Futures beat swaps for some derivatives users, writes RBS senior derivatives trader Philip Ljubic
The property derivatives market has been around for more than five years and more than £25bn worth of contracts have been traded. Most of these trades have been via property swaps. However, in recent months more clients have been conducting trades – and looking to conduct trades – through property futures contracts.
Royal Bank of Scotland believes that for some clients there are distinct advantages to using property futures rather than swaps. In essence, a property derivative future is similar to a property derivative swap contract. Both markets run in parallel, so one can directly compare the daily pricing between the two markets. Where the difference lies is that futures are traded on an exchange – EUREX in the UK – while swaps are not.
The key benefits for clients going down the futures rather than swaps route are:
- Minimal paperwork: none of the usual International Swaps and Derivatives Association (ISDA) or Credit Support Annex documents that underpin many derivatives deals are required, allowing for much faster trade execution;
- Counterparty risk is virtually eliminated, which is not the case for swaps;
- Much of the reporting and monitoring of trades is effectively outsourced, so less burden is placed on the internal systems for the likes of property fund managers;
- The regulatory climate appears to be favouring derivatives that are traded on an exchange such as futures;
- It appears trading via an exchange may satisfy funds that are UCITS compliant.
How futures trading works
Like the better-known property swaps market, property futures give users the opportunity to buy and sell UK commercial property exposure. This exposure is also based on the IPD UK All-Property Total Return Index, although later this year it is hoped sectors and sub-sectors will start trading on the exchange.
The table above shows futures pricing (columns 1 and 2) on 3 May 2011 for contracts over the next five years. Using this pricing, an investor wanting to buy £10m of UK commercial exposure for the period covering calendar year 2012 can do so at the 104.35 offer price. What this means is that if the percentage change in the IPD UK All-Property Total Return Index exceeds 4.35%, then the buyer makes a profit; or if the index change is below 4.35%, the investor makes a loss.
For example, if the calendar year 2012 IPD index total return is 9.35%, then our buyer’s profit is 5.0% (9.35% less 4.35%) on their £10m contract, which equates to £500,000 (5.0% of £10m). The buyer’s internal rate of return would be 59%, because on entering the contract the buyer only needs to put down 8.5%, or £850,000, of the contract’s notional £10m value, meaning that the implied leverage is 11.76 times (£10m divided by £0.85m). This 8.5% is the initial margin.
To use another example, let’s say our buyer wanted £10m of UK commercial property exposure over the next two years, covering calendar years 2011 and 2012. In this case, two separate contracts would have to be executed (unlike a swap, which could be structured as a single contract for the period): a £10m Calendar 2011 contract, at the 105.55 offer price shown in column 2 of the table; and a Calendar 2012 contract, at the 104.35 offer price.
In each separate calendar year, the initial margin the buyer will have to deposit is 8.5%. So under this two-year example, the buyer of Calendar 11 and Calendar 12 contracts will have to put down 17% of the notional value: 8.5% on the £10m notional for Calendar 11, plus 8.5% on the £10m notional for Calendar 12. For sellers of UK commercial futures contracts, exactly the same principle applies, the only exception being that when executing a trade sellers will be doing so on the ‘bid’ side of the table (column 1).
For example, a seller of a £10m Calendar year 2012 contract will do so at the market bid price of 103.35, or 3.35%. This seller will also need to post the 8.5% (£850,000) initial margin. It is relatively easy to get set up to trade property futures. The first stage is to contact a clearing member of the EUREX Exchange. There are 40 general clearing members of the exchange that can clear customer business and they are listed on the EUREX website (www.eurexchange.com).
For many funds, the most convenient clearing member to use will most likely be their current custodian, or the bank at which they keep the cash of their fund. At this stage, the clearing member’s team will carry out the standard know-your-client procedures. The clearing member’s role is principally to execute customers’ orders and settle transactions. However, as part of the relationship they will also have to monitor the positions of the client and administer both the initial margin and any cash flows that result from changes in the daily valuation of the contracts (also known as the variation margin).
Some fund mandates might impose restrictions on trading in listed derivatives such as property futures, so in this case a mandate change may be necessary. Clients will need to check whether internal compliance approval is required for the funds to trade these products. Once a fund is able to trade futures no further documentation (such as an ISDA agreement) is needed, because the legal framework around these contracts is set by the exchange.
When the clearing member has been selected and the necessary client checks have been completed by the clearing member, a client will be assigned their own individual ‘futures trading account’ or ‘futures account’. The clearing member uses this account to transfer cash (in the form of initial margin and variation margin) to and from the customer, clearing member, and the EUREX Exchange.
The EUREX Exchange has firm bid and offer pricing on a daily basis for property futures. However, because the futures market runs in parallel with the swaps market (where banks such as RBS rather than the exchange provide daily two-way firm pricing) it is possible that pricing between the two markets may be different when compared on a like-for-like basis.
But while at face value, there are differences in pricing between the two markets, it is possible to convert swap pricing to the same format as futures pricing and directly compare the two markets on a like-for-like basis. Last month, RBS published a report called Exchange traded property derivatives futures, which includes an outline of the calculation. However, customers can directly receive this daily pricing from banks rather then conducting these calculations themselves.
Crucial pricing difference
It is vital that customers understand the pricing difference, because on occasions the swaps market may have better pricing than the futures markets, or vice-versa. In fact we have noticed that this is the case at the moment. We can clearly see this by comparing the futures and swap prices shown in the table. For example, buyers of a calendar year 2012 contract can buy at a cheaper price implied by the swaps market (104.13 using the offer price) than in the futures market (104.35, again using the offer price).
While many customers may not be able to directly conduct swaps trades, they can still transact a future using the better pricing from the swaps market. To do this, a customer would directly call a bank to get this cheaper price (rather than get pricing directly from the EUREX exchange). The two parties then agree on the price, but rather than deal directly between each other – whereby the counterparty exposure of the bank is with the end customer and vice versa – both parties ‘wash’ or clear the contract through the EUREX exchange. Here the customer’s exposure is with the exchange, and the bank’s counterparty exposure is also with the exchange.
This is what is meant by ‘dealing off the exchange’ and this is discussed at length in the RBS property futures report. Dealing in lot sizes a client wants is also important. At the moment clients using the exchange will typically see daily firm pricing that works in a lot size of 100 contracts (or £5m, as one lot on the exchange equals £50,000).
Obviously, this may put off some clients that want to execute trades of a greater size. However, it is possible and easy to execute trades in greater size – even at better pricing than that shown on the exchange. This can be done by carrying out deals ‘off exchange’, as discussed earlier. In the swap market, RBS shows firm bid and offer pricing (at the All-Property level) every day in a size of £10m. In fact in the swap market it is fairly easy to get firm pricing in much larger contract sizes too. If a bank and a client were to execute a large trade ‘off exchange’ then this is then simply ‘washed’ or ‘cleared’ through the exchange.