The U.S. market maker for S&P 500 variance futures is optimistic new initial margin rules could prove to be the catalyst the instrument needs to take off, following the execution of one such trade last week that involved a single December 2018 contract.
The future was first launched in December 2012 but it has struggled to attract market interest in large part because the margin requirements for trading the product compare unfavorably with the same requirements for trading its over-the-counter swap counterpart.
The product was designed to function as a listed alternative to the over-the-counter variance market, but it has not gained much traction, said Rob Hocking, global head of equity volatility trading at DRW Trading Group. That could start to change, since dealers have until Oct. 3 to comply with new collateral rules that require they put up initial margin on uncleared over-the-counter swaps. The capital cost of complying with that rule for an OTC variance swap could start to make the variance future look a bit more competitive, Hocking said.
“Everybody is preparing for what this means for the over-the-counter market,” Hocking said, adding, “A lot of banks started seeing what else is out there.” The Dec. 2018 trade last week may have been something of an experiment from a market player looking for an alternative to the OTC variance swap, Hocking suggested, noting that the trade executed was small. The December 2018 future was a “one lot” or 1,000 vega, compared to the typical minimum 50,000 vega trade in the OTC market, Hocking said.
Still, not everyone is convinced the variance future is a viable listed alternative to the variance swap. “Nobody understands what it is,” said Michael McAleer, professor of quantitative finance at National Tsing Hua University in Taiwan. The VIX index is easy to grasp because it has been dubbed the fear index, but it is harder to understand the value of trading variance, McAleer said. “Variance is just average variation, which is a standard measure of risk,” he said, adding, “Why would you want to look at the most primitive measure and ask what it’s going to be [in the future]?” The December 2018 contract is the longest-dated S&P 500 variance future available.
The future was designed to take into account feedback from market players who wanted it to resemble the variance swap as closely as possible, Hocking said. “In order to accomplish this, a certain level of complexity is necessary,” he said, adding that DRW and CBOE have been working on materials that explain its methodology.
Hocking is optimistic that as more dealers get used to the initial margin rules, there could be further interest in variance futures. Separately, the Options Clearing Corporation has been working on new margin enhancements that could help market players to further capital efficiencies through cross-margining of portfolios. The details may not be finalized until next year, Hocking said, but it could also help boost the capital efficiency of the variance future.