Where are the growth opportunities in derivatives?

October 18, 2024

Key Takeaways

  • More investors are using derivatives to manage risk amid volatility
  • Index options and ETFs are growing fast
  • Crypto derivatives are in the ascendant and increasingly cleared

In today’s financial landscape, volatility and uncertainty are never far from investors’ minds. Enter derivatives! In addition to being a tool to generate profit, these financial instruments play a pivotal role in mitigating risk and have grown exponentially in recent years.

According to the Bank of International Settlements (BIS), the global over-the-counter (OTC) derivatives market had a notional value of USD 715 trillion in 2023, representing a 16% increase from the end of 2022. Exchange-traded derivatives are a smaller segment but growing fast, with FIA data showing annual trading volume hitting 137.8 billion contracts last year versus 89.9 billion the year before, mostly led by a retail investment boom in India.

In a highly competitive and increasingly interconnected global market with stricter regulatory requirements, the buy-side and sell-side are constantly looking for new revenue streams.

The rise of index options

One of the biggest opportunities is index options, which allow investors to hedge portfolios, speculate on market trends, or diversify their risk exposure cost-effectively. Retail investors benefit from increased liquidity and market activity to optimize portfolio returns, while institutional investors utilize sophisticated strategies such as volatility arbitrage or sector rotation using these instruments.

In 2020, the COVID-19 pandemic sent shockwaves through global financial markets, resulting in significant losses and unprecedented levels of volatility. As global inflation surged and interest rates climbed, investors flocked to index options.

An analysis conducted by CME Group reveals that equity index options have risen strongly since 2020 and are expected to break all records in 2024. Index options are becoming a standard tool for investors. According to Nasdaq, the average daily volume of non-equity option trading increased by 7.5% between 2022 and 2023, and from 2023 to 2024, the growth rate was 6.8%. The S&P 500 index-pegged options posted a 31% increase from 2022 to 2023 and 8% from 2023 to 2024.

Greg Ferrari, head of exchange business management at Nasdaq, said the options market in the US is only in the ‘early innings of growth’.

Leveraging ETFs

Exchange-traded funds (ETFs) are fast becoming the go-to investment vehicle globally and for all investor profiles due to their flexibility, cost-efficiency, and accessibility. In 2023, the value of ETF assets worldwide crossed USD 10 trillion, and, according to Blackrock, by the end of 2024, they are likely to breach the USD 14 trillion mark.

The ETF universe is increasingly diverse, from equities to fixed income and passive to active strategies. Leveraged exchange-traded funds (LETF) are a prime example of ETF innovation and one that has grown in popularity. They are financial instruments used by active traders that harness derivatives and debt to magnify the returns of the index or assets it follows. Certain LETFs focus on individual stocks, cryptocurrency markets, or futures prices, adding a layer of intensity to an already high-risk trading strategy.

A September report by ETF.com stated that there are 284 US-listed leveraged ETFs on the market, with an aggregate of USD 114 billion in assets under management.

Tapping crypto growth

According to Ernst & Young, more investors are investing in crypto derivatives, with the monthly volume in September 2023 hitting USD 1.33 trillion, significantly exceeding the spot market. A CCData report says derivatives trading volumes on centralized exchanges were USD 3.07 trillion in September 2024. Combined with spot, the total was USD 4.34 trillion.

Platforms offering regulated, cleared futures and options on digital assets provide institutional investors with safer, more secure access to the crypto market. Following the 2008 market crisis, US regulators ushered in reforms to increase transparency in the market, like the Dodd-Frank Act, which mandated central clearing for many derivatives. Such initiatives enhance participation in cleared derivatives, improving liquidity and reducing counterparty risks.

Chicago-based derivatives and securities exchange Cboe announced earlier this year that it planned to integrate its digital asset derivatives into its broader global derivatives and clearing businesses. It aims to create efficiencies and leverage its global technology platform to support the growth of the exchange-traded digital asset derivatives market.

Bitnomial received a clearinghouse license in December 2023 to clear margin digital asset futures and options trades in the US, while in Europe, LCH SA clinched regulatory approval in April this year to clear cash-settled Bitcoin index futures and options contracts.

Opportunities under pressure

Not everybody is comfortable with crypto yet. A June survey by trade body FIA and Acuiti said that although crypto has growth potential, many respondents said they would not be entering this investment area. The report on the challenges and opportunities for European listed derivatives found that interest rates and energy derivatives had the most potential in the medium term.

Brokers, clearinghouses, asset managers, hedge funds and exchanges have many growth avenues to explore that could alleviate the pain points they face in trading.

A report on industry trends released in March by FIA and Coalition Greenwich highlighted operational efficiency, regulatory reporting, and allocations/give-ups as challenges. According to the survey of more than 200 market participants, standardizing operational processes and using tokenization to manage collateral had the most potential to transform trading and clearing workflows.

Additionally, respondents generally agreed that volatile financial markets and economic uncertainty might boost derivatives trading during the next several years. Market intermediaries saw potential in India and China, where futures and options have been growing fast. Market operators, including exchanges and asset managers, saw more potential from the increasing participation of retail investors.

From index options to ETFs and crypto derivatives, there is an abundance of choice. But, as we have written before, trading firms globally are operating in a tough environment where a combination of more regulatory burdens, intense competition, higher costs and fee compression are squeezing revenue and profit. As well as looking outwards for new revenue streams, firms must look inwards to ensure they are operating at optimal efficiency with integrated front-to-back workflows and making the difficult investment decisions required.

ION Markets

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