Life in an Equity
Low Volatility World
A CME Group Global Survey
How the world advances
July 2014	 1
Introduction. .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  . ...
July 2014	 2
With the last meaningful spike in equity volatility having
occurred three years ago in August of...
July 2014	 3
An overwhelming majority of customers, 89 percent,
agreed that the current volat...
July 2014	 4
how they were positioned and how benignly participants
behaved in 2008 when the VIX skyrocketed from 16.30 in...
July 2014	 5
and income replacement strategies (also known as “vol
selling programs”); these programs are becoming more
July 2014	 6
low volatility era of Q4-2004 through Q1-2007, due to post-
2008 regulatory and capital restrictions, the ban...
July 2014	 7
concerned with the impact on volatility of the removal of
the current monetary policy tools and more concerne...
July 2014	 8
There were, however, several suggestions as to where CME
Group could add value by expanding the equity produc...
July 2014	 9
CME Group® is a registered trademark of Chicago Mercantile Exchange Inc. The Globe logo, CME, Chicago Mercantile Exchange,...
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Life in-an-equity-low-volatility-world-a-cme-global-survey


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In an effort to better understand the customer impact of the low volatility equity environment, CME Group spoke with equity clients across asset managers, banks and hedge funds.
This report summarizes the feedback and observations shared, including:
Whether the environment represents a cyclical trend or secular shift
How buy- and sell side perspectives on this topic vary
When market participants anticipate a major uptick in volatility
What products, services and resources CME Group can provide in the interim

Published in: Economy & Finance
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  1. 1. Life in an Equity Low Volatility World A CME Group Global Survey How the world advances
  2. 2. July 2014 1 TABLE OF CONTENTS Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 The Trend Is Not Your Friend. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Banks and Customers – Their Changing Roles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 The Horizon. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Going Forward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
  3. 3. July 2014 2 INTRODUCTION With the last meaningful spike in equity volatility having occurred three years ago in August of 2011, and historical periods of protracted volatility lasting two to three years, conventional wisdom would suggest that the equity market is near the end of this low volatility regime. However, there is nothing conventional about the current environment or the unprecedented market intervention by central banks that has kept volatility levels depressed while elevating equity prices. While market conditions are expected to change, this change is not likely to occur at least for another 12 to 18 months. In an effort to better understand the customer impact of the current low volatility equity environment, during late June and early July, CME Group engaged in a dialogue with top equity clients across asset managers, banks and hedge funds. The following report summarizes the feedback and observations shared. • A cyclical trend: A vast majority of customers agreed that the current volatility environment represents a low-point in a cycle, rather than a long- term trend. Some banks dissented, labeling the trend as a secular shift. However, not one respondent said that market fundamentals have changed or that a new norm is being established. • Outlook disparities: Several banks said they are constantly looking to pitch new products or ideas, including low volatility strategies and“vol selling programs.”A number of buy-side customers said they are immune to these selling advances and they would prefer to see innovative ideas on how to more efficiently extract risk premium in the market, for example. • Feeling the squeeze: Reduced volatility in non- equity asset classes has caused asset allocations to shift toward equities. This shift has encouraged firms to enter the equity trading space and forced new and established firms to increase equity execution technology and infrastructure spend. Due to economies of scale in equity trading, lower share volumes translate to higher per-trade cost and less agency execution for traditional bank equity business. • A return to volatility: While a few customers said the earliest they could see an uptick in volatility is near the end of 2014, corresponding with the December FOMC meeting, most customers said volatility will return with a reduction in central bank intervention, likely in mid-to-late 2015. • Getting creative: Customers said that CME Group provides the tools to help investors manage risk; however, the challenge is that there is currently “too little risk to manage.” Customers suggested listing new equity and non-equity products – from SP 500 dividend futures to listed credit spreads – and increasing the number of observable price points in key products to expand the range of products and allow for greater disagreement on price.
