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Hedge Funds Review: Renaud Huck on “The future of listed derivatives”

Release date: 17 Oct 2014 | Eurex Exchange

Hedge Funds Review: Renaud Huck on “The future of listed derivatives”

With the regulation moving forward across the clearing market space market’s requirements are changing. The move to exchange clearing produced new products and solutions to meet the challenges of the evolving environment.

Renaud Huck, Head of Buy Side Relations at Eurex Exchange, and Bruno Pannetier, Chief Investment Officer at Old Park Capital, discuss the evolution of the listed derivatives market and the opportunities and challenges that it represents within the current regulatory landscape. How far will the futurization of European investment markets go, and how much more change is there to come?
If you prefer reading, here is the transcript.

Hedge Funds Review: Bruno, your career began in the structured products markets and now you’ve moved – you’ve started your own hedge fund and you’re focused in terms of solutions on listed derivatives products. So your career is tracking the ascent of listed derivatives and, perhaps, the decline of structured products. Is that a fair way of summing it up?

Bruno Pannetier: That would be a fair way to sum it up. I started in the structured products world in the mid-1990s, and I have enjoyed witnessing the growth of the structured products market, especially on the equities side of the business. This was my area of expertise. I took part in the sophistication of the payout in structured products in the 1990s and also over the last decade. I could see along the way the frustration of some investors regarding the way the valuation of structured products could affect a portfolio. Often, there was a clear understanding of how the structured product would benefit the portfolio at a given point in time, at a given horizon, which is the investor’s horizon.

This is what the structured product is about, actually to work with the investor on a customized solution to define the payout of a product at a given point in time. But what happens between now and this point in time is that the product valuation may behave in a way that the investors do not actually expect. Along the way, there can be a lot of frustration in terms of the valuation and mark-to-market of the product.

Obviously, this has been emphasized with the financial crisis, which started in 2008 and led to a number of surprises for investors in terms of transparency, in terms of valuation of the product and in terms of counterparty risk associated with a structured product.

Taking the lesson of this and having been pushed by some investors who had been involved along the years, I decided to form Old Park Capital with some people from my team in 2009, to focus on providing investment, which gives investors control and transparency – but not only at a given point in time, but also to control the path of performance and to control the mark-to-market valuation of their product within some parameters. This is what Old Park Capital specializes in. Old Park Capital is an alternative investment manager specializing in dynamic systematic strategies using listed derivatives, futures and options, which enable investors to have full control of their investment strategies.

Hedge Funds Review: We’ll perhaps talk about some specific examples of how listed products can achieve that control a little bit later. But the other part of the story, Renaud – about the increasing volumes in the listed world – is, of course, regulation and the wave of regulation that has followed the financial crisis, Dodd-Frank in the U.S. and the European Market Infrastructure Regulation (EMIR), here in Europe. Could you give us your overview from Eurex on what the regulatory landscape looks like now, why it’s encouraging listed products, and how that landscape is going to change going into 2015?

Renaud Huck: The answer to this question comes down to two elements that Bruno just spoke about transparency and counterparty risk. The current incoming European regulation has as an objective to address those two elements. As outlined in the famous G20 commitment from 2009, standardized OTC derivatives shall be traded and cleared on regulated markets and CCPs. Why so? Purely, as Bruno said, clearing houses have processes in place that allow them - on listed derivatives - to give a net asset value (NAV) at the end of the day, a mark if you want, the possibility of seeing where the value of an instrument is at any given time.

From a buy side perspective, there’s nothing more you could wish to have, which is to give transparency to your investors on the products that you are invested in. I think that’s maybe the big picture that the European regulators and U.S. regulators want to address, to give a bigger framework for the industry to be able to achieve transparency to achieve good NAV and good valuation of their portfolios. Also to give it to entities, clearing houses, which by nature are very conservative and have processes in place and can process and have a good idea of where those products trade or should be at the end of the day. Equally, on the trading side to offer a very different trading avenue than the OTC space.

On the one side, you have the processes but, on the other side, you have exchange-listed liquid products or products that will be liquid at some stage, to give the trading community two possible trading alternatives, whether the OTC space or the listed derivatives space. These avenues are in parallel and I’m sure that later we will elaborate a bit more about the futurization of products. Why is there such a trend in the marketplace? Why do buy side clients want to go towards those products, the listed products? How is it going to modify the market place, the regulatory field, but equally the rules of engagement between the buy side and the sell side whenever they transact?

