Trader TV’s Etienne Mercuriali is joined by Kevin McPartland at Coalition Greenwich, and David Litchfield from Cboe Global Markets to discuss how credit futures are constructed, priced and traded.
McPartland and Litchfield articulate for us how the time is right for credit futures as liquid economically viable credit exposure vehicles.
We discuss the current trading ecosystem and how the offering might grow and diversify in the future from duration hedged product, to different tranches.
Transcript:
Etienne Mercuriali Welcome to The Vol Show, a Trader TV production where we cover every corner of retail and institutional derivatives trading. I’m Etienne Mercurialli and with me today to discuss credit futures are Kevin McPartland at Coalition Greenwich and David Litchfield at CBOE Global Markets. Your market structure expert, could you walk us through the impact of the launch of credit derivatives and credit futures on exchanges as on the whole credit market?
Kevin McPartland Absolutely. So I think we should first step back and acknowledge that the change in the corporate bond market has been nothing short of incredible in the past decade. So electronic trading growth, whereas in the U.S., now almost half of investment-grade bonds trade electronically, the massive acceleration of portfolio trading in the last five years. And with all of that, a market that has become so much more automated, and the automation has allowed for more systematic investing strategies that weren’t possible before. And more systematic trading. So with that backdrop, derivatives are a key part of almost every other liquid electronic market, which is effectively what the corporate bond market has become over the past decade. Think about the equity market, of course. The interest rate market, right, relies very heavily on derivatives, as does the FX market. So we’re reaching a point in credit, or we have reached the point in credit markets, where credit markets need the same. So this is not the sort of first time that the credit market has looked to futures products to try to achieve that goal. But the last time that was tried, we were in a very different market with a very different focus. As I pointed out, so much has changed now. So now really is the time, right? So providing these products for whether it be for hedging or for developing new arbitrage strategies or for just being able to put on exposure more quickly and cheaply than existing products. There’s just a huge opportunity. And it really does feel like we’re in a market state where now is the time.
Etienne Mercuriali Kevin, David, what are the main advantages of trading credit futures rather than OTC?
David Litchfield The vehicles are very different. If you think about the beta landscape within credit, you have the cash bonds themselves, the ETFs, and they track benchmarks and do what they do extraordinarily well. And then when you get into the derivative space, you’re looking at OTC derivatives. So traditionally, the go-to instrument has been CDS indices, and then the standardization of the total return swap market about a decade or so ago. And one of the pieces of that jigsaw that has been missing has been a listed, centrally cleared derivative. So the futures fill that void, and I’m very much at pains to say to people, we’re not saying futures are better in all circumstances. They just do different things for different people and tick a few different boxes that the other instruments don’t. So if you just want that credit spread exposure, CDS indices give you that. The futures give you the entire exposure to the cash bond, so duration and spread risk in there. So if just want spread, trade a spread instrument. If you want a cash instrument, then the futures can be for you.
Etienne Mercuriali So a follow-up question to that David is what are the different use case you’re seeing for those products?
David Litchfield So we’ve seen demand from the entire user base, from asset owners all the way through asset managers, wealth managers and private banks, all the down into even high net worth and dare I say perhaps retail. And the use cases are varied, which means that the marketplace is a very healthy marketplace for liquidity. Different users using the futures for different reasons at different times, rather than it being liquidity provisioned by the sell side versus the buy side user base. And that can be from the leverage angle, they are listed, so if one has a mandate restriction from OTC derivatives, I mentioned before those credit instruments only reference the credit spread, so hedging a cash bond portfolio with simple instrument that looks at the credit spreads isn’t perhaps optimal. If you mix that duration risk in there as well, then you get perhaps a better hedge for the portfolio you’re looking to achieve. And then into other use cases like CTAs and futures. Commodities, equities, interest rates, been around since the dawn of time. Corporate credit has been locked off for a lot of these users because there has not been a listed product that they can trade on screen systematically.
