THFJ interviewed Tim McCourt, Executive Director at CME Group Equity Products, to hear about CME Group’s new alliance with FTSE/Russell indices. Prior to joining CME Group, McCourt traded a variety of equity derivatives including indices, delta one instruments, swaps, exchange-traded funds and equity borrow.
Joining forces with FTSE/Russell expands CME Group’s menu of equity derivatives geographically, by currency, and even by style of investment. CME Group has secured the exclusive US rights to offering futures on four indices, FTSE 100, FTSE Emerging Markets, FTSE Developed Europe, and FTSE China 50, for the next 12 years. CME Group will also offer the Russell 1000, Russell 1000 Growth and Russell 1000 Value indices, with the Russell 2000 contract start date delayed until July 2017.
CME Group already has partnerships with five exchange groups in the equity space: BM&F Bovespa, Nasdaq, Nikkei, National Stock Exchange of India (NSE), and S&P Dow Jones Indices. These add up to 23 indices across four countries (US, Japan, Brazil and India) with two currencies so far, the USD and the Yen. The FTSE/Russell deal, which adds seven new indices by the end of January 2016, marks CME Group’s first move into European equity indices, and opens up access to more countries. As well as single country indices such as the UK equity benchmark, the FTSE 100, and China 50, there will be multi-country and multi-region indices such as FTSE Developed Europe and FTSE Emerging Markets, with the pound sterling and the Hong Kong dollar added to the list of currencies.
“The deal significantly increases our international equity product offering,” says McCourt, who explains the alliance was inspired by engaging with customers to see what the market wants.
CME Group is introducing the first FTSE Emerging Market and FTSE China 50 futures contracts in the US. “The FTSE Emerging Markets index has 22 country constituents so it is a complex cash equity trade whereas the future is cleaner,” McCourt explains. The FTSE China 50 Index is made up of the largest and most liquid Chinese stocks. It contains a mix of H Shares, Red Chips and P Chips, all of which are traded on the Stock Exchange of Hong Kong, with H Shares incorporated in the Peoples’ Republic of China while Red Chips and P Chips are incorporated elsewhere.
To match customer needs for more international coverage, McCourt explains that CME Group needed an index provider with global reach. He feels that “the recent combination of FTSE and Russell is uniquely attractive in creating this value proposition. Russell has more than 30 years of index innovation experience and FTSE is a global index leader. The combined FTSE Russell Indexes sits very well with our existing franchise and is highly complementary in terms of platform and capital efficiencies.”
The Russell 1000 – which is comprised of approximately 92% of the US equity market – complements CME Group’s existing broad US index futures (on the S&P 500, Nasdaq, Dow Jones and S&P 400 Mid Cap). Additionally, CME Group will be offering style biased benchmarks in the form of the Russell 1000 Growth and the Russell 1000 Value indices. CME Group already offers sector indices for 12 US industrial sectors: utilities, real estate, MLPs, health care, biotech, materials, consumer discretionary, consumer staples, industrials, technology, energy and financials.
The FTSE Russell deal fills out CME Group coverage by offering “the right combination of country specific, region specific and other global indices in a very unique partnership,” says McCourt. CME Group customers are already eagerly awaiting the first eight new equity products with the first being available for trade September 21, and “it is an exciting time for the ecosystem as customers can now access more delta hedges for other option products” explains McCourt.
Benefits of margin offsets
Precise contract specifications are available on www.cmegroup.com/ftserussell and are listed by and subject to the rules of CME. Contract maturities mirror those on the existing equity index suite, with a typical cycle following Gregorian calendar quarters (March, June, September and December).
It is clear that core CME Group principles will apply to the new indices. “Margin offsets are automatically extended on one common platform to all customers and the new index contracts will benefit from being part of the CME Groupequity complex,” says McCourt. For instance customers are already taking advantage of offsets amongst the S&P 500, Nasdaq and Nikkei 225 indices, and CME Group will offer other offsets on the new contracts, enhancing liquidity and capital efficiencies. Participants do not need to specifically request or negotiate the margin offsets, and the methodology for calculating them is transparently published in the website.