Hedge Funds Review: What’s the next big change that Bruno and his clients should expect?
Renaud Huck: The next big change is definitely the futurization trend on the trading side, meaning that exchanges like us will launch new listed instruments that will replicate the OTC space and will give more transparency, but equally – at the end of the day – a mark, a settlement price and an independent settlement price in order for them to market their books but will also give them tradable instruments. This can be seen in different asset classes, so, for example, in fixed income or equity, but also the foreign exchange space. I think the regulation is going to cover all relevant asset classes, a lot of processes, to hopefully help – that’s the ultimate objective of this regulation – the buy and sell sides in the way they transact and in the way they trade products and have choice, because this is all about choice.

Bruno Pannetier: I completely agree with Renaud and the three points he made regarding why I also believe listed derivatives and futures should prosper and take more and more market share in the overall derivatives space. The first point, which I believe is the most important point, is transparency – to have a market price, an undisputed price for a given instrument at the end of the day or during the day, as opposed to a value based on the model given by a counterparty with all the problems that may derive from this, as we have seen during the crisis, where we had a number of OTC products, especially in the credit space, but also in respect to other asset classes, which were difficult to value.

Even the originator of the product – the bank originating the product – had some difficulty in valuing its own product. Obviously, in the futures market, in the real listed world, when they are assuming there is enough liquidity to create a market, then the value is the value of the market, which is the fairest possible valuation. It’s not model-based, it is an actual value. There is no underlying hypothesis underpinning the valuation of a portfolio or unpinning the valuation of a particular instrument for the investor. I think this is a huge plus for any investor.

The second point is counterparty risk, obviously. If you are in the OTC world, or in the formal OTC world where you are dealing with a given counterparty, obviously you have this counterparty that creates risk. Also, over the years, there have been a number of mechanisms to mitigate such great risk, in particular the credit support annex (CSA), but the ultimate mechanism to mitigate the great risk is to trade over an exchange. The sole reason why futures are listed options, and listed derivatives should take more market share in the future, is simply the practicalities of trading them.

Hedge Funds Review: You talked earlier on about using listed products to exercise better control on a portfolio. Can you give an example of how that works with the sort of mandates you have? Is that your active management of the portfolio, or is it more specific decision-making on market views on the part of your customers?
Bruno Pannetier: Old Park Capital is specializing in systematic strategies. So the control comes from the system and our dynamic management of the portfolio according to the system. The system is explained to investors and the system enables them to control their portfolio in a given way. So I will come back to a practical example, and I will show you one of our products, the Maestro strategy, which is our flagship product.

But, before coming to this specific example, just to make a metaphor to understand the point. If you are dealing with a taxi and you want to go from London Victoria to Piccadilly, you ask the taxi driver to go from Victoria to Piccadilly. This, I would say, is the normal way to do this, but this is a structured product because you focus on the destination point and you delegate to the taxi driver the actual route that he will take to your destination point. In fact, you have no control over the route. For example, if there are roadworks along the way that the taxi driver may not be aware of, then this can cause problems and affect the quality of your taxi journey.

Hedge Funds Review: And the cost.

Bruno Pannetier: And the cost. This is basically the structured products way of doing things. You have control of the destination point, but you may not have control of the time and you may not have control of the cost. Basically, you delegate this to the taxi driver, and it’s their ability to optimize this cost and the control for you, which in some cases may present a conflict of interests for the taxi driver. This is exactly the same between the dynamic asset management industry and the structured product.
The structured product will give investors the control over the payout at a given point in time. For example, a typical structured product is in the equity space. If I look at the structured products that were popular at the end of the 1990s and the start of the 2000s, I would give you a high coupon if all the stocks in the particular basket of stocks have been positive over three years, for example. You can have a pretty good view of what the payout would be in five years’ time but, along the way, you don’t have any control over the actual valuation of this particular product.

It will depend on the volatility of the stocks, on a number of market valuations, including the credit spread, of the structured products provider and of the issuer. This is what we feel and this is why investors come to us and people such as at Old Park Capital, investors really want to understand the distribution of the path of the return, they need to know whether the product can have a drawdown of -10% at one point in time – within one month, within one day or within one week. They may be absolutely fine with this, but they need to know.

