Summary

The capital allocated to trading and investment strategies can be a scarce commodity; thus, there is pressure to ensure managers deploy such capital efficiently in the pursuit of their portfolio objectives. This paper will cover the following points to showcase factors impacting capital utilization and the increasing need for more efficient trading vehicles:

  • Why capital efficiency matters
  • Capital efficiency of listed futures
  • Why Uncleared Margin Rules (UMR) are impacting an ever-greater number of clients
  • Increase in the minimum margin required to be posted under the Standard Initial Margin Model (SIMM) calculation since December 2021
  • The listed OTC alternatives quickly gaining client adoption given the industry challenges of optimizing capital 

Why capital efficiency matters

Using capital efficiently within a portfolio can be important for three main reasons:

  1. To avoid performance drag caused by not being fully invested in the market. Negative cash drag can occur in fully funded portfolios that only use stocks or ETFs to gain exposure. These cash equity instruments are capital-intensive, as they are fully funded (i.e., to gain $100 of exposure, one needs to deploy $100 upfront). If such a portfolio requires some cash to be set aside to manage subscription or redemption flows or to retain dividend income to be paid out later, this results in not only a slight underinvestment, but the cash balance is also not earning a market return associated with the fund’s benchmark. These factors combined can be a “drag” on performance.

    Many portfolios use derivative exposure such as futures to avoid the cash drag and stay fully invested in the market. This is because a futures position is not fully funded and often requires a risk-adjusted amount of initial margin to gain the same exposure (i.e., to gain $100 of exposure, one might need only to deploy $5-$10 upfront). This process is known as cash equitization.1
  2. To increase market exposure and free up capital. If a portfolio wishes to use leverage to increase its exposure to the market, it typically uses derivatives such as futures, swaps or even options. These all have pros and cons, but from a capital efficiency perspective, it is becoming clear that listed products typically have an efficiency advantage over OTC products. Meaning, often less capital needs to be deployed in listed derivatives than OTC products to gain the same level of market exposure, as a result of the different market structures. This in turn frees up capital to be deployed elsewhere and earn a return.
  3. To optimize capital deployment. Some portfolio mandates can implement short positions in addition to long ones. Doing this efficiently in terms of both capital deployment and implied borrow costs is a further important decision for managers to keep in mind when choosing between instruments which give similar market exposure.

Investors’ decision on the optimal instrument

The choice of which instrument to use to obtain a given market exposure can be significant in terms of the total cost incurred. Explicit trading commissions, bid-ask spread, liquidity, counterparty risk and capital efficiency all factor into the decision of which instrument may be optimal to use. Capital Efficiency has become increasingly important as the phasing in of regulation such as Uncleared Margin Rules (UMR) has impacted the OTC space and the number of clients affected by these rules increases over time.

Equity index exposure can be obtained via fully funded instruments such as stocks or ETFs, however, these are capital intensive as described above. OTC derivative instruments that can provide leverage have had their efficiency eroded over recent years. Bilateral swaps or forwards have been subject to increasing margin requirements, notably when ISDA raised the minimum SIMM requirements (margin) at the end of 2021 from 15% to a minimum 19% for developed equity indices (also recall this requirement was in the 5-6% range prior to UMR being imposed). For single stock derivatives, the margin requirements are even higher with a minimum of 23% on developed market names.

The capital efficiency of futures combined with the liquidity, mitigation of counterparty risk, and transparency of the products are leading to increasing adoption of traditional futures such as the E-mini S&P 500, while also generating demand for listed OTC alternatives such as Adjusted Interest Rate Total Return futures (AIR TRFs), Dividend futures, and Sector futures from CME Group.

What are UMR and SIMM?

Uncleared Margin Rules (UMR) are a set of rules that apply to margin (collateral) on Uncleared OTC derivatives and were introduced by regulators in the wake of the 2008 financial crisis.