Cross-margining
There are not only margin offsets between the various equity index futures traded at CME Group, but there are also degrees of cross-margining with related contracts on other trading venues. For instance, there are offsets with cash index options at CBOE, agreed with The Options Clearing Corporation (OCC), which has been cross-margining since 1989. The Mutual Offset System (MOS) with the Singapore Exchange dates back even further, to 1984. The Nifty and Nikkei indices are both MOS eligible, meaning that the contract can be executed at either and cleared at the other. “We are looking to engage with SGX to add more offset agreements,” says McCourt. Whether margin offsets will be offered on futures based on other asset classes, remains to be seen; some prime brokers are well known for multi-asset cross-margining.
The clearing house calculates, and updates, margin offsets and many customers find it convenient to use only one clearing house, from many angles. Not only does CME Group enhance capital efficiency in terms of reducing initial and variation margins; but also, operational efficiency is improved through technology and operational protocols and it is more convenient to have Futures Clearing Merchants (FCMs) engage with only one clearing house.
Liquidity and pricing efficiency
Perhaps most importantly, greater liquidity can be accessed on a major futures market. “We are looking to replicate the benefits already provided on other CME Group products,” underscores McCourt, who explains that liquidity on equity index futures is around seven times greater than on Exchange Traded Funds (ETFs) and also larger than in the cash markets. On Monday 24 August 2015, some ETFs were reportedly changing hands at very large (double-digit percentage) discounts to the value of their constituents, whereas equity index futures were reported to be trading within a fraction of a percentage point of fair value. This could be partly a function of how different financial products are constructed. CME Group does not need to go out and buy index constituents in the way that those issuing physically replicated ETFs would need to. In fast-moving and volatile markets, where some stocks gapped down 30% on that Monday, it may be difficult to perfectly synchronize the pricing of ETFs with that of constituents.
In contrast, the futures contract is between the buyer and seller, with CME Clearing sitting in between and it is settlement at expiration that ensures the future matches the value of the index. Differently, physical ETFs need to be redeemable against physical delivery at all times. Equity index futures are financially settled; although all are EFP (Exchange for Physical) eligible so some market participants can negotiate the exchange a future for the related physical basket, or an ETF, in a delta-neutral manner under the EFP rules. EFP users include stock lenders that want to increase their inventory of lendable securities and index arbitrageurs that cannot carry positions overnight.
Versatile execution choices
Equity index futures trade 24 hours a day on CME Globex whereas some ETF liquidity can be limited by its primary market venue trading hours or fragmented across several venues in after-hours trading. The extra trading hours offer one source of flexibility and CME Group has also worked to meet the needs to different customer types, giving them access to different execution styles: the central limit order book, EFP and block trades. “If you need intraday liquidity, the central limit order book may suit you, but if you are managing inventory you might want to switch to Exchange for Physical” McCourt explains. He adds that “this flexible execution lets customers access different liquidity pools, potentially tapping into delta one desks at sell side banks, index replicators, and traditional market makers on CME Globex or elsewhere.” Either passive or active index traders could utilize these features.
Cost comparisons with ETFs
CME Group has provided market participants with information for calculating and comparing costs of futures with other investment instruments accessible on the company website, http://www.cmegroup.com/education/files/ftse-russell-indexes-futures-versus-etfs.pdf. Earlier in 2015, CME Group carried out a cost comparison of ETFs and futures for the S&P 500 index, entitled The Big Picture. This study was based on the 2002-2014 period and made a number of assumptions. For example, it assumes that prime brokers will charge a spread of 40 basis points referenced to three month Libor, for either leveraged or short positions in cash instruments. It considered eight investor types: fully funded, leveraged, short sellers, and international (i.e., non US) investors, each for holding periods of below and above three months. The study concluded that only fully-funded investors with holding periods over three months, would have found ETFs more cost effective than futures over the observation period. Prime broker financing spreads, which may have increased post-crisis, are the main reason why futures are thought to be cheaper for leveraged and short investments.
