A new report from Acuiti, produced in association with Nasdaq in conjunction with the launch of its Custom Basket Forwards, has found that investors are faced with a trilemma when it comes to the products they can leverage to execute their ESG, climate and thematic investments.
The main products available to firms today in that market are OTC equity swaps, listed index derivatives, listed single stock equity derivatives and total return futures.
OTC swaps are highly-customisable but firms face lower margin efficiency and, for many, higher costs compared with listed indices. These listed indices however, while being margin and capital efficient and boasting lower trading costs, are not customizable.
Indeed, none of the available products offer all three elements of capital and margin efficiency, low trading costs and customizability.
Adoption of listed products is growing, particularly in the ESG markets where there has been a significant increase in the available products listed on derivatives exchanges globally over the past five years.
However, the majority of trading for firms executing thematic and ESG strategies remains in the OTC markets.
Among the rising number of products being used for thematic investment, basket trading has emerged as a highly popular tool. This has developed rapidly in the OTC markets, where baskets are executed through swaps, but listed alternatives are also starting to come online.
However, to date, most listed products have been aimed at the major sell-side banks. An increasing number of hedge funds, macro funds, multi-asset managers and some long-only funds are using basket trades to go long or short on a theme, but doing so in OTC markets.
This conflicts with attempts by many firms – across the buy-side in particular – to reduce OTC exposures in the wake of post-crisis reforms such as the Uncleared Margin Rules, which have increased the costs and reduced the capital efficiency of OTC trading.
In addition, the cost and complexity of managing ISDA agreements when trading OTC is driving interest in listed alternatives.
As well as the complexity of managing ISDA agreement, for smaller firms, the required specialist back-office operations, collateral management systems and inhouse expertise are often too costly to run OTC basket trading strategies.
Nasdaq has developed Custom Basket Forwards to solve the investment trilemma and develop a listed product that can be used by the buy and the sell-side to execute tailored investing around specific themes. The products are cash-settled forward contracts on a customised equity basket, which are centrally cleared.
The Acuiti study found strong demand for the products from both buy-side and sell-side firms. For the buy-side the major benefits were the lack of a requirement to trade under an ISDA agreement, lower counterparty risk and capital efficiency. In addition, they enabled firms to further reduce OTC exposures.
For sell-side firms, they bring the opportunity to offer new products to existing clients and, particularly for smaller firms such as regional banks, the ability to engage clients that do not have the operational resources to manage ISDA agreements or are unwilling to trade in OTC markets.
Nasdaq’s CBF are the latest in a range of “futurised” products designed to replicate offerings in the OTC market but listed on an exchange and centrally cleared. After initial hype in the wake of Dodd-Frank and Emir, the path to futurisation has been long.
However, total return futures have seen considerable success and CBFs are a significant addition to the suite of products available to investors. CBFs mark the next stage of development of this market offering the ability to customise exposures.
Not only do futurised products enable firms trading in OTC markets to trade in a listed and cleared environment, the experience of total return futures shows that they also bring new clients to the market.
As thematic, ESG and climate investing grows, adoption of CBFs and further innovation across the market will increase in line with that growth.
Download the full report here: https://www.acuiti.io/solving-the-investment-trilemma/
