Derivatives: Eurex represents future hopes for stagnant synthetic market

Switch from swaps to exchange trading may stem property derivatives’ decline, writes Jane Roberts

Even its strongest supporters will admit that the property derivatives market is at a very low ebb. Trading volumes of IPD All-Property total return swaps, which until very recently made up the majority of the market and were boosted by interbank trading, have been declining since 2009.

However, volumes fell even faster last year and reached their lowest ever level in the last reported quarter: just £54m of notional trades were recorded in Q3 2012, of which only about £10m was swaps. This compares with average quarterly volumes over £1bn in the heyday between mid 2006 and 2008.

Banks supported the market initially, both to trade on their own account and in the expectation that property investors would eventually pile in. When this failed to happen, they cut back and some left the market altogether.

This year, the property derivatives market has been hit again, by other changes within banks. These have affected both banks’ ability to trade using their own balance sheets to make profits and their desire to sell ‘fully- funded’, structured products to raise bank funding – which in property is mainly IPD-linked notes.

Charles Ostroumoff of broker BGC, which is still very active in property derivatives, says: “Banks are more restricted now, due to Basel III regulations and their own (tougher) capital requirements. This restricts their capability to warehouse risk, so they can’t buy and sell risk; they can’t trade as freely.”

This isn’t only affecting property derivatives and nor is another generally positive change for banks, which has had the side-effect of hitting many structured products: the government’s new Funding For Lending scheme.

One broker says the scheme has played  a part in “decimating a lot of structured product desks. Banks can get money so cheaply that they no longer need to do structured products. It has made property derivative note pricing very expensive.”

Some banks still in the market

However, some banks are still putting out prices for property derivatives and main-taining in-house experts. Although two very experienced traders have left the market this year, Phil Ljubic and Andy Fenlon at Royal Bank of Scotland and Santander respectively, they leave behind them Helen Dixon, who still covers property derivatives at Santander, and Alex Winward and Stephen Gent at RBS.

Barclays and Deutsche Bank are also still open for property derivatives trading. But sources say that banks have had to put up their margins as a consequence of the new Basel regulations and low trading volumes, to help offset their increased cost of capital to hold these positions.

“Banks price risk differently on balance sheet now,” says one market participant. “The cost of risk-weighted assets on derivatives is penal, so the margins they are looking to charge are so wide: 1% of total return, 50 basis points on either side.”

Hope for the market’s future health  now rests with property futures, the ‘on exchange’ derivative product introduced to the UK in 2009 by Eurex, the derivatives exchange owned by Deutsche Borse. While swaps, an ‘over the counter’ product traded off exchange bilaterally with a known counterparty, are in decline, exchange trading is growing – albeit in the case of property, from a very low base.

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Trading volumes of property futures were tiny initially – £82.6m in 2010, the first full year of trading, and £173.8m in 2011. In the 11 months to November this year the total was £419.8m and the total volume traded since inception had just tipped £700m by then (see graphs).

In the past two quarters, Eurex’s market share has been higher than swaps: in Q2 2012, when according to IPD, the total notional volume traded was £102m, 27% was swaps and 73% was through Eurex.

Futures overtake OTC trades

In Q3 2012, IPD reported the total notional trading volume as £53m but said: “As the futures market has overtaken the OTC market we will no longer publish the split between OTC and futures”. But Eurex’s reported volumes that quarter were £42.7m, implying just £10m was off-exchange.

There are a number of positive reasons why the futures market could continue to grow, apart from the fact that it is increas-ingly the only trading option.

For those using or interested in using the synthetic market, Eurex’s advantages include: almost no counterparty risk, as all trades are cleared through the exchange; low entry cost to trading; relatively cheap trading costs, at 50bps or less per trade, including brokerage, clearing bank and exchange fees; and little burden on internal systems, as reporting and monitoring of trades is usually outsourced.

“The exchange market is a lot more user-friendly, very much a plug-and-trade model, and you only pay for what you trade,” says Ostroumoff. “On the exchange, you can trade with anyone and can buy or sell more quickly without breakage costs. All barriers to entry have gone; it costs nothing to set up to trade and there’s no counterparty risk.”

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Legal & General Investment Management has been using property derivatives to buy and sell property risk since 2009. Phil Bayliss, property business development manager, who established and continues to run the property derivatives desk, says L&G has traded around £500m in that time.

With the trading infrastructure of the whole L&G group behind the property team, he was easily able to use swaps and did, but this year he has been using Eurex, including taking one large, £50m-plus position.

This change to the exchange is a structural, favourable one that will build momen-tum,” he says. “Over the counter swaps are very good for me because we have L&G’s back office here to use, but others in the property market, such as the specialist real estate investment management houses, don’t have that. Eurex frees the market up a bit.”

One abiding perception in some quarters of the property market about the swaps market and Eurex is that there isn’t enough liquidity and particularly not enough sellers. This has been true at the longer end of the curve, in trading two to three years ahead, where few investors have deeper insight or information advantages over others.

However, Paul Ogden, founding partner of fund manager and property derivatives specialist inProp Capital, says he hasn’t found it to be the case at the shorter end of the curve. InProp buys property futures to get access to IPD property returns for clients in its open-ended UK Commercial Property Fund, which has monthly liquidity.

The fund has grown since its launch just over two years ago, when Scottish Widows Investment Partnership, ING (now CBRE Global Investors) and PRUPIM invested £40m on behalf of their authorised property unit trusts, to assets under management of around £150m, having peaked at around £180m, Ogden says. New investors include a local authority pension fund and multi asset class fund managers.