CME Group is “looking at a similar analysis for the new products,” says McCourt, who points out that one key variable is the embedded management fees of ETFs versus the implied financing and roll costs of futures. Index providers will often charge ETF product providers an index licensing fee for their intellectual property, but this will not have any direct impact into the pricing of equity index futures contracts traded in CME Group’s markets. Of course individual investor circumstances will vary in terms of funding costs, commission rates, market access, tax issues and a whole host of other factors so CME Group emphasizes the need for each investor to consider all of the variables that are relevant to them. Costs are only one factor, however, as investors should also be cognizant of structural differences that exist between broad-based index futures and ETFs, which are regulated as securities, where futures do not have the same regulatory requirements as ETFs when pursuing leveraged or short-selling strategies.
Easier to leverage futures
For leveraged players – or perhaps those that need to free up cash for purposes such as currency hedging – the ease of obtaining leverage has long been an over-riding benefit of futures. For US investors, Regulation T setting minimum margin of 50% effectively caps leverage at two times while Regulation U for portfolio margin, setting margin of 12.5% to 15%, effectively caps leverage at six to eight times. In contrast, McCourt adds that a typical margin requirement of 5% on the S&P500 future can allow for 20 times leverage – or simply free up 95% of the exposure for other purposes such as risk management, yield enhancement or day-to-day cash management.
Easier to sell short
The advantages of futures can be even greater for short sellers, because futures markets do not distinguish between buyers and sellers in the way that cash markets – and various regulations – do. “In futures markets, there is no need to access prime brokerage platforms for short selling and portfolio swaps,” explains McCourt. There is also no need to locate physical borrow in advance or at delivery nor a positive bid test or threshold test, and no order tag requirement as the SEC’s Regulation SHO does not apply to futures markets, which are regulated by the Commodity Futures Trading Commission (CFTC). Nor indeed is there any requirement to pay explicit security borrow fees on futures. Regulatory risks are also arguably lower. While European agency ESMA has in 2015 allowed the Greek financial regulator, The Hellenic Capital Market Commission (HCMC), to ban short sales, and sought to impose fines on short sellers, futures traders have not faced such obstacles during crises. “During times of selloff, every product worked efficiently and was a mechanism for price discovery during crises,” recalls McCourt. All in all, McCourt argues “the future clears at a more efficient level with no explicit cost or supply constraint for shorting.”
Clinching the close
Recent innovations have made futures even more user-friendly. On 21 September 2015, CME Group premiered Basis Trade at Index Close (BTIC) mechanism on CME Globex with the Russell 1000. This allows customers to obtain the official cash index close in futures form. McCourt finds this uniquely compelling because he sees “more and more dollars migrating towards the close.” The official close is so important for the buy side, swap hedgers and option holders who may be held to that level by OTC product specifications. “Some participants have a fiduciary responsibility to replicate the index and want to avoid frictional costs.” The full mechanics of how BTIC works are explained on CME Group’s website, but briefly the BTIC is released 45 minutes after the index close and the basis can be positive or negative, depending on the dividends and implied financing that explain the difference between the futures and the cash price. The BTIC feature is of great benefit to some customers. Says McCourt, “previously if customers needed the official close, they did not have an efficient way to obtain it in futures form because they had to do an EFP after executing in cash or ETF markets. Now they can get the close directly with CME products.” The BTIC functionality will be added to the new indices. It can be valuable for both passive and active index traders. The BTIC feature can also be used by those seeking to arbitrage discrepancies between cash and futures, though they may need to trade an ETF or closing auction as well.
Ongoing Equity Index Future Developments
The FTSE China 50 index future being on-boarded is a future on the index that tracks the top 50 China stocks listed on the HKSE, which It will likely offer HKD and USD versions. Index partners are increasingly offering dividend indices, on which CME Group may provide futures. For instance, the CFTC recently approved dividend futures on the S&P 500. “There are all kinds of products we may bring to market and we may add more dividend futures in response to customer feedback,” says McCourt. Currency hedged indices could also be offered on more indices as the USD denominated Nikkei future has been popular with investors that wanted to play “Abenomics” by taking a positive view on Japanese equities without having to hedge Yen exposure. CME Group’s cautious attitude toward liquidity is illustrated by their game plan for adding options on the new futures. “We can list options on the futures but typically we will establish the liquidity of the future first and then see which indices make good sense,” says McCourt.