AT A GLANCE
- The maturation of cryptocurrencies has led to increased adoption of crypto products, including regulated and centrally cleared crypto derivatives
- With sustainable investments set to grow, derivatives products based on an index will be central to hedging ESG exposure
2021 was a significant year in the world of financial markets. We witnessed a retail revolution, increased crypto enthusiasm and Environmental, Social and Governance (ESG) growing deep roots in financial institutions. As we move into 2022, I believe these exciting trends are likely to be front of mind for many equity and alternative market investors.
As phase six of the Uncleared Margin Rules (UMR) approaches in September 2022, another significant theme will center on a greater proportion of the buyside coming into scope of UMR and the requirement to post more initial margin on a variety of instruments, including uncleared equity derivatives.
Diversification Through Crypto
Heading into 2022, clients stopped asking “should I invest in crypto?” and now ask “how much should I invest in crypto?” Particularly against a backdrop of increasing inflation, clients are looking to add crypto exposure to their portfolios to diversify with non-correlated returns.
The maturation of clients’ understanding of cryptocurrencies, and how they can be added to portfolios, has led to increased adoption of crypto products, specifically regulated and centrally cleared crypto derivatives. Being able to access a new, and still relatively nascent, market in a trusted and known manner via regulated futures and options has allowed institutional clients to embark on investing and trading assets such as bitcoin and ether. This trend is certainly one to continue watching in 2022.
The continued innovation of new, right-sized micro contracts alongside more larger-sized crypto futures will also allow for the deployment of traditional equitization and investment strategies by risk-savvy institutional investors, all the while continuing to expand the participant base by attracting more sophisticated, active individual traders to the market.
Derivatives and ESG
The rise of ESG factors within finance has been inspirational. Maturing from an academic consideration to an element in many investment decisions, ESG increasingly influences equity, bond and commodities markets, as evidenced by the launches of more robust index screening and carbon offsets products. As sustainable investments are set to grow in 2022, so is the need for risk management solutions that are specifically tailored to ESG criteria.
Risk management needs to be both straightforward and economic. Achieving this through derivatives based on ESG versions of existing benchmarks, such as the S&P 500 ESG index futures, allows firms to manage specific risks related to ESG factors in an efficient and liquid manner. S&P 500 ESG futures allow funds to meet target allocation in a more cash-efficient way than investing directly in the underlying stocks, potentially enabling more capital to be channelled towards sustainable investments.
Using derivatives products based on an index with a reliable calculation methodology will be central to effectively hedging the varying forms of ESG exposure. One such example is the S&P 500 ESG index by S&P Dow Jones Indices, which is considered Article 8 compliant under the EU's Sustainable Finance Disclosure Regulation (SFDR).
UMR Phase 6
A key regulation which will garner further attention from the buyside community in 2022 is UMR. With the Average Aggregate Notional Amount (AANA) threshold dropping from €50 billion in phase 5 to €8 billion in phase 6, a significantly greater proportion of funds will come into scope from September 2022 and they will be required to post initial margin on uncleared OTC derivatives. ISDA estimates that 775 counterparties will be captured in phase 6 of UMR, versus 314 counterparties in phase 5.
While attention to date has understandably focused on FX and Rates instruments, equity swaps have gone somewhat under the UMR radar even though OTC equities have a higher initial margin attributed to them than some other asset classes. This is likely to change throughout 2022 with margin efficiencies becoming ever more important for market participants.
As such, greater attention is likely to be paid around the margin efficiency provided by listed and cleared equity futures, such that participants can minimize the performance drag and expense created by increased initial margin requirements mandated for non-cleared equity swaps under UMR.
Moving into 2022
An important factor to note is that these three key themes are all underpinned by an ongoing challenge for the buyside, which is rising industry costs. Moving further into 2022, as firms look at the application of crypto and ESG products in their portfolios, while adhering to regulatory change and trying to become more cost-efficient, the use of listed derivatives to manage risk and improve returns will become even more important.