager is in the process of widening funds to include derivatives - for as many purposes again, depending on the fund. Derivatives can help manage liquidity in open-ended funds, and in other funds to hedge and to rebalance portfolios quickly.

"If you're able to use your derivatives capability, you have a competitive advantage," says Skinner. "There's not a lot that would stop us using them, though the approval processes are onerous and the level of liquidity in the market might limit exposure."

Tomorrow and tomorrow and tomorrow
It's a question of changing the mindset and getting investors to understand that it is an efficient way to invest in property or - LaSalle's angle - to use as a risk management tool.

Even if you get the participants and the volumes, there are limits to what derivatives can do. Arguments why pension funds should consider derivatives have been well rehearsed. They allow investors to hedge; to rebalance their portfolios; and to get money into the market quickly. Tactically, if you have a direct portfolio and you want to bet on or away from office, for example, they offer a neat way to do that. "That's the theory. But, given the volumes, unless you buy the whole of the market - the IPD - you'll find it very difficult," says Crawshaw.

"We have very little information even in the UK at the sector and sub-sector level, so it's more of an asset allocation tool. You don't get the fluidity you need," agrees Patel.
"Property has heterogeneous characteristics," he adds. "There's only one Gherkin and one Cheese Grater. Derivatives don't cover the subsector level. The closest you'll get is in the UK, where they could be a great financial tool, but you want to make sure they are usable. It needs to be based on clear, transparent pricing."

But if derivatives players are looking only at getting enough market participants involved to make a credible market and at enough transactions to make it liquid, others are looking far beyond that to what derivatives can do next. Skinner identifies the fact that you can't hedge at the sector level as a barrier to derivatives being embraced.

"So far, it has been about asset allocators looking to increase or decrease at a higher level," says Skinner, but Ostroumoff reckons that will change in time. Once there is a reliable index, you can build a product, he says. "Once the market is fully established, I can see there being derivatives of all sorts of things - rental values, for example. It depends what people want," he says.

In the meantime, there's more waiting to be done. At some stage, derivatives will be a useful tool, at least in the UK, according to Crawshaw - even if now "you can't really do anything even if you like the idea". The problem is, someone has to be first.

"That's where the problem lies. The most likely user will be a traditional fund manager who might use derivatives to do a tactical play," he says. Some fund managers have, like Aviva, asked permission to lift fund restrictions that prevent derivatives being used, but none have used them at this stage.

"It's a chicken-and-egg thing," says Clayton. "Investors will be worried about the lack of liquidity and don't want to go first. But somebody has to. With many investors going back to basics, it should lead them back to a toolkit that includes derivatives and property swaps. With investors and investment managers struggling to buy properties they want, they might choose instead to invest in derivatives.

"I'm hopeful because derivatives are an incredibly useful tool," he adds. "It could help the asset class as a whole by helping investors to manage portfolios more efficiently. But it scares real estate people to think investors could do it without them."