Total Return Derivatives: Can Repo Emerge as a New Asset Class?

Mr. Porcheret, back 3 years ago, long-term Eurostoxx repo rates decreased to historical lows, partly due to regulatory uncertainty, limiting banks appetite to provide liquidity. What trend are you observing in the TRS market for 2017?

First of all, it is important to mention that global equity repo rates have gradually rebounded in 2016 after three years deep in negative territory. Two drivers explain this rebound in our view: regulation, once again, and investor positioning. As far as regulation is concerned, liquidity and capital constraints set by Basel III have not only been already well absorbed by global banks, but some of these very constraints have also backfired, putting buying pressure and increasing the volatility of repo rates. When it comes to investor positioning, both short- and long-term flows have led repo rates to grind higher.

We at BNP Paribas expect repo rates progressively to normalise in positive territory in 2017. It is our belief that the decline in the inventory of equities available for securities lending will eventually offset regulatory constraints. However, we note that the implementation of the Net Stable Funding Ratio (NSFR) from 1 January 2018 could jeopardise this normalisation.

We are convinced that the volatility of equity repo will increase across regions. A lack of liquidity and flexibility in global financial markets should lead to sharp rises and falls in equity repo in short periods of time, depending on market conditions. Japan’s case is an illustration of what could be the new normal in equity repo volatility.

As an active market participant, you're well poised to comment on the market make up. What is the breakdown of users of equity index based TRS today?

Equity repo is not just the price of going short a security, it is at the confluence of derivative pricing, financing needs, new regulation and collateral management. Therefore, an increasing number of financial players have been using Total Return Swaps. Institutional investors – such as pension funds – have been trading TRS not only to position directionally or hedge in a cheaper way, but also to benefit from dislocation in repo levels or source attractive yields or financing. Hedge funds have also been very active on this market, mostly for arbitrage purposes. BNP Paribas has been providing liquidity on TRS to a diversified range of clients.

What impact will the planned introduction of bilateral margining for non-cleared OTC swaps in Europe have on your TRS business and how do you see the European buy-side community react to these new regulations?

BNP Paribas welcomed the new sets of regulation, such as the European Market Infrastructure Regulation (EMIR) and the Dodd-Frank Wall Street Reform and Consumer Protection Act, that have been designed for more stability, transparency and efficiency in markets. As part of its wider remit to mitigate risk in the derivatives markets, EMIR includes the obligation to (i) centrally clear over-the-counter (OTC) derivative contracts through Central Counterparty Clearing (CCP) or (ii) apply risk mitigation techniques when they are not centrally cleared. The clearing obligation applies to EU firms that are counterparties to an OTC derivative contract, including equity derivatives.

Among the mitigation techniques proposed, regulators indeed require OTC trades to be collateralised bilaterally, ie counterparties to post both initial and variation margins. Overall EMIR may cause more collateral to be posted at CCP. A considerable number of equity-linked transactions are still done OTC. According to the Bank of International Settlements (BIS), the notional amount of OTC derivatives linked to equities totaled USD 7.1trn at the end of June 2015, stable year-on-year.

It is difficult to measure the exact collateral shortfall that will result from EMIR, but we think this regulation is likely to exacerbate the scarcity of high quality assets needed for collateral posting, in addition to the deployment of large scale asset purchases by the European Central Bank and the introduction of the LCR. Counterparties are likely to keep posting the cheapest assets for collateral and fixed income high quality assets should remain their preference.

Therefore, while we remain uncertain regarding the impact of bilateral margining for non-cleared OTC swaps, we are convinced that the introduction of Total Return Futures will alleviate the concerns over collateral management, as well as fungibility and market transparency. This should attract even more market participants into trading implied equity repo.

The TRF (total return future) introduced by Eurex Exchange aims to replicate in a cost efficient way the payoff of an OTC Equity Index TRS. Could you briefly explain the differences between both products and what are the key advantages of trading a listed solution?

TRFs constitute a listed solution to mitigate concerns surrounding the envisaged introduction of bilateral margining for non-cleared OTC swaps. They are designed to increase market transparency, consolidate liquidity and bring fungibility to the current TRS market.

The key advantages of TRFs are:

• A fully-fungible product replicating the payoff of OTC TRS in a cost-efficient way;
• OTC-like trading convention via the TRF spread expressed as an annualised rate in basis points (+/-);
• Exposure up to 5 years (21 quarterly expiries listed at all times);
• Price discovery and liquidity provided by market makers;
• Portfolio margining with other equity and equity index ETDs within PRISMA (Eurex's portfolio-based risk management engine);
• Mitigate risk with Eurex Clearing as a central counterparty.

TRFs are seen as a listed solution for implied repo trading. Could you provide a simple example of a trade, typically on a calendar spread strategy?

Futures and forwards, total return swaps, vanilla and exotic options are all exposed to the repo rate. The repo exposure term is the maturity of the derivative traded. Different products are traded on specific maturities – cash, futures, vanilla options, and exotic options, creating a term structure of repo rates.

Investors have been increasingly trading TRS calendar spreads to benefit from the term structure of repo rates. In a TRS spread, the delta position on the index cancels out, as well as the EURIBOR/LIBOR payments. Therefore, the investor’s cash flows depend on the levels of the short-term repo, the long-term repo, and the spot level. The repo exposure changes linearly with the spot.

The final P&L is calculated as:   

At maturity of the short-term leg, the investor would have to decide whether to:

• Unwind the long-term TRS

OR

• Roll the short-term TRS.

What's the most important factor that will contribute to future growth in the market for TRFs? Could the TRF on SX5E serve as a template for other underlyings such as MSCI?

The future success of TRFs will depend on the ability of liquidity providers such as BNP Paribas to make repo emerge as an asset class of its own - like we did on dividends – and serve their clients in a fair and cost efficient manner.

Implied equity repo has been traded on all major global indices, namely EURO STOXX 50, S&P 500, Nikkei 225 and HSCEI. TRFs could definitely be the new format.

CV Antoine Porcheret

Antoine Porcheret is a Senior Equity & Derivative Strategist at BNP Paribas. His role is to lever fundamental content and parameter dislocations to express trading themes and cross-asset views at index, sector and single stock levels. Before joining BNP Paribas, Antoine spent seven years at HSBC as an equity derivative trader, from co-heading the world exotic single stocks book to managing the CEEMEA equity derivative trading desk.