Cboe has launched options on Cboe iBoxx iShares Corporate Bond Index futures, and widened its trading hours to further expand the user base and liquidity window for fixed income trading.
What’s behind the launch of Cboe Options on Futures?
David Litchfield: The overarching theme in fixed income markets, specifically credit markets, is the expansion of the toolkit along the lines of what is available in equity markets. The desire to access beta exposures is there, because it’s additive to portfolio management. A practical example is our futures offering. As with S&P e-Mini futures for equity mandates, investors can now use high yield and investment grade futures in dollar credit portfolios. People are used to using options in an equities portfolio, buying put options to protect the portfolio; selling calls to enhance yield, etc. Now they can do that on their credit portfolio as well, because we’ve launched options on futures. While exchange traded fund (ETF) options provide some support, there are a number of users that can’t do what they want to do in ETF options.
Two big challenges are early exercise risk, and the inability for dealers to make a tradable price further down the curve.
How are they addressed?
The fixed income ETFs pay their income out every single month in the form of dividends. Because the options are American style, this creates early exercise risk. If one has a call option that’s in the money, one would be better off exercising that call option and getting the shares, because one also gets the dividend on top.
Around eighty five percent of the open interest in ETF options, is in the front two months because of the risk of getting exercised early.
In addition to that, because the forward volatility is extreme, especially in high yield, pricing optionality further out reflects this. If a dealer is pricing a December 2024 (Dec 24), option on HYG, the funding cost that they’ve got to try and predict is extraordinarily variable. Last year the borrow cost of that ETF went from very low to double digit percentage for a number of clients. One customer quoted 12% that they were asked to pay to borrow HYG. If I’m trying to price an option, based on that forward variability, my options prices will have to be very wide and no one’s going to trade on it.
With futures, one has the ability to mitigate that forward volatility by trading that forward. Pricing a Dec 24 option, I can cross my delta with the Dec 24 futures, I’ve already hedged with that future today, and then my day-to-day delta hedging can be managed in that Dec 24 future if there’s liquidity or in the front month future. We have Dec 23 options listed currently, with Dec 24 planned as customers report that the three-month to six-month options bucket is their sweet spot.
You have also expanded global trading hours, what’s driven that?
The need and desire to trade corporate credit outside of US hours is significant. Corporate bonds obviously don’t trade like equities do, there are not the same proxies for trading across international markets for example from an e-Mini future to a FTSE, Nikkei, or Hang Seng product open at the time of trading. So in August we opened our US fixed income futures to 23-hours trading, five days a week. The early days will still likely see limited liquidity in APAC hours but we have seen market makers price during European hours and have already had trades go through. That is a function of two things; it’s closer to the US open, but also there are European-domiciled ETFs that trade during European hours (IHYU and LQDE).
What needs to happen structurally to support this?
There are market makers more than happy to price dollar credit outside of US hours. That manifests itself into UCITS European domicile ETFs. Similarly, it can manifest itself into the futures. We saw trades going through on the second day of the European hours being made available which is indicative of the demand that is out there to transact, and the liquidity that’s available. Given the demand that we have in Europe, but also the Middle East, that’s only going to grow. Some European money managers will likely wait for the US to open if they need to transact a large amount of risk, but there is always that need to trade for immediacy around an event in the European day; plus smaller rebalances are a hassle to hold back, so getting clips off in European sessions provides value. Perhaps this is evidenced by the UCITS ETFs which trade during European hours.
The demand is there and the ability to price is there. We’re happy to bring those two things together. In the longer run, I also expect the ability to price during APAC hours. There are a couple of APAC ETFs that typically trade by making a price based on the end of day’s NAV price in the US, but during the actual session, they struggle to trade. I’m not saying that the futures will make that trading fully possible, but they will be additive. This is bringing new people to the market with new tools for them to express their views.
What is your specific commercial advantage over rivals?
Our roots as an exchange in the options market, bringing options to the listed market back in 1973, make us the ideal firm to deliver credit options to the listed market. No one does it better than us. We still have an open outcry trading floor for SPX that trades huge volumes every day. Leveraging our expertise gives us the ability to launch a new product with credit indices, and bring that to market, supported by our depth of client relationships across the buy side and the sell side, and our expertise in product knowledge and design.
How will these potentially change behaviour and market activity?
The most exciting potential is the increased diversity of the user base. The current credit world trading credit default swap (CDS) indices is predominantly centred around fundamental credit managers. The commodity trading advisor (CTA) community with trend-following strategies in the futures space is hugely additive. They are trading these from a completely different perspective and supply liquidity when others might need it. Volatility players don’t care whether the underlying goes up or down, just by how much it goes up or down. So, if a volatility player finds value, in buying a call option and selling a put option in times of heightened volatility when the market is falling, that is providing liquidity against the wider market direction as the liquidity provider is hedging by buying futures.
To learn more about the product and how it trades please reach out to David Litchfield at dlitchfield@cboe.com
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