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Life in an Equity Low Volatility WorldA CME Group Global Survey
How the world advances
July2014 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
July2014 2
INTRODUCTION
Withthelastmeaningfulspikeinequityvolatilityhaving
occurredthreeyearsagoinAugustof2011,andhistorical
periodsofprotractedvolatilitylastingtwotothreeyears,
conventionalwisdomwouldsuggestthattheequity
marketisneartheendofthislowvolatilityregime.
However,thereisnothingconventionalaboutthecurrent
environmentortheunprecedentedmarketintervention
bycentralbanksthathaskeptvolatilitylevelsdepressed
whileelevatingequityprices.Whilemarketconditionsare
expectedtochange,thischangeisnotlikelytooccurat
leastforanother12to18months.
Inanefforttobetterunderstandthecustomerimpactof
thecurrentlowvolatilityequityenvironment,duringlate
JuneandearlyJuly,CMEGroupengagedinadialogue
withtopequityclientsacrossassetmanagers,banks
andhedgefunds.Thefollowingreportsummarizesthe
feedbackandobservationsshared.
• A cyclical trend: Avastmajorityofcustomers
agreedthatthecurrentvolatilityenvironment
representsalow-pointinacycle,ratherthanalong-
termtrend.Somebanksdissented,labelingthetrend
asasecularshift.However,notonerespondentsaid
thatmarketfundamentalshavechangedorthata
newnormisbeingestablished.
• Outlook disparities: Severalbankssaidtheyare
constantlylookingtopitchnewproductsorideas,
includinglowvolatilitystrategiesand“volselling
programs.”Anumberofbuy-sidecustomerssaidthey
areimmunetothesesellingadvancesandtheywould
prefertoseeinnovativeideasonhowtomoreefficiently
extractriskpremiuminthemarket,forexample.
• Feeling the squeeze:Reducedvolatilityinnon-
equityassetclasseshascausedassetallocations
toshifttowardequities.Thisshifthasencouraged
firmstoentertheequitytradingspaceandforced
newandestablishedfirmstoincreaseequity
executiontechnologyandinfrastructurespend.Due
toeconomiesofscaleinequitytrading,lowershare
volumestranslatetohigherper-tradecostandless
agencyexecutionfortraditionalbankequitybusiness.
• A return to volatility:Whileafewcustomerssaid
theearliesttheycouldseeanuptickinvolatility
isneartheendof2014,correspondingwiththe
DecemberFOMCmeeting,mostcustomerssaid
volatilitywillreturnwithareductionincentralbank
intervention,likelyinmid-to-late2015.
• Getting creative: CustomerssaidthatCMEGroup
providesthetoolstohelpinvestorsmanagerisk;
however,thechallengeisthatthereiscurrently“too
littlerisktomanage.”Customerssuggestedlisting
newequityandnon-equityproducts–fromS&P
500dividendfuturestolistedcreditspreads–and
increasingthenumberofobservablepricepointsin
keyproductstoexpandtherangeofproductsand
allowforgreaterdisagreementonprice.
July2014 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
July2014 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.”
July2014 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
July2014 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
July2014 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 S&P 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.”
July2014 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 S&P 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 S&P 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 S&P 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.
July2014 9
FOR MORE INFORMATION ABOUT CME GROUP’S EQUITY INDEX OFFERING, CONTACT THE EQUITY INDEX PRODUCTS TEAM:
CHICAGO
Scot Warren
+1 312 634 8715
scot.warren@cmegroup.com
Tom Boggs
+1 312 930 3038
thomas.boggs@cmegroup.com
Richard Co
+1 312 930 3227
richard.co@cmegroup.com
NEW YORK
Tim McCourt
+1 212 299 2415
tim.mccourt@cmegroup.com
Giovanni Vicioso
+1 212 299 2163
giovanni.vicioso@cmegroup.com
LONDON
Matt Tagliani
+44 20 3379 3741
matthew.tagliani@cmegroup.com
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