By only controlling the destination point, you actually delegate, or you relinquish control of, the actual route. Whereas, if you have a dynamic strategy – which is a high liquid strategy and especially in what we do, we are dealing with a daily strategy, so a strategy manufacturing a return on a daily basis – then the path of the return is controlled in the sense that investors can have a clear view of what the path of the return may be, not just the destination point.

Hedge Funds Review: So you’re going back to your point about the model, and you gave the example of a correlation-based structured product; it’s very hard if you want to take a view against the provider of the product, you’ve got to have your own model. Whereas, what you’re saying is, you can test the efficiency of what you’re doing on a daily basis with listed products?

Bruno Pannetier: Yes, I think that, in a way, a structured product can be quite intuitive regarding the destination point. If I take the example of the correlation product we have just mentioned – that is, a product delivering a high coupon if all the stocks in a particular basket have a positive performance over five years – then the destination point, the final payout, is quite intuitive.

But the valuation, or the mark-to-market, of the product between now and the horizon, so a five-year time horizon is not intuitive at all to the investor because it depends on a number of variables, which are: the correlation – the way the correlation will behave; the dividends; the volatilities of the stocks; and the volatility of the correlation between the volatilities. It’s extremely complicated, whereas there is a requirement for products that are intuitive, but not only regarding their final value – the value at a given point in time – but the path of the valuation, so the dynamic of the valuation at any point in time.

Hedge Funds Review: But does that mean that complex products are finished? Or, because you can have an array of simple products that make a complex…

Bruno Pannetier: Yes, that’s right. It doesn’t mean that finance should stop being sophisticated. It means that the sophistication is not the enemy of simplicity and transparency. It has to be sophisticated in terms of value creation – there is a lot of fine-tuning in what we do – but we are just choosing a simple component, which can interact in an intuitive way. To come up with a simple formula, you need to put in a lot of creativity. If you want E=mc2, it’s a very simple formula, but you need a lot of work to reach this point.

Hedge Funds Review: Renaud, how does this scenario translate into demand for Eurex products that you have, and what are you doing in terms of the evolution of your product base? How are you responding to this demand?

Renaud Huck: That’s a crucial question to ask and to give clear answers about it. I think it is fair to say that part of the role for exchanges and the European exchanges like us is to offer our client base tradable instruments. But, as you just talked about, instruments and the marketplace, are changing constantly. The needs are different. Before, the needs were to list plain vanilla bond futures, plain vanilla equity index futures. Now those products have been launched, there is a need for more sophisticated instruments, but still structured in a simple way.

As Bruno said, you can be sophisticated using simple instruments - and that’s what we want to offer. We want to offer sophisticated, niche products, but in a simple and pragmatic way that allows the trading community to have access to these asset classes and the opportunity to have the exposure that their investment strategy requires. So, concretely, what have we done? We have spoken to the industry. It has to be a very collaborative approach, purely because, now with the incoming regulation, it is obvious to say and it is quite an easy observation to make that, going forward, if you are a small- to medium-sized buy side entity - and I would say it would be the same for a sell-side entity - it will be very difficult going forward to trade OTC instruments.
Economically speaking, it is going to be more of a challenge for smaller players to keep accessing the OTC space. Why? Because, if the most liquid OTC products, such as interest rate swaps, have to be cleared at the end of the day, as it is the wish of the regulators. I’m not sure that all the Clearing Members will be in a position to offer clearing of OTC products to their clients. It has to be economically viable for the Clearing Member and for the dealers, but equally for the buy side clients. So, at some stage, when EMIR is implemented, the different parties will have to assess what makes most sense for the business to continue transacting, whether to stay in the OTC space, but at the same time to trade listed products, or to shift their OTC trading habit into a listed trading environment.

About Renaud Huck

Renaud is Head of Buy Side relations at Eurex Exchange and covers hedge funds, asset managers, sovereign wealth funds and central banks. Before he started there, Renaud worked at the CME where he headed up Europe, Middle East and Africa (EMEA) coverage of hedge funds and sovereign wealth funds. Prior to CME, Renaud spent 15 years trading at investment banks.


So in order to prepare for that transition, we have engaged with the buy side and the sell side on some of the products that we knew were going to follow that trend. Quite simply, interest rate swap futures, which we launched in early September, are those kind of products because now you have the possibility of trading a two-year, five-year, 10-year, 30-year plain vanilla swap on exchange. Before it was a purely OTC bilateral transaction. Now this is changing.