For the APUTs, inProp UKCPF provides “a liquidity layer”, Ogden says, as an alternative to holding cash or equities. For the multi asset class investors it can be a way of accessing the asset class itself in a convenient and liquid form.

“Our fund is long-only exposure with liquidity,” Ogden says. “We usually have to manage two futures contracts, the near and the next year’s, and we’ve managed to do that without hassle, without moving the market and within our monthly liquidity requirements. On occasion this has meant dealing significantly more than £100m in one month. We’ve never had any problem trading; so far we’ve been able to pick up the phone and the deals have been done.”

Bayliss has sold as well as bought risk and uses derivatives for a range of investment strategies. “Often one of our fund managers or asset allocators wants to reduce exposure but keep the upside in an asset where the sale price at the time might be ‘100’ but we see it as ‘110’,” he says. “We’ll sell the forward curve via derivatives and keep the asset, while we see the property through, say, a three-year business plan.

“This is a really positive use of derivatives  that has been very successful for us. Even if you lose some money on a swap, as long as your business plan generates a net profit including the swap loss versus the sale option, it will deliver outperformance that would not be available without derivatives.”

Sub-sector trading to expand product range

One drawback to Eurex, if a necessary one in its infancy, is that property futures launched with only one product: calendar- year contracts based on the IPD UK All- Property Total Return Index. However, in February, Eurex plans to start IPD sub-sector annual contract trading (see above).

“Sub-sectors are a sharper tool for fund managers to implement their strategy” Bayliss points out. They can remove some of the basis risk inherent in keeping specific assets and only being able to hedge the whole, all-property, market.

Ostroumoff argues: “Being able to buy or sell IPD sub-sector exposure synthetically in annual chunks will give property fund managers more short-term risk management strategies, namely hedging and portfolio rebalancing. Their introduction may provide more reasons why investors may want to buy or sell, because a sub-sector trade is not binary, like an all-property trade.”

He adds: “Switching sub-sectors – for example, selling a year’s exposure in City offices while simultaneously buying annual exposure to shopping centres – is a way of achieving high risk-adjusted returns with relatively cheap trading fees.

“Capital values can be protected in the short term and managers do not have to be rushed into making panic decisions. In this regard a direct portfolio is like an oil tanker, which can be slow and difficult to manoeuvre, whereas property futures could be likened to a speed boat.”

After three years, Bayliss is realistic about the possibilities and expects momentum to slowly return. “I am more encouraged than I was at the beginning of the year because Eurex is exciting and it feels like a structural change – delivering ease of access to the market, pricing and volume transparency and effectively no counterparty risk. However, the theme still is that we need more participants.”

Derivatives group wants more rewarding slot for banks that hedge risk

The Property Derivatives Industry Group, a special interest group of the Investment Property Forum, is in talks with the Bank of England to investigate how banks may be given credit for cutting their exposure to real estate market risk by using derivatives.

PDIG’s chairman, Paul Ogden, founder of fund manager inProp Capital, says the group has met with senior BoE officials. “Real estate market risk blows up banks every 10-15 years and it’s a systemic risk because market risk is, by definition, correlated across lenders,” he says. “Regulators want to reduce exactly that sort of risk. IPD is a good proxy for market risk, but not for idiosyncratic risk, ie risks that are specific to a bank’s particular loan book. Idiosyncratic risk is what keeps banks honest, so it is beneficial to the system that they should carry that risk.”

PDIG proposes that banks hedge market risk through property derivatives. “The problem is that the way Basel lll – and slotting, which is based on it – works is banks are not given credit if they hedge the way they should and keep the risk they should be keeping,” Ogden adds.

Slotting – the risk-weighting regime the Financial Services Authority requires banks to apply to property lending – is happening now and regulators are discussing how loans are applied to slots with individual banks (see September issue).

“Suitable risk-reducing techniques, such as hedging with property derivatives, need to be taken into account when slotting,” PDIG’s chairman argues. “If hedging sufficiently reduces its risks, an otherwise ‘weak’ loan could be promoted to a ‘satisfactory’ slot. In that case the regulatory capital would be halved and banks would get a better return on equity for real estate lending.”

Eurex counts down to sub-sector trading in 2013

In the first quarter of next year Eurex will start listing standardised futures contracts based on calendar total returns of five IPD sub-sectors: City offices, West End & Mid Town offices, shopping centres, retail warehouses and South East industrial.

“We are aiming for a launch in February 2013, although this still has to be confirmed,” says Christian Csomos, who is responsible for product development at Eurex.

As with All-Property futures, each contract will have a notional £50,000 value and buyers of annual exposure will pay a fixed price, with sellers receiving a fixed price.

The exchange has firm daily bid and offer pricing and it is also possible to deal off exchange if, for example, pricing (and fees) are favourable. This means that customers who can get better pricing from a bank but  are not set up to directly conduct swaps trades, or don’t wish to, can agree the price with the bank then ‘wash’ or clear the contract through Eurex. Their counterparty exposure is with the exchange – as is the bank’s. This, however, depends on banks being active and competitive.

Cashflows are settled once the final IPD figure for the total returns performance for that specific index is published. The final settlement price reflects the nominal par value of 100 plus the annual return for the segment.

Slightly confusingly, what Eurex calls  a 2013 contract actually relates to 2012 performance; the 2013 refers to the March settlement date following contract expiry. Users of Eurex have to post a margin, which is usually 8.5% of the trade’s notional value and this is the biggest cost of trading.

Retail, office and industrial sector trades were introduced last year but take-up has been limited to a handful of small test trades – 11 in all and none of them this year. Brokers and investors say this is because the market is clear that it wants to trade sub-sectors, not sectors, of IPD returns.