The rules have been phased in over time, initially affecting only those clients with the largest OTC exposures; however, the threshold notional of OTC exposure used to determine whether a client is affected by UMR has been consistently lowered in phases. In September 2022, phase 6 of UMR will commence, which means clients with a calculated uncleared OTC exposure over $8 billion notional will be subject to the rules. This will significantly increase the number of firms affected by UMR given the previous phase 5 threshold was $50 billion.2

The amount of margin that needs to be posted is often calculated according to ISDA’s Standard Initial Margin Model known as SIMM. The SIMM levels are adjusted over time and in December 2021 were raised further to 19% for developed equity indices.

Why listed derivatives are being embraced

The current margin on a E-mini S&P 500 future is approximately 4.8%1, and the total cost and capital efficiency on offer combined with other attributes of a centrally cleared product are summarized in the table below.

Features Stocks ETFs Equity Index swaps Equity Index futures
Minimum margin required4 100% 100% 19% 5%
Listed or OTC Listed Listed OTC Listed
Counterparty Risk Limited with a T+2 settlement cycle

Limited with a T+2 settlement cycle and risk dependent on ETF structure

Yes Limited with a T+0 settlement cycle 
Locate required to go short Yes Yes No No

Data as of February 4, 2022

Beyond just the traditional equity benchmarks such as the S&P 500, Nasdaq-100, Dow Jones and Russell 2000, clients are increasingly adopting listed OTC alternatives such as Adjusted Interest Rate Total Return futures (AIR TRFs), Dividend futures and Sector futures. These products are generating rapidly increasing volumes and open interest over the last two years ─ a clear signal that clients are turning to more capital-efficient vehicles and actively reducing their bilateral OTC exposures.

Adjusted Interest Rate Total Return futures (AIR TRFs) on U.S. indices are designed to provide a total return exposure with an overnight floating rate built in. The enhanced contract design provides similar economics to an equity index total return swap with the capital efficiency of listed futures. The S&P 500 AIR TRF debuted at CME Group in September 2020, and in a little over one year has garnered over $40 billion in open interest; and at the start of 2022, is trading roughly 5,000 contracts per day (over 250% vs 2021 ADV).

S&P 500 Dividend Index futures are an alternative to an S&P 500 dividend swap. This market has seen a large amount of the activity migrate to the listed venue, resulting in significant growth in terms of both liquidity and open interest in the product. This is reflected in the rise of large open interest holders (LOIH).5

Sector futures are a capital-efficient alternative to both Sector futures and Sector ETFs. This is helping to drive growth in the Sector futures products at CME Group, as can be seen in the S&P Select Sectors growth chart, where volumes were up 40% in 2021 vs. 2020 and reached new all-time highs. 

Conclusion

Although capital efficiency isn’t the only factor to consider when choosing which instrument is optimal to provide equity exposure, it is an increasingly important one. The adoption of listed products such as futures is only likely to grow as UMR captures more clients in phase 6 and beyond and the increasing SIMM levels impact portfolios.

References

  1. To learn more about cash equitization please visit https://www.cmegroup.com/education/articles-and-reports/cash-equitization-with-e-mini-equity-index-futures.html
  2. Timeline for SIMM 2.4, effective as of Dec 4, 2021 – please visit https://www.isda.org/2021/09/09/isda-publishes-isda-simm-v2-4
  3. For further details on UMR thresholds and timelines – please visit https://www.cmegroup.com/education/navigating-uncleared-margin-rules.html
  4. Some fully-funded investors may choose to hold stocks in a margin account but that would require a minimum of 50%. Futures margin set by the relevant exchange and subject to change.
  5. Defined as anyone holding 200 or more contracts of the S&P 500 Annual Dividend futures

Adjusted Interest Rate (AIR) Total Return Futures

Get total return swap exposure with the capital efficiency of futures on indices such as the S&P 500, Nasdaq-100, Russell 1000 and 2000, Dow Jones Industrial Average, and FTSE 100.


All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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