Equity Derivatives: Already Ubiquitous in North America, But Still Growing
( Greenwich Associates )
(November 16, 2006)
Thursday, November 16, 2006 Greenwich, CT USA - Greenwich Associates' 2006 North American Equity Derivatives Study confirms that flow equity derivatives have become ubiquitous among North American institutional investors: Every one of the 113 institutions participating in the study says it now uses liquid "flow" equity derivatives, with 81% trading single-stock options, 75% trading index options, 74% using ETFs, and two-thirds using index futures.
"While the use of all these products is expanding, the next phase of growth for equity derivatives is unfolding in products like equity and variance swaps," says Greenwich Associates consultant Jay Bennett. "During the 12-month period covered in the study, the proportion of institutions using equity swaps rose from 38% to more than half, and the share of institutions using variance swaps on indexes doubled to 20%."
j"Flow" Product Growth Driven by Swaps
While hedge funds account for much of the volume and growth in several equity derivative products, other types of investors also are integrating derivatives into the fabric of their businesses. Roughly half of self-reported derivative users interviewed by Greenwich Associates are long/short equity portfolios. When it comes to options, hedge funds and mutual funds are the most active users in the United States, while passive funds, pensions and long-only investors in general are the biggest users of futures.
Close to 100% of the hedge funds and mutual funds participating in the Greenwich Associates study say they use single-stock listed "vanilla" options, as do approximately two-thirds long-only of investment managers and pensions.
In terms of growth, the proportion of institutions of all types telling Greenwich Associates they trade index options jumped from less than two-thirds in 2005 to three quarters in 2006, with mutual funds the most active segment at 82%. The proportion of institutions reporting use of index futures also rose from roughly 60% to two-thirds, with pensions far and away the most active users.
But the most impressive growth by far was seen in equity swaps. Greenwich Associates estimates that the 52% of institutions that traded equity swaps captured in the study are doing a notional amount of around $75 billion "As the number of users grows, so too does the liquidity," says Greenwich Associates consultant John Colon. "In turn, as liquidity increases, more institutions feel comfortable using equity swaps not only as an efficient way to hedge, but also as an effective way to take on exposure to certain markets that they cannot access directly under their charters."
Of course, hedge funds remain the biggest users of equity swaps, with 60% of the hedge funds participating in the study identifying themselves as users, up from approximately 45% last year. So too in variance swaps and swaps on single stocks. The proportion of institutions surveyed using swaps on single stocks tripled to 12% over the 12-month period, but the bulk of that activity is generated by hedge funds. "The same pattern holds in dividend swaps and dispersion/correlation trading," says Greenwich Associates consultant John Feng. "Among all institutions, usage of dividend swaps is up from 12% to 16% and the proportion of institutions active in dispersion/correlation trades increased from 7% in 2005 to 15% in 2006. But a big part of this business comes out of the hedge fund community."
Flat Demand for Structured Products
The ubiquity of equity derivative flow products in the U.S. marketplace stands in marked contrast to the more limited demand for structured, customized, and hybrid OTC equity derivatives. "Unlike the situation in Europe, where the market for these products is booming, use of structured, customized, and hybrid derivatives in the United States is sporadic," says Jay Bennett.
There are three main reasons that demand for these products continues to lag in the United States and Canada. First, the availability of a wide range of flow products means that institutions more often than not can meet their needs with these more liquid products. Second, U.S. institutions are operating in what they perceive as a strict regulatory environment. As such, institutions tend to gravitate toward products that are more transparent in both structure and pricing. "In addition, North American institutions for the most part are not in the business of selling these products on to retail customers or high net worth clients to the same extent as their European counterparts," says John Colon.
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