  4. 4. July 2014 3 THE TREND IS NOT YOUR FRIEND An overwhelming majority of customers, 89 percent, agreed that the current volatility environment does not represent a secular change in market structure but is simply the low-point in a cycle, which has historically occurred once a decade. Opinion was fairly homogeneous among the buy side, with the majority of dissenting views on cyclicality coming from the banks.This is likely due to several factors, but most notably the structural changes that have been forced on the banks by new regulations in the last five to seven years. The increased cost of capital, compacted balance sheet and reduced ability to take on risk has fundamentally shifted the banks’business models towards more agency- style execution services. Revenues previously generated through risk-taking and directional market views must now be replaced by fees generated on day-to-day transaction volume.This shift creates an extreme short-term view where banks need to generate flow for the purpose of printing trades and collecting fees.This suggests that the divergence between the cyclical and secular views may be more a question of market role and timescale of revenue than anything else. Market cyclicality is not new for equities. However, the unanimous consensus is that the current volatility environment is the manifestation of central bank activity around the globe: a zero interest rate environment, excess liquidity, purchasing of risky assets and their perceived willingness to provide additional intervention and accommodation should the need arise. Despite this discussion of central bank policy and intervention, not one respondent suggested that market fundamentals have changed, or that a new norm is being established. While the market is setting all-time record-high index levels and, at the same time, multi-year low levels of both implied and realized volatility, many respondents pointed out that this is not unusual in the grander scheme and anticipated that implied volatility, as well as short-term rates, would continue to drift lower in the near term. The reason for this is that the seemingly “one-way markets” in equities has pushed portfolio and fund managers to shift assets out of other asset classes and into equities. As these are generally buy-and-hold positions, overall levels of equity market turnover drop, as does realized volatility. Fund managers that use overlay strategies (usually selling upside call options on long physical positions) to generate additional yield exert additional downward pressure on levels of implied volatility. While there are some small balancing effects to this picture, notably funds replacing long physical positions with calls (to limit their losses in the event of a market correction) or purchasing puts for protection, the general trend is one of an excess of supply of volatility sellers and a ceiling-like behavior of implied volatility. The frustration with this governor on volatility was captured by the sentiment from one respondent who said “income nature of selling volatility to increase yield needs to stop.” In terms of the discomfort and vexation experienced by some market participants around the current low-volatility environment, part of the issue is perception. For many, the current period feels more uncomfortable than other similar periods simply because of the magnitude of the last few volatility spikes and how clear the memories still are. With historical perspective anchored by VIX levels of 45.79 and 48.00 in May 2010 and August 2011, respectively, several clients said that “volatility at 10 is more normal than volatility at 40,” others said that the market would be remiss to ignore the fact that since the burst of the dot- com bubble, everyone has experienced a decade and a half of “this time is different” arguments that were subsequently shattered by geopolitical events and market behavior. If a sobering reminder is still needed, customers should recall
  5. 5. July 2014 4 how they were positioned and how benignly participants behaved in 2008 when the VIX skyrocketed from 16.30 in May to 80.86 six months later on November 20. BANKS AND CUSTOMERS – THEIR CHANGING ROLES Historically, when implied volatility is trending down, the sell side tends to do better than their buy-side customers as a function of their ability to take positions, commit capital and facilitate trades, while earning commissions and positive trading revenue from risk positions. During a low volatility period “nobody wins,” as the active traders in both communities lack opportunities to outperform. When volatility returns to the market, both the buy- and sell side are overly exuberant in the pursuit of profit and cause exaggerated short-term spikes in volatility that, in turn, elicit aggressive pricing and fee compression as dealers compete over the return of revenue. All customers with whom CME Group engaged are seasoned market