Etienne Mercuriali It certainly looks to me as a good speculative instrument. I suppose one of the questions we have is, oh, you look to deepen the liquidity in those credit features and options.
David Litchfield So that is through the adoption. When we started these futures, as Kevin said, it’s not necessarily the first time futures have been tried, but we linked our futures explicitly with the two big ETFs, so HYG for high yield and LQD for investment grade. And linking those futures explicitly with those ETFs taps into that liquidity pool that they bring, very deep borrow markets, options markets, and they trade three, three and a half billion dollars a day on exchange. So, deepening that liquidity pool. The futures are liquid. You can lean on the liquidity of those ETFs to supply liquidity in the futures. But in terms of visible liquidity, on-screen activity and the open interest, that’s where adoption is really going to be the key. And as more users use it, as I say, we have long holders, short holders, tactical, strategic. The more users interacting in that pool, the better.
Kevin McPartland The other thing that really strikes me is exciting in this iteration of credit futures, right? There’s really two things. So the first iteration was post-financial crisis. There really was a focus at the time of a future rising, if you will, the swaps market. To some extent that happened, but really what happened was we got a more robust ecosystem for trading and clearing swaps and OTC derivatives. So the focus of those futures was to bring swaps traders into the futures market and perhaps to bring core futures trading firms into the credit market. To a large extent, that’s not how history played out. Sort of conversely, today we have a much more robust credit ecosystem as we already discussed, right? So the electronification has brought in. So many more investor types, trading firms that never would have come into the market in the past because maybe it was too slow or not electronic enough. We have that ecosystem now that already exists. And to David’s point, the products have been developed in such a way that they work in today’s ecosystem. So we’re not trying to take swaps traders and bring them into futures. We’re trying to provide this futures tool to this robust credit ecosystem where they’re already using multiple products. And to my earlier example about other markets where futures are so critical, it’s a tool that those markets have become accustomed to over decades and the futures market just hasn’t had that opportunity. So put all of that together and it really does feel like we’re in sort of a very different time that should see these sort of product adoption take off.
Etienne Mercuriali Interesting. And I suppose with this new population trading those instruments, what do you see as their future needs? Where are we going?
Kevin McPartland Yeah, so it’s a good question, right? So the initial, and David can talk to this in more detail, right, but the core products today focus on investment grade, high yield, emerging markets. You could certainly see those products expand, right. Maybe it focuses on sectors. Durations, I think, could be quite critical for certain segments of the market as well. So maybe you want shorter duration or longer duration, for instance. So there’s several permutations from the current crop of futures offerings as those pick up. You’ll see investors immediately requesting more. And we see some of that coming through some new research that we’ll be publishing in just a few weeks. And that’s exactly where investors are going, primarily into that of duration and sector focus.
David Litchfield Yeah, with the overarching theme being more indexation of the credit markets and tradable product on the back end. So famously, there are more equity indices and there are actual equities. I don’t think we get there in credit. But I think the proliferation of more and more indices, as Kevin said, slicing the world into more duration buckets, sectors, even geographies, I think that will come. And crucially on the backend of that, more tradable products. And I keep saying… Taking the equity toolkit from a portfolio manager’s perspective and bringing it into credit. Hedging a credit portfolio, the instruments available in today’s world, hedging an equity portfolio, maybe you want to buy a put, buy a puts spread, sell some calls, do something non-linear. Bringing that equity toolkit into the credit world I think is going to happen.
Etienne Mercuriali Giving a lot of flexibility to a new population of trader.
David Litchfield Absolutely. Great. And that user base of varied users, options players using it for completely different reasons to a fundamental credit manager, again, lends liquidity and brings liquidity to that market.
Etienne Mercuriali So there is a lot more flexibility coming to the credit market. I would like to thank David and Kevin for sharing their knowledge with us today and of course you for watching. To catch more other shows including Trader TV this week every Monday at 6.45am UK time go to TraderTV.net. Thank you David.
David Litchfield Thank you very much for having me.
Etienne Mercuriali Thank you, Kevin.
