Futures adding transparency and depth to credit market
Credit index futures, which have grown sharply with ~$10 billon in open interest currently, have been a gamechanger in the credit markets. They have expanded access to more players, improved transparency and increased the speed of transitioning in and out of risk, according to panelists at a Crisil Coalition Greenwich webinar on Credit Futures: Uses, Growth and What’s Next. The webinar was hosted by Kevin McPartland, Head of Market Structure & Technology Research at Crisil Coalition Greenwich.
“The introduction of futures has opened up the suite of macro credit products to an increasingly wider range of clients,” said David Litchfield, Director, Derivatives Sales, Cboe Global Markets.
“We're bullish on the growth of this asset class or this means of accessing the asset class,” added Saul Doctor, Research Analyst, J.P. Morgan.
Supportive economic environment
Their popularity tracks the growth and maturity of the credit market, spurred by economic events from the pandemic-led to the current artificial intelligence-driven borrowings, and starting with the rise of corporate bond exchange-traded funds (ETF) to the growth in portfolio trading in ETFs.
Add to this the evolution of the credit trader, which has lent itself to greater “transparency and a faster ability to move in and out of risk,” pointed out Ben Kimble, Credit Trader, BlackRock. “These futures lend themselves perfectly to that use case… They're well suited for this time.”
According to Doctor, asset managers are increasingly using credit futures “as a useful tool to dial up and dial down the beta of portfolios as well as to manage inflows and outflows.” Interest is also emerging from commodity trading advisors (CTA) and bank hedging desks because of the product’s simplicity, with clearing done through the exchange. “We onboard a number of clients every week and continue to see that grow,” he said.
How do credit futures work?
While the idea of putting “corporate credit into a futures wrapper” is not new, Litchfield attributed their ongoing success to their explicit link with ETFs, which has put “liquidity at the forefront.”
“At a high level, they look and smell like an equity future… You're not getting delivered a basket of bonds; it's simply cash settled,” he explained. That has enabled faster transactions and enhanced transparency.
Futures versus CDS and TRS
Growth in credit futures has not diminished the dominance of credit default swaps (CDS) and total return swaps (TRS) either. “Futures have grown without taking liquidity away from other products by offering a new avenue for clients... It's been additive to the overall ecosystem,” said Doctor.
That’s because they have filled some gaps in the market. The CDS market does not track the cash bonds market, and access is restricted to major counterparties, said Litchfield. And TRS has a “bit of a lack of transparency and intraday pricing,” pointed out Kimble.
“We see futures as a next iteration in the credit-trading ecosystem in which we can express views more aligned with how our portfolios are looking to serving our clients” said Kimble, adding that use cases at BlackRock have been “additive to the portfolio on top of the existing products we already leverage.”
“This allows us transparency of pricing in conjunction with the ability to have an exchange-traded product in credit that we're able to move in and out of in a faster, more efficient way,” he stated.
Transparency and visibility
Pricing transparency has also improved data visibility. “Being that leveraged instrument, you can back out the financing… You can then start to back out where the pricing is for that borrower of the ETF. So, if you're thinking about implementing a short, you can start to appreciate how much it might cost in terms of the equivalent borrowing of the ETF,” explained Litchfield.
Being exchange-traded, credit futures have also “democratized borrow cost,” he added.
Liquidity moves off-screen
Doctor estimates daily trading volumes in credit futures are $1 billion–$1.5 billion as compared to $150 billion in CDX indices. “But the trading in futures is largely real risk transfer amongst clients” with fewer “intra-day traders passing the risk amongst themselves.”
Moreover, while on-screen trading has “been very helpful in keeping everyone honest around the pricing,” a lot of the liquidity “happens off screen,” he revealed.
At J.P. Morgan, most credit futures trades are block trades. Explained Doctor, “That would essentially be a client coming in through their sales contact, connecting with the trading desk, agreeing to the [trade] terms, and then executing through the exchange. So, although the information goes through the exchange, the trade itself happens off the exchange. Clients have found that process to be very seamless and easy.”
Kimble pointed to the need to look beyond trading volumes and open interest. “Sophisticated dealers and market makers who are trading this product will look deeper into how they can hedge themselves and offload the risk and recycle it in ways outside of trying to trade it on screen,” he said.
And added: “A true differentiation in client base is critical for getting CTAs, real money, market makers participating at the same time to support on-screen liquidity.”
Resilient during volatility
Although the futures market hasn’t experienced a Covid-like stress scenario, liquidity has held up relatively well during volatile periods like Liberation Day, pointed out Kimble. “I didn't see any hesitancy from dealers to pull back. If anything, folks were leaning in.”
Added Doctor, “These things will continue to trade in line with the other macro products, which traded pretty well during [crisis] periods.”
That’s because of the explicit link between ETFs and futures, said Lichfield. “Those arbitrage channels are extraordinarily tight… It means that the liquidity of the futures is almost analogous with those of ETFs. So, as dealers are buying ETFs, they can buy and sell futures and port liquidity from one market to the other.”
What’s next?
Refinements to credit futures are already underway. Cboe’s clients are excited to trade options on its credit futures. “It’s bringing that toolkit that an equity manager has used for decades into the credit market…. The advancement of that into ever-more granular exposures [is] where the market will head in the next 5-10 years,” said Litchfield. He also expects “many more indices with tradeable products” to emerge.
Doctor is equally “bullish” on options gaining traction. J.P. Morgan already trades “a lot of” CDS index options. “I expect options to take off more significantly in the next couple of years… We’re seeing a plethora of opportunity to launch different products,” he said, pointing to the emergence of credit tenor and loan futures.
Added Kimble, “The ability to get more granular…is certainly a growth area for these products and the entire ecosystem, as there's a need for different means of expression and different ways to exploit risk.”