veterans; not only did they remember recent periods of both high and low volatility, but they have also successfully traded through them. However, it generally appeared that the buy side had well-established strategies for investing in both market environments and had shifted their approach to their low volatility model. Real money managers appeared to be slightly more comfortable than their hedge fund counterparts, more so because they enjoy a broader passive-index based mandate; some hedge funds can only operate within a narrow trading mandate, such as long volatility, or long/short overlays, where non-performance, while perhaps understandable, is still nevertheless painful. While the impact of this environment is almost universally negative for banks, a few participants quantified this impact and said they were down between 12% and 20%, which supports public warning statements and 10-Q filings made by the major banks over the last several months. More than one-third of the bank respondents commented that in this environment, the cost of doing business for clients has become magnified. Some customers who otherwise would hedge their trade will demur in this environment. A hedge fund trader said,“there is a sense of apathy or lethargy that has crept into the approach to hedging; people are content to wait to a relative point in time where the hedge is cheap.” So, it is of no surprise that during this sustained period of reduced volatility, the bank dealing desks are looking at ways to increase and create revenue – not all of which are well-received by customers. More than half of the sell-side respondents said that they have increased their efforts to reach out to their clients and provide additional services, e.g. research on topical issues, new product ideas, educational pieces, etc., in a bid to ensure that customers reach out to them whenever a trading need arises. But the buy side said they often perceive recent sell-side pitches as too short-dated and focused on the current quarter, while the customer is focused more than one year out. Several asset managers and hedge fund traders said that they have noticed a disparity between bank and customer time frames: “banks are looking one to three months out and are in a survivalist mentality, while [their customers] need to look five to ten years out.” Some buy-side customers said the sell side is looking for ways to “print volume and write tickets.” One manager said that banks are pushing short-term strategies aimed to increase ticket charges and revenue; at the same time, they are floating artificial bearish strategies aimed to offset their natural long inventories. Several banks said that they are constantly looking to pitch new products or ideas, including low volatility strategies “There is a sense of apathy or lethargy that has crept into the approach to hedging; people are content to wait to a relative point in time where the hedge is cheap.”
  6. 6. July 2014 5 and income replacement strategies (also known as “vol selling programs”); these programs are becoming more expensive for customers and could perpetuate the low volatility environment. The more clients deploy these “vol selling” strategies, the more the volatility is suppressed. Several hedge funds that are long volatility strategies said that staying true to their mandate is becoming more expensive; they are playing more defense than offense and looking for new ways to implement their strategies at lower costs. One area where buy-side customers said they are willing to pay premiums is for tail event protection; though this also arose as something that the banks want, suggesting a healthy demand but lack of willing suppliers. Buy-side customers said they would rather see innovative ideas on how to more efficiently extract the risk premium in the market, buy longer-dated protection at these depressed levels and short variance in the near-term without going short gamma (in case that impending sell-off actually happens). Several buy-side customers said that they are not currently interested in product and idea pitches, so they are immune to the banks’ advances. Twenty-eight percent of these customers are looking to actively reduce risk and are trading less and observing less natural flow in the market. Common themes attributed to less trading include: • the desire to reduce positions and carry cost until opportunities return to the market. • that “no one wants to be a hero,” so there is less event- driven trading, which means no pre-event positioning and no reversion or liquidation trading post-event. • that risk tolerance is lower in this environment, where funds are running a fraction of the VAR they did months ago. Some buy-side customers surveyed are not as transactionally-minded as their sell-side counterparts and deploy a multitude of index-benchmark as well as absolute- and relative return strategies, both within equity markets and across asset classes.Allocations to equities are generating stable returns, and given the lack of opportunities in other asset classes, equity allocations and fund inflows are growing at the expense of fixed income allocations. For funds that are mandated to be long volatility, though, this is a“very painful environment,”as they are being carried out of their trades, they said. Perhaps surprisingly, bank equity trading desks are not as unilaterally pleased with the shift of capital to equities as one might expect.The reduced volatility in other asset classes – particularly in rates – has caused risk capital and investment budgets to be shifted towards equities in an effort to generate more favorable returns.This trend has encouraged new entrants into the equity trading space and forced both new and more established equity houses to increase their spending on equity execution technology and infrastructure. These cost increases, when combined with reduced volumes and volatility, have compressed margins for the incumbent equity desks. Due to the economies of scale in equity trading businesses, lower share volumes mean higher per-trade cost and, therefore, less agency execution for traditional bank equity businesses.This, in turn, hurts revenues from trading and direct market access (DMA) businesses, which causes still more liquidity to evaporate.This somewhat self- perpetuating negative spiral creates a paradox that reinforces a low volatility environment and presents the question: does low volume cause low implied volatility or vice-versa? Several buy-side customers, who rely on sell-side dealers for providing OTC exposure, noted that there is a belief that with the return of volatility there will likely be an accompanying market sell-off – a reversion of the currently diverging fronts. The real issue is that “this time will be different.”Volatility will return in force, but unlike the last
  7. 7. July 2014 6 low volatility era of Q4-2004 through Q1-2007, due to post- 2008 regulatory and capital restrictions, the banks will not be able to step in on the sell-off to facilitate customers, which will only lead to more volatility in the overall market. The issue of dealer inability to facilitate customers is not hypothetical, and in fact is already occurring. One hedge fund in particular spoke about how they are taking the other side of their dealers’ flow, and that the dealers are outsourcing risk to the hedge fund. For the index-benchmarked assets, the low volatility environment is not particularly problematic given that it has been accompanied by a slow grind higher and a sufficient degree of dispersion in single stock returns within sectors to allow for some outperformance through stock selection. Several respondents cited the current low volatility environment as providing an opportunity to express directional views with less risk – either through the purchase of downside protection or, more often, expressing long views through options. Furthermore, a handful of customers said that they are shifting their risk allocation away from index volatility to single name volatility, where it is generally a more active volatility landscape. Others said that their success at stock-picking is dependent upon whether or not it was an incremental strategy and possibly insulated by a high-beta passive strategy, or their only mandate. Without volatility in the market, stock pickers and active-only managers have a tougher challenge, as they are funding their picks longer with fewer correct calls and fewer high payoffs, according to one customer. For funds focused on absolute return and yield generation, the current environment is considerably more challenging, as the low absolute volatility levels make selling downside puts less attractive (selling cheap insurance policies with the market hitting all-time highs); the excess supply of upside calls has pushed implied volatility levels so low that very little additional yield can be generated from them. Several customers who employ more sophisticated volatility strategies – such as playing the difference between implied and realized volatility, or trading dispersion – said that while conditions are challenging, there are still opportunities to generate returns. The challenge occurs in pursuit of these rare trading prospects, in that the trade quickly becomes crowded and it is hard to monetize the opportunity. The trade develops fast and is hurriedly propagated by analysts, and there is not enough profit to be extracted to satiate the overwhelming number of veteran traders lying in wait. Unless one reacts quickly enough to participate in the initial move, the trade opportunity dissipates as the crowd dynamism mines the value back to unattractive volatility levels. THE HORIZON When do market participants anticipate an uptick in volatility? At the short end of the spectrum, a handful of respondents anticipated a pickup near the end of 2014, citing the December FOMC meeting as “the earliest possible point” but not necessarily a definitive catalyst. A majority of those asked felt that volatility would return once central bank intervention – notably Fed policy – was reduced, likely in mid-to-late 2015. Many respondents agreed that it would not necessarily be the act of raising rates that causes volatility to spike, but rather the first unexpected rate hike after the initial Fed move. One trader elaborated further that the rate policy change required must go beyond the tapering of Quantitative Easing. While the Fed may already be tapering, there is an expansion of central bank intervention in Europe and Asia, which means there will be sources of cheap liquidity – and therefore a cap on volatility – for some time. In the longer term, there were several respondents who felt that the gradual reduction in central bank intervention was inevitable and would be easily digested by markets and that this low volatility period could last for “many years” – well past 2016. These customers were less
  8. 8. July 2014 7 concerned with the impact on volatility of the removal of the current monetary policy tools and more concerned by certain worrying scenarios they see on the horizon and how central banks will respond. Specifically, they are concerned about the materialization of inflation and how the Fed’s reaction may lead to increased volatility. While inflation was a common theme, some felt that changes to policy aimed at addressing unemployment or labor participation rate may have a greater impact on volatility. A dissenting voice – who believes that the current volatility environment is driven by the economic cycle – said that the next shock may come in the form of a US recession in a zero interest rate environment and the uncertainty around what the Fed will do and how markets will react. In addition to the dampening effects of current monetary policy, the lack of economically-significant geopolitical events further exacerbates the market. Based on respondents’ feedback about the current geopolitical landscape, whatever the event is that eventually drives implied volatility higher, will be unforeseen and unimaginable. While more than three-quarters of customers agreed that an unforeseen event or disaster would bring short-term volatility back to the market, the event in question would need to be catastrophically unique and demonstrative of a clear and present danger to broader developed-market contagion to change the atrophic nature of the current volatility regime. Most respondents echoed similar sentiments through a geopolitical lens, where a few noted that the market shock could also come in the form of an unforeseen technical or trading error that is severe enough to remove market participants and or venues. Traders cited the recent upwelling of activity in Syria and Iraq as interesting, but not an event that they, or the market, need protection from.The news, while distressing, has become commonplace and is already reflected in asset prices.A handful of participants said that the bellwether to watch for a signal that geopolitical events are likely to impact equity volatility is the price of oil.When oil reacts, it is the signal that the interests and anxiety of the market has been collectively piqued, and the precipitating event could be the market catalyst needed to break the current volatility status quo. A smaller subset of market participants said that since the 2008 financial crisis, there is a longer trend developing, where today’s environment has not occurred by accident, and is not purely cyclical.They said that regulators wanted to“intentionally suppress the market volatilities,”in order to “reduce leverage and proprietary trading in the long term.” Through Basel III, the Volcker Rule, Dodd-Frank and their non-US equivalents, the market has seen leverage reductions and increased capital requirements, which have forced banks to reduce their presence in the market and, by implication, have cooled the whole market from a risk and volatility standpoint. Overall, the question appears to be whether this legislative-enacted force suppressing volatility will last much longer than the current lack of catalysts in the short-run. Non-US markets moving to new highs, coupled with Treasury yields moving back above 2.5% while the SP 500 dividend yield has moved below 2%, may attract investors to other strategies and cause them to abandon their current yield strategy in the US Equity market. GOING FORWARD As part of this outreach, customers were asked a simple concluding question: “What can CME Group do to help?” This was, for many, the hardest question to answer. Clearly, there is little that an exchange can do to alter the current central bank-induced low volatility environment, and as one respondent expressed, CME Group provides tools to help investors manage risk; the challenge now is that there is “too little risk to manage.”
  9. 9. July 2014 8 There were, however, several suggestions as to where CME Group could add value by expanding the equity product complex to provide a more complete toolkit for investors. In the delta-one space, there were requests for CME Group to list dividend futures on the SP 500 (the most common request) and total return index futures. Among volatility products, the recurrent themes were extending the range of maturities on options on the E-mini SP 500 future to five years (and beyond), as well as products for trading variance and skew in future format. There were also several mentions of non-equity products, notably listed credit products and spreads, and additional alpha-generating products, such as liquid high-yield or investment grade product. Customers also suggested changes related to CME Group’s trading environment and market structure. Several customers suggested lowering exchange fees as a way to support their performance, but one or two also extended this argument into a new area of dynamic tick sizes. Specifically, could the tick size in certain key products, such as E-mini SP 500 or Eurodollar futures, be adjusted to a smaller increment during lower volatility environments? Customers said that increasing the number of observable price points allows for greater disagreement on price, which in turn, increases trading that results in additional volume and volatility. CONCLUSION The goal of CME Group’s outreach was to better understand the current low volatility environment in equity markets and how it is affecting buy- and sell-side clients. While the dialogue provided significant insights into the relationship between the current market environment, global central bank policy and changes in regulation, no single culprit emerged and unfortunately, no antidote was discovered. What is different about the current low-volatility regime is that that unlike previous periods that could be attributed to “natural market forces”, this period has clear and well- defined causes - globally-coordinated central bank policy and excess liquidity. The ease with which equity markets have absorbed significant geopolitical events in Syria and Iraq underscores just how dominant central bank policy is as a driver of current market conditions. The evolving business model of the sell side has also reinforced the lower levels of volatility. Banks have migrated to a more agency-based model as regulation has limited their ability to take on risk and commit capital – both on a proprietary basis as well as in customer facilitation. This shift has removed one of the most active segments in equity trading from the marketplace, leading to lower volumes and lower volatility. On the buy side, the current market environment has impacted distinct client groups in very different ways. The steady grind higher of equity markets has provided strong absolute performance for the more traditional, low- turnover end of the asset management spectrum, while the active community has experienced significant headwinds due to higher costs, lower liquidity and less reward for the risk taken. The interaction of all these factors has resulted in an environment of persistently low volatility with rising markets over the last several years. The question that remains is what will be the catalyst that returns volatility to the market? Absent a change in market participants’ ability to access capital and increase risk, or an accelerated cessation of central bank intervention, the catalyst to move the market to a new and more dynamic state is left to the market itself. To this end, history suggests that market triggers and the “unknown unknown” tend to occur at the most unexpected times and in unforeseen places, which leaves market participants watching, waiting, and hoping that this market does not disappoint.
  10. 10. July 2014 9 FOR MORE INFORMATION ABOUT CME GROUP’S EQUITY INDEX OFFERING, CONTACT THE EQUITY INDEX PRODUCTS TEAM: CHICAGO Scot Warren +1 312 634 8715 Tom Boggs +1 312 930 3038 Richard Co +1 312 930 3227 NEW YORK Tim McCourt +1 212 299 2415 Giovanni Vicioso +1 212 299 2163 LONDON Matt Tagliani +44 20 3379 3741
  11. 11. CME Group® is a registered trademark of Chicago Mercantile Exchange Inc. The Globe logo, CME, Chicago Mercantile Exchange, Globex, CME Direct and CME Direct Messenger are trademarks of Chicago Mercantile Exchange Inc. Chicago Board of Trade is a trademark of the Board of Trade of the City of Chicago, Inc. NYMEX is a trademark of the New York Mercantile Exchange, Inc. Standard Poor’s and SP 500® are trademarks of The McGraw-Hill Companies, Inc. and have been licensed for use by Chicago Mercantile Exchange Inc. Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. All examples in this brochure are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. The information within this brochure has been compiled by CME Group for general purposes only and has not taken into account the specific situations of any recipients of this brochure. CME Group assumes no responsibility for any errors or omissions. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME, NYMEX and CBOT rules. Current CME/CBOT/NYMEX rules should be consulted in all cases before taking any action. Copyright © 2014 CME Group. All rights reserved. PM1124/0714 CME GROUP GLOBAL OFFICES Chicago New York London +1 312 930 1000 +1 212 299 2000 +44 20 3379 3700 Singapore Calgary Hong Kong +65 6593 5555 +1 403 444 6876 +852 3180 9387 Houston São Paulo Seoul +1 713 658 9292 +55 11 2565 5999 +82 2 6336 6722 Tokyo Washington D.C. +81 3242 6232 +1 202 638 3838 CME GROUP HEADQUARTERS 20 South Wacker Drive Chicago, Illinois 60606