To name another instrument, we’re about to launch EUR Secured Funding Futures in mid-November. Why? Because we know that the trading community going forward might face some difficulty in refinancing or finding liquidity in order to finance their positions. So we have to be innovative enough to read the market and to see how the market is going to change with the new incoming regulations and to explore new avenues that other exchanges haven’t.

In July, we launched FX Futures, foreign exchange being the most actively traded asset class in the world. FX Futures already exist in the U.S., but now it has been launched by a European exchange, so you now have the possibility of having FX Futures under a compliant European regulatory regime. That’s also something that will grow. Going forward, we can see that other asset classes, such as inflation, will potentially have to follow that road. In the equity space in late September we also launched Variance Futures. We already have dividend futures.

So these products, which before were very OTC-driven, now have equivalents in the listed space. Once again, it is to offer choice to the trading community and progressively, as those products find momentum and find liquidity, it makes more sense for the trading community to use them and to have the possibility of coupling them with OTC products and, as Bruno was saying, the possibility to create structured instruments, having a product that has an OTC look but potentially with a listed flavor, so combining the best of both worlds in order to provide transparency, compliance and NAV to such a product.

Hedge Funds Review: Some of the largest ‘mainstream’, for want of a better description, asset managers – firms such as Blackrock – are talking about volatility as an asset class. Volatility is a cheap asset class, particularly in the situation we’re anticipating arising in rates and where volatility is beginning to return to foreign exchange markets. Is that something that’s part of your thinking, your planning, in terms of your product range?

Renaud Huck: Yes, we offer volatility futures and options based on VSTOXX® already. There are similar products on the other side of the Atlantic to measure volatility on equity. For a few weeks now, we have also been offering variance futures. It’s true that this is a constant dialogue with the buy side and with the sell side - in order to calibrate the best possible products and in order to offer choice and alternatives.

It takes some time in terms of research, formatting, calibrating the products and then marketing and promotion, but I think that what we have seen recently is that it has a purpose, and once you really put a finger on the needs of the industry, you really give a good service to the trading community. We did it recently with the launch of the French bond futures OAT. There was a void, we filled that void and now the bond futures on the French debt is very liquid, so it fulfils a role, which is, for any French bond-holder, the possibility of hedging the yield curve.

Hedge Funds Review: Bruno, what sort of developments would you like to encourage in terms of the development of new products, the services provided by exchanges such as Eurex?

Bruno Pannetier: I think that exchanges such as Eurex are a key instrument in terms of refining the market price discovery of a number of asset classes. For example, this is true for volatility and this is true for dividends. I remember trading dividends for hedging purposes at the end of the 1990s, and there was no market view of the dividend. So even if you had the largest institutions, the largest bank, it had a completely different view on what the dividend of the Euro STOXX, for example, over a five-year period would be worth.

This is the same thing with correlation as with volatility at the beginning of the 1990s, and the fact that you have a number of people coming together – of market participants on the buy side and the sell side coming together on exchange, it is a way to reveal the actual market price of a particular instrument or asset class. In fact, the so-called hidden asset classes with an exchange, do not become hidden any more. The purpose of the exchange is also to reveal the asset price and to transform a hidden asset class into an asset class that can actually be traded by a variety of market participants.

Also, the more asset class material that we will use to combine dynamically and create strategy - these are the basic bricks that we rely on to combine to serve our investors. The more asset class instruments that are available in the liquid market, the better it is for us. Clearly, for today’s market and dividends, you can’t really have a dynamic strategy only based on dividends. It would be unthinkable.

Hedge Funds Review: Can you describe that strategy? Can you sum up the strategy on dividends?

Bruno Pannetier: We do not currently offer a particular strategy on dividends. I was just mentioning that, but, off the top of my head, for example, if dividends vary according to the market. So you could have a strategy based on how you trade dividends and dividend futures in a dynamic way to hedge your equity portfolio, because – according to whether the market goes up or down – then you will have an effect directly on the price, but you will have also an effect on the dividend.
So dividends are not fixed according to the price of stocks. The short-term dividends are fixed, especially if they have already been announced, but then, a dividend one-year, two-years etc., may move according to price movement. Given the importance for some investors of dividends in terms of carrier, revenues that they can get from their stock portfolio, they may want to hedge this and they use a dynamic approach using dividend futures to do this.

Hedge Funds Review: To keep things in perspective, a lot of the work you’re doing for your clients is obviously in the efficiency of the wrapper?

Bruno Pannetier: Yes, in fact, the primary product that we offer is a strategy, and volatility is quite cheap right now, and it may be interesting to take a view on an increase in volatility. What is interesting right now and one of the major themes is to have in your portfolio as a diversification product an investment strategy that will move in a particular way according to the strategy. Our mission as an asset manager, this is also the mission of structured product providers on the working side of the business, is to offer convexity to clients, to identify and enable clients to get an asymmetric position.

About Bruno Pannetier

Bruno is Chief Investment Officer at Old Park Capital, which is a hedge fund he co-founded and launched in 2009. He has a long track record in derivatives-based investment solutions, starting at Crédit Industriel et Commercial (CIC) in Paris, then Bear Sterns and then at Macquarie Bank, before he started Old Park Capital.


Otherwise, if you don’t have an asymmetric position, whether it’s asymmetry in terms of probability or in terms of outcome, it’s like gambling basically – you’re better off going to the casino. So, the name of the game from the investor’s standpoint is to take an asymmetric position in respect to a particular asset class. So, right now, what investors would ideally like is a strategy that will still benefit – so, provide a decent performance if the volatility stays stable at this very low level, historically low levels that we are in right now – but a strategy that would provide outsized performance if the volatility actually goes up, if there is a shock at some point in time, especially in the context of a possible increase in interest rates on the other side of the ocean.
This is exactly what the maximum strategy that we offer does; it provides clients with an asymmetric exposure to volatility, but without actual use of an option. You could do this by buying or selling an option in volatility, but this implies that you may have a cost in terms of the premium of the option, so what we have to try to do is provide the same kind of convexity, but at no cost or even at a gain for the client. This is what we do with our maximum strategy. We basically arbitrage the deviation of the futures price, and especially equity index futures such as EURO STOXX® futures and S&P futures after hours.

Hedge Funds Review: Renaud, you’re speaking to asset managers in Europe all the time. That’s your job. Do you see growing demand for exactly that kind of sophisticated investment approach? Because we’ve talked about the decline of complex structured products, but we’re not talking about the end of complexity, we’re talking about a more sophisticated investment approach.

Renaud Huck: Definitely. We see end-clients and European asset managers and European hedge funds interested in these very products, which are products that will help them to mitigate their risk, so whether curve risk or equity index risks. That’s what we deliver and, as Bruno was saying, that’s the very reason why we launched volatility futures, which are growing very well, and the reason why we decided to launch Variance Futures.

To answer your question thoroughly, we see the trading community of the buy side interested in having instruments that they can use in order to help them manage their portfolios, to catch and capture trading opportunity and market opportunity, but equally to fulfil the role of a futures instrument, which is also to hedge your position against either increasing interest rates or falling interest rates, but also a similar thing on an index side. So I think that what we see is the need from buy side entities for exchanges to explore new trading avenues and new products, so that’s why we launched Euro-Swap Futures.

It’s true that, if you look at the big picture, the OTC swap market being the largest in the world in the fixed income space, one could wonder, “why is there a need to launch listed derivatives?” But the reality is that there is a need. There is a need to have choice from the buy and sell side communities, and there is a need to have different tenors, different maturities in those products in order to be able to express a view on the different part of the yield curve. So I think that, going forward, exchanges will explore new asset classes, new products, they will explore products that are maybe more niche, but equally where there is a need for transparency, risk mitigation and, at the end of the day, to provide a good mark-to-market.

Bruno Pannetier: To highlight one of the aspects that Renaud has mentioned regarding the need for listed futures products, even in the space such as interest rate swaps, which is well covered by OTC derivatives, the fact is that the administrative burden of monitoring the position is mitigated with the use of a listed market. If you take a simple interest rate swap, this may be quite complex to monitor, both by the sell side and by the buy side, because you have the counterparty risk and obviously the counterparty risk is mitigated with the CSA, which is basically a bilateral margin system between the buyer of the swap and the provider of the swap, but still the correlation mechanism may be complex for some entities to monitor, but also complex in terms of valuation, for example.

During the crisis, we have seen that there was a misunderstanding of the cost of the collateral. For example, whether the collateral was paid in euros or in dollars, it mattered. In normal conditions, it doesn’t matter at all, but when the basic spread between euro and dollar, and the liquidity conditions are different between euro and dollar for example, then these kind of things matter. So, basically you have not only the administrative burden, but an economic impact on optimizing the collateral process in an OTC transaction. Obviously, in a listed transaction, then the mechanism of the exchange does